A simple way of improving your return on investment is reducing the fees you pay while investing. This is important enough to be an Investment Rule: Reduce your costs.
The only way to reduce your costs is by knowing the cost of every investment you make. Nothing on this Earth is free. Not lunch. Not good advice. Certainly not bad advice. And it’s fair that you should have to pay for guidance on making investments, as long as you’re not being overcharged. You would think that it shouldn’t be hard to figure out if you’re being overcharged, yet fees are often hidden. Some fees are disclosed in an investment’s prospectus, while others can only be found by requesting a Statement of Additional Information from the asset. This is available free upon request.
Over time, these fees can take a tremendous bite out of your investments, even out of your retirement funds. I suppose that’s why so many of them are hidden. Understanding these costs is essential in choosing a fund or deciding whether to remain in a particular fund.
Since some costs are notoriously obscure, I will briefly describe the different fees charged by the most popular investment vehicle: mutual funds.
Fee Disclosed in Prospectus
Expense Ratio: This is the cost of operating a mutual fund, and is often the only cost investors think they are paying when they buy shares of a mutual fund. This fee is typically used to pay marketing costs, distribution costs, and management fees. According to a 2014 Morningstar article, the average open-end mutual funds’ expense ratio has gradually decreased to 1.25% (in 2013), from a peak of 1.47% in 2003. Sadly, this does not represent the total cost of investing in a mutual fund. In truth, it likely only represents one-third of a fund’s costs.
Hidden Fees
These can take some detective work to uncover. Hidden fees are not mentioned in the prospectus, yet they can amount to as much as double the expense ratio. So even if the expense ratio is 1.25%, you could be paying as much as 3.75% in fees and costs! The following are some examples:
Turnover or Trading Costs:
Mutual Funds are compilations of different investments, e.g., stocks, bonds, and cash equivalents. The fund manager, using his best judgment, decides to sell or buy different assets throughout the year. Every transaction, however, incurs transaction fees. Sometimes a fund will trade most or even all of its assets in one year. Because the fund manager does not know in advance how many trades will be made, or even how much each trade costs to make, instead of estimating the anticipated transaction fees in the prospectus, such fees are listed as a “fund turnover” or “trading percentage.”
The Bid/Ask Spread: If you want to sell stock, you don’t typically sell directly to a prospective buyer. Instead, you sell it to a brokerage firm, which then finds a buyer to purchase the stock. Because the stockbroker doesn’t know whether he’ll be able to find a buyer willing to pay more for the stock than the broker paid you, he must offset this risk by paying you less than what he’s hoping to receive when he resells the stock. The more volatile the stock, the lower the price the broker is willing to pay. The Bid/Ask Spread is the difference between what the broker paid you for the stock and what he sells the stock for to the next buyer. It’s similar to a markup you’d pay in a store: the store buys something wholesale then sells it to their customers at a marked-up retail price.