The concept of paying fees for service is certainly not unfamiliar to anyone. It might be seen as burdensome, but when value is received and it’s understood what’s being paid for, it’s a cost most people are willing to pay.
Fees are clearly noted on any number of bills, including those from your cable company, your wireless provider and your municipality (property taxes). Some fees, however, are hidden within the cost of the service, so you can’t see what you’re paying for and how much you are being charged; this practice is rampant among investment professionals, unless you work with a fee-only advisor.
Fee-only advisors collect their fees directly from clients, which means they are clearly disclosed. This ensures objectivity and incentivizes financial advisors to recommend investments that will best serve their clients.
Unfortunately, most of the industry doesn’t work that way. Advisors who work under the traditional fee-based model are often swayed by incentives funds offer them to send clients their way, and even more galling is the fact that they have gotten really good at hiding fees, so investors have no idea what they’re paying for and how much they’re paying.
Let’s take a look at the sources of these fees:
Fund management fee
This is usually 0.5-2% of a client’s assets. The average management fee is 1.8%, but an index fund may charge as little as 0.2%. This might not seem like a big difference, but over time it can really mount up.
Advisors typically get 5-10% of what their clients invest. At the high end, that means a $100 investment is really only $90, and you can see how that can add up as the dollars invested rise.
This is the difference between what was paid for a stock or bond and what it was sold for, and it’s a major source of income for brokers. For instance, you may be sold a $1 million municipal bond portfolio that the brokerage paid $900,000 for—so its gain was $100,000.
Market impact cost
This hidden cost occurs due to the fact that when you sell shares, their price goes down. Conversely, when you buy a stock or bond, you push up the price. Thus, in a herd mentality, which is all too common, prices move away from you as you buy more—offering more opportunities for brokers to profit. (Incidentally, as shares get scarce, spreads get wider, too, worsening the problem.)
Financial advisors who represent hedge funds have really insulated themselves from risk while taking a big chunk of your investment. They typically charge a 3% management fee and also take 30% of any upside—but are immune from any downside.
How can you figure out how much you’re paying in fees? You can pretty much triple your management fee to determine the overall fees you’re paying to your advisor and the brokerages. That figure is often 3% or more, which can be a significant outlay, especially when you don’t know what you’re getting for it.
In my next article I discuss Knowing What You’re Paying For!
Other posts from Christopher Van Slyke
In my previous article, Investment Fees – The Hidden Cost, I discussed the sources of fees that clients unwittingly...