Do you really know how much your investments are costing you? There is more to keep track of than performance, asset allocation and market exposure. Investors often pay more than necessary without realizing. I’m not referring to deceitful investments or Ponzi schemes. I’m talking about misunderstanding the layering of fees that you may be charged.
Let’s review a hypothetical client who recently came into our office whom we’ll call “James”. James is a successful business owner with an investment portfolio of around $2,000,000. Before coming in to meet with me, he provided statements to review his investments with his current advisor. James and his advisor had been working together for the last 10 years. Once or twice a year, James would get a call from his advisor and receive an update on his investments and performance. In conversation with his advisor, James was led to believe he was (only) paying a 1% annual fee, which is common for a fee-based relationship. James believed he was billed at a rate of 1% per year x $2,000,000 for an asset management fee of $20,000 per year. After reviewing James’ investment holdings, I made it clear to him that he was actually paying $55,000 a year in fees. As you could imagine James was shocked and horrified.
In a case like James, just how likely is it that an investor might unknowingly pay $35,000 more in fees on a $2 million account? Unfortunately, this lack of understanding is quite common for clients of large brokerage firms and registered advisors. Unlike the purchase of a home, car or other item with a clear price tag, investments that generate additional fees and commissions to advisors come in all shapes and sizes. Advisors are required to disclose all the types of fees he or she is charging a client, but far too often clients don’t read or understand what it says in the fine print. This misunderstanding and blind trust of advisors can very often lead to diminished returns over years that can dramatically affect your investment performance, ultimately leading you to fall short of your goals and objectives.
Let’s break down how James was paying an extra $35,000 per year:
1. Half of the investments were in mutual funds. I asked James if he was aware of this and he told me he was. On the surface, there’s nothing wrong with mutual funds. In fact, when you’re getting started with investing, mutual funds or Exchange Traded Funds (ETF’s) are a great way to diversify a portfolio without the need to purchase many stocks or bonds to achieve a reasonable level of diversification. However, very little in this life comes free. Mutual funds by nature have various share classes available to investors. Each share class of the same fund may have different ongoing expense ratios (which I will explain later) as well as a one-time “front-end load” or “back-end load”. In James case, his sales charges and expenses ranged from 1.00% to 5.75% depending on the investment amount in each of his various mutual funds. On average, the fees and expenses resulted in a cost of 2% which is taken from the investment value. ($1,000,000 x 2% load fees = another $20,000). That’s an additional $20,000 paid in fees and commissions. That’s 2% that could have been an increase in the value and retained by James!
2. In addition to the commission the advisor was earning on James’ mutual funds, mutual funds have expenses that are pooled from the fund and paid directly to the fund managers. These are referred to as “fund expenses” and “12B-1 fees”. Some mutual funds are highly complex and can charge nose-bleed high fees of 2% or more annually (note: these fees are payable to various mutual fund companies). In James’ case he had an average of 1% per year in expense ratios on his various mutual funds. James’ $1,000,000 in mutual funds reduced his return by $10,000 per year to pay for these fees.
3. I mentioned before that only half of James’s money was invested in mutual funds. That is because the other half was allocated to third party money managers (TPMM’s) otherwise known as separately managed accounts (SMA’s). TPMM’s or SMA’s are another useful platform for investors. These managers typically oversee a larger pool of money. TPMM’s are similar to mutual funds in that a third party is overseeing the investing, but what makes them unique is that rather than owning an undivided interest in a pool of assets, as you do in a mutual fund, you own the individual positions directly, which may make the investment more tax efficient. Using a typical TPMM for a $1,000,000 account has an additional layer of 0.5% in fees, which would have been disclosed in the fine print that was paid directly to the TPMM manager. That’s an extra $5,000 a year in fee’s that James misunderstood he was paying for!
If you add the cost of the load mutual fund fees, TPMM fees, and the costs incurred from the mutual funds expense ratio, the total adds up to $35,000 a year in “fees” that James did not realize he was paying.
As I previously mentioned, advisors are required to disclose any and all additional commissions and fees that their clients incur. Unfortunately, time and time again I meet with prospective clients who have not read the disclosures or do not understand the various types of fees they are paying and how much they ultimately cost them. In James’ case, instead of only 1% he had thought to be paying, he was spending 175% more than he realized. Imagine purchasing a home and discovering it’s 175% more expensive than you’d planned on!
The Latin phrase “caveat emptor” or “let the buyer beware” comes to mind. The onus falls on the individual client to dig in and determine exactly how he/she is being charged and if they are comfortable with those charges. A discussion between you and your advisor as to what works best for you and your investment goals is mandatory. You should speak with your advisor and read the disclosures they are required to provide which detail all the fees you are paying for your investments.
This discussion should also indicate any conflicts of interest the advisor may have that impact your relationship. Are there any conflicts that sway your advisor to make a recommendation that is not in your best interest and that benefits them more than you? You will want to understand how these conflicts impact your relationship and what they are doing to mitigate any conflict.
James’s “hypothetical” case is far too common and something I see on a regular basis. Finding the right advisor to work with can be difficult. Here are some suggestions that can make your search a little easier.
Start by working with a fiduciary. The term “fiduciary” has been thrown around a lot in recent years. What does fiduciary actually mean? In the context of the investment advisory world and the fees or products your advisor recommends, it boils down to this: Is your advisor putting your interests before his or her own?
Another common way to find help determine if your advisor is putting your interests ahead of their own is to work with a fee-only advisor. There are fewer potential conflicts with a fee-based advisor as they are not paid commissions and are not incentivized to trade your investments to increase their earnings. Most fee-only advisors will advise on broader aspects of a client’s financial life, in addition to their investments. Moreover, many fee-based advisors hold, industry certifications such as the Certified Financial Planner® (CFP®) designation. A CFP® is a professional planner rigorously trained in 72 areas of financial expertise who must accrue thousands of hours of experience prior to earning their certification. Certified Financial Planner are held to a high standard of fiduciary responsibility.
You don’t need to be the expert to choose the right financial advisor. Asking the right questions will go a long way. How they are compensated? What are their conflicts of interest? How many years have they been practicing? How do they measure success? The answers will help give you a better understanding and will let your prospective advisor know that you deserve more attention and are not just another client adding to their bottom line.
Avitas Wealth Management is here to help. Whether you’re interested in a complimentary consultation or would like to learn what makes Avitas unique, please reach out to us by email at info@avitaswealth.com or by calling our general line at 424-371-9010 where someone is here to answer your call weekdays from 6am to 5pm Pacific Time.
Another great resource to help determine if you are working with the right financial advisor is the National Association of Personal Financial Advisors (NAPFA) at http://www.napfa.org/HowtoFindAnAdvisor.asp. Learn more about fee-only advisors, or what it takes to be a fiduciary. You can also order a free booklet provided by NAPFA by calling 888-333-6659.
Written By: Amit Josef, CFP®