It’s Your Money
Fees and expenses in the investment management and mutual fund industries.
If you are investing in mutual funds or hiring an investment adviser, it's important to know what you are paying for—and what you are paying. You can hope that you have chosen a good stock picker, but you'd better KNOW that you're going to get wise diversification and reasonable fees. Thoughtful diversification will reduce risk without reducing your return, and it goes without saying that lower fees add directly to the performance of your portfolio.
If you've decided to invest in mutual funds, you'll make your own decisions about diversification among stocks, bonds, and the various world markets. Your next step should be to look at fees. Yes, you should study the track record of each fund, but there's a reason why they say that past performance is no guarantee of future returns. Put a thousand monkeys to work picking stocks with darts, and you will discover that a quarter of them turn out to be pretty good stock pickers. . . . .
Even if you do identify some good managers, you'll want to check frequently to see that they're still at the helm. The good ones have a habit of running off to start their own firms, and their substitutes might not be as capable. Whatever you decide, you should resign yourself to the fact that even the best managers go through slumps that can last for two years or more. That piece of information will be small comfort after the second year of lousy performance, but studies have shown that you can lose a lot of money by jumping from one “hot” money manager to another.
So let's return to the topic of fees, which come in many flavors and disguises. The first question is whether you'll be charged a "load", or commission to your stockbroker. The traditional no-secrets upfront commission, which might take 5% of your assets on day one, has almost disappeared; but it was a far better thing than the undercover rear-end load. If that sounds like a dirty diaper, it is. Rear-end-loaded funds have oversized annual expenses—often exceeding 2%—which allow the fund company to provide handsome compensation for your broker, your insurance salesman, your financial planner, or—horrors—your accountant. Those who try to bail out of these overpriced funds are hit with a huge withdrawal charge.
Not all mutual fund investors pay a load, but all have to pay management fees, marketing expenses, legal fees, insurance expenses, and all sorts of other things. Most of these are captured by the "expense ratio", which averages 1.31% for U.S. stock funds, according to Morningstar (foreign stock funds generally pay more). This expense ratio does not include the brokerage commissions that the fund itself has to pay to outside brokers to buy and sell stocks in the fund. Heavy-trading funds suffer more than those that buy and hold, and some funds pay excessively large commissions that result in a "soft dollar" kickback to the fund company.
There is also an undisclosed "spread" loss in trading that results from trying move large blocks of stock into or out of the market. When a fund buys it pushes the price up, and when it sells the price goes down . . . . The sum of the "spread" cost and the fund's brokerage commissions can be larger than the expense ratio. A study authored by professors of finance at Boston College, the University of Virginia, and Virginia Tech found that these trading costs average 0.77% per year for funds which buy large-company stocks, and 2.85% per year for funds which buy the stocks of small companies. It's not easy for a big fund to buy the stock of a company that normally trades just 20,000 shares a day.
Professional Management, Tailored to Your Needs
Investors with substantial assets have the option of turning the diversification question over to an investment advisory firm. The annual fees charged in this industry are usually reasonable—and they become even more reasonable as the size of your account increases—but it’s not uncommon to see clients paying two layers of fees. For example, they might pay 1% to an investment manager, and another 2% to the mutual funds that he puts into the accounts in lieu of individually-purchased stocks and bonds. Or there might be a “wrap fee”; a 1% fee collected by the brokerage firm that referred you to the investment adviser.
Many investment advisers also pay unnecessarily-high brokerage commissions in exchange for soft-dollar kickbacks. But the impact on your account will not be significant unless the firm does a great deal of trading. It’s the trading that kills you, because in good years it creates short term capital gains, and the rest of the time it produces losses. Ask about the brokerage commission rates and soft-dollar arrangements of the firms that interest you, but be sure to verify that their trading activity is low.
Investing offers many tradeoffs. High risk tends to accompany high returns, while low risk brings low returns. You can battle against these heavy truths with hard work and good judgment, but at the end of the day the only free lunches in investing are low expenses and thoughtful diversification. We wish you success in the year ahead.
John Lumbard, CFA