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.
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 study by PriceMetrix 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 of 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.