Even if you manage your own portfolio you may want to read the rest of this article. The
costs of investing involve more than fees for professional management and advice.
Investment fees and taxes take a significant bite out of investor’s returns but surprisingly
few people pay much attention to them.
We tend to cringe when we hear people rave about “how nice” their investment advisors
are. Certainly it’s nice to have a friendly advisor but if they are smiling at you at the
same time they’re picking your pocket, I’d rather have a grump for an advisor who
charges reasonable fees for his/her services. Clearly, the majority of investment
advisors are honest. Nevertheless, investors need to understand the costs they are
incurring.
Most investment advisors make their money in one of two ways. They either charge
commissions for your investment transactions or they provide fee-based services.
The fees paid to advisors who charge commissions can readily be seen on your monthly
statements or trade confirmation statements if you’re trading stocks and bonds or similar
investments. If you buy mutual funds, whole life insurance, or annuities, however, it may
not be clear what the commissions are.
There are two basic types of mutual funds: funds with a load (a.k.a. commissions) and
no load (no commission) funds. When you buy a no load fund and invest say $1,000,
you will buy $ 1,000 of that fund. There are no commissions paid when you buy a no
load fund. All mutual funds charge expenses for the management of the fund. Those
fees are deducted from fund earnings. Fund fees between 1% and 1.5% are not
unusual although they vary considerably, depending on the type of fund.
When you buy a mutual fund with a load, it is more difficult to discern what commissions
were involved. The most common types of load mutual funds are Class A, Class B and
Class C funds. Class A funds charge an up front load (commission) when you buy the
fund. You will see no commission charge on your statement. The reason? When you
buy a load fund, the commission is effectively subtracted from your purchase funds so
that fewer shares are purchased than if there was no load. Associated commissions are
never detailed on brokers’ statements (If anyone does detail them, we’ve never seen an
example of it!). Loads on “A” funds are typically 4% to 5% or more.
Since many investors are concerned with up-front commissions, investment firms
created Class B funds. These funds charge a back-end load when you sell the fund.
The back-end load declines a percent or so each year over a number of years (typically
4 or 5 years). At the end of that time, the fund converts to a class A fund. Prior to
conversion, the management fees are higher than for a Class A fund. The affect of the
higher management fees is that you pay just as much or more than for the Class A
fund. The back-end load also serves as a deterrent to selling, in effect preventing you
from moving the funds elsewhere.
Class C funds charge a higher (than Class A funds) constant management fee and
often have a smaller (than Class B funds) back-end load. The bottom line is that Class
A, B and C funds all charge a sales commission one way or another. Brokers often offer
discounts on loads for investors with larger portfolios. However, some brokers have
been criticized in the past for failing to make clients aware of the discount rates.
In addition to fund loads and management fees, investment management companies
may charge small transaction fees for the purchase of certain mutual funds and often
charge fees if funds are not held for some minimum period of time. This protects fund
investors from market timers whose short-term trades can have a negative affect on
funds held by long-term investors.
Advisors that don’t charge commissions typically charge a percent of the value of the
assets managed, annually (known as fee-based management, or asset management).
Such fees typically average around 1%. For larger portfolios the fee is often reduced to
as little as 0.5%. Some advisors charge as much as 2.0%. Many feel this approach is
better than a commission arrangement since the advisor is not motivated to sell any
particular asset just because he/she will receive a commission. They are motivated to
grow the clients portfolio, since the larger the portfolio is, the higher their fee will be. On
the other hand, the work involved as the portfolio grows remains essentially the same.
It should be noted that although pure fee-based management involves no commissions,
there are still mutual fund management fees being charged for the funds in the
portfolio. Note too that a number of advisors receive mixed compensation from both
fees and commissions.
While fee-based management appears to be a superior approach to commissions based
advice, the fees can be substantial. For example, a $ 1million portfolio will generate
$10,000 a year in fees at a1.0% rate and $ 5,000, at a 0.5% rate.
In addition to commission and fee-based approaches, a small percentage of advisors
utilize a fee-only approach, charging hourly rates or fixed fees disclosed up front. We
believe fee-only is the best approach for the average investor.
The bottom line? It’s important to understand how you are being charged for investment
advice as well as other fees associated with your investment portfolio. Taking time to be
sure you have a clear picture of these expenses can have a significant impact of your
investment returns.
Note: Patterson Advisors is a fee-only advisor. For a related article that will help you
determine if your financial advisor is acting in your best interest, visit our web site (see
link below) and review our past article titled “Is Your Financial Advisor Acting in Your
Best Interest?”.
David C. Patterson, CFP® and Erin Patterson, CFP® are the owners of Patterson Advisors, LLC, a fee-
for-service-only financial advisory firm. Patterson Advisors, LLC is a Registered Investment Advisor,
registered with the State of Michigan, helping clients in Waterford, Clarkston and Royal Oak, Michigan
as well as other Oakland County, Michigan communities . Visit www.pattersonadvisorsllc.com for more
information or call 248-674-2108.
Published in the Oakland Insider, March, 2008, Retitled: Investment Expenses Can Take
Big Bites
Do You Know What You're Paying for Your Investments?
By David and Erin Patterson