Table of Contents
- Know What Investment Fees You’re Paying
- Commissions & Trading Fees
- Mutual Fund Fees – Front-End & Back-End Loads
- Expense Ratios
- 12(b)-1 Fees
- Margin Interest
- Investment Manager Fees
- How Much Do Investing Fees Impact Your Investments?
- How to Reduce Your Fees and Keep More Money in Your Investment Portfolio
When it comes to investing, most folks concentrate mainly on the overall rate of return on their portfolio. Investment fees fall somewhere further down on the priority list.
But let’s say you pay an average of 2% in investing fees on a $100,000 portfolio. Over 30 years, that will cost you $60,000 — to say nothing of how much you’ll lose if that portfolio increases in value.
That’s why it’s critical to keep your investment fees low. Investing fees have the net effect of lowering your returns.
Just by reducing — or eliminating — investment fees, you can instantly improve the performance of your portfolio.
So how do you lower your investment fees?
Know What Investment Fees You’re Paying
Before you can work on lowering your investment fees, first you must know what they are.
Here are the main offenders.
Commissions & Trading Fees
These are fees charged by your broker for the buying and selling of various securities and funds. Most brokers base commissions on a flat fee — say, $7.95 per trade.
That may not seem like a lot if your trades are high dollar amounts, but it can take a big chunk out of your smaller transactions. And multiplied over many trades, those fees can really add up.
You can reduce these fees by shopping around for a lower-cost discount brokerage or by making less frequent trades.
Mutual Fund Fees – Front-End & Back-End Loads
These are sales fees charged by mutual funds themselves. In general, they range between 1% and 3% of the fund amount, but they can actually go much higher. It’s not uncommon for some loads to exceed 5% of the amount invested, and they can go as high as 8.5%.
Some funds charge loads upfront (front-end loads) and some upon the sale of your position (back-end loads or redemption fees). Still others charge both.
Many back-end loads are called contingent deferred sales charges. These fees shrink each year until they disappear. For example, you might pay a 5% redemption fee the first year, 4% the second year, etc., until there are no more redemption fees.
Front-end and back-end loads may not matter so much if you buy and hold funds for many years, but they can become significant if you frequently trade positions.
The simplest definition of an expense ratio (ER) is the cost to own the fund. Expense ratios are annual fees charged by all mutual funds, index funds and exchange-traded funds (ETFs). The ER is represented as a percentage of your investment. The lower the expense ratio, the more money you get to keep in your portfolio, and the more money you’ll have working for you.
We can think of these as stealth expenses, since most investors aren’t aware of them unless they’ve read their mutual fund prospectus very carefully.
That’s mostly because 12(b)-1 fees usually aren’t a direct charge to the investor, but are paid through a reduction in your principal balance each year.
These fees can range between 0.25% and 1% of the fund assets and cover expenses such as fund advertising and marketing. Obviously, you’ll want to favor funds that are on the lower end of that expense range whenever possible.
It’s not technically a fee, but margin interest can reduce your investment performance nonetheless.
A margin account is a brokerage account that lets you borrow money from a broker to purchase stocks or other securities. Because you can borrow up to 50% of a trade’s value, using margin enables you to double the rate of return on your actual principal.
For example, let’s say you invest $5,000 in a stock that goes up by 10%. You’ll profit $500 on the trade.
However, what if you borrow another $5,000 to invest a total of $10,000 in that stock? When the trade’s value increases to $11,000, after you pay back the $5,000 and not counting your initial investment of $5,000, you’ll have made $1,000.
Unfortunately, there’s no such thing as a free lunch. You’ll need to pay interest on your margin loan.
With margin rates currently running as high as 10%, this can represent a substantial charge against your profits, as well as being a magnification of any losses that you may experience.
Investment Manager Fees
You won’t pay these if you’re a DIY investor. But you may be paying these fees if you use a financial advisor to help manage your investments.
There are many ways investment managers get paid, including:
- Commissions – A kickback from the mutual fund company, usually a percentage of the front load
- Assets Under Management – A percentage of the assets they manage, typically 0.5% – 1% of managed assets
- Fee-only – A flat rate, often based on an hourly rate, or for creating an investment plan or annual review
- Some combination of the above.
It’s essential to know and understand how your investment advisor is paid so you can determine if there’s a conflict of interest in the advice and recommendations they’re making. Not all investment advisors have a fiduciary duty to act in your best interest, and their recommendations may serve their interests more than yours.
If you decide to pay an investment advisor to manage your investments, be on the lookout for frequent trading, high loads, high expense ratios, and other activity in your investment portfolio that can trigger large expenses on your behalf.
You can also look at a service such as Vanguard Personal Advisor Services (PAS), which pairs you with a personal advisor for a low management fee. You get the best of both worlds: access to financial advisory services at a low cost.
How Much Do Investing Fees Impact Your Investments?
If you want to know how much you’re actually paying in investing fees each year, you need to total up what you pay for each of the above fees, as well as any other costs that you’re being charged, such as taxes, advisor management fees, etc. The impact can have an enormous drag on your anticipated returns.
Cumulative Impact of Fees Over Time
The following chart, courtesy of Vanguard, illustrates the impact fees can have on your investment returns:
The Impact of Paying 1% or More in Investment Fees
On the surface, paying “only” 1% in fees on your investments doesn’t seem like much. But according to Vanguard, it actually reduces your returns by 25.8% over a 30-year period. Let’s pause for a moment and let that sink in.
A 1% expense ratio on your investment fund can cost you 25% of your returns over a 30-year period.
The higher the expenses you pay, the less money you keep in your portfolio. And less money in your portfolio means compound interest won’t work in your favor as much.
Why stop at 1%? It’s easy to rack up investment fees of more than that.
Here are some hypothetical fees you could pay on a mutual fund. None of these are out of the ordinary:
- Commissions and Trading Fees – Variable; usually a one-time fee, per trade
- Mutual Fund Load – 3-5%; usually a one-time fee, per trade
- Expense Ratio & 12(b)-1 fees – 1% (ongoing expense)
- Investment Advisor / Management Fees – 1% (ongoing expense)
Reducing your ongoing fees has the greatest impact.
You should never ignore the one-time fees, since commissions and loads can add up quickly, particularly when you or your advisor trade frequently.
But it’s the ongoing expenses that have the largest impact. The Vanguard study and chart referenced above pertain only to ongoing expenses. It doesn’t account for commissions and loads.
As seen from the above hypothetical expenses, it’s easy to reach 2% in ongoing expenses with just the expense ratios and advisor fees. Paying ongoing expenses of 2% will reduce your earnings by 44.8% over 30 years. That’s almost half your total returns, all for giving up “only” 2%!
How to Reduce Your Fees and Keep More Money in Your Investment Portfolio
Only once you know how much you’re paying in fees – and it can be shocking – can you begin to reduce those expenses.
There are strategies you can use to make that happen.
In general, favor low-cost index funds or funds that don’t charge loads, reduce the frequency and types of trades, use low-cost or discount brokerages, and diversify your investments.
Finally, if you use an investment advisor, be aware of how they’re compensated and work on reducing your exposure to ongoing management fees, if possible.
The following tips can help you implement these strategies.
Favor No-Load Funds
Since mutual fund loads can take as much as 3% off your investment, you should favor no-load funds. Fortunately, there are more no-load funds available now than ever, thanks to greater investor awareness as a result of the internet.
In general, exchange-traded funds (ETFs) don’t charge a load. This is largely because ETFs are more likely to be index funds. Those funds typically don’t have loads because the funds themselves require very little management. They involve very little trading because they’re established to replicate the composition and performance of the underlying index.
Mutual funds are much more likely to involve loads. This is because mutual funds are much more likely to be actively managed funds. That means they’re funds in which management attempts to outperform the general market — a strategy that involves more hands-on portfolio management and a lot more trading.
It’s not unusual for portfolio turnover to exceed 100% per year in an actively managed mutual fund. But all of that adds to the cost.
The downside of actively managed mutual funds – and why you should favor no-load index funds – is that the vast majority of actively managed funds actually underperform the market indexes. In fact, a recent article from the Financial Times reported that 86% of active equity funds underperform the market.
That should make switching to no-load index funds very easy!
Invest Through a Lower-Cost Discount Brokerage Firm
Exactly how important this step is depends on how actively you trade your portfolio. If you make more than a few trades per month, these seemingly small commissions can add up and hurt your investment performance over the long term.
There are a number of large, well-known brokerage firms that offer relatively low commissions of between $7.95 and $9.95 per trade. That’s not bad, but you can actually do quite a bit better.
For example, several low-cost brokerages, such as Ally Invest, Firstrade, and some others, do not charge commissions on stock trades and on some mutual funds.
Some trading platforms — such as Robinhood — don’t charge any commissions or fees on stock or options trades. While the investing options tend to be more limited at these sites, commission-free trades are certainly appealing.
If you currently make, say, 20 trades per month, at $9.95 per trade, you’re paying roughly $200 per month in commissions. But by switching to a lower-cost discount brokerage firm you can cut that number in half and save yourself $100 per month.
That’s $1,200 per year, which will improve the rate of return on a $100,000 portfolio by 1.2% per year.
Keep Trading to a Minimum
If you’re an active trader, you should seriously consider if all of the additional activity is actually improving your rate of return compared to simply investing in an index fund.
For example, say an index fund returned 10% in the past year. At the same time, your custom, actively traded stock portfolio returned 17% but cost you 8% in investing fees. Your profit – 9% – is lower than what you’d get with the fund.
Very few people have the time, talent, resources or inclination to outperform market indexes on a consistent basis. But you can spend a lot of money on commissions and other fees trying to do just that.
Unless your trading activity is consistently outperforming market indexes – after deducting for the additional investment expenses – you’ll almost always be better off avoiding trading as much as possible.
Diversify – But Don’t Take It Too Far
Most investors readily understand the importance of diversification when it comes to investing. But at some point, diversification can become counterproductive. You don’t need to own 80-100 stocks. That’s what mutual funds and ETFs are for.
At the same time, you don’t need to hold 20, 30 or 40 funds in your portfolio, either. You can actually achieve an excellent level of diversification by investing in just a few funds.
As a matter of fact, this is exactly what “robo advisors” do.
For example, Betterment uses just six stock ETFs and six bond ETFs to cover the entire market. The stock funds cover the total U.S. stock market, large-, mid-, and small-cap stocks, international stocks and emerging markets stocks, giving you exposure to virtually the entire global stock market with just six plays.
Wealthfront uses a similar allocation but also includes funds that invest in real estate and natural resources.
By limiting your portfolio diversification to ETFs, you’ll avoid investment fees that are inevitable in a very widely diversified portfolio. And chances are your investment performance will be at least as good with a smaller number of allocations.
You owe it to yourself to drop your investment fees down as low as possible. It could mean the difference between, say, a 6% annual rate of return and an 8% rate of return.
Put that in your investing calculator and see what it could do to your portfolio over the next couple of decades.
Leave A Comment: