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The Many Costs of Investing

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I recently ran across an article (this one from Forbes) about some of the pitfalls of putting gold or silver coins into an IRA. The main thing that caught my attention was that the qualified custodians who set up a special IRA that can hold coins typically have a 17% - 33% spread when you buy the coins, which is simply an insane cost to invest in gold. This article reminded me of so many of the hidden costs of investing, so I wanted to help my readers understand the multiple costs that go into investing, what to expect, and how to recognize when the costs are just too high. Below I focus on the fees paid to buy/sell mutual funds, although some of these fees and costs are universal to all investments (like your advisor fees and the bid/ask spread).

 
Advisor/Broker Fees

It’s reasonable, at least from my viewpoint, for clients to pay the person they interact with to invest (e.g., your financial planner). These professionals will either work for an RIA (like me), or a Broker/Dealer (like Edward Jones). RIAs charge fees to work with your investments, though they may be paid commission for other things like selling insurance. The fees you pay to your RIA should be obvious, and if not, ask and you should receive a full accounting of the fees that you paid to the RIA pretty quickly. You should also be given a copy of the Advisory Agreement that you signed and your fee should be plainly laid out in the contract (usually on or near the last page).

Broker/Dealers are paid commission for the investments that they sell to you. This isn’t necessarily a bad thing depending on your situation and the amounts and types of commissions paid. These fees should also be clear because your investment professional should have explained all of the fees for you in an easy to understand way before you invested. That’s not always the case, and even when it is there is a lot to keep track of.

So here’s a quick rundown of the types of commissions or “loads” you may have paid or can expect to pay on your mutual funds when you buy/sell them through a broker.

  • Front-end Load - Mutual Funds have multiple classes. Class A mutual funds charge a front-end load that is paid as commission to the person who sold the mutual fund. This load is typically around 5% of the investment. The nice part is that you don’t have to pay extra to invest because the fee simply comes out of your investment. The bad part of this is that you thought you invested $10,000, but you really just invested $9,500. The ugly part is that you have to earn 5.26%, more than the 5% you paid, on your $9,500 investment just to get to the $10,000 you thought you invested. This is because the dollar amount is the same ($5,000), but now you are working with less principal ($9,500 instead of $10,000).
  • Back-end Load - Class B mutual funds have a “Contingent Deferred Sales Charge” or a back-end load usually around 6% that decreases each year for a period of time, usually 6 years. At that time some B shares convert to A shares which is important for the annual sales charge listed below. Class C mutual funds typically charge around 1% if you sell the fund within one year of purchase.
  • Annual Asset-Based Sales Charge (12b-1 Fees) - Class A, B, and C mutual funds all charge an annual sales charge. This is lower for A than it is for B and C. B shares typically convert to A shares after 6 years and start charging the lower annual sales charge. C shares never convert and always charge the higher annual fee. Part of this fee goes to the broker who sold the fund, part of it goes to “distribution and marketing”, or sending prospectuses and advertising.
 
Custodian Fees

In order to invest in the stock market, you must have someone who has a seat on the stock market that holds your money and invests it on your behalf. Broker/Dealers do this for their clients, and Custodians do this for clients of RIAs. Regardless of who is holding the account for you, these are fees that you may pay in order to invest.

  • Transaction Fees - This fee varies depending on what you are investing in. Typically a company will waive this fee if you are buying one of their products. Otherwise this can vary from around $5 for buying stocks or ETFs to $35 for buying a mutual fund. You typically do NOT pay transaction fees for reinvesting dividends in an investment, only when you buy or sell from/to the cash portion of the account.
 
Trader “Fees”

Someone is actually executing the trade for you. Depending on where your account is held, this could be the company holding your account, the mutual fund company, or a third party. Technically these traders are called market makers or designated market makers (if they focus on only one company’s stock). If you are buying or selling mutual funds though, you actually pay the fund company directly, and don’t pay these fees to purchase or sell the mutual fund, but when they buy or sell individual securities they pay these on your behalf.

  • The Bid/Ask Spread - This is not technically a “fee”, but it sure acts like one. The person selling you an investment had to buy it from someone else, but how do they make money? Let’s say you buy shares in Company A for $100. For this to happen someone else had to be willing to sell you shares of Company A for $100. Except that you actually pay $101.50 and the seller actually receives $98.50. That difference, the Bid/Ask Spread is paid to the trader or the company that made the trade, the “market maker”. (Bid = what they will pay you for your shares, Ask = what they want you to pay them for their shares). Think of it like buying a house, except you don’t buy it from the previous owner; instead, the real estate agent buys it from the previous owner, marks it up, then sells it to you. The negative aspect is the cost, the positive is that it generally speeds up the market because most of the time, market makers are willing to buy shares of stock even if they don’t have a buyer to sell them to at that exact moment. The spread tends to be smaller on securities that trade more frequently and larger on securities that don’t trade very frequently.
  • Turnover Ratio - The Bid/Ask spread is not a direct cost to buy or sell a mutual fund, but it does impact the cost of investing in a fund. The fund also has to pay the spread to buy individual securities, a cost which they pass on to you. So that if you’re comparing two mutual funds and all else is equal, the one with the lower turnover ratio will be cheaper to invest in.
Mutual Fund Fees / ETF Fees

The Fund Company that created the mutual fund or ETF that you are buying has a lot of staff to pay, not to mention their profits to look after, so of course they also charge fees. There are a lot of regulations around clearly stating these fees, but you still need to understand what to look for, especially since not all financial professionals go over these fees with you since they are “clearly stated in the fund’s prospectus.” You know, that book that you threw away as soon as you saw the small type and the dense tables of numbers that went along with the finance jargon.

  • Purchase Fee - This is a fee that some mutual funds charge up front to buy the fund. It is not paid to the broker but goes directly to the fund company.
  • Redemption Fee - Again this fee is paid directly to the mutual fund, but is similar to a back-end load and is paid to the fund company when you sell the fund.
  • Exchange Fee - Similar to a redemption fee, this is paid when you exchange one fund for another in the same fund “family” (company)
  • Account Fee - Not many firms still charge an account fee, though some still do charge a fee if your balance falls below a set amount.
  • Transaction Costs - In addition to the loads that you may pay a broker to buy investments for you, most investments also have some or all of these costs:
    • The turnover ratio, as mentioned previously, adds costs to the fund because of the bid/ask spread when buying or sell individual securities.
    • There’s also the impact of the mutual fund moving the market when it buys or sells large amounts of a position. Basically, when you sell a lot of a position then there’s suddenly more supply and the price falls, so the last sales you make are worth less than the first few. Conversely if you are buying a significant amount of a stock, the demand suddenly goes up and the price can rise while you are still buying shares.
  • Expense Ratio - These fees are front and center, both as part of the prospectus for any mutual fund, and often on any research site you might use when looking into mutual funds. They are basically the cost of running the mutual fund or ETF and include fees for accounting, administration, auditing, board of directors, legal, management, shareholder reporting, etc.
    • Management/Maintenance Fees - These fees are easy to find if you look for them. They are an annual fee paid to the fund company which they use to pay the team that picks the investments bought and sold by the mutual fund.
    • 12b-1 Fees - As previously mentioned part of this fee goes to “distribution and marketing” for the mutual fund and goes to the fund company, not the broker or investment advisor.

 

That’s a LOT of fees. So why is investing so expensive?

 

Yes it is a lot of fees, but these fees have been declining over the past few decades and investing is now more affordable than ever before. In the 1980's you would pay at least $45 to execute a trade (though many trades were still done on commission that could reach the thousands of dollars), while today "discount brokers" charge less than $7 for trade fees. So yes, a lot of people have their hands in the pot, but their share of your money continues to shrink as people become more aware of these fees. Even so, you still have to pay attention to how much you are paying. Here are two examples to make that point.

Example A:

Adam goes to a broker who suggests buying mutual fund A (a made-up fund for which I’m using real world expense numbers for a real mutual fund). You decide to invest $10,000, but because of the 5.5% front-end load you then have $9,450 invested. The broker works for the company that made the fund so they waive the typical $25 transaction fee. The annual expense ratio of 0.82% is relatively low. So if the fund hypothetically returns 5% (it may have been higher if not for the bid/ask spread and the 20.1% turnover ratio, but this is hard to nail down and isn’t reported by mutual fund companies), you receive 4.18% of that return, and now after a year invested in this fund you have $9,845.01. So even after the market had a positive return, you have less than your initial investment!

Initial Investment: $10,000
Less Load @ 5.5%:  ($550)
Actual Initial Investment: $9,450
One Year Returns at (5.00% - 0.82% = 4.18%) : 395.01
Amount invested after one year: $9,845.01
Fees paid: ($627.49)

Example B:

Betty goes to an RIA who suggests buying an indexed mutual fund B (a made-up fund for which I’m using real world expense numbers from a real index mutual fund). This fund is not the same as the one in Example A, and may or may not be appropriate for any particular individual based on their situation, but let’s press on to show the impact of fees. You decide to invest $10,000. I chose this particular fund because there is no load and no transaction fee for buying into the fund, so you actually have $10,000 invested, but then the advisor charges their first quarterly fee of 1% for your assets under management (AUM) and you now have $9,975. The annual expense ratio is 0.16%, which is actually a little high for an index fund. So if the fund hypothetically returns 5% (which would have been very slightly higher if not for the 3% turnover ratio) you receive 4.84% of that return, and now after a year invested in this fund you have $10,484 if not for the advisor’s fee. Since your advisor has charged you a quarterly AUM fee of 1% this reduced your ending investment to $10,381.35.

Initial Investment: $10,000
Q1 Fee: ($25)*
Actual Initial Investment: $9,975
Q2 Fee: ($25.24)*  
Q3 Fee: ($25.48)*
Q4 Fee: ($25.72)*
One Year Returns at (5.00% - 0.16% = 4.84%): $482.79
Amount Invested after one year: $10,381.35
Fees paid: ($117.40)

*(Under the Assets Under Management fee model your fee is based on your end of quarter balance, so if your investments are growing, so is your fee. For this illustration I grew the investment quarterly to calculate the fee, but for simplicity and an apples to apples comparison I used the lower annualized return for the one year return.)

For mutual fund A to outperform mutual fund B it would need to return 10.75% to make up for the up-front load and the larger expense ratio. Technically it would need to be a little higher since fund A has a 20.1% turnover ratio and fund B has a 3% turnover ratio, but the actual cost of that turnover is hard to measure.

Example A:

Initial Investment: $10,000
Amount invested after one year: $9,845.01
Fees paid: ($627.49)

Example B:

Initial Investment: $10,000
Amount Invested after one year: $10,381.35
Fees paid: ($117.40)

So while fees should not decide your entire investment strategy, they are important to pay attention to. If the hypothetical funds A and B were similar enough, it would be quite impossible for A to double the performance of B and makeup for the drag on return from the fees.

Wow that was dense! So my best advice at this point is to meet with your financial professional and ask them to explain ALL of the fees that you pay, until you completely understand them.