What You Should Know About Hidden Fees
According to 16th-century astronomer Galileo, scientific achievement comes on the heels of discovery. The same could be said about achieving your financial goals. Consider that to become a successful investor you must discover what investment strategy and risk exposure can help meet your needs. Once you understand those “investment truths,” it can be easier to see what portfolio can lead you to your goals.
“All truths are easy to understand once they are discovered; the point is to discover them.”–Galileo
One truth mutual fund investors have come to easily understand is that costs matter, as cost and return are inversely related – the less you pay in costs, the more of the return you keep. Even a difference in cost less than 1% can have a huge effect on your returns over time. Hypothetically, an investor with a $100,000 portfolio that earns an average annual return of 6% would have $532,899 after 30 years when paying an annual cost of 0.25%. If that annual cost was 0.9%, the investor would have earned nearly $100,000 less with $438,976.
While some sophisticated investors are aware of the importance of investment costs, they may have yet to discover they are being charged hidden fees. Some fees do not show up on account statements or are obscurely titled in a fund prospectus. In the worst cases, investment advisers receive certain incentives to sell funds so it is in their best interest to keep the fees hidden behind the scenes.
Therefore, as you embark on achieving your financial goals, always be aware of the following hidden fees:
Definition: A fund’s expense ratio is the cost incurred by the fund to operate; it includes everything from management fees to administrative fees. While expense ratios are readily disclosed, what they are used for may not be. For example, some funds charge a 12b-1 fee, which is an additional charge to current shareholders to cover advertising and promotional expenses in order to attract new shareholders. Some fund expenses are distributed to investment advisers in compensation for selling the fund.
Effect: According to the Investment Company Institute (ICI), the average expense ratio for actively managed funds was 0.89% compared to 0.12% for index funds.
Location: Expense ratios can be found in a fund’s prospectus. Investors are encouraged to ask if their investment adviser receives compensation from any fund providers.
Definition: Whenever a security is bought or sold, there are transaction costs. These include costs from trades made within a fund, which are passed to shareholders, as well as the cost of trading shares of the fund itself through a broker or by your adviser. The cost of trading is based on the frequency in which the fund replaces securities, known as its turnover. A high rate indicates frequent trading. In addition, a fund that attempts to trade a large quantity of a security can create a market impact cost in which the fund’s buying or selling moves the price of that security.
Effect: Unknown. In a study published by the Financial Analysts Journal, the average trading costs of thousands of mutual funds was 1.44% of total assets. However, trading can also cost investors in additional taxes that result from any capital gains realized throughout the calendar year, both from portfolio managers trading securities within the fund itself and from trading shares of the fund, at the individual investor level, which you may not discover until the end of the year.
Location: The turnover rate of a fund is typically included in a prospectus in the form of a percentage, although it may not always be easily found. Meanwhile, an adviser should be transparent about the fund’s trading operations.
Definition: A sales load is a commission paid to the salesperson of the fund. It is either a front-end load taken out of the initial investment when shares are bought, which will reduce the amount of shares you can buy, or a back-end load deducted from proceeds when shares are sold, which may reduce your profit. It can also be another form of compensation provided to advisers from fund providers.
Effect: The average front-end sales load for stocks, according to the ICI, was 1% in 2013, but they could reach as high as 5.3%.
Location: The sales load charged by a fund, if any, should be stated in its prospectus. Whether your adviser receives such commissions will not. Therefore, ask your adviser whether no-load funds or load funds are used in your portfolio.
When it comes to investing, complexity and unnecessary expenses do not translate into better results. You get what you don’t pay for. Instead, you may discover that investments that are easy to understand can provide more in the return you get to keep. Low-cost index funds, for example, have the established goal of replicating a published index. Therefore, there are no expenses for managers or research. It is one reason why, on average, index funds operate with lower in cost than actively managed funds. Another reason is that they generally have low turnover, because trading occurs only in the event of a change in the index it tracks or the need to raise cash for redemptions. This is why index funds tend to be tax-efficient.
The same can be said about investment advisers. Those that are fiduciaries, meaning they are legally bound to work for best interest of their clients rather than themselves, may help investors discover and understand what can work best for them to meet their financial goals.