Unveiling the Hidden Costs: Understanding Investment Expenses
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, we’ll talk about fund management fees. We’ll cover custodian/brokerage costs next.
Fair Fund Management Fees
One reason we typically recommend investing in a mix of index or index-like funds is their ability to efficiently capture global market returns without your 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 0.02% (2 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 we prefer 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. We’ll cover what those costs look like next.
