Are Your Investments Robbing You?
by Dan Picinich
Life is expensive. Your dollars are your dollars. Make them count.
Thoughtful, targeted investment guidance is not free. But the path to successful long-term investing shouldn’t do you out of a serious chunk of your investment dollars right of the bat. The structure of fees within mutual funds and retirement plans is one of the most controversial, talked about topics in the media right now, especially on the heels of the recent Department of Labor changes defining the fiduciary responsibility of those providing investment advice.
Often, people are introduced to investing via employer-offered retirement plans. Moving beyond the 401(k), however, most of us need some guidance when choosing the most beneficial investments for the long-term. Beyond understanding the types of investments themselves, understanding the fees imbedded in those investment products is just as crucial, and often overlooked. It’s vital to have a clear idea of what fees you’re paying and why, and if they are reasonable by industry standards. Half of one percent may not seem like much, but compound that number over thirty, forty, or even fifty years, and those fee dollars definitely add up.
There are three common categories of investments held by the typical personal investor: individual stocks, index mutual funds, and actively managed mutual funds. How much should you expect to pay in fees for each type? And how do you determine what you’re actually paying?
Buying and selling individual shares of a particular company’s stock is also referred to as direct investing. It’s the oldest and most common avenue to investing on your own. Today, direct investing is often done through companies like e-trade and other discount brokers online. The only out-of-pocket costs you incur when buying and selling individual stocks are commissions, usually less than $10 per trade. However, the responsibility of research and monitoring is yours. This can be invigorating and interesting, or it can be burdensome, leaching time away from other pursuits.
Direct investing can also be accomplished through “full service” or “full commission” brokers. Theoretically, these brokers will provide research and educated opinions to justify their higher per-trade commissions. But, building a diversified portfolio of even ten or twenty individual stocks through a full service broker can become very expensive.
Then There Are Funds
Achieving diversification in a more streamlined, cost-effective way is where mutual funds come in. At the basic level, funds are simply collections of individual stocks purchased as a group, like a carefully curated gift basket. There are two main categories of mutual funds – index funds and actively managed funds.
Index funds are also known as passively managed funds. Index funds can have a broad scope, mimicking the performance of the S&P 500, the Dow Jones Industrial Average, or the international markets. Or they can be more narrowly defined to cover a specific sector of the markets, such as technology, energy, or healthcare. Index funds are intended to be bought and held over a long period of time, only changing when stocks are bought or sold from within the underlying index . Designed to be pretty static, the fees for these funds are generally lower than actively managed funds, usually less than .25%. Investing in an index fund means you get the return of the underlying index, positive or negative. Great in a rising market, but disconcerting in a falling market. The trade-off for lower fees can be costly, especially if you will soon need to liquidate your investments.
Actively managed funds fall within the realm of the professional money manager, built to outperform the indexes. These funds are constantly monitored and adjusted. They command higher fees to support the hands-on management, research, and administrative tasks associated with selecting the stocks within the fund. Actively managed fund costs vary based on the design and objectives of each fund. For instance, a fund investing in mainly large, domestic companies will have a lower research cost and lower fees than a fund targeting international or small company stocks.
Four basic costs are inherent in fund investing, whether you choose index funds or actively managed funds.
Management fees are paid to the company building and managing the fund itself. These fees can cover a range of costs from research and analysis, to sales and marketing.
Distribution fees are paid to the broker or advisor who sells shares of the fund and services your account. Sometimes these fees are covered by a straightforward sales commission, known as “load.” Sometimes they take the form of a surrender fee to sell your shares in the fund. There are also “no load” funds that charge annual fees.
Transaction costs are the fees incurred by the fund itself to trade securities (shares of stock). These costs are passed on to you, the investor, as the fund trades hundreds of thousands of shares of stock through its transactions. Transaction costs cover a multitude of actual costs, including brokerage commissions; spreads, which are basically the differences between bid and ask prices for stocks based on supply and demand; and research costs, sometimes folded into the transaction cost figure to keep the fund’s reported management fee lower. Transaction costs are paid for directly with shareholder dollars, not incorporated in a fund’s published expense ratio.
Taxes are paid by fund shareholders on dividends received and capital gains distributed to shareholders by the fund. Sometimes fund managers will realize unnecessary gains just to distribute income to shareholders, a feel good strategy that, in the end, is not sound financial practice.
What is your Total Cost of Ownership
No matter what kind of approach you take to investing, you should understand what the fees cover and whether they’re reasonable. Your broker’s “pricing guide” and fund-specific websites are a good place to start. But it can be easy to feel lost in the fee swamp of all the specific costs involved in the investment process, because fund managers and advisors are not obligated to disclose all of these fees specifically. Here are a couple lifelines to grab.
Expense ratios represent the percentage of a fund’s assets used to pay all the operating costs that make up the fees, all that research, management, marketing, and administration. Expense ratios legally must be disclosed for all mutual funds.
A typical expense ratio for an actively managed fund is between .5% and 1.25%, depending on the objective of the fund.
Turnover ratio represents the change in a portfolio over a given period of time. It tells you what percentage of the fund is sold and subject to transaction costs, is a key indicator of how expensive a fund will be overall. A turnover rate under 25% means the fund is following a buy and hold strategy. For example, an S&P 500 index fund would have a turnover ratio around 4%.
personalfund.com. Personal Fund, Inc., 1999-2016. Web. October 2016.