Why Fees Matter
More and more people are turning to financial advisors to guide their financial planning and investment management. These often life-long relationships with advisors usually begin with a discussion of your financial goals, the services that the advisor can provide, and the cost of working with the advisor. While it is important to consider the fees that an advisor charges, these fees are only part of the story. It is important to understand what is known as the “all-in fees.” These “all-in fees” include the investment management fee as well as trading fees, mutual fund and ETF fees, and platform fees. According to Inside Information’s advisory fee benchmarking survey, the median “all-in fees” cost is roughly 2.40% for portfolios under $1 million, and 2.0% for portfolios under $3 million. Some investors are paying increasingly high costs – higher than 3% and, in a small handful of cases, above 4% a year.
A large component of the “all-in” fee is comprised of mutual fund and ETF fees. These fees, known as a fund or ETF’s “expense ratio,” is expressed as a percentage of the investment that is deducted on an annual basis. For example, if you hold a mutual fund that earned 5% in one year and has an expense ratio of 1%, the actual growth experienced is 4%, Not all mutual funds and ETF’s are created equal. Mutual fund Class A, B, and C shares indicate a sales commission paid to the advisor who purchased the share for you. Class A shares charge a “front load” fee, in which you pay a percentage of your purchase amount every time you buy shares. Class B shares charge a “back load” fee, in which you pay a percentage of the dollar value of shares sold. Class C shares charge a “level load” fee, which is an ongoing fee for as long as you hold the fund. Load fees can range from 1% to over 5%! These fees increase the cost of the fund, and drag down your return. Most mutual funds offer identical no-load funds. Ideally, you should not be paying fees on any of these funds.
Investment fees may also vary by the asset class in which you are invested in. Because information regarding international funds is hard to obtain for your typical American investor, you typically see larger fees for international funds, particularly emerging markets funds, than you would for U.S. stock or U.S. bond funds. Per Morningstar’s database of over 27,000 mutual funds, international developed large-cap funds have an average expense ratio of 1.10% across over 1,500 funds. In the same vein, diversified emerging markets funds have an average expense ratio of 1.39% across over 800 funds. However, the average expense ratio of U.S. stock funds (Large-Cap Blend, Growth, and Value) is 1.03%. U.S. intermediate-term bond funds have an even lower average expense ratio of 0.77%.
Although the average expense ratios for the above four asset classes are at least over 0.70%, investors can find openly traded-funds with expense ratios that are significantly lower. These funds with lower expense ratios (sometimes with ratios smaller than 0.05%) are typically what we call “passive funds” while the ones with higher expense ratios are called “active funds.” These names perfectly describe the nature of the funds they classify. Actively managed funds are characterized by a higher dependence on the fund manager to research and select the underlying holdings in the fund, and therefore have higher expense ratios and trading costs. Because of their dependence on the fund managers, active funds are also subject to more biases and emotion-based decisions than their passive counterparts. Passive funds follow indices and are less dependent on their fund managers. As a result, they have lower expense ratios and trading costs.
But does paying the premium for active funds pay off in the long-run? A common misconception is that active funds perform better than passive funds, especially during down markets. According to Wealthmanagement.com, U.S. active large-cap core mutual funds underperformed S&P 500 index-tracking funds by more than 1% in the first half of 2018 with these passive funds gaining 2.65%. In addition, less than one-third of active funds outperformed the top S&P 500 index-tracking funds. In the small-cap fund space, less than one-fifth of active funds outperformed the top index funds. Active funds experienced a year-to-date outflow of $48 billion.
When it comes to investing their hard-earned money, too many investors focus on what they can’t control rather than on what they can. There are significant gains to be had for disciplined investors that understand the fees that they pay and avoid the unnecessary ones.