How Fees Eat Your Lunch -- It Still Adds Up To Dollars

Here's an excerpt from the book The Intelligent Portfolio: Practical Wisdom on Personal Investing from Financial Engines. For my thoughts on this subject, see Costs Matter If You Want to Maximize Investment Returns.

Financial service firms have many ways of charging fees to their customers. You should at least be aware of the basic types of fees that you are likely to be charged, either by the fund company or by your investment advisor or broker. This is definitely one of those areas where ignorance is not bliss. Some fees vary with the amount of money invested in the product, while others (like brokerage commissions) are often fixed in magnitude.

Explicit Fees

The following section provides a brief discussion of the explicit types of investment fees that investors pay for funds and individual stocks.

• Expense ratios: A fund expense ratio is the fee charged by the fund operating company for operational expenses and investment management fees. It is typically expressed as a percentage of the net assets (e.g., 1.0 percent or 100 basis points) of the fund and is updated annually. This fee is deducted from your investment returns as a shareholder of the fund on a daily basis. Some funds tie their expense ratios to the total assets of the fund or to investment performance, and so their expenses may change over time. All mutual funds have expense ratios, as do the nonretail institutional funds often found in large 401(k) plans.

• 12b-l fees: These fees are fees charged by the mutual fund company to cover marketing, promotion, and distribution expenses. They are expressed as a percentage of net assets and are included as pan of the overall expense ratio for the fund. 12b-l fees are set at an annual level of 1.0 percent or less. Even so-called "no load" mutual funds can have 12b-l fees embedded in their expense ratios, but not all mutual funds charge such fees. Often a portion of 12b-l fees go to compensate brokers who distribute the funds to investors.

• Loads: A load fee is a sales charge or commission that is added to the price of a fund when it is purchased or sold. There are front-end loads, which are added to the purchase price of a fund, and back-end loads, which apply to the price of the fund when it is sold. Usually, back-end load charges decay over time so that if you hold the fund for more than six to eight years you can avoid paying the load when you sell the fund. For mutual funds, front-end loaded funds are typically known as Class A shares, while Class B and Class C shares may involve back-end load charges. Front-end and back-end load fees are generally not charged to participants in defined contribution plans such as a 401(k) plan.

• Redemption fees: These fees are a relatively recent phenomenon for most mutual funds. Redemption fees may apply if you choose to hold a fund for a short period of time. For instance, some funds charge a fee of 1.0 percent of the amount sold if the fund is held for less than 60 days. Unlike load charges, redemption fees are fairly common in defined contribution plans. Also, redemption fees are paid back into the fund, as opposed to going to the investment manager. Such fees exist to discourage investors from rapid trading in and out of the fund, which can raise the transaction costs for other investors in the fund. In many situations it makes sense to avoid incurring redemption fees, unless the benefits of getting out of a poor position are significant.

• Transaction fees: Transaction fees apply when you purchase or sell certain funds in a brokerage account or brokerage window. Generally transaction costs are expressed in dollars and for fund trades are not tied to the size of the transaction. For instance, a brokerage firm might charge a transaction fee of $25-$50 for the purchase or sale of certain mutual funds. For stocks, the transaction fees are known as brokerage commissions and can vary widely in magnitude, depending on the nature of the account. Usually brokerage commissions for stocks are structured as a flat fee for trades up to a certain size, with a variable fee on shares above that amount. It is worth noting that for these types of fixed fees, the impact on your account is sensitive to the size of the transaction. For large transactions a $25 fee may not be meaningful, but if you have small transactions, especially if they are recurring, the fees can add up. For example, if you purchase $500 worth of a mutual fund that charges a $25 transaction fee, you are paying the equivalent of a 5.0 percent transaction fee ($25/$500 = 5 percent), which is a very steep hit to your expected returns.

• Investment advisory fees: If your money is being managed by a registered investment advisor or financial planner, you may be paying an asset-based investment advisory fee on top of the fees for your investment funds. This fee is intended to cover the expense of allocating your assets, providing investment advice, and monitoring your portfolio over time. Such fees can vary widely depending on the level of services and the amount of assets under management. Typically, investment advisory annual fees range from 0.50 percent to more than 2.00 percent of assets under management.

Implicit Fees

In addition to the previously discussed explicit fees, there are also hidden or implicit fees that reduce the performance of mutual funds. These fees are almost never disclosed in advertising materials or a prospectus, but they can have a significant effect on your net returns.

• Brokerage commissions: When a fund manager trades securities in the fund portfolio, he or she is required to pay brokerage commissions to the firm that processes the trades. These commissions are paid out of the assets of the funds, and hence detract from the net returns to investors. The more the fund manager trades, the higher the level of commissions. Generally mutual fund managers pay far less than individual investors for executing trades, but the costs can still be significant, particularly with active managers who trade frequently or those who invest in less mature markets with higher trading costs (such as developing countries).

• Bid-ask spreads: When a fund manager makes a trade, in addition to brokerage commissions, she or he must pay the difference between the market price and the price at which she or he can buy the security (the ask) or the price that she or he can sell the security (the bid). The ask price exceeds the bid price and the difference between the two is known as the bid-ask spread. This spread between what it costs to buy a stock and what you can sell it for is part of the cost of executing a stock trade. Generally these costs are higher for stocks that have lower trading volumes and a smaller number of shareholders. This tends to be true for small-capitalization and some international stocks. For larger-company stocks with very deep trading volume, the spread between the bid and ask tends to be lower. Similar to brokerage commissions, the more frequent the trading by the fund, the higher the costs associated with paying the spread between the bid and ask prices in the market. Like brokerage commissions, these costs lower net returns to investors. It is particularly important to pay attention to bid/ask spreads when trading in securities with very low share prices, as the gap between the bid and the ask can be a significant percentage of the stock price itself. Not surprisingly, active mutual funds tend to incur much higher commissions and bid-ask spread costs than index funds due to their higher rate of trading.

What is interesting about these implicit costs is that they are widely estimated as being comparable in size to the explicit costs associated with expense ratios and loads. One study estimates that the average cost to fund shareholders from brokerage commissions and trading spreads is 0.78 percent, and that the costs for specific funds can vary widely. This implies that many mutual funds have total costs in the range of 2.00 percent when these implicit costs are added to the explicit fees charged by the fund company (and even more for funds with load charges). Such fees have big implications for the ability of funds to generate wealth for you.