What Are Investment Fees?
Investment fees are fees charged to use financial products, such as broker fees, trading fees, and expense ratios. Investment fees are one of the most important determinants of investment performance and are something on which every investor should focus.
Over time,minimizingfees tends to maximize performance. However, it is important not to let fees dominate your investment decision-making process.
Key Takeaways
- Investment fees are fees charged to use financial products, such as broker fees, trading fees, and expense ratios.
- Investment fees are one of the most important determinants of investment performance and are something on which every investor should focus.
- While minimizing fees tends to maximize performance over time, it is important not to let fees dominate your investment decision-making process.
- Certain investment products inherently carry high fees, such as derivatives and other more esoteric assets.
- Some asset classes tend to have lower fees, like indexed ETFs and bond funds.
Understanding Investment Fees
It is easy to forget about fees when focusingon other important subjects, such as asset allocation or security selection. However, in addition to the overall market movements and an individual's stock-picking abilities, the level of fees paidis one of the most important determinants ofperformance.
The numbers below assume you contribute $3,000 to your retirement account in year one. Each year, as your salary increases, you increase your contribution by $250. So in year two, you contribute $3,250, in year three you contribute $3,500, and in year four you contribute $3,750.
Youcontinue to gradually increase your contributions for the remainder of your career (30 years) and earn an 8% annualized return on your diversified portfolio. Although you earn 8% gross returns, your net return will be reduced by the amount of fees you pay. The higher the fees, the lower the return you actually receive.
The only difference in the investment programs in the chart below is the level of fees—everything else is identical. Look at the difference in the amount you end up with at retirement, depending upon how much you pay in fees each year:
| Gross Return | Fees | Net Return | Account Value Without Fees | Account Value With Fees | Amount "Lost" Due To Fees |
|---|---|---|---|---|---|
| 8.00% | 0.50% | 7.50% | $648,118.44 | $596,477.60 | ($51,640.84) |
| 8.00% | 0.75% | 7.25% | $648,118.44 | $572,454.51 | ($75,663.93) |
| 8.00% | 1.00% | 7.00% | $648,118.44 | $549,551.41 | ($98,567.03) |
| 8.00% | 1.50% | 6.50% | $648,118.44 | $506,887.81 | ($141,230.63) |
| 8.00% | 2.00% | 6.00% | $648,118.44 | $468,078.69 | ($180,039.75) |
A common retirement goal is to be able to withdraw between 3% and5% of an investment portfolio each year during retirement. In the scenario above, if two individuals invested throughout their careers in a similar manner, but one person had paid 0.5% in fees and the other had paid 2%, the difference in their annual income during retirement would be more than $5,000 each year.
That means one person would have $420 less each month, just because they had paid excessive fees on their investment portfolio during their working years.
Investment Fees Example
While it is not always necessary to aim for the lowest possible fees in a portfolio, it is generally a good idea to select investments and investment providers that fall within a certainrange. With that in mind, the matrix below demonstrates some typical fees. (Note: the fees in the matrix below are indicative and are intended to serve as a starting point for further research and analysis.)
| Online Brokers | Stock Trade ($) | Option Trade ($) |
|---|---|---|
| Brokerage 1 | 8.95 | 8.95 + 0.75 per contract |
| Brokerage 2 | 7.99-9.99 | 7.99-9.99 + 0.75 per contract |
| Brokerage 3 | 7.95 | 7.95 + 0.75 per contract |
| Brokerage 4 | 9.99 | 9.99 + 0.75 per contract |
| Brokerage 5 | 7.00 | 7.00 + 1.25 per contract |
| ETFs | Issuer X | Issuer Y |
|---|---|---|
| S&P 500 Index | 0.06% | 0.09% |
| Small Cap Index | 0.17% | 0.28% |
| U.S. Bond Index | 0.11% | 0.24% |
| EAFE Index | 0.12% | 0.35% |
| Emerging Market Stocks | 0.22% | 0.69% |
| Commodities | 0.75% |
| Mutual Funds | |
|---|---|
| S&P 500 Index Fund | 0.17% |
| Large Cap U.S. Stocks Average | 1.13% |
| U.S. Small Cap Index Fund | 0.31% |
| Small Cap U.S. Stocks Average | 1.40% |
| U.S. Bond Index Fund | 0.22% |
| Intermediate-Term Bonds Average | 0.94% |
| International Large Cap Stock Average | 1.37% |
| Emerging Market Stocks Average | 1.69% |
High Fee Investment Types
There are certain types of investment products that inherently carry high fees. Generally speaking, the more esoteric an asset class, the higher the fees you will pay.
For instance, frontiermarket mutual funds generally carry higher fees than U.S. large-cap stock funds, commodity ETFs usually carry higher fees than an ETF trackingthe EAFEIndex of large-cap international stocks, and purchasing a corporate bond from Brazil will have higher fees than a U.S. Treasury bond.
Many derivativescan also carry high fees. While standardized options contracts and futures contracts can havereasonable and transparent fees, products such as equity-linked notes are notorious for their opacity and high fee structure.
Investment TypesWith Low Fees
Just as some asset classes gravitate towards high fees, some assets are geared towards low fees. Indexed products such as ETFs and index mutual funds usually offer relatively low fees and are therefore attractive to value-conscious investors. There are often alternatives available from several providers to evaluate (e.g.multiple S&P 500 index funds.)
Fee-conscious investors should pay careful attention to one particular type of mutual fund: those that carry front-end load charges, which can be up to5.5% of the investment amount.
Since the products are all essentially the same, the level of fees is likely to be the main source of diverging returns in the future; therefore, it really pays to select the lowest cost provider for indexed products. Remember, in general, the more mainstream the asset class, the lower the fees, and vice versa.
Fee-conscious investors should pay careful attention to one particular type of mutual fund. Although mutual funds as a wholeare not inherently expensive, some of them carry front-end load charges up to5.5% of the investment amount.
This initial hit to your principal makes it very difficult to outperform the market going forward. Many financial professionalsrecommend never buying any mutual fund carrying asignificant sales charge since similar alternatives are often available without it.
The Bottom Line
If you do decide to purchase funds with a front-end fee, make sure you research the fund thoroughly to determineyou are getting sufficient value (in the form of expected future performance) in return for paying the fee.
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