There are all sorts of clichés about the old economic dictum: There's no such thing as a free lunch. For instance, you always "get what you pay for" and "nothing in life is free," and so on. These nuggets of wisdom are very apt for talking about portfolio management. There are all sorts of fees – management fees, trading commissions, expense ratios – some are easy to spot, but some are more surreptitious. Either way, fees have to be taken into account when considering the right investment strategy.
Client: I'm in the process of evaluating a number of money managers for my retirement assets. I know that I need to pay close attention to fees, but there are so many different types…it's hard to keep them all straight. Can you shed any light on these for me?
Advisor: You're absolutely right in saying that differentiating between the types of fees and costs associated with managing a portfolio can be dizzying. Some are clear enough, but a lot of the time investors never have any idea what they're being charged (or why). Let's look at a quick sampling of the types of costs you may see in your account:
- Management Fee – This is a fee generally charged by a professional manager for services rendered. The fee, which can take various forms, is usually charged as a percentage of assets under management or, in some cases, as a flat rate.
- Transaction Costs – Transaction costs are fees charged by the executing broker for buying or selling a security. For the sake of simplicity, I'll put equity commissions, mutual fund loads (a fee charged for either buying or selling a mutual fund) and commissions on fixed income (embedded in the price) in this category as well.
- Account Service Fees - These fees are charged for administrative functions such as asset transfers, wires, account maintenance, etc.
There are many, many other types of costs, but most of them fall into one of these three categories.
Client: Yikes. I'm thinking about hiring a broker who will be using mutual funds to manage my portfolio. He is only charging me 0.75% to do this – good deal?
Adviser: Good question, as this is one of the most common money management options available to investors. Let's break this down piece-by-piece.
First, 75 basis points is a pretty reasonable amount to pay for this type of relationship. There are many brokers and managers out there who would charge far more than that. However, that 0.75% is just the tip of the iceberg. What many investors fail to understand is that not only will you pay the broker a fee to manage the assets, you'll also pay a management fee to the mutual fund managers in addition to brokerage fees incurred inside the fund. When you consider that the average equity mutual fund carries an expense ratio of 1.41% (1), all of a sudden that relationship doesn't look so cheap. Keep in mind there may also be a fee to enter or exit the mutual fund known a "load." In some cases, this load (either front- or back-end loaded) can be as high as 5 or 6%.
Client: What are some of the cheapest investments alternatives? The most expensive?
Advisor: Depending on the manager, separate account management can be done at a reasonable cost. The management fee can be relatively low and transaction costs can be constrained, especially if the value of your account is high enough to qualify for fee breaks. As far as actual investment costs go, the cost of owning individual equities can be low (especially if you're not excessively trading the account). Exchange traded funds or index funds also generally carry very low fees but come with no advice.
As far as the most expensive investment, the first place to look is annuities. Not only are annuities a generally poor alternative for most investors, they also contain very high fees that can prohibit success. Not to mention that figuring out the true cost of buying an annuity can be like getting information out of the Pentagon. Hedge funds, which usually take a percentage of profits on top of a standard management fee, can also be extremely pricey.
Client: So, what's the bottom line?
Advisor: Before entering any agreement with a professional manager, I always recommend that investors have a crystal clear understanding of the fees that will be assessed. Get that information in writing if need be, and don't be afraid to ask your advisor questions if you don't understand the information.
At the end of the day, fees should always be viewed in context of the returns provided. Over time, fees essentially act as a tax on the gains in your portfolio, so it's important to find a manager or product that can justify the fees being charged. Considering that most professional managers have a hard time keeping pace with the equity markets, this can be a tall order. However, if you value advice and find a manager with solid credentials, don't let the fees scare you away. Sometimes, you really do get what you pay for.
1 Source: Morningstar -- the average cost on equity funds (no load).
Each week The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.