Do You Know What You’re Paying for Your Investments?

Investment fees have received heightened attention recently, especially in light of the Supreme Court ruling on 401(k) plans this past May.  In Tibble vs. Edison International, the Supreme Court unanimously ruled in favor of the Edison employees, who brought a class-action law suit against their employer essentially for offering mutual funds in its retirement plan with unnecessarily high fees.  Mutual funds can have a variety of different kinds of fees, some of which are harder to discern than others, and mutual fund companies do not always have an incentive to present their fees clearly.  In this post, we present the most common types of fees and our perspective on them below. 

Front- and Back-End Loads.  Some mutual funds charge a commission or sales charge, otherwise known as a front-end load, when an investor buys its shares.  Others charge a back-end load (or, contingent deferred sales charge) when an investor sells shares. This charge often declines as time passes from the date of purchase and may disappear completely after holding the shares for approximately 5 to 7 years, but such funds will generally charge higher ongoing expenses (in the form of 12(b)-1 fees, see below) until the 5 to 7 year waiting period expires.  Front- and back-end loads often range from 3% to 8% of the amount of your investment. 

Trade Fees.  To buy or sell a mutual fund through a discount broker, an investor must generally pay a fee for each trade (e.g. at the brokerage we typically use, TD Ameritrade, the fee is $24/trade).  The broker receives this fee.

12(b)-1 Fees.  Sometimes referred to as hidden loads, 12(b)-1 fees cover the distribution and marketing costs for a mutual fund and generally range from 0.25% to 1% per year.  The SEC announced in the spring that they were investigating the use of these fees given that mutual fund companies sometimes use them in seemingly duplicitous ways.  For example, many funds advertise No-Transaction-Fee (NTF) share classes but then charge 12(b)-1 fees on those investments, which often exceed the amount of transaction fees that a custodian would have collected for trades of those shares.  For example, for a $25,000 investment, a 0.25% 12(b)-1 fee would mean that the investor pays $62.50 per year in fees, regardless of the number of trades.  For buy and hold investors, this will far exceed the amount that they would pay in $24 trade fees over time.

Management Fees.  Management fees are charged annually to cover the administrative costs of operating a mutual fund.  These can range from as little as 0.05% of the value of your investment to 2% or more per year.  The amount of the fee depends largely on the fund company, the type of investment strategy, and the type of assets in the fund.  For example, passively managed funds, especially those tracking a stock index, will generally have lower management fees than actively managed funds; funds investing in U.S. equities will have lower fees than those investing in international markets; etc.

Our Perspective on Fees.  Some investment managers try to justify load funds or high management fees by suggesting that their strategy will somehow earn above average returns as compared with the market and will do so consistently over time.  However, as we discussed in a prior post, the odds are not in these managers’ favor.  Their strategies generally rely on some form of market timing, and, as Vanguard founder John Bogle once observed, “In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently…. [T]rying to do market timing is likely, not only not to add value to your investment program, but to be counterproductive.”  At PFS, we started out using more expensive, actively managed funds, but after a short period of that experience, we decided that we would rather invest in a diversified portfolio using low-cost funds, rather than throwing away clients’ money on extra fees without gaining additional value over the long term.  The funds that we use only charge management fees, and they are quite low as compared with industry standards (e.g. DFA U.S. Large Company fund has an expense ratio of 0.08%, DFA Large Cap International fund has an expense ratio of 0.28%).

As economists like to point out, there is no such thing as a free lunch.  If you are investing your assets, you are paying some sort of fee or transaction cost.  Make an informed choice regarding the fees you pay and what you receive in return.