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4 Investment Costs to Watch Out For

By Roger Wohlner - Mar 4, 2016 at 9:06AM

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Investment fees and expenses are a big drag on your returns over time.

The fees and expenses that come with investing can drastically reduce your portfolio's returns.

According to Vanguard, an investor who invests $100,000 and earns a 6% return every year would watch their investment grow to $574,349 over 30 years, assuming no investment costs. Add expenses of 0.25% -- about what you'd pay for a typical index-tracking fund -- and this amount drops to $532,899. If the expenses increase to 0.90% -- what you might pay for a relatively low-cost mutual fund -- then the ending balance drops to $438,976. That's a 24% haircut off your returns before fees.

In order to prevent fees from wrecking your portfolio's returns, you should understand and look out for the four major investing expenses below.

1. Expense ratios
Mutual funds and exchange-traded funds charge an annual expense ratio, a fee that's based on a percentage of your assets. Expense ratios cover the fund's costs of trading, technology, salaries, and other overhead. And the funds certainly build in some profit. Nobody expects to invest for free.

However, investing is one place where a higher price does not necessarily get you something of higher quality. In fact, there is often as not an inverse relationship between price and performance. That's why so many investors are flocking to low-cost, passively managed exchange-traded funds -- particularly ETFs that track popular indexes like the S&P 500 Index. Index-tracking ETFs and mutual funds attempt to replicate the performance of the underlying index by owning the stocks or bonds that comprise the index. The best index-tracking funds perfectly replicate the returns of the index, less their expense ratio.

For an infinitesimal expense ratio of 0.05%, you can own the Vanguard 500 ETF (NYSEMKT: VOO), which grants exposure to the entire S&P 500 index in a single investment, giving you broad diversification in the large-cap space. Over the five years ended Feb. 19, 2016, the ETF ranks in 19th percentile of its large blend peer group, according to Morningstar.

According to Morningstar, the average expense ratio for a large-cap blend ETF is 0.42%, while the average mutual fund in the same category charges 1.08%. A low-cost index fund or ETF has a huge cost advantage over its active peers.

2. Front-end sales loads
A front-end sales load is a fee, based on a percentage of the assets you are investing, paid up front to a stock broker before any of your money is invested. You'll typically pay this fee when purchasing "A" shares of a mutual fund. For example, the popular American Funds Growth Fund of America A (NASDAQMUTFUND: AGTHX) charges a 5.75% up-front sales load. This means that for every $10,000 invested, only $9,425 actually goes to work for you.

That $575 fee is a commission that goes to the broker and their firm. While this particular fund has a reasonable expense ratio of 0.65%, the initial hit is a lot to overcome. Brokers will argue that this fee pays for their advice and service, whereas a financial advisor charges an ongoing fee based on a percentage of the assets under management, and they each have a point. However, as an investor, you need to understand what this front-end load buys you in terms of ongoing advice and determine whether it's worth the price.

If you are investing on your own, there are many no-load mutual funds that don't charge any sort of up-front fee. ETFs can typically be purchased for a low commission rate on the order of $8.95 or so per trade. Several brokers, including Schwab and Fidleity, offer a menu of no-transaction-fee ETFs, and account holders at Vanguard can trade their ETFs for free. In researching a no-transaction-fee platform, it's important to be sure that the ETFs offered work for your portfolio.

3. 12b-1 fees
These fees are a part of the expense ratio of mutual funds that assess them. It has been my experience that funds with 12b-1 fees generally have higher expense ratios than those that don't have them. These fees were originally intended to cover the cost of marketing and distribution for these funds, but in reality they have become another form of compensation for brokers and registered reps.

The American Funds Growth Fund of America has a 12b-1 fee of 0.24% as part of its expense ratio, and it serves as trailing compensation for the broker.

There are two no-load versions of this fund. The American Funds Growth Fund of America F-1 (NASDAQMUTFUND: GFAFX) has an expense ratio of 0.70% with a 12b-1 fee of 0.25%. The other version, the American Funds Growth Fund of America F-2 (NASDAQMUTFUND: GFFFX), has an expense ratio of 0.43% with no 12b-1 fee. Which version your financial advisor recommends might depend upon whether or not they take the 12b-1 fees as compensation.

4. The cost of financial advice
If you work with a financial advisor, they may charge you in several ways.

  • Fee-only advisors receive no compensation from the sale of any financial products or from trailing commissions like 12b-1 fees. Fee-only advisors charge based upon a percentage of the assets under their management, a flat fee, or an hourly charge. This will vary based upon the services provided and the fee structure of the particular advisor.
  • Fee-based advisors are compensated from both fees and the commissions from financial products they sell. One model might have them crafting a financial plan for a fee and then implementing their recommendations via the sale of commissioned financial products. Another version is the wrap account, an investment account the advisor manages for a flat fee. They will often fill these accounts with mutual funds that generate 12b-1 fees, which they collect as well.
  • Commissioned advisors receive all of their compensation from the sale of financial products.

Whatever form your advisor's compensation takes, you should fully understand what you are being charged and what you're getting for these fees. Even with a fee-only advisor, a fee of 1% or more is a drag on your returns. In this era of robo-advisors and fee compression, investors should always be sure that the fees they're paying to their financial advisor are reasonable and that they're getting plenty in return. 

Ger your money's worth -- and them some
They say a penny saved is a penny earned, but in the world of investing, a single penny might earn you a dollar in the long run. Investment fees and expenses might seem small, but they're a big drag on your returns over time, so make sure you keep your costs under control and make sure every penny you pay in fees is worth it. 

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