Buying my first car in 1981 was a great learning experience. After signing on the dotted line and agreeing on what I thought was the final price, I was sent to the finance manager to learn that the price I had negotiated was not the final cost. I learned that I had to pay extra for floor mats, an extra charge called dealer prep, rust proof undercoating, and a few other charges that added nearly $500 to the cost of my $6,100 car. I started to realize that what I didn’t know could hurt me or worse, what I thought I knew to be true… wasn’t. Maybe you feel the same way about your investments. A potential termite in the 2x4s of your investment portfolio could be the fees and commissions you pay to purchase your mutual fund, real estate investment trust (REIT), variable annuity, or any other product commonly offered by brokers.
This article will focus primarily on mutual funds and the cost of ownership and questions you can ask your financial advisor to try to ensure you are not being exposed to certain avoidable charges.
According to the Wall Street Journal1, fees have a huge impact on your realized returns. Here are some of the ways mutual fund companies reduce your return on investment through fees, charges, trading fees, platform fees, taxes, marketing fees called 12-b1 fees, bid-ask spreads, and cost impact on the market. Although mutual fund companies are required to disclose the trading fees for the last three years and the prospectus, it is difficult in some cases to determine the actual cost as an annual percentage.
Here are some of the pesky fees that can be avoided or managed.
1. Buy A shares – this type of mutual fund has the letter “A” in the name of the fund. This means that an initial commission is paid to the broker on your initial investment. It can go up to 5.75%. 2
Some mutual fund families give you a price reduction if you put enough money into their family of funds. Ask your broker if you can benefit from a discount by investing more in the same family of mutual funds. Generally, A-share mutual funds are best suited for investors who plan to change their portfolio less and want to stay in the same mutual fund for 11 to 15 years. If you don’t think you’ll stay in the mutual fund that long, maybe you should consider buying “C” stock mutual funds. They usually have higher management fees, but you can switch mutual funds without having to pay another initial commission to the broker if you change your mind within the next 10 years.
Let’s take a look at a very popular fund called American Funds AIVSX -Investment Company of America Class A shares:
The initial commission (charge) is 5.75%. – The maximum that can be charged on A shares. The turnover of the fund is -23%
The expense ratio disclosed in the prospectus is 0.61%. However, the fund has the following costs in addition to the disclosed expense ratio.
Here is the TCO breakdown: $100 investment
Your share of the fund trade costs $29 / 0.29%
Amount you paid for managing the fund $37 / 0.37%
Amount you paid for distribution of funds $23 / 0.23%
Taxes you paid to own the fund $31 / 0.31%
One-year total cost of ownership $120 / 1.20%
Now, if you include the 5.75% commission and a 1% advisor management fee, your true cost of ownership is significantly higher than the 0.61% listed as the expense ratio. These costs are paid by the investor. You may not see them, but just like a termite works happily in the dark, walking away one bite at a time from your home, these fees are quietly eating away at your return on investment. If the performance is good, you might not mind paying higher fees. Some mutual funds and many exchange-traded funds have lower fees than this, and many may perform better. This is where the research and work of a good financial planner with analytical skills comes in handy.
This fund has a five-year performance according to Morningstar.com of -0.22% as of February 2, 2012. Adding any additional cost of (1% advisory fee + 0.59% internal and transaction fee + 0.575% sales commission), your annual performance over the last five years would be reduced to -2.39%. (1.39% if there were no additional advisor fees.) In other words, on an investment of $10,000 in this fund, you would have paid $178 per year to have the privilege of losing $139 per year. If your holding period was less than 10 years, your annual cost could be even higher.
Remember that advisor fees may be tax deductible, but mutual fund fees you pay generally are not. Most online pricing services do not include advisor fees in their information.