Nov 23, 2021 -

Posted at 2:18 pm News/Resources

What are your investments really costing you? If you’re not sure, you’re not alone. It’s not like you’re handed a menu of charges to choose from when it’s time to place your order. Even when you know where to look for investment costs, the information can be difficult to digest.

Let’s fill in some of the blanks by covering two significant sources of investment costs: fund management fees, and custodian/brokerage (trading) costs.

First – fund management fees.

Fair Fund Management Fees

One reason we typically recommend investing in a mix of index or index-like funds is their ability to efficiently capture global market returns without your having to personally juggle thousands of individual securities at a time.

What a hassle that would be. That’s why you instead hire a fund manager, investing in their funds, and letting them do the heavy lifting for you. In exchange, fund managers deserve reasonable compensation for services rendered.

What’s “reasonable”? To discover how much fund management is costing you, start by looking for each fund’s expense ratio (or, in Canada, its management expense ratio, or MER). You can find this information in the fund’s prospectus, or by searching online for its name or ticker symbol. Many broad market index mutual funds or ETFs have annual expense ratios of 0.02% (2 basis points) or less. If a fund’s annual expense ratio approaches 1% (100 basis points) or more, you should probably think twice about investing in it.

Some fund managers also pile on extra fees, or loads, beyond the ones reflected in their expense ratios. These should also be disclosed in the fund’s prospectus, and can include:

  • A one-time front-end load when you buy shares of the fund
  • A one-time back-end load when you sell shares of the fund
  • Similar contingent deferred sales charges (CDSCs) and other redemption fees

Hiding and Seeking Fund Fees

Because fund management fees are typically bundled into each fund’s share price, you’ll barely notice they’re there. But they still cost you real money.

For example, in a recent working paper, “Obfuscation in Mutual Funds,” academics from the University of Washington, MIT, and The Wharton School at the University of Pennsylvania compared the 2019 costs and performances of two S&P 500 Index mutual funds. Before fees, their gross returns were nearly identical at 31.46% vs. 31.47%. But one fund manager charged a lean 0.02% (2 basis points). The other one charged up to an all-in 5.08% (508 basis points). Once you know that, it’s easy to tell which fund will leave more money in your pocket after fees.

Are you having trouble finding a fund manager’s fees to begin with? Consider this central finding from the same paper:

“Using bespoke measures of complexity designed for mutual funds, we find evidence consistent with funds attempting to obfuscate high fees.”

In other words, the study found that lower-cost funds usually provided short, easy to understand fee disclosures; the higher-cost funds often buried their costs in lengthy and complex legalese.

Why complicate things? When searching for a particular type of investment, there are almost always funds available that do not charge loads and similar add-ons, and do clearly disclose their costs. That’s why we prefer simple and thrifty over complex and expensive fund management.

Comparing Costs

Low costs are important. But they’re not the only reason to favor one fund over another. Some funds cost more to manage because it’s more expensive to participate in their target market.

For example, an emerging markets fund will usually have higher expense ratios than a general U.S. market fund. So, first, identify available funds that fit your unique investment goals. Compare their expense ratios, apples to apples. Weed out any funds that charge loads, or bury their fee disclosures in long-winded blather. Then select suitable funds with the lowest costs.

Next – Custodian/Brokerage (Trading) Costs.

Now, let’s take a step back from the mutual funds, ETFs, or other holdings you decide to invest in. Where do these holdings live—and what does it cost to buy, sell, and hold them?

An Account of Your Accounts

First, let’s define a few terms:

Investment Accounts: It’s easy to answer where your holdings live. They live in two main types of investment accounts:

  • Individual accounts, which you set up and manage on your own (along with your financial advisor, if you have engaged one).
  • Employer retirement plan accounts, such as 401(k) or 403(b) plans, which your employers set up and manage for you.

Custodians/Brokers: There are two kinds of custodians where your individual and retirement plan accounts typically reside:

  • Traditional custodians, like Schwab or Fidelity.
  • Online platforms or “robo-advisors,” like Robinhood, Wealthfront Advisers, or Schwab Intelligent Portfolios®.

Your custodian uses brokers to actually execute your trades. Some custodians double-duty as the broker; others contract with third parties.

The Cost of Doing Business

So far, so good? Now that you’ve got a lay of the land, here’s an important insight …

It really doesn’t matter which types of accounts you’ve got, which custodians or brokers you’re using; or what your investments are. Come what may, you’re not the one trading in the market. You (or your advisor) place trading orders. Your account custodian takes it from there.

Therein lies additional costs: the costs of holding and trading everything you’ve got.

Those “Free” Frills Can Cost You

Until a few years ago, brokers would almost always charge a commission whenever they executed a trade for you. In a more recent “race to zero,” many providers are now touting commission-free trading. But is that trading really free? If you take one thing from today’s piece, here it is:

As an investor, whenever you’re being led to believe you’re getting something for nothing, your best bet is to assume exactly the opposite.

It stands to reason: Custodians and brokers must be profitable, or they’d go out of business. If they’re not charging a commission on your trades, they’re still making money somehow. It’s just not where you’d expect to see it, nor can you tell how much it’s really costing you.

Tricks of the Trading Trade

Unfortunately, hidden costs usually mean higher costs. Following are a few tricks of the trading trade that often replace or augment more transparent pricing.

Cash Sweeps and Lending Practices: Ideally, you actually invest most of the money you’ve earmarked for investing. But you probably also hold a little or a lot of cash in your investment accounts. Some custodians have been profiting handsomely by quietly sweeping this cash into their in-house, low-rate bank accounts, instead of paying you market-rate interest. They can then reinvest your cash in higher-rate holdings, or lend it out and earn interest on it—and keep the difference for themselves. Add everyone’s cash together, and the profits can pile up.

To illustrate, a 2018 San Francisco Chronicle piece reported average money market rates were around 2% at the time, while average bank sweep accounts were paying closer to 0.27%. The article described these practices as “similar to the way many airlines have cut fares and made up for it with fees for baggage, seat assignments and overpriced food.”

Payment for Order Flow: As described above, your custodian arranges for your trades to be executed. In theory, they’re required to seek “best execution” for your trades. In practice, one common technique is to use payment for order flow to seek competitive trading bids from third parties. Sometimes, this can generate more competitive pricing that benefits you. But it also can create conflicting incentives if an entity offers your custodian more payment (for them), without also ensuring best execution (for you).

Platforms have been under scrutiny on this front, including a 2020 U.S. Securities and Exchange Commission (SEC) charge that Robinhood was misleading customers about the true costs of their trades. Neither admitting to nor denying the charge, Robinhood paid a $65 million fine and agreed to review their payment for order flow and other best execution policies and procedures.

Bond markups/markdowns: If you’re trading in individual bonds, there are usually significant hidden costs known as markups and markdowns. When bonds are bought and sold, there is the equivalent of a “wholesale” versus “retail” price. The markup/markdown is the difference you pay above the “wholesale” price. This undisclosed difference typically goes to the broker, in addition to any disclosed commissions paid.

A Conversation About Advisor Fees

Before we wrap, let’s talk about our own advisor fees.

These days, you don’t need an advisor to manage everything we just discussed. You can look up fund expense ratios on your own, and watch for loads and other fees. You can set up and fund your individual accounts, and decide how you’d like to invest your retirement plan assets at work. You can be diligent about minimizing uninvested cash in your investment accounts.

As an independent, fee-only, fiduciary advisor, we certainly help our clients with all these logistics, and more. But more than that, we provide professional, objective advice on everything related to your total wealth:

We advise you on managing your wealth across your total investment portfolio, wherever your accounts may reside. If your only advice comes from a custodian or trading platform, it’s likely to only apply to your investments with them, without considering assets you hold elsewhere. Plus, if you could do better elsewhere, don’t expect to hear about it from them.

We advise you on your total wealth interests. Do your investments best reflect your personal financial goals and risk tolerances? How should you use insurance to protect your wealth? How can you spend safely in retirement, and which accounts should you spend down first? What about Social Security? Are your estate plans up to date, with accurate beneficiaries across your various accounts and policies? How can you effectively draw personal wealth out of your business? What about those corporate stock options? How can you integrate your charitable giving with optimal tax planning? These are just a taste of the areas we advise on.

We advise you according to your highest financial interests. Even “free” trading can be horribly expensive if it runs counter to achieving your greatest financial goals. In our fiduciary relationship with you, we’ll show you how to minimize hyperactive trading, make the most of the market’s available returns, and manage the very real risks involved. A commission- or fee-based advisor representing others’ interests is unlikely to do the same.