The Importance Of Fees To Your Returns

We are always hearing about the performance of the market or of a company's stock, you know, the market was up 11.2% in 2007, etc. These are gross returns, or they sometimes will include dividends and be called total returns. However these are not the returns you will receive! When we talk about investing and getting a return or increase in our invested money, we really must think in terms of the net after-tax return. After all your account doesn't care if the money distributed from it goes to you, the government, or the financial services company - but you should care!

We have already discussed keeping the government's share to a minimum here. Now we need to talk about keeping your money away from financial services companies. Overall, the financial services industry expects to make about 2% in fees and expense charges on your money, and many companies hope for more. That's too much! The 2% or more you lose to them dramatically affects your investment results in your 401(k), IRA, and brokerage accounts.

If you are unaware of these fees, it is because they are often hidden in fine print. in their fees and expenses.

What fees are we talking about? Well, first there are transaction costs. These include:

Commissions on the purchase and sale transactions which can range from zero to say $30 these days.

Bid/Ask spreads, the difference between the price you can buy a stock and the price you can sell it,

Execution slippage, where the price changes as you buy or sell as the market reacts to your trade (this only applies to larger trades or thinly traded securities),

Then there are the fees of your financial service firm or advisor for their 'expert' advice. If you have a financial advisor, you may be paying a fixed fee for a particular plan or piece of advice, or be paying a retainer fee for advice over a period, annually for example. This is a fee-only type of arrangement, and is used by Bay Area Planners. Alternatively, many money managers and financial planners charge an Assets Under Management fee, that are typically around 1% for smaller amounts of a few hundred thousand dollars, and reducing for larger account values. Finally some advisors, including a lot of stockbrokers, receive a commission on their sales. This commission amount is built into the price you pay in one way or another.

If you invest in mutual funds, the mutual fund will have management expenses and marketing costs that it must cover, these are called 12B-1 fees.

Indeed it's possible to be charged multiple types of fees or multiple layers of fees. For instance, Hedge Funds will have an assets-under-management fee of 1 to 2%, plus take a 20% share in any gains in the portfolio, i.e. a performance based fee. Notice there's no downside for them - they don't share in losses to your portfolio. If they make high risk investments that pay off, they become rich, and if their risk taking doesn't pay off, they close the fund and walk away leaving you holding the loss. A way to incur multiple layers of fees is to pay an advisor a fee to manage investments like mutual funds that include their own fees.

Let's say you are 25 years old, earn $30,000 a year and want to save 10% of your income in your company's 401K account each year until you retire at age 67. You invest in a 70/30 mix of stocks and bonds. Let's assume inflation is 3% and your income rises each year by 4%.  Don't we wish we had been this thrifty?

If you could invest at no cost, and hit the average rate of return on the 70/30 portfolio of 9.29% each year, your savings would grow to $2,168, 526, or 22.3 years of your final salary at age 67, not even counting Social Security benefits, You would be set for retirement.

But, if your return is reduced by the 2% for fees and expenses, you will only accumulate $1,325,212, or 13.4 years of your final salary. That's a reduction of nearly 40%.

Worse still is paying these fees on the retirement savings as you draw them down for income. We know that a higher percentage withdrawn each year increases the risk of running out of money. Let's say you want to withdraw 5% for income. If you are still paying a 2% level of fees, then the investments must actually earn 7%.  Put it another way, when your investment advisor tells you to expect a return of 7% from your investments, ask if you will receive 7%, or really only 5%.

At these levels, fees are as big a problem as taxes or inflation.

What can you do? Take a look at Index investing using Exchange Traded Funds (ETF's). These have the lowest expense structures and low fees, as low as seven one hundredths of one percent. Or look for Index Mutual Funds with very low fees; for example, the Vanguard Balanced Index fund has fees of only 0.22%. The net return from a low cost index fund will beat the majority of managed investments.

The take-away from this is to be aware of net returns as opposed to gross returns, and question your advisor on the fees you are paying.

To learn more about how we approach asset allocation and fees, call (408) 725-7135, or click here.

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