Steve TeSelle, CFA, CFP ™
February 2004
I think most people agree that keeping investment costs down will
improve the performance of their portfolio. The problem is that many folks have
no idea what their costs are and where these costs crop up. So here’s a
brief rundown on the types of fees and charges you’re likely to see.
Some mutual funds carry loads, or sales charges. Sales charges are based on a percentage of the transaction. These charges are a mechanism to pay whoever sold you the investment. Mutual funds have various classes of shares (A, B, C, etc.). The class of shares tells you whether you pay the sales charge up-front, when you buy the investment, or on the back end, when you sell the investment, or somewhere in between.
Sales charges do not reflect the quality of the investment. They are simply a means to pay the investment sales person.
Some mutual funds offer their funds without a load. You can invest in these funds without paying a sales charge. As you might imagine, sales people who get paid based on sales charges aren’t terribly excited about selling no-load funds. If you have an advisor who recommends no-load funds, this advisor probably charges an hourly fee, or a fee based on the assets that he or she manages for you.
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The most common fees are either based on a percentage of assets or on an hourly rate. For example, I typically charge 1% of assets under management. I also have a small number of clients whom I charge $100 per hour for advice because I don’t really manage their portfolios.
If you use an advisor on a fee basis, make sure you both understand what you’re paying for. Typically, if you pay based on assets under management, the advisor is responsible for portfolio performance. The advisor may also be responsible for monitoring asset allocation. If you pay based on an hourly fee, the advisor may not have any responsibility beyond the advice that you paid for. Different advisors have different arrangements, so just know what you’re getting into.
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Whether you’re in a load or no-load mutual fund, you will be charged an
annual fee by the mutual fund company for managing the fund. This fee gets deducted
from the assets of the fund and is based on the assets within the mutual fund.
Vanguard’s index funds have some of the lowest costs in the industry -
annual fees are currently about 0.2% of the funds’ asset value. But fees
can get pretty high, up to 3% per year. You can find how much your mutual fund
charges by looking in the fund’s annual report and/or prospectus. You can
also find this information from companies, such as Morningstar and Value Line,
that analyze the mutual fund industry.
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Everything I’ve mentioned up to now is an explicit cost. You can find the expense if you’re willing to ask, or to look for it. Trading is an area where there are both explicit and hidden costs.
The explicit cost is the commission. If you trade through Merrill Lynch, Schwab, or Fidelity, you pay some fee for buying or selling a stock. The fee is usually calculated as a certain number of cents per share with a minimum charge. For example, if you buy 200 shares of General Electric, at 3 cents a share the commission would be $6. But the minimum charge is $29.95, so you pay $29.95. If you buy 2000 shares, the commission would be $60. That’s above the minimum, so that’s what you pay. If you bought 30 stocks for your portfolio, you could total up the commissions, which would give you the explicit cost of those trades.
The hidden cost in trading is based on whether you’re getting a good price, which depends on factors such as whether you’re trying to sell when everyone else is (which drives the price down farther), and how liquid the stock is (which affects pricing). There are people who try to figure out what the hidden costs of trading are. I’m not one of them. But I do think hidden costs are lurking out there, so I try to keep trading to a minimum.
Even though part of the trading cost can easily be calculated, it never is. Proceeds from stock sales are calculated net of commissions; that is, after commissions have been deducted. You can’t find trading costs anywhere in the annual report or prospectus. Trading costs, both explicit and hidden, are included in the performance of the investment.
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No matter how you invest, you’ll incur trading costs. The hourly fees or sales charges are for advice. Most advisors aren’t giving out free advice, unless perhaps they don’t need to make any money from their business. I leave it up to you which advice you prefer to follow - that based on hourly fees or that based on sales charges. Just don’t fool yourself into thinking that you’re getting free advice.
Any decent advisor should be able to explain to you how he or she gets paid. If he or she refuses, or gives you an answer that makes little sense, I suggest you head for the exit.
© Dorato Capital Management, LLC. All rights reserved.
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