As an advisor, I am constantly surprised when I review a prospect’s investment portfolio and discover the different funds, be it ETFs or mutual funds. There are three things that jump out at me:
- Over/under diversification
- Investment performance
- Fee Cost
Each one of those items deserves a separate discussion. This article (as my title so subtly hints) will discuss the latter item.
Before I talk about the varying fee structure of ETFs and mutual funds, I would like to take a slight detour and talk about transaction costs. This is the cost that the brokerage firm, or custodian, charges you to place a trade. There is a huge disparity between the different custodians (that’s what I will call them going forward) in this industry. I can give you a few examples. At my previous employer, if a client traded a mutual fund the cost would be $20. However, if an investor was not a client but was at the same custodian (known as a retail investor) the cost would be $76. My previous employer utilized two custodians so if a client were to trade a mutual fund at the other custodian the cost would be $75. I spoke with a tax client of mine and he explained that he receives one hundred free trades a year from his custodian. I also know that there may be no transaction costs at a custodian if you trade their funds. This is the case with places like Vanguard or Charles Schwab.
As you can see in the five(ish) examples, transaction costs differ depending on the custodian, if you are working with an advisor, are you using the custodian’s funds, etc. My point is that transaction costs really do not matter if you have one million dollars, or even five hundred thousand depending on how many funds are comprised in your portfolio. However, it DOES matter when you are investing one hundred thousand, or fifty thousand, or lower amounts for beginning investors. In my opinion, this is when the custodian really does matter as the investor needs to be very cognizant of every trade that is placed. For example, if the investor has ten thousand dollars, five different funds, and he/she would like to rebalance twice a year then it would cost (using a $75 transaction cost since that’s most realistic for a retail investor) $750! Look at the percentage of those costs to the portfolio
$750 / $10,000 = 7.5%!!!!!
You may think, “Well I would never trade that much?” However, placing ten different trades throughout the year is by no means excessive trading. Even the most conservative investors could easily place that many trades throughout the year. This just shows you that you have to be VERY CAREFUL when dealing with smaller size portfolios. My opinion would be to stick with index funds of the custodian you are utilizing as they may (should) be free of transaction costs. It will save you so much money! In other words, it is like EARNING a 7.5% return for being diligent.
Sorry for the tangent. Let’s move on to the main discussion, the underlying fees of the funds you (or your advisor) utilize. Some people are not even aware of these fees since they never see the fees “pulled” from their account. It is because the fees are not visible that oftentimes they are never discussed. And just like the transaction costs, there is a wide disparity between different funds. The demand for ETFs was generated by having lower management fees than mutual funds since earlier ETFs were only index funds and needed little management. For example iShares core S&P 500 has an annual fee of 0.007%, in other words 7 basis points. There are 100 basis points (bps) in 1%. However, as active managers are sliding into ETFs the management fees are beginning to rise to the lower end of mutual funds, which are in the 45 bps to 75 bps range. For mutual funds, the average fee ranges between 50 bps and 125 bps.
You must be thinking, “Why would anyone purchase a fund that has a management fee of 100 bps when they could purchase a fund that charges 50 bps?” I can give you two quick answers.
- They simply are not aware of the annual management fee.
- They are sold the mutual fund that has a higher fee.
You may now be asking, “Okay 50bps difference, that’s HALF of 1%! That’s minuscule.” In order to answer that question I created the below chart.
I used a real life example. A client asked that I review her portfolio. The first thing I noticed was her high accumulative fee in the fifteen different funds (over-diversification!) she held. It was 94 bps. For comparison purposes, my core investment model is 43 bps. As you can see, there is a clear difference in fees but the amazing thing is the opportunity cost to those fees! Over a twenty year time-frame, an investor starting with three million dollars would lose over a million dollars! That is just with a 51 bps difference per year…..Not so minuscule now.
The above chart focuses more on the accumulative damage and opportunity cost of the fees. The below chart displays just the fee difference on a yearly basis.
Every year, investors lose tens of thousands of dollars to fees that could be avoided. Do not run into the same pitfall.
As always, this if for informational and educational purposes. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.