What are your investments really costing you? If you’re not sure, you’re not alone. It’s not like you’re handed a menu of charges to choose from when it’s time to place your order. Even when you know where to look for investment costs, the information can be difficult to digest.
Let’s fill in some of the blanks by covering two significant sources of investment costs: fund management fees and custodian/brokerage (trading) costs. Today's discussion will be about fund management fees. Custodian/brokerage costs will be covered next time.
Fair Fund Management Fees
One reason Escient Financial typically recommends investing in a mix of index or index-like funds is their ability to efficiently capture global market returns without having to personally juggle thousands of individual securities at a time.
What a hassle that would be. That’s why you instead hire a fund manager, investing in their funds, and letting them do the heavy lifting for you. In exchange, fund managers deserve reasonable compensation for services rendered.
What’s “reasonable”? To discover how much fund management is costing you, start by looking for each fund’s expense ratio. You can find this information in the fund’s prospectus, or by searching online for its name or ticker symbol. Many broad market index mutual funds or ETFs have annual expense ratios of 0.05% (5 basis points) or less. If a fund’s annual expense ratio approaches 1% (100 basis points) or more, you should probably think twice about investing in it.
Some fund managers also pile on extra fees, or loads, beyond the ones reflected in their expense ratios. These should also be disclosed in the fund’s prospectus, and can include:
- A one-time front-end load when you buy shares of the fund
- A one-time back-end load when you sell shares of the fund
- Similar contingent deferred sales charges (CDSCs) and other redemption fees
Hiding and Seeking Fund Fees
Because fund management fees are typically bundled into each fund’s share price, you’ll barely notice they’re there. But they still cost you real money.
For example, in a recent working paper, “Obfuscation in Mutual Funds,” academics from the University of Washington, MIT, and The Wharton School at the University of Pennsylvania compared the 2019 costs and performances of two S&P 500 Index mutual funds. Before fees, their gross returns were nearly identical at 31.46% vs. 31.47%. But one fund manager charged a lean 0.02% (2 basis points). The other one charged up to an all-in 5.08% (508 basis points). Once you know that, it’s easy to tell which fund will leave more money in your pocket after fees.
Are you having trouble finding a fund manager’s fees to begin with? Consider this central finding from the same paper:
“Using bespoke measures of complexity designed for mutual funds, we find evidence consistent with funds attempting to obfuscate high fees.”
In other words, the study found that lower-cost funds usually provided short, easy to understand fee disclosures; the higher-cost funds often buried their costs in lengthy and complex legalese.
Why complicate things? When searching for a particular type of investment, there are almost always funds available that do not charge loads and similar add-ons, and do clearly disclose their costs. That’s why there's a preference to simple and thrifty over complex and expensive fund management.
Comparing Costs
Low costs are important. But they’re not the only reason to favor one fund over another. Some funds cost more to manage because it’s more expensive to participate in their target market.
For example, an emerging markets fund will usually have higher expense ratios than a general U.S. market fund. So, first, identify available funds that fit your unique investment goals. Compare their expense ratios, apples to apples. Weed out any funds that charge loads, or bury their fee disclosures in long-winded blather. Then select suitable funds with the lowest costs.
Up Next … Custodian/Brokerage (Trading) Costs
In addition to your fund management costs, custodians, brokers, and trading platforms also make money off your investment activities. Those costs will be looked at next. Until then...This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Digital assets and cryptocurrencies are highly volatile and could present an increased risk to an investors portfolio. The future of digital assets and cryptocurrencies is uncertain and highly speculative and should be considered only by investors willing and able to take on the risk and potentially endure substantial loss. Nothing in this content is to be considered advice to purchase or invest in digital assets or cryptocurrencies.
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