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The editors of Fidelity Interactive Content Services (FICS) selected this content because it offers valuable information for investors.

How low costs can drive returns

Investors looking for an advantage may do well to seek out lower expenses on brokerage products.

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Key takeaways

  • Costs compound over time, so the lower costs are, the greater potential impact on your portfolio's performance.
  • Consider cost and value for trades, margin, and other investment products.
 

Active investors are said to always be looking for an advantage: new information, a new perspective, or a new strategy that can help boost investing returns. There is one place you can get an advantage that comes with certainty—if you pay less to execute your investment strategy, you will improve your bottom line. That's why taking steps to reduce your fees may be among the easiest and most effective ways to improve your investment performance, particularly for active investors who regularly make changes to their portfolio.

"It pays for investors to seek out value," says Ram Subramaniam, head of brokerage and investment solutions at Fidelity. "If you can get quality service, research resources, and the trade execution you need for a lower cost, it can help improve your performance and ensure that more of your return ends up in your pocket."

Fees matter

For investors, saving on investment transactions and products can have a significant impact over time. If you choose to invest the amount you have saved on fees, that gives you more capital to invest, and the potential to compound the savings through your investments.

Consider this hypothetical example. An investor who trades 100 times a year changes brokers to save $5 on each trade, and also get better execution, saving an extra $1.50 per trade through price improvement. Let's say this investor was trading in a tax-deferred IRA and earning a hypothetical annualized return of 7%. If they reinvested all the savings over 10 years, the savings, and investment returns on those savings, would be worth more than $9,000 before taxes (see chart).

This article looks at a few different types of investment fees to show how they can affect you—but this is just a sampling. You should consider the costs of all your investment products.

Stock commissions

Investors buying and selling individual securities are exposed to commissions and other fees that accompany these transactions, such as the flat per-transaction fee or percentage-of-assets commission they may pay when buying stocks or exchange-traded funds (ETFs).

These fees tend to be small in dollar terms, so you may simply accept them as a cost of investing. But if you trade frequently or tend to trade small amounts, these costs add up and can have a noticeable effect on your investment returns. For example, if you trade 100 times each year, the difference between a $4.95 commission and a $9.95 commission would total $500 annually.

Along with commission amounts, active investors should look for value—that means consider the quality of trade execution. Price improvement is an important consideration for traders. Here's how it works: Brokers will send an order to an exchange, electronic communication network (ECN), or other market for execution. If a sell order executes at a price higher than the best bid listed, or if a buy order executes at a price lower than the best offer listed, it is considered price improvement.

One way to measure price improvement is to focus on the percentage of trades receiving price improvement. But it may be more meaningful to consider the average price improvement per trade, as that statistic reveals the true financial benefit from price improvement. Even if a large percentage of trades are price improved, the average price improvement per trade may be relatively small. It makes sense to consider both the average price improvement per trade and trading commissions when evaluating overall cost.

Options contracts

When you trade options, most brokers apply an additional charge per contract to the standard trade commission. That extra cost may appear small, but even saving a small amount can add up over hundreds or thousands of contracts.

Margin rates

When investing on margin, you borrow money, using your portfolio as collateral, and invest the money you borrowed. The leverage created by the borrowed assets affects your performance either positively or negatively. Costs can play a significant role in these transactions.

You pay interest on the loan, of course—and the higher the interest, the less of any gain you get to keep (or the greater your loss will be). Margin fees often vary based on the loan balance, and the broker. As of December 2018, the lowest published retail margin rates available at major brokerages ranged from 5.50%–7.50%.*

Bond markups

Bonds aren't traded on open exchanges the way stocks are, and compared with stock trades, they can have some less transparent charges.

When you buy a bond on the secondary market, some brokers include a "markup" in the selling price—a transaction cost that is the difference between the price a broker-dealer pays for a bond and the price at which it is sold to you. Other dealers, such as Fidelity, display secondary bonds with their prices as they receive them from traders and add a concession to the offer price. With new-issue bonds, the broker’s compensation or fee received for distributing the bonds is included in the face value and paid for by the issuer, so you, the investor, do not pay a separate transaction cost.

Bond markups vary by issue, order size, and broker. The markups can be small amounts, such as 0.1%, or more significant—in some cases, more than 2% of a bond’s face value. Making matters tougher for investors is the fact that certain brokers bundle this fee with the quoted bond price, making it hard to evaluate how much you are paying your broker. If these fees are large, they can take a big chunk out of your returns. Say you set up a bond ladder, investing $500,000 across 20 bond issues in $25,000 allotments. A 0.1%-per-bond ($1-per-bond) markup, compared to a 1%-per-bond markup, equates to a savings of $4,500.

"Understanding bond markups and how much you are paying the broker is very important, particularly in today's bond market," says Richard Carter, Fidelity vice president of fixed income products and services. "If you are buying a bond that yields 2% and you're charged a 1% markup, it could erase a significant portion of your income and total return."

Mutual funds and ETFs

Stock mutual funds come in lots of different flavors, including passive index funds and ETFs that attempt to track a basket of stocks in a particular index, and actively managed funds that attempt to outperform an index. Just as the different funds offer different types of services, fees can vary widely too.

Virtually all mutual funds and ETFs include an annual fee for investment management. They also charge for other services, such as recordkeeping, taxes, legal expenses, accounting, and auditing. Some funds also charge a marketing fee. All these expenses are included in the expense ratio, which is published in the fund’s prospectus.

Typically, index funds and passively managed ETFs charge lower fees, and attempt to re-create the performance of a benchmark index by holding a basket of stocks. Actively managed funds attempt to perform better than their benchmark through analysis of individual stocks, and ongoing portfolio construction, and may charge higher fees. But even within the universe of actively managed and index funds, there are significant cost differences. Expense ratios may not capture all the costs investors should consider when selecting funds. There are a few costs that are not included in the expense ratio—including sales charges, or "loads," that are paid when you first buy a fund, which are often used to compensate advisors for their advice. Some funds also charge deferred sales charges and redemption fees.

How much do fees matter? A fund's expense ratio is subtracted directly from its return, and because costs compound the same way earnings do, even small differences in price can make a big impact over time. At the same time, performance has the potential to more than offset differences in cost, so you should consider expenses within the context of the performance you expect.

Managing the risk of paying too much

Diversification is sometimes described as the only "free lunch" in investing—a way to potentially reduce volatility without necessarily sacrificing returns. However, this is not quite accurate: You can do the same by managing costs. Being mindful of fees and other expenses in your investment process can make a considerable difference in your overall return and in your ability to meet financial goals.

"Investors have to weigh service, strategy, and performance potential along with cost when choosing products and services," says Subramaniam. "But it makes sense to consider value too—because anything you save on fees can be put to work in achieving your investment goals."

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