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The Costs of Investing

All investments carry real costs—not merely the opportunity costs of an investor choosing to forego one asset in…
The Costs Of Investing

All investments carry real costs—not merely the opportunity costs of an investor choosing to forego one asset in favor of another. Rather, these costs and comparisons are not dissimilar to those consumers face when shopping for a car.

Unfortunately, many investors ignore critical investment costs because fine print and jargon can confuse or obscure them. But they don’t have to be. The first step is understanding the different types of costs.

KEY TAKEAWAYS

  • Investing involves real costs, which reduce any returns you might get on your investments.
  • Savvy investors know how to minimize investment costs to maximize their gains.
  • Common investing costs include expense ratios, market costs, custodian fees, advisory fees, commissions, and loads.
  • Research has shown that lower-cost funds have better returns than higher-cost ones.
  • Ways to reduce investment costs include knowing when to buy and hold, understanding tax implications, and using tax-exempt or tax-deferred investments.

Types of Investing Costs

Different investments carry different types of costs. For example, all mutual funds—one of the most common investment instruments—charge an expense ratio. This is a measure of what it costs to manage the fund expressed as a percentage.

It is based on the total assets invested in the fund and is calculated annually. This fee is typically paid out of fund assets so that you won’t be billed for it, but it will come out of your returns. If the mutual fund returns 8% and the expense ratio is 1.5%, you’ve only earned 6.5% on your shares.

A high expense ratio has two problems. First, more of your money goes to the management team instead of you. Second, the more money the management team charges, the more difficult it is for the fund to match or beat the market’s performance.

Ironically, many higher-cost funds claim they’re worth the extra cost because they enjoy stronger performance. But, expense ratios, like a leak in a bathtub, slowly drain some of the assets. Therefore, the more money management takes out in fees, the better the fund must perform to earn back what’s been deducted.


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Marketing Costs

Moreover, in some cases, these fees help pay for marketing or distribution costs. This means you pay managers to promote a fund to other potential investors. This particular cost is called a 12B-1 fee.

Annual and Custodian Fees

Annual fees are often low, about $25 to $90 yearly, but every dollar adds up. Custodian fees usually apply to retirement accounts (e.g., IRAs) and cover costs associated with fulfilling IRS reporting regulations. You can expect to pay anywhere from $10 to $50 annually.

Loads and Commissions

A front-end load is a fee charged when you buy shares, and 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 has not made it easy to untangle all these complex and often hidden expenses; however, the U.S. Securities and Exchange Commission (SEC) has clarified these costs for investors.

To protect retail investors, the SEC, in its 2018 priority list, indicated its intent 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 planned to target firms that engage in practices such as receiving compensation for recommending specific securities, ignoring accounts when the assigned manager has left the firm, and changing fee structures from commission-only to a percentage of client assets under management.

While the SEC plays a valuable role in safeguarding investors, the best defense against excessive or unwarranted fees is carefully researching and asking plenty of questions. Taking the time to understand what you’re paying is critical because fees, over the long term, rob investors of their wealth.

Other Costs

Some mutual funds include other costs, like purchase and redemption fees, a percentage of the amount you buy or sell.

Why Investing Fees Matter

Fees almost always appear deceptively low. An investor might see an expense ratio of 2% and dismiss it as inconsequential. But it’s not. A fee expressed as a percentage doesn’t reveal to investors the dollars they’ll be spending and, more importantly, how those dollars will grow.

Important: Just as compounding delivers growing returns to long-term investors, high fees do the opposite; a static cost rises exponentially over time.

The result may be anchoring bias, in which irrelevant information is used to evaluate or estimate something of unknown values. But everything is relative. This means that if our first exposure to investing involves excessive fees, we may view all subsequent expenses as low even though they are, in fact, high.

Scenario 1

Suppose you have an investment account worth $80,000. You hold the investment for 25 years, earning 7% annually and paying 0.50% in annual fees. At the end of the 25 years, you’ll have made approximately $380,000.

Scenario 2

Now, consider the same scenario, but with one difference: You aren’t paying attention to costs and hand over 2.0% annually. After 25 years, you’re left with approximately $260,000. That “tiny” 2.0% cost you $120,000.

Are Expensive Investments Always Worth It?

Imagine that an advisor or even a friend tells you that a mutual fund, while pricey, is worth it. They tell you that while you’re paying more, you will also get more in the form of a superior annual return. But that is not necessarily true.

Studies have shown that lower-cost funds produce better future results than higher-cost funds. Researchers found that the cheapest equity funds outperformed the most expensive ones across five-, 10-, 15-, and 20-year periods.

This finding has been proven time and time again. Consider similar research from Morningstar, which found, “Using expense ratios to choose funds helped in every asset class and every quintile from 2010 to 2015. For example, in U.S. equity funds, the cheapest quintile had a total return success rate of 62%, compared with 48% for the second-cheapest quintile, 39% for the middle quintile, 30% for the second-priciest quintile, and 20% for the priciest quintile.”

What’s the message? “The cheaper the quintile, the better your chances.” This finding was consistent across various asset classes. International funds and balanced funds all showed similar results. Even taxable and municipal bond funds exhibited this characteristic of low costs associated with better performance.

Brokerage Fees Come in All Shapes and Sizes

Account Maintenance Fee

This is usually an annual or monthly fee for using the brokerage firm and its research tools. It is occasionally tiered. Those who want to use more robust data and analytic tools pay more.

Sales Load

As mentioned above, some mutual funds include a load or a commission paid to the broker who sold you the fund. Be wary of these charges for two reasons. First, many mutual funds today are no-load and are cheaper alternatives. Second, some brokers will push funds with larger loads to pad revenue. 

Advisory Fee

This is sometimes referred to as a management fee for the broker’s expertise in wealth strategies. It is a percentage of the investor’s total assets under the broker’s management.

Expense Ratio

As discussed, this fee is charged by those managing the mutual fund.

Commissions

These are common, and they add up fast. As mentioned above, commission fees are the cost of executing any buy or sell trade. This payment goes directly to the broker. This cost usually ranges from $1 to $5 per trade and, in some cases, will be waived if the investor reaches an account minimum. Occasionally, this fee is calculated as a percentage of the value of the trade.

Remember that full-service brokers who provide complex services and products like estate planning, tax advice, and annuities will often charge higher fees. Fees range between 0.5% and 1.2% of the value of the assets managed.

The burden of expensive fees becomes greater over a longer period. Therefore, young investors just getting started face a bigger risk because the total dollars lost to costs will grow exponentially over the decades. For this reason, it’s particularly important to pay attention to costs in accounts you will hold for a long time.

Active vs. Passive Management

Passive management describes investments like mutual funds replicating market indexes like the S&P 500 or the Russell 2000. The managers of these funds only change the holdings if the benchmarked fund changes. Passive management seeks to match the market’s return.

Hedge funds are an example of actively managed funds, which seek to outperform the market significantly; however, studies have shown that hedge funds still can’t beat the S&P 500.

In contrast, an active management strategy is a more involved approach, with fund managers making a concerted effort to outperform the market. Not happy with simply matching the return of the S&P 500, they want to make strategic moves that seek to exploit the value of unrecognized opportunities in the market.

Different Costs

Active and passive funds carry different costs. The average fee for actively managed funds in 2020 was 0.71%, whereas passive mutual funds averaged just 0.06%. Despite a continued decline since the 1990s, it’s important to note that as the total amount of assets in an actively managed fund decreases, these funds generally raise the expense ratio.

As one study from ICI Research determined, “During the stock market downturn from October 2007 to March 2009, actively managed domestic equity mutual fund assets decreased markedly, leading their expense ratios to rise in 2009.”

This finding underscores an important truth: Expense ratios are often unrelated to performance. Instead, they’re tied to the total value of assets under management. If the assets decrease—usually due to poor performance—the managers will raise their prices.

Some investors will argue that “you get what you pay for.” In other words, while an active fund may charge more, the higher returns are worth the expense because investors will earn back the fee and then some. These advocates for active management occasionally have the annual performance to back up such claims. However, this assertion often has a problem: survivorship bias.

Survivorship Bias

Survivorship bias is the skewing effect of mutual funds merging with other funds or undergoing liquidation. Why does this matter? According to research at Vanguard, “merged and liquidated funds have tended to be underperformers; this skews the average results upward for the surviving funds, causing them to appear to perform better relative to a benchmark.”

Of course, some actively managed funds outperform without the help of survivorship bias. The question here is, do they outperform regularly? The answer is no. The same body of research from Vanguard shows that the “majority of managers failed to outperform consistently.”

The researchers looked at two separate, sequential, non-overlapping five-year periods. These funds were ranked into five quintiles based on their excess return ranking. Ultimately, they determined that while some managers consistently outperformed their benchmark, “those active managers are extremely rare.”

Moreover, it is nearly impossible for an investor to identify these consistent performers before they become consistent performers. In attempting to do so, many will look at previous results for clues on future performance; however, a critical tenet of investing is that past returns are no predictor of future gains.

Ways to Minimize Investing Costs

Know When to Buy and Hold

The more you move money around, the more costs accrue. As discussed above, there are fees associated with buying and selling. Like a pail of water passed from one person to another, each successive hand-off causes a little spill. Moreover, buy-and-hold strategies typically yield better returns than those based on frequent trading.

Consider Tax Implications

This is the most ignored aspect of investing costs, and it’s also the most complicated. Even seasoned investors find it beneficial to get help from a professional regarding taxes. The savings generated often more than compensate for the professional’s fee.

For example, many investors are unaware that realized losses on investments—money lost after selling a stock for less than it costs- can be used to offset taxable gains. This is called tax-loss harvesting.

Ordinarily, an investor will pay either a long-term capital gains tax (securities held over one year) or a short-term capital gains tax (securities held for less than one year). If it’s a long-term capital gain, the investor will pay either 0%, 15%, or 20%, depending on their income level and filing status (single, married filing jointly, married filing separately).

Short-term capital gains are taxed as ordinary income. The rate varies from 10% to 37%, depending on income level and filing status.

Tax-deferred or Tax-Exempt Accounts

Investors might be surprised to see how much they hold on to with a tax-deferred or tax-exempt account. Tax-deferred accounts safeguard investments from taxes as long as the assets remain untouched. Examples include 401(k)s and traditional IRAs. These account options are great ways to save big on burdensome taxes.

However, there’s a catch. As mentioned earlier, you’ll lose the tax advantage (and get hit with penalty costs) if you withdraw money early, before the age of 59½. Younger investors should consider Roth IRA accounts. If you have owned the Roth for five years, earnings and withdrawals made after 59½ are tax-free. These are great ways to save over the long term if you know you won’t need to touch the money.

FAQs

1. What Fees Do You Pay When Investing?

Ans: When investing, Common fees are expense ratios, investment management/advisory fees, transaction fees, load fees, surrender charges, commissions, account fees, and custodian fees.

2. How Can I Avoid Investment Fees?

Ans: To avoid or reduce investment fees, start with no-fee brokers. Most online brokers now do not charge fees or commissions for transacting buy-and-sell orders of stocks. Utilize low-cost index funds with low expense ratios. Similarly, choose no-load mutual funds. Using a free robo-advisor can also be a good strategy.

3. How Do Fees Impact My Investment?

Ans: Fees impact investments by creating costs that reduce an individual’s returns on their investment. This is particularly true if an investor buys and sells often, and each transaction has a fee. It is also true if a long-term investor has to pay an annual fee for their investment portfolio. Small fees add up over time.

The Bottom Line

Do your homework. We live in an age of unprecedented access to information. While some investments may obscure their costs in the fine print, anyone can quickly find out with the wealth of online information. There’s no excuse for investing in an asset without knowing the full costs and making the right choices.

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