Mutual Fund Fees and Advisor Compensation, Explained in Plain English
Yes, I’m tackling this one head on. How do financial advisors get paid, and what does that mean for you as their client?
Make no mistake about it, it’s necessary for you to educate yourself and learn how your advisor is paid. It will help you understand whether or not your advisor puts your needs ahead of their own. It becomes a slippery slope if your advisor puts HIS/HER needs ahead of your own when dealing with YOUR life savings.
To start, we need to understand the three ways advisors are paid:
Fee-only
Fee-based
Commission-based
**Note - There are other ways advisors get paid, but they do not make up the majority, so for now we won’t explore other forms of compensation (hourly rate, retainer, salary, etc).
Fee-only
Pay close attention, FEE-ONLY ADVISORS ARE THE ONLY ADVISORS REQUIRED AT ALL TIMES TO ACT AS A FIDUCIARY - that is, to put your needs first.
Fee-only advisors collect payment as a fee for service. The fee is typically charged as a percentage of total assets under management (AUM), or put another way, as a fee for the total dollars you invest with them.
If I invest one million dollars with an advisor that charges a 1% AUM fee, I pay that advisor $10,000 per year to manage my money. If that advisor prepares a financial plan for me, there is likely an additional fee for that plan.
Fee-based
Think of these advisors as hybrid advisors.
A fee based advisor charges fees much like a fee-only advisor. However, a fee-based advisor has the option of also earning a commission on certain securities he/she invests your money in (mutual funds, insurances, etc). This means you, the client, need to make sure you clearly understand why your advisor has chosen your specific investments.
Commission-based
In my opinion, having a commission-based advisor that invests exclusively in products like mutual funds and insurances where they earn a commission doesn’t make sense.
Commission based advisors do not charge you a fee for their service. Instead, they are paid by the companies who create the “product (i.e. mutual fund)” your money is invested in.
Even if the advisor is the most honest human on the planet, they are paid by specific investment companies to use their products, and to compound that issue, some fund companies pay higher commissions than others. Rest assured they will invest your money in them, completely eliminating thousands of other potential investment options, and the higher commission companies will get preference.
Imagine this scenario: You visit a doctor, and that doctor has a suitable (often used word in investments) drug for your ailment. You know (or even worse you don’t know) the visit to the doctor is free. Instead, the pharmaceutical companies pay that doctor a commission based on the volume of their drugs he/she prescribes.
Knowing doctor willingly excludes thousands of potential medicines that could heal you, would you still visit that doctor?
Interestingly, even though the visit is free, nobody says yes to visiting that doctor, yet that scenario happens every day in the investment world.
Make sure you clearly understand what type of advisor you’re working with, and when necessary, ASK QUESTIONS about your investment portfolio. It’s YOUR HARD EARNED MONEY. You have every right to know where it’s going.
If you aren’t confused yet, buckle up.
Earlier I referenced mutual funds as often-used products in individual investment portfolios. In addition to your advisor’s fees, those mutual funds come with their own built-in fees. And, as you probably guessed, those fees are almost always passed on to you.
According to Gallup, 52% of Americans invest in the stock market, and 43.6% of US households own a mutual fund. Suffice it to say, mutual funds make up some portion of the majority of investment portfolios in the US, so they’re most noteworthy.
Exchange Traded Funds (ETFs) are rising to power, true, and while they have similar fees to mutual funds, they are not actively managed. Thus, their fees tend to be slightly less than their counterpart, but we can save that explanation and my distaste for them for another day.
Let me help you understand the fees associated with a mutual fund.
**Note, if your advisor invests exclusively in individual stocks like we do at Beck Bode, you can turn your brain off. This section is not for you.
Expense ratio:
Generally, this is the only additional cost people consider when they own a mutual fund.
The expense ratio pays for the annual costs incurred to run the fund (management fees, administrative fees, operating costs, etc).
It may be helpful if you think of a mutual fund as a physical product, say an iPhone. Apple pays fees to vendors, salaries to employees, dollars toward marketing budgets, etc, just to get the iPhone on store shelves. Those costs are rolled into the sticker price when you buy a new iPhone. Expense ratios are calculated similarly for mutual funds. According to Morningstar, the average mutual fund’s expense ratio in the S&P 500 is about 1.1% of total dollars invested in the fund.
Transaction costs:
These costs are difficult to quantify. Trade volume, market fluctuation, and other variables hugely influence transaction costs. Without boring you to death with the details, just know there are three major transaction costs that affect every person who owns a fund: brokerage commissions (commissions earned by brokers buying and selling stocks within the fund), market impact costs (since a fund managers’ buy/sell decision making is influenced by how the volume of their trades could affect the overall price of stocks in the fund, and whether that manager elects to buy or sell could cost you potential investment gains), and spread costs (difference between bid price and ask price of each stock traded in the fund). A Forbes article from a few years ago estimates these costs at about 1.4%.
Tax costs:
When a stock appreciates in value and is sold for a gain, you pay a capital gains tax (short-term = 1 year or less, long-term = greater than 1 year). Since growth mutual funds, for example, are an accumulation of 50-200+ different stocks, gains and losses happen regularly in actively managed funds. Everyone that owns the fund (you, in this case) shares proportionally in its taxes. Seems fair, right?
But what happens when you buy into a fund that owns a stock which appreciated prior to your joining and is sold after you join? You guessed it. You share in the capital gains tax even though you didn’t benefit from any of the gains.
For example, if one of the stocks in the fund appreciates from $50 to $75 during months January to July, and you buy that fund in August, you’re on the hook for the $25 appreciation if the fund manager sells the stock even though it was already at $75 when you bought the fund. These costs, according to Forbes, are estimated at 1% for a taxable account.
Cash Drag:
Fund managers often hold a small portion of your money in cash when you invest. When others sell their holdings and need to be paid out, your immediate cash makes the fund highly liquid (which is an attractive attribute of a mutual fund). But there is a major opportunity cost to holding that cash, especially if the market is doing well - instead of sitting in cash, it could be invested and making you more money.
To put it another way, if your intention is to buy and hold the fund, your available cash is paying for more active investors who buy and sell frequently when, instead, it should be invested on your behalf. Again, Forbes estimated these costs at .83%.
Let’s total the additional costs and see what the real cost of owning a mutual fund could be. Remember, we are using averages, so these numbers can vary, but it’s good to know the costs exist and unfortunately don’t need to be disclosed to you.
Going back to the earlier example, let’s say you invest one million dollars in mutual funds, and you pay your advisor a 1% fee, or $10,000. The additional fees incurred by investing in mutual funds can run your total out of pocket costs much closer to 5%, or $50,000!
I hope this article hammers home the point that being an educated consumer is in your best interest, especially when selecting your advisor.
I cannot stress this enough, you work hard to earn your money. It’s important you know what you’re paying for when someone is managing it on your behalf.