Investors measure success by looking at the rate of return on their investments. This is as it should be. Those who actively manage their portfolios are often looking for an edge, a winning formula that will help them outperform a peer group or a benchmark. They seek out companies that are poised to take off, mutual funds with five-star ratings and asset managers with the best track records. But most of them miss a huge opportunity to boost portfolio returns; one that is easy to implement and proven to deliver significant long-term benefits. With so much focus on picking securities and timing the market, they fail to properly manage the cost of their investments.
How important are investing costs? Consider a scenario where you and a friend both invest $100,000 at age 30, in a portfolio that earns an average annual return of 7%. Assume that your investing costs are 2% of the portfolio value annually (resulting in a 5% net return) and your friend’s investing costs are 1% annually (6% net return). At age 65, with the power of compounding, your portfolio will be worth about $551,000, which is a nice little nest egg, but your friend will be sitting on about $768,000! Over a long time horizon, even a small difference in investing costs can be very important indeed.
Investing costs can vary widely from one investment to another and from one advisor to another. To manage them effectively, you need to know what they are and whether they apply to the investments you hold in your portfolio. When new clients come to us, the costs we see most frequently relate to mutual funds, which are among the most widely held investments in individual portfolios. Just for this one investment product, there are a handful of costs that come into play, and they include the following:
- Sales Loads – these are commissions that are paid to the investment manager who sold the fund, and they can be up to 5.75% of the amount invested. Load funds highlight a distinction between commission-based advisors and fee-only, fiduciary advisors. The first group earns their compensation by selling financial products, and often must sell their own company’s funds or a tightly controlled lineup of funds approved by their firm. Fee-only advisors, on the other hand, never sell load funds because we don’t accept sales commissions, and paying such commissions would not be in the client’s best interest, which we are legally obligated to uphold.
- Expense Ratios – these are annual fund management expenses that are stated as a percentage of the assets in the fund. They can range from almost nothing to more than 2% per year. Expense ratios highlight another important distinction, and that is between actively managed and passively managed (or index) funds. Active fund managers generally have an objective to outperform the benchmark or peer-group return for a given asset class. Because these funds often have large teams of research analysts and traders, their management expenses are relatively high, often in the 1% to 2% range annually. Passive funds, on the other hand, simply buy and hold all the stocks that make up a given index, such as the S&P 500. They have much smaller research teams (if any) and very little trading activity. Expense ratios for these funds are generally below 0.5%, and often below 0.1% annually.
- 12b-1 Fees – these are fees investors pay to the fund management company to support their fund marketing efforts. They typically range from 0.25% to 0.75% annually. Most fund managers have revenue-sharing arrangements with commission-based advisors as an additional incentive for the advisor to sell their funds. Most fee-only advisors avoid 12b-1 fees for the same reason they avoid sales loads: they are not in the client’s best interest.
- Turnover – a fund’s turnover ratio is not an explicit cost figure, but it does factor into the overall performance of the fund. A high turnover ratio signifies more active management, which brings higher trading costs and taxes than in less active funds. Index funds typically have very low turnover ratios, which reduce the drag of trading costs and taxes on fund performance.
In our practice we often see investors who hold actively managed mutual funds that were sold to them by a commission-based advisor. Not only did they pay a 5.75% commission to invest in the fund, but they might be paying management expenses of 1.5% and a 12b-1 fee of 0.25%, meaning the total annual expense ratio is 1.75%. The index-based funds we recommend have no sales loads, no 12b-1 fees and expense ratios that average about 0.1% per year. In other words, their fund-level investing costs can be reduced by 1.65% per year and they avoid a 5.75% sales commission. And those savings compound every year in the form of higher net investment returns. That’s a pretty nice boost to portfolio performance, don’t you think?
How do advisors and fund managers justify these additional costs to their clients? Mostly by claiming that they have the skill and expertise to outperform the market. They might believe this is possible, but the evidence tells a different story. The fact is that only a small portion of actively managed funds will outperform their respective benchmark each year, and only a tiny sliver will outperform consistently over any meaningful time period.
Some of you will say: “wait a minute, don’t fee-only advisors charge an annual fee for the assets they manage?” It’s true, fee-only advisors charge an annual fee for assets under management (AUM), and many commission-based or fee-based advisors charge these fees as well. The question to ask is: “what value does the client receive for the AUM fee?” Is the advisor simply managing assets or are they integrating portfolio strategy with comprehensive financial planning? Many fiduciary advisors focus heavily on financial planning and some, like Fullen Financial, even include these planning services as part of the AUM fee.
If any of this makes you think you are paying too much for financial advice, you probably are. Take a hard look at your investing costs and you might find an easy way to boost portfolio performance. You might also find your way to a more objective, comprehensive approach to financial advice.
About the Author: Kevin Fix, CPA / PFS is a fee-only fiduciary Senior Financial Advisor at Fullen Financial Group. He has worked for more than 25 years in accounting and finance, with much of his career spent in public accounting and company financial management. He has extensive experience managing finances and investments for individuals, small business owners and large corporations. Kevin earned his CPA license in 1992 and became an independent Registered Investment Advisor in 2011.
Kevin earned Bachelor’s degrees in Accounting and International Studies from Miami University, and a Master’s degree in Business Administration from the University of Chicago Booth School of Business. He is a member of the American Institute of CPAs and their Personal Financial Planning practice section. Kevin lives in Upper Arlington with his wife, Amy, and their three children, and is an active member of the business community.
Disclaimer: All expressions of opinion reflect the judgment of the authors on the date of the post and are subject to change. All investments and investment strategies have the potential for profit or loss. · Content should not be viewed as an offer to buy or sell any of the securities mentioned or as personalized financial advice. Legal and tax advice is general in nature. You should always consult an attorney or tax professional regarding your specific legal or tax situation. Fullen Financial Group is not engaged in the practice of law. · Hyperlinks on our posts are provided as a convenience. We cannot be held responsible for information, services or products found on websites linked to ours.