Whether you are using a financial advisor or managing your own investments, knowing how much you are paying is critically important. Paying high investment management fees can have a significant impact on your total return and ability to achieve your financial goals. While it may seem like a simple question, what you’re paying in investment fees can be complex and vary greatly from investment advisor to investment advisor.
The fees and other costs that you pay can typically be broken down into three components:
When evaluating your total cost of investment management, it’s important to consider the three together. For example, you may be justifiably happy paying very little in advisory fees. Unfortunately, if your advisor is choosing very high cost or tax inefficient funds, the outcome on your portfolio’s net returns is the same as paying very high advisory fees with low expense funds.
Let’s take a closer look at the three typical components of investment management fees.
When evaluating the fees associated with working with financial advisors (such as Dowling & Yahnke Wealth Advisors), there are two important questions to ask – “What am I paying?” and “What level of service am I receiving?”
What you pay your investment manager should be transparent, easily understood, and structured to minimize conflicts of interest. Fee arrangements can vary from a structure based on assets under management to one based on the commission from the sale of a particular investment or product. It’s important to know when advisors get compensated based on commissions (placing their clients in different products), their interests may not be fully aligned with those of the clients they serve. At Dowling & Yahnke, we strive to minimize potential conflicts of interest. As a result, we charge advisory fees based on assets under management. You can find information on Dowling & Yahnke’s fee structure here.
What an advisor charges for investment management fees should also reflect the level of service provided. Costs can vary significantly between a robo-advisor or a full-service advisor. See “Are Financial Advisors Worth It” for more detail on the services provided by different types of financial advisors.
When it comes to choosing your advisor, paying a little more may make sense depending upon your needs. A robo-advisor typically will not provide the level of in-depth financial planning, customized advice, or coordination with your tax professional and estate planning attorney that a full-service advisor can. Regardless of the type of financial advisor you work with, make certain to ask about service fees if you are unclear what you are paying for.
The individual investments you or your advisor choose also plays a factor in the total cost of investment management. When purchasing mutual funds and exchange traded funds (ETFs), generally speaking, there are two types of fees: expense ratios and loads.
An expense ratio measures the amount of the fund’s assets that go towards the administration and other operating expenses of the mutual fund or ETF. It is calculated by dividing a fund’s operating expenses by the average dollar value of its assets under management and are disclosed by the fund provider. According to Vanguard, the industry average mutual fund and ETF expense ratio is 0.57%1.
Some mutual funds charge a percentage fee or “load” to purchase or sell the fund. Front-end loads are charged by some mutual funds when the investor is purchasing the mutual fund. There may also be back-end loads which require the investor to own a particular fund for a specified period before fees associated with selling are waived. Lastly, there are “no-load” mutual funds that only charge annual expense ratios.
Generally, no-load funds allow for the greatest trading flexibility when managing a portfolio, for example to rebalance or tax-loss harvest.
Mutual funds can have various share classes with different fee structures. ETFs, on the other hand, only offer one share class that actively trades on an exchange. Fees for ETFs are typically lower than that of mutual funds, but not always. Of course, purchasing individual stocks or bonds can eliminate expense ratios entirely. However, only holding individual positions may limit the benefits of diversification that can be achieved with a mutual fund or ETF.
The expense ratio and loads discussed above are examples of explicit costs. Fund managers are required to disclose them, and generally they are not difficult to identify. In addition, mutual funds and ETFs also incur implicit costs that are a direct results of trading activity inside the funds. While these costs can be comparable or even higher than expense ratios, they can be very difficult to measure accurately, and fund managers are not required to disclose them. Nonetheless, their impact is reflected in the lower returns delivered to investors.
Understanding the total cost of ownership can be complicated. While cost should not be the only factor when considering an investment strategy, choosing high cost investment options may create a significant performance damper on your portfolio.
The final component of investment management fees is the cost to trade when buying or selling positions. Recently, there has been a significant reduction in costs across the financial services industry. Many brokerage firms and custodians don’t charge any trading fees to trade stocks and ETFs and minimal fees to trade mutual funds. While costs have gone down, frequent trading can still create a drag on the portfolio’s total return over the long run.
Additionally, individual investors who trade frequently may be subject to unfavorable tax rates for positions held less than one year, an additional cost of frequent transactions.
While often overlooked, controlling investment management fees and other costs is a critical component which can impact your financial goals. Advisory fees, fund fees, and transaction fees add up, and, if you aren’t careful, can have a negative impact on your portfolio’s performance. If you work with an advisor, make sure you know how much you are paying and understand the value of that advice. Regardless of whether you use an advisor or do-it-yourself, you should also review the costs associated with the funds you are invested in and the transaction costs associated with trading.
If you would like to learn more about Dowling & Yahnke Wealth Advisors’ services, please contact our knowledgeable financial advisors today for more information.