Management fees are constant source of confusion for investors. For an industry that spends a lot of time emphasizing transparency and regulation, the payments in the financial industry are anything but clear and simple.
Very few of us would walk into a restaurant or store and purchase something without asking the price. Yet, people do that every day when they are investing. They take advisors at their word that a vehicle is “low cost” or “free of hidden fees.” But, no one is doing the work for free. So it is important to look further to learn how much and how you are actually paying in fees.
Financial fees is an enormous topic, so today I am focusing solely upon management fees.
First, what is a management fee? Very simply put, a management fee is an amount of money, generally expressed as a percentage, that an investment manager charges to manage and invest money.
Advisor Fees: One Type of Management Fee
One way many investors pay fees is directly to a financial advisor who directs the investments of their specific portfolio. In terms of financial advisors you will find that many are compensated based upon Assets Under Management or AUM. These are generally expressed as a percentage of the amount of money being managed on an annual basis. For example, if an advisor charges a 1% management fee to someone and they are managing $100,000 for that person, then the person will pay $1,000 for that one year of management.
The fees are usually charged quarterly or monthly basis. Depending upon the advisor they may assess the value of an investors portfolio on specific days, commonly the last day of the month or quarter, and bill based upon the balance on those days. Alternately, some advisors may average out the daily balance and charge based upon the average portfolio value. Financial Advisors who change based upon AUM may simply manage a portfolio and provide service items. Alternately, they may be including specific or comprehensive financial planning services within their fee.
Advisors may also be paid in alternative ways such as hourly (like me!), by retainer/fixed fees, or through commissions. You can find more details on different types of financial professionals and the compensations in my prior blog post, Advisors, Planners, and Brokers, oh my! Financial Advisors may simply manage a portfolio and provide service items or they may be including specific or comprehensive financial planning services. When paying based upon AUM or retainer you should be clear as to which specific services are included for that fee, which services cost extra, and which services are not offered.
Brokerage Fees: A Management Fee for Transactions
Beyond advisor fees, investors should be aware of the fees associated with specific investments or types of investments.
Most people are familiar with the idea of brokerage commissions. This is a form of management fee that you pay per transaction.
When you buy a stock online you will generally pay somewhere between $4.95 and $20 to cover the costs of the transaction. In recent years brokerage or trade commissions have been decreasing drastically. Most recently we have seen the advent of brokerages that offer free trading and make their money by selling data to market makers.
Expense Ratios
Expense ratios are a fee charged by mutual funds (including index funds) and exchange traded funds (ETFs). The expense ratio is changed as a percentage of your investment. Expense rations are calculated based upon the total assets invested in the fund each day. These are taken prior to the calculation of the value of the fund. So, you will never see “expense ratio” as a line item on your statement. Instead, the returns on the fund will be slightly lower than they would be if there was no fee taken.
For example, say you invested in a fund that had a 4% return and 1% expense ratio. If the fund had no expense, you would have actually earned a 5% return (this is an over-simplification of the math, but gives a basic idea of how the expenses work. What this means is that a higher expense ratio will negatively effect your earnings. And the expense ratio is paid no matter how the fund does. If the same fund shows losses of 3% it has really had a 2% loss with the 1% expense added in.
The Composition of Expense Ratios
The expense ratio in a fund is charged to cover several different expenses:
- The Management Fee
- The 12b-1 fee
- Other Costs
A fund must provide its expense ratio in it’s prospectus. Realistically, however, the fund company will probably also provide this information on their website and in a fund “fact sheet.” Many online financial sites will provide tools to allow you to compare the expense ratios of multiple funds.
The management fee, as the name implies, covers the salary of the fund manager. It also covers the cost of the analysts and other research expenses. This is probably the most self explanatory portion of the expense ratio.
A 12B-1 fee is the rather off putting name used for marketing and distribution fees. Someone has to pay for marketing and distribution. Sometimes this is in the form a transaction fee and at other times it is included as part of the expense ratio.
Other costs can include a whole host of items such as client service, operations, and administration of the fund.
Comparing expense ratios
Expense ratios range from .10% to 2%+. You may have heard others say that you should look for funds with low expense ratios. This is because of the drag on the returns caused by higher expenses. At the same time, you need to consider the scope and objective of the fund you are investing in. Some types of investments are more difficult to research and administer than others. A reasonable expense ratio for one type of fund may be less reasonable for another type. You should compare the expense ratio of your investment with those funds in similar areas to see how they stack up.
Mutual funds may be actively or passively managed. Those with active management are usually more expensive because you are paying for analysis and research on the underlying investments within the fund.
Passively managed funds, or index funds, are much cheaper to administer. The investments within the fund are set to match a specific index or segment of the market. The goal of these funds is to mimic that index or market sector as closely as possible. This can be done much less expensively than active management.
Exchange traded funds (ETFs) also track an index, sector, or other asset. Unlike mutual funds, ETFs are traded on a stock exchange in the same way as regular stocks are. ETFs have low expense ratios because, like index funds, they are not actively managed. The expense ratios are often lower than mutual funds because they are structured differently and do not have shareholder costs included.
Sales Loads
Mutual funds may be categorized as “load” or “no load.” The word load refers to a sales load, which is a sales fee charged to investors. Loaded funds have a trading fee that is paid to the broker or salesperson.
Sales loads are regulated by FINRA (The Financial Industry Regulatory Authority) and can not exceed 8.5% of the transaction amount. There are different types of sales loads including front-end loads, back-end loads, and level loads. This Nerdwallet article goes into more detail on the different types investment fees including mutual fund sale loads.
ETF or Index Fund?
Based upon what I have written above, you clearly need to invest in a mutual fund if you are seeking an actively managed fund. But, what if you are looking for a passive investment? Should you invest in an ETF or a Mutual Fund?
When comparing the fees of ETFs v. Index funds, ETFs often have a long term advantage of lower expense ratios. The ETFs, however, may have a transaction fee, or brokerage fee, that you pay when you purchase the fund. You can buy no load index funds without any transaction fee. So, you need to consider the up front transaction cost against the expense ratio.
There are many considerations when deciding whether to invest in an index fund or an ETF. One factor to consider is the length of the investment. Will you hold the fund long enough for a higher expense ratio to offset the transaction fee?
Another factor to consider is the size of your investment. Generally the transaction fee is a set amount. A $4.95 commission will have a much smaller effect upon your returns if you are investing $100,000 than if you are investing $100. Conversely, the difference between a .02% expense ratio and a .05% expense ratio is more meaningful if you are investing more money.
A final factor to consider is the frequency of your investments. If you are dollar cost averaging (investing a set amount on a regular basis) into a fund, you may find a mutual fund with no load to be more cost effective than an ETF that charges a per-purchase fee.
What To Do with All of This Information
There are a lot of different numbers to look at and factors to consider when you are investing. We tend to think that everyone has the same objective – to make money – and so there is a single investment that would be best for all of us.
In reality, however, we all have different needs. We are all investing different amounts of money at different intervals. We have different time horizons until we plan to withdraw the money. We have different tolerance for risk. All of these factors will effect our investment decisions.
Generally speaking, it pays to avoid high expense ratios, loads and commissions. If you are paying the money in fees, then it is not in your account working for you. But, fees are far from the only factor to consider in choosing an investment. The most important take away is to be aware of what fees you are paying so that you can make informed decisions.