Investors Need to Know About Fee Structures

Many times investors may feel like they’re on stage with Monte Hall playing “Let’s Make a Deal” when it comes to selecting investments. When trying to compare different products and approaches to investing, it’s very rare that you can make an apples-to-apples comparison.

Even though they might not be identical, one thing you should always be aware of are the fees associated with any service or product you’re thinking about utilizing. This is true wherever you invest your money, be it in individual securities, mutual funds, hedge funds, insurance products, etc., because fees cut into profits, as shown in the accompanying table.

Just like any other service or product you consume, in the investment world fees differ greatly for different approaches. I’ve been in the investment business now for more than 15 years and one thing that has held constant is the confusion surrounding fees, so I thought I would take this opportunity to put down in writing some general information about fees and some of the common misperceptions.

One could do an entire doctoral thesis on the subject, but since I only have a page, I’ll just hit the highlights. Should you ever have a question about fees, please feel free to call us and if we don’t know the answer, we’ll do our best to find it.

One area of investing most people are familiar with is mutual funds. Mutual funds charge a number of fees such as sales, management and advisory services, administrative costs, and marketing and advertising.

Sales charges come in the form of front-end loaded and back-end loaded. Front-end loaded funds charge a fee when you buy the shares and usually range between 2 percent and 6 percent. Back-end loaded funds charge a fee when you sell your shares.

The back-end loaded fees usually are highest when you first invest and gradually decrease over time. All the other fees outside of the sales charge are lumped together in what is called the “expense ratio” which can range anywhere between 15 basis points to over 2 percent annually depending on what type of fund it is.

For instance, an international mutual fund will typically have a higher expense ratio than a government bond fund. There are also thousands of no-load funds, which have no sales charge but the flip side to that is they typically have a little higher expense ratio than ones with sales charges.

These loads typically get split between the fund company and the financial professional selling you the fund. In addition to the sales charge, the financial professional may also share in ongoing annual fees such as those for marketing and advertising or better known in the industry as 12b-1 fees.

Annuity products work very much the same way, but the fees are typically even higher than in mutual funds. Annuities usually have very large surrender charges if you need to withdraw the money before a stated number of years, which is usually between 7 and 10 (similar to the back-end load).

Several years ago we were talking with a prospective client about our services. She had a portfolio worth around $500,000 with a few individual stocks and several mutual funds.

Her mutual funds were the front-end loaded type that she had paid a 5.75 percent up front fee to invest in and then had annual expense ratios north of 1 percent.

It cost $28,750 (5.75 percent of $500K) to invest in the mutual funds and then more than $5,000 a year in additional fees for management and advisory services. When she asked about the fees we charge, she was a little taken back by the 1 percent annual fee and that she would receive an actual bill from us on a quarterly basis showing exactly what was owed.

When my colleague explained to her that her mutual funds are costing her as much or more on an annual basis and that she could have hired Garrison Asset Management to invest her portfolio for over five years for what she was charged in front-end loads to invest in her current mutual funds, the light bulb clicked and she said “oh yeah, you’re right, where do I sign up?”

I’m happy to say that was more than three years ago and she’s still a client at Garrison Asset Management.

That’s not to say that mutual funds (front, back or no-load) or annuities don’t have their place. Different things work for different people. You just need to make sure that the additional fees are due to some additional feature that you desire and are worth the extra cost. The problem I see is that many investors don’t understand the true cost they are paying.

I can safely say that most people we talk to don’t realize they are paying those investment management fees when investing in insurance products and mutual funds, because a mutual fund or annuity never sends an actual invoice.

The fees are deducted and reflected in the price of the fund (we like to think of it as hidden) rather than sending Mr. Investor a bill where the fee is clearly spelled out. These fees are clearly stated in the fund or annuity prospectus and if you choose to do some digging, you can find it.

As an SEC registered investment advisor, we are required to send our clients a bill. Why mutual funds companies and insurance companies don’t have to do the same is beyond me. The issue of fee transparency is making its way to the forefront with regulators, but to date no concrete changes have been made.

There are any number of ways to be a successful investor and you need to find the style and approach that makes you comfortable. One way to help you get comfortable is to truly understand what you’re getting and what it costs.

No matter how the terms of the fee are stated, you should always make sure you understand exactly how they will impact your bottom line. Don’t be afraid to ask your financial services provider the hard questions:

• What are the fees associated with this product, expressed as a percent of assets (1 percent or 100 basis points) and/or in total dollars ($1,000 annually), preferably both?
• How much of the fee is the financial services provider getting?

If your financial services provider is truly watching out for your best interest, there should be no hesitation or reluctance to clearly and concisely explain all the fees involved.

And always remember what your grandmother taught you: a penny saved is a penny earned.

(James B. Bell is a certified financial adviser with Garrison Asset Management of Fayetteville. E-mail him at [email protected].)