It’s hard to believe, but many investors still have no idea how much they really pay every year for investment advice. What’s even worse? A lot of advisors don’t know (or perhaps more accurately, don’t want to know) either. Here’s how to put an end to this nonsense.
First, let’s dispense with the pervasive unicorn fallacy: there’s no such thing as cost-free investing. Frictionless trading doesn’t exist and even low-cost evangelist John Bogle of Vanguard won’t work for free. Now that we’ve put that behind us, you simply need to answer three questions: 1.) What am I willing to do myself? 2.) What are the unbundled costs of services? and 3). Am I unwittingly paying for any of these services more than once?
Second, every investor should understand that fees for investment advice fall in three basic categories: planning fees, management fees, and transaction fees. Whether applied individually or bundled, paid to one firm or parceled out to multiple firms, investors should bear in mind it’s always the total cost of advice that matters most. Not to put too fine a point on this last remark, but it’s worth repeating: It’s always the total cost of advice that matters most.
Let’s examine the costs of each component.
Transaction fees are brokerage commissions, SEC fees, and sales charges associated with the purchase and sale of individual stocks and bonds, exchange traded funds (ETFs), or mutual funds. These fees are activity based and go to compensate the salesman or offset advertising or other distribution related expense. Mostly, they go to compensate the salesman. Executing trades on behalf of a retail or institutional client requires a broker licensed to conduct business in the state in which the business is transacted. If there is a lot of activity, for example activity tied to a proprietary trading strategy, transaction fees can be significant. More passive strategies like buy & hold or indexing typically require lower activity to maintain and consequently are more economical. This does not however, imply passive strategies provide superior returns vs. active strategies. There is great debate around this point, and frankly, we’re not going to settle it here. Finally, when thinking about transaction costs, keep in mind that many “no-load” mutual funds carry trailing fees paid to the salesman or contingent deferred sales charges that could get triggered if you fail to maintain your investment for some minimum holding period. In simple terms, transaction fees are the costs associated with acquiring and disposing of investment holdings.
Estimated annual transaction fee: $1-$2 per $1,000 of market value
Management fees on the other hand are the fees paid to a portfolio manager to research individual securities, construct diversified portfolios, and monitor/adjust holdings according to a pre-defined investment policy statement and changing market conditions. More often than not, these positions are staffed by a Chartered Financial Analyst (CFA). Portfolio managers are typically employed by mutual fund companies to manage pooled investment vehicles or by registered investment advisors (RIAs) to manage segregated accounts for individual clients. Investors using large category domestic index funds will experience lower management fees as these products are mechanically administered. Investors employing active strategies (i.e. strategies that attempt to outperform the general market) or whose portfolios include alternative investment strategies like hedge funds, private equity, pooled commodities, or foreign currencies should expect to experience slightly higher management fees. Along with custodial fees, audit & legal expenses, portfolio management fees represent your cost of maintaining (vs. acquiring) a mutual fund or portfolio of individual investments.
Estimated annual management fee: $4-$5 per $1,000 of market value
Planning fees are the cost of advice associated with developing a personalized and thoughtful strategy around available resources, savings habits, asset protection, preferred consumption patterns, attitudes and tolerance regarding risk or volatility, time horizon, and final distribution of assets to your heirs…all in the presence of taxes and inflation. The financial planning fee may also includes elements such as a detailed implementation plan or ongoing services such as monitoring performance to plan, periodic rebalancing, and extended reporting. This role is firmly in the territory occupied by a Certified Financial Planner (CFP). Unlike the ancient Chinese proverb that counsels “the journey of a thousand miles begins with a single step”, a CFP thinks it always begins with a map.
How much planning you want or need is subjective and often boils down to a matter of personal preference. Just getting started and need to map out a plan for accumulation? A flat fee plan or hourly service plan may be all you need. On the other hand, a C-Level executive with stock options, deferred compensation issues, disability insurance questions, multiple homes, and 2 kids heading to her Ivy League alma mater probably requires a more labor intensive financial plan when contemplating a career move or an early retirement offer.
Estimated annual planning fee: $5-$7 per $1,000 of market value
Do these estimates represent the lowest cost way to obtain advisory services? Not by a long shot. Using a computer assisted investment service like Schwab Intelligent Portfolios or Betterment in combination with low cost index funds like Vanguard, a confident self-directed investor having relatively straight forward needs could get the entire job done at a total cost somewhere between $4-$5 per $1,000 of market value. If that represents the baseline price of advice, then the total cost of complex fully outsourced advice really shouldn’t ever exceed $14 per $1,000 of market value.
Don’t know where you stand? Ask. A fiduciary advisor will easily be able to provide accurate figures for each of the respective categories, disclose exactly who is receiving those fees, and identify any potential for conflict of interest. Ideally, this should all be done on the front end of any engagement. Any time the total cost seems too high or you simply can’t figure out exactly how much (or who) you are paying ought to raise red flags – and leave you wondering if the advice is actually worth the price.
Michael Reid, CFA is a Managing Director and Partner at Exchange Capital Management who has been accused of practicing extreme thrift. Mostly this stems from his occasional viewing of YouTube videos on how to cut your own hair. The opinions expressed in this article are his own.