At Flat Fee Portfolios we believe very strongly that fees matter and investors should know exactly what they are paying in real dollars. High cost advisors and expensive investment products create a significant drag on investor returns. In today’s low interest rate, low expected return environment, controlling costs becomes even more important. Ways to potentially reduce cost include unbundling your financial services and asking the right questions about the total cost of any investment.
Understanding Bundled Services
Many financial advisors charge a percentage of assets-under-management (AUM) fee to provide financial services. The “all-inclusive” fee covers a variety of services bundled together which typically includes asset allocation, trading, financial planning, and retirement advice. Although the AUM fee structure is a reasonable option for some investors, it is not necessarily the best option for everyone. The AUM scenario works best for those seeking the convenience of working with a professional investment advisor who manages their complete and often complex financial advisory needs on an ongoing basis.
Each investor needs to determine their individual needs. If your financial planning needs are relatively simple and change little from year to year, then you’re likely overpaying for bundled services. It may be more economical to purchase your financial services ala carte by utilizing an hourly financial planner and a separate, low-cost investment advisor.
At Flat Fee Portfolios we believe in providing investors the option to separate portfolio management and financial planning services. By not bundling the costs for all possible services into a "one size fits all" fee structure, you only pay for what you need.
Understanding the Total Cost of An Investment
Investment products can come with a variety of commissions, fees, and expenses. Some are hidden, some are explicit, and some are so hard to determine that they can only be estimated. Most investors don’t even know what questions to ask if they were going to try to understand the total cost of their investment advice. Important questions to ask are as follows.
What’s the advisory fee? Is it reasonable?
Evidence suggests that middle-income investors are losing too much to advisory fees. A recent study found that the average advisory fee for households with $250,000-$500,000 was 1.5%. 25% of clients were paying more than 1.75% and 15% were paying 2% or more!
What’s the expense ratio of the underlying funds?
Actively managed funds are several times more expensive than passively managed alternatives. If a manager can add enough value to overcome the additional expenses it may be worthwhile, but determining luck from skill is difficult.
Source: Dimensional Fund Advisors, 2011, www.dfaus.com
What are the hidden trading costs of the funds?
The expense ratio of a fund doesn’t capture all of the costs. Trading and transaction costs are not reported in the expense ratio and can make an actively managed fund considerably more expensive than advertised. Transaction costs are explicit in the case commissions and implicit in the case of market impact. They are so difficult to determine that they need to be estimated. A recent study estimated that the average U.S. stock fund has 1.44% of total assets and for every $1 in trading costs only $0.56 of benefit was received by fund shareholders. This implies that trading costs add about 0.63% to fund expenses. Investors should examine portfolio turnover and try to ascertain manager skill to determine whether or not trading activity adds value.
When I add it all together, how much am I paying each year in real dollars for my portfolio management?
On average, an investor with an actively managed mutual fund portfolio could be paying 1.5% or more to an advisor, 1% to a fund company for their expenses, and a net .63% in trading costs. This adds up to just over 3.1% in total expenses. Stating fees and expenses in terms of a percentage may make them appear less significant than they really are. For example, for a $500,000 portfolio, the fees above equate to roughly $15,500 per year!