A key element of being a successful investor is to understand what you are receiving for the price you pay. Discovering the price you pay often manifests in a conversation about fees. It’s hard to have a conversation about investment fees without first identifying the various kinds of fees and what those fees are intended for. For starters, the most prevalent fees include the Investment Management Fee, Transaction fees and Advisor Fee.
Management Fee – Fund Operating Expenses
This is the internal fee charged by the mutual fund company (or exchange traded fund company, ETF) for their operation and implementation of the investment strategy. An important consideration of this fee is the style of management, active versus passive.
Actively managed mutual funds most often have a higher management fee than those passively managed to an index; and by now, in 2022, it should be no secret that actively managed mutual funds lose investor assets each year going back more than two decades. Here is a chart going back to 2006 from Morningstar, full article at https://www.morningstar.com/articles/1075161/us-fund-flows-smashed-records-in-2021:
The report suggests that actively managed funds are not worth the extra cost and supports the claim by pointing to the trend that assets move each year to passively managed low-cost mutual funds and exchange traded funds (ETFs). Recent investment innovations in actively managed ETFs have blurred the line between active and passive approaches.
If you are using the DIY approach to invest your wealth, it’s Important to be aware of all investment expenses, which can eat into your portfolio’s return; and review them periodically, since management fees change often due to intense competition. Historically, it has been the investor driving expense ratios down, as asset fund flows have consistently moved to lower expense funds from higher expense funds.
Lake Tahoe Wealth Management, Inc. (LTWM) uses 10 different equity asset classes to achieve the value and size factor premium tilts in our globally diversified portfolios. Based on current management (expense ratios) the average cost for the all-equity LTWM mutual fund portfolio is 0.30% or 30 basis points. The average cost of the all-equity LTWM ETF model is 0.25%. LTWM implements both portfolios with several Dimensional Funds Advisors (DFA) funds and ETFs. DFA recently lowered fees across 47 mutual funds and three ETFs on February 28, 2022. The overall fee reduction was 13% of weighted assets. If you would like a copy of the article, please let us know.
While it is an excellent portfolio strategy to diversify globally, international and small cap funds are going to have higher expense ratios than domestic large cap funds. The average expense ratio for all small-cap funds with assets greater than $5 million is 1.6%, while the average expense ratio for large-cap funds is 1.45%, based on recent research from Morningstar. Make sure you check your retirement plan’s investment choices for higher-than-average expense ratios, especially for index tracking funds. Any investment strategy that tracks an index, should not have a high expense ratio. We can help with the analysis of your retirement plan investment choices.
Other important considerations
In addition to a fund’s management fee, other hidden costs include turnover and internal trading fees. Mutual funds that purchase and sell securities during the year, will be required to distribute net capital gains (if any) and dividends. The higher the turnover, the higher the distribution of capital gains in a bull market. Any fund with a turnover approaching 100% would be considered very high and the additional capital gain distribution will increase your taxes for the year.
Transaction Fee
This is a fee the custodian charges for the recording and record keeping associated with buying and selling of assets. Trading fees have declined substantially since Schwab announced commission-free trading of stocks and ETFs in late October 2019. TD Ameritrade and Fidelity followed with similar announcements during the same time. You may still see trading commissions on ETF and stock trades if you request paper monthly statements. Mutual fund trades still have commissions between $10 and $20 per trade and that is why we have ETF model portfolios with client relationships less than $200,000, so that trading commissions do not create a drag on the portfolio performance. LTWM mutual fund trading fees for larger portfolios typically are a very small percentage annually, between 0.05% to 0.1% or 5 to 10 basis points, depending on the amount of stock volatility and the size of the portfolio. The larger the portfolio, the smaller the percentage.
Advisor Fee/Compensation
For the sake of simplification, there are three broad camps of financial advisors: Fee-Only, Commissioned, and a combination of the two called Fee-Based
How a financial advisor is compensated brings us to the topic of mutual fund share classes. The differences amongst most share classes ultimately boils down to the different ways that mutual fund companies pay distribution costs - i.e., commissions - across various sales channels. Fees associated with distribution costs are often referred to as 12B-1 fee. For commissioned Advisors, those who preferred upfront commissions would sell A or B shares and the client would pay a percentage upfront and receive a smaller “trailing” commission (12b1 fee) in subsequent years. Commissioned advisors who preferred levelized commissions would sell C shares with no percentage upfront but would receive a larger “trail”. These commission and loads are reflected in the fund prospectus. Here is an example of share class comparison, example is from Capital Group/American Funds Growth of America:
For Fee-Only Advisors who are paid an advisory fee by their clients instead of a commission from the mutual fund company would typically use institutional or advisory share classes instead. Retirement plans (such as 401k, 403b, or 457) and 529 plans cut their own deals, as well, for their own share class alternatives. By way of comparison, here is an example of an institutional share class management expense from Dimensional Fund Advisor’s US Large Company Portfolio:
The fee you pay to your financial advisor will vary greatly depending upon the compensation model they work within. The average cost of hiring a Registered Investment Advisor (RIA) is 1.17% annually, according to Investopedia, https://www.investopedia.com/articles/personal-finance/071415/how-cut-financial-advisor-expenses.asp#citation-5. Other advisors may use funds that have an average expense of 1.1% and the DIY approach is likely close to 1.6% if active strategies are used. If your advisor is compensated by rotating your portfolio into other funds, trading costs may average 0.2%. The DIY approach likely involves short-term trading strategies, where trading costs may average 0.5%. Turnover costs for frequent trading that includes short-term gains may average 0.4% to 0.8%.1
It may help to see the total annual costs of investing summarized in a bar chart
Academic and professional research points to the added value or “Alpha” of working with a fiduciary (Vanguard’s Advisor Alpha White Paper). At LTWM we believe we add value to our clients with the implementation of globally diversified portfolios using cost-effective funds and applying active rebalancing and asset location strategies. We educate clients on the emotional behaviors that can destroy wealth and use proven cash management strategies for those in the distribution phase of their portfolio. This added value can be as much as 3% per year over the DIY approach.
Each year we are required to conduct a best execution review, among many items for review, and that includes the management and transaction fees our clients are paying. LTWM clients are in good shape with the latest review, and we are proud that our fee includes comprehensive financial planning and a fiduciary standard of care. Please reach out to us if you have questions about the total cost of investing or if you would like to learn more about our investment approach.
1 Averaged expenses are from a variety of sources and are only meant for educational and illustrative purposes and is not to be considered financial planning advice.
