Table of Contents
- All investments come with real costs, not just the opportunity costs of choosing one asset over another. These costs and comparisons are similar to what consumers face when shopping for a car.
- Sadly, many investors overlook important investment costs because the fine print and jargon can make them unclear or hidden. However, they don’t have to remain hidden. The first step is understanding the various types of costs.
KEY TAKEAWAYS
- Investing comes with real costs, which can diminish any returns you earn from your investments.
- Smart investors understand how to minimise investment costs to maximise their returns.
- Typical investing costs include expense ratios, market costs, custodian fees, advisory fees, commissions, and loads.
- Studies have shown that lower-cost funds tend to deliver better returns than their higher-cost counterparts.
- Strategies to reduce investment costs include knowing when to buy and hold, understanding tax implications, and utilising tax-exempt or tax-deferred investments.
Types of Investing Costs
Different investments come with various types of costs. For instance, mutual funds, which are among the most popular investment vehicles, charge an expense ratio. This represents the cost of managing the fund, expressed as a percentage.
The expense ratio is calculated annually based on the total assets invested in the fund. This fee is typically deducted from the fund’s assets, meaning you won’t receive a bill for it, but it will reduce your returns. For example, if the mutual fund yields 8% and the expense ratio is 1.5%, your actual return is just 6.5%.
A high expense ratio presents two major issues. First, more of your money goes to the management team instead of benefiting you. Second, the higher the management fees, the harder it becomes for the fund to outperform or even match the market’s returns.
Ironically, many higher-cost funds claim their extra fees are justified by stronger performance. However, expense ratios, like a leak in a bathtub, gradually drain the fund’s assets. Thus, the higher the management fees, the stronger the fund must perform to make up for the fees that have been deducted.
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Marketing Costs
Additionally, in some cases, these fees are used to cover marketing or distribution costs. Essentially, you are paying managers to promote the fund to other potential investors. This specific cost is known as a 12B-1 fee.
Annual and Custodian Fees
Annual fees are typically low, ranging from $25 to $90 per year, but every dollar adds up over time. Custodian fees generally apply to retirement accounts (such as IRAs) and cover expenses related to complying with IRS reporting requirements. You can expect to pay between $10 and $50 annually.
Loads and Commissions
A front-end load is a fee charged when you buy shares, while a back-end load is incurred when selling. Commissions are fees paid to the broker for their services.
As you can see, the financial world makes it challenging to untangle these complex and often hidden expenses. However, the U.S. Securities and Exchange Commission (SEC) has worked to clarify these costs for investors.
To protect retail investors, the SEC, in its 2018 priority list, stated its intention to “Focus on firms that have practices or business models that may create increased risks that investors will pay inadequately disclosed fees, expenses, or other charges.”
In other words, the SEC aimed to target firms engaged in practices like receiving compensation for recommending specific securities, neglecting accounts when the assigned manager leaves, and shifting fee structures from commission-based to a percentage of client assets under management.
While the SEC plays a crucial role in protecting investors, the best defense against excessive or unnecessary fees is thorough research and asking plenty of questions. Understanding what you’re paying is essential because, over time, fees can significantly erode an investor’s wealth.
Other Costs
Some mutual funds come with additional costs, such as purchase and redemption fees, which are a percentage of the amount you buy or sell.
Why Investing Fees Matter
Fees often appear deceptively low. An investor may see an expense ratio of 2% and dismiss it as insignificant. However, it’s far from inconsequential. A fee expressed as a percentage doesn’t show investors the actual dollars they’ll be spending, and more importantly, it doesn’t reveal how those dollars will accumulate over time.
- Important: Just as compounding generates increasing returns for long-term investors, high fees have the opposite effect; a fixed cost grows exponentially over time.
The result can be anchoring bias, where irrelevant information is used to assess or estimate something with an unknown value. However, everything is relative. This means that if our first experience with investing involves high fees, we may perceive all subsequent costs as low, even when they are high.
Scenario 1
Imagine you have an investment account valued at $80,000. If you hold the investment for 25 years, earning 7% annually and paying 0.50% in annual fees, you will have approximately $380,000 at the end of the 25 years.
Scenario 2
Now, consider the same scenario, but with one key difference: You ignore the costs and pay 2.0% annually instead. After 25 years, you’re left with approximately $260,000. That “small” 2.0% has cost you $120,000.
Brokerage Fees Come in All Shapes and Sizes
Account Maintenance Fee
This is typically an annual or monthly fee for using the brokerage firm and its research tools. It is sometimes tiered, with those who seek more advanced data and analytical tools paying a higher fee.
Sales Load
As mentioned earlier, some mutual funds come with a load or commission paid to the broker who sold you the fund. Be cautious of these fees for two reasons. First, many mutual funds today are no-load and offer more affordable alternatives. Second, some brokers may promote funds with higher loads to boost their revenue.
Advisory Fee
This is often called a management fee for the broker’s expertise in wealth strategies. It is calculated as a percentage of the investor’s total assets managed by the broker.
Expense Ratio
As mentioned, this fee is charged by those overseeing the management of the mutual fund.
Commissions
These fees are common and can accumulate quickly. As mentioned earlier, commission fees are the costs associated with executing any buy or sell trade. These fees are paid directly to the broker and typically range from $1 to $5 per trade. In some cases, this fee may be waived if the investor meets an account minimum. Occasionally, this fee is calculated as a percentage of the trade’s value.
Keep in mind that full-service brokers, who offer more complex services and products like estate planning, tax advice, and annuities, tend to charge higher fees. These fees generally range from 0.5% to 1.2% of the assets under management.
The impact of expensive fees becomes more significant over time. For younger investors just starting, the total amount lost to fees can grow exponentially over the years. That’s why it’s especially important to be mindful of fees in accounts you plan to hold long-term.
Active vs. Passive Management
Passive management refers to investments such as mutual funds that replicate market indexes like the S&P 500 or the Russell 2000. The managers of these funds make changes to the holdings only when the benchmarked index is updated. The goal of passive management is to match the market’s return.
FAST FACT
Hedge funds are an example of actively managed funds, aiming to significantly outperform the market. However, studies have shown that hedge funds still fail to surpass the S&P 500.
In contrast, an active management strategy is a more hands-on approach, where fund managers put in a deliberate effort to outperform the market. Rather than being content with simply matching the S&P 500‘s return, they aim to make strategic decisions that capitalise on unrecognised opportunities in the market.
Different Costs
Active and passive funds come with different costs. In 2020, the average fee for actively managed funds was 0.71%, while passive mutual funds averaged just 0.06%. Despite a steady decline since the 1990s, it’s important to note that as the total assets in an actively managed fund decrease, these funds generally raise their expense ratio.
One study by ICI Research revealed, “During the stock market downturn from October 2007 to March 2009, actively managed domestic equity mutual fund assets decreased significantly, leading to an increase in their expense ratios in 2009.”
This finding highlights a key point: Expense ratios are often unrelated to performance. Instead, they are tied to the total value of assets under management. If the assets decrease, usually due to poor performance, the fund managers tend to raise their fees.
Some investors argue that “you get what you pay for.” In other words, while an active fund may charge more, the higher returns justify the expense, as investors will earn back the fee and more. Advocates for active management sometimes have annual performance to support this claim. However, this argument often has a flaw: survivorship bias.
Survivorship Bias
Survivorship bias refers to the distortion caused by mutual funds merging with other funds or being liquidated. Why does this matter? According to research from Vanguard, “merged and liquidated funds have tended to be underperformers; this skews the average results upward for the surviving funds, making them appear to perform better relative to a benchmark.”
Of course, some actively managed funds do outperform without the influence of survivorship bias. The real question is, do they outperform consistently? The answer is no. Vanguard’s research shows that “the majority of managers failed to outperform consistently.”
The researchers analysed two separate, non-overlapping five-year periods. The funds were ranked into five quintiles based on their excess return ranking. Ultimately, they concluded that while some managers consistently outperformed their benchmark, “these active managers are extremely rare.”
Furthermore, it is nearly impossible for an investor to identify these consistent performers before they become consistent. In attempting to do so, many will look at past results for clues about future performance. However, a key principle of investing is that past returns are not a reliable predictor of future gains.
Ways to Minimise Investing Costs
Know When to Buy and Hold
The more you move money around, the more costs accumulate. As mentioned earlier, there are fees involved in buying and selling. Like a bucket of water passed from one person to another, each hand-off causes a small spill. Additionally, buy-and-hold strategies usually generate better returns than strategies focused on frequent trading.
Consider Tax Implications
This is one of the most overlooked aspects of investment costs, and it’s also one of the most complex. Even experienced investors often find it beneficial to consult a professional about taxes. The savings generated typically more than justify the professional’s fee.
For example, many investors are unaware that realised losses on investments—money lost after selling a stock for less than its purchase price—can be used to offset taxable gains. This strategy is known as tax-loss harvesting.
Typically, an investor will pay either a long-term capital gains tax (for securities held over a year) or a short-term capital gains tax (for securities held for less than a year). If it’s a long-term capital gain, the investor will pay 0%, 15%, or 20%, depending on their income level and filing status (single, married filing jointly, or married filing separately).
Short-term capital gains are taxed as ordinary income, with rates ranging from 10% to 37%, depending on the income level and filing status.
Tax-Deferred or Tax-Exempt Accounts
Investors may be surprised by how much they can keep in a tax-deferred or tax-exempt account. Tax-deferred accounts protect investments from taxes as long as the assets remain untouched. Examples include 401(k)s and traditional IRAs. These accounts are excellent ways to save significantly on taxes.
However, there’s a catch. As mentioned earlier, you’ll lose the tax advantage (and face penalty costs) if you withdraw money before the age of 59½. Younger investors should consider Roth IRA accounts. If you’ve held the Roth for at least five years, earnings and withdrawals made after 59½ are tax-free. These accounts are ideal for long-term savings if you’re confident you won’t need to access the money early.
What Fees Do You Pay When Investing?
Investors often face a variety of fees when making investments. These include expense ratios, investment management/advisory fees, transaction fees, load fees, surrender charges, commissions, account fees, and custodian fees.
How Can I Avoid Investment Fees?
To minimise or eliminate investment fees, begin by selecting no-fee brokers. Many online brokers now offer commission-free buying and selling of stocks. Opt for low-cost index funds with minimal expense ratios and consider investing in no-load mutual funds. Additionally, utilising a free robo-advisor can be a smart way to reduce costs.
How Do Fees Impact My Investment?
Fees impact investments by introducing costs that reduce the overall returns an investor earns. This is especially true for frequent traders, where each transaction incurs a fee. Similarly, long-term investors may face annual fees for managing their portfolio. Over time, even small fees can accumulate significantly.
The Bottom Line
Do your research. We live in an era of unprecedented access to information. While some investments may hide their costs in the fine print, anyone can easily uncover the details with the vast amount of online resources available. There’s no excuse for investing in an asset without fully understanding its costs and making informed decisions.
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