Whether for our own entertainment, our children’s, or our grandchildren’s, I believe it’s safe to assume we’ve all seen Shrek by now. As it turns out, the core concept of Shrek’s famous onion analogy (below for your reference/enjoyment) can be extended into the world of investing rather directly.
Shrek: For your information, there’s a lot more to ogres than people think.
Shrek: Example? Okay, er… ogres… are… like onions.
Donkey: They stink?
Donkey: Or they make you cry.
Donkey: Oh, you leave them out in the sun and they turn brown and start sproutin’ little white hairs.
Shrek: NO! LAYERS! Onions have layers. OGRES have layers. Onions have layers… you get it. We both have layers.
Donkey: Oh, you both have layers. You know, not everybody likes onions. CAKES! Everybody loves cakes! Cakes have layers!
Whether you are an experienced investor or just getting started, it is vital that you understand what you’re paying for advice and your investments. It is important that you continue to evaluate these costs over your investing lifetime as they change frequently, and new alternatives/strategies emerge.
Here I will outline the common “layered” costs investors encounter in our modern environment and provide a bit of commentary on which are most valuable and which are to be avoided.
Asset-Based Investment Management Fees
Definition: Fees charged as a percentage of assets managed by your advisory firm.
Commentary: This is becoming the most common model for financial advisors – particularly registered investment advisors. Typically, fees start between 1%-1.5% and are reduced on a tiered scale based on the amount of assets managed. You’ll want to discern whether your asset-based fees purely cover your investment management or if these fees also provide for auxiliary services (namely financial planning). Both structures are common, but it goes without saying that you get the most bang for your buck in the case that asset-based fees cover both.
In my opinion, this model serves clients best because the fees paid are directly tied to how well their investments perform. Clients will still encounter other costs (detailed later), but on a regular basis, expect these to be your primary expense.
Definition: A service charge assessed by an investment advisor for recommending and handling the purchase and/or a sale of an investment.
Commentary: Commission-based service models are the primary alternative to Asset-Based Management Fees. While still common (especially with traditional stockbrokers), these models are losing favor as the investment advisor’s interests are not directly tied to the performance of the client’s investments, nor are the brokers bound to select the investment that best meets the client’s unique needs. Commission-based advisors also rarely provide financial planning related services without additional charges.
Definition: Tax liability created by the purchase, sale, and re-characterization of investment assets.
Commentary: When investing after-tax dollars, a certain level of tax liability is inevitable thanks to distribution of dividend income, interest income, and capital gains. It is important to work with your investment advisor to understand their tax management strategy. Investment managers that trade more frequently often incur larger tax liabilities for their clients. Conversely, many managers employ strategies (tax-loss harvesting, capital gain budgeting, asset location, etc.) to mitigate tax liabilities. Be sure that your investment managers tax strategy aligns with your expectations and objectives.
Ad Hoc Service Charges
Definition: Additional fees charged by an advisory firm for services beyond pure investment advice and management (financial planning, tax planning, estate planning, insurance evaluation, etc.).
Commentary: As I mentioned earlier, these services are frequently included in an advisory firm’s asset-based fees. However, when assessed separately, they can add-up quickly.
Definition: A flat fee assessed by the brokerage institution for the purchase or sale of an investment on a per trade basis.
Commentary: Over the past several years, trade fees for individual stocks and many ETFs have been largely reduced or eliminated (reducing the negative impact of frequent trading by investment managers). Still, trade charges remain for most mutual fund transactions and for all investment assets at some smaller institutions.
If you are paying for an investment manager whose strategy employs assets that still incur additional trade fees, you may wish to re-evaluate the value they provide. It may be that you remain satisfied, but this “layer” of fees is not an unavoidable one.
Investment Expense Ratio
Definition: The percentage of an ETF or Mutual Fund’s (excluding individual stocks and bonds) underlying assets used to cover the cost of managing (administrative, trading, operating and marketing) the investment itself.
Commentary: These fees vary widely. While larger mutual funds often feature fees well below 1%, the most expensive funds can charge well beyond 10%. Be sure to take account of the expense ratio of any mutual funds and ETFs held in your portfolio.
While there are excellent arguments for the value provided by these types of investment products, when overlayed with investment manager fees, that value can be diminished very quickly.
Load Fees (Front-End and Back-End)
Definition: Commissions assessed directly by the investment fund managers for the purchase or sale of their investment products.
Commentary: Much like trade fees, load fees are becoming rare. Barring a uniquely attractive opportunity, I recommend that you avoid investment vehicles that charge load fees.
Definition: A broad group of fees charged by account custodians (banks, brokerage firms, etc.) for the “maintenance” (and often closure) of investment accounts. The custodian is the firm that actually holds your assets.
Commentary: These fees are typically both nominal and unavoidable. Nevertheless, you should always take note of any miscellaneous fees charged to your investment accounts by the custodian. To the extent you encounter fees you feel are too high, reach out to your investment manager or account provider – on occasion these fees can be waived as a courtesy.
With a better understanding of the potential costs associated with your investment portfolio, you should be better equipped to evaluate and maybe realign your strategy to better serve your needs and preserve your resources. Are the costs you pay a layer of the “cake” that you don’t mind eating or is your investment portfolio a bitter onion layered with fees that won’t efficiently drive toward your unique goals?
If you’d like some help evaluating your current costs, we, at Buckhead Capital, are more than happy to determine just where you stand and identify exactly where you may be able to make some improvements.