Fees And Expenses; Just Not Adding Up

I am accustomed to seeing a variety of emotions from people when they first come to see me; confusion, urgency and fear, to name a few. In fact, over the years, I’ve gotten pretty good at recognizing and identifying how people are feeling before they even start talking to me.

Anyway, last week I had an appointment with a gentleman named John. John’s a good guy. He worked hard his whole life. He is about 68, married, and has two kids and four grandkids. Before he even sat down I could feel John’s confusion and it didn’t take long for him to tell me what was bothering him. He said that he thought his advisor only charges 1 percent in fees for his financial planning services, but recently he looked at the details of his family’s portfolio, and the numbers were “well . . . just not adding up.” John said that it seems like his returns are lower than they should be if there is only a 1 percent fee, and he didn’t understand how that could be.

Hmm . . . John’s suspicions were right on the money (no pun intended).

Understanding the costs associated with an investment strategy is an important part of selecting the right one for your planning goals. Oftentimes, however, only one aspect of those costs is clearly identified, the advisor fee. In John’s situation, however, the advisor fee does not reflect the entire expense of his investment strategy. There are additional, less transparent costs, associated with his current strategy. Let’s take a look.

John has invested his $1 million dollars in approximately 10 “growth” mutual funds consisting largely of stocks. He uses a broker who charges him 1 percent for his services. This is the fee that John was previously aware of. After researching and evaluating his mutual funds, however, John came to understand that his portfolio is subject to additional fees and expenses.

The Wall Street Journal has reported that the average mutual fund has operating costs in the neighborhood of 1.3 percent of assets. These expenses are disclosed in the prospectus. Mutual funds also have transactional costs which, according to Forbes, typically total about 1.4 percent of a fund’s assets. Think about it. These large mutual funds are buying and selling stocks, bonds and securities every single day. Who is paying the cost? Yes, the people who own the mutual fund! Where are those expenses explained? The simple truth is that these expenses rarely show up in a fund’s prospectus. And I have never seen them on any brokerage statement, have you?

Mutual funds also suffer the effects of what is referred to as cash drag. Cash drag results from the portion of the mutual fund that sits in cash at all times to meet a fund’s liquidity needs. Cash drag typically costs about .8 percent. This expense results from investors paying a mutual fund’s operating costs on 100 percent of the fund’s assets, despite the fact that not all of the assets are invested.

The following is a summary of the fees associated with the average mutual fund:

Operating Costs - 1.3 percent
Transactional Costs - 1.4 percent
Cash Drag - .8 percent
Advisor Fee - 1.0 percent
Total Expenses: 4.5 percent

We also discussed the importance of analyzing investment behavior during both bull and bear markets. After our analysis, John realized that he does not have a strategy in place to minimize losses during bear markets. John now understands that, as currently structured, his portfolio has significant risk with no downside protection.

With John’s situation, it was easy to see an opportunity to minimize his expenses as well as to lower his overall portfolio risk. Since markets seem to have a correction every five to seven years, John’s future strategy should be tactical in nature. He should seek investment strategies that focus on managing downside risk in tough years such as 2001, 2002 and 2008. You know, it is not always what you earn, but it is always what you keep and John simply cannot afford to lose half of his portfolio if we enter another negative market cycle. John should also seek strategies that charge a flat fee that includes all of the above expenses. Strategies such as these are more transparent, usually about half of the cost, and oftentimes much more efficient.

With the numbers and calculations laid out in front of him, I could feel John’s stress and confusion draining. Was he paying more than the 1 percent? Absolutely! But could he minimize many of those “not so” transparent costs by using a different strategy? Yes, again!

Folks, make sure you do your homework to find out what you are really paying, and decide if what you are getting is worth it.