You can’t control whether stocks go up or down, whether interest rates rise or fall, or how fast the economy grows. But you can control a major factor that affects your bottom line: the amount you pay for investment products and services. Taking steps to reduce your fees may be among the easiest and most effective ways to improve your investment performance.
But beware of simply chasing low costs. “Like anything you buy, investment products cost money; however, it is important to look at the overall value provided for the services you want and need,” says Ram Subramaniam, president, Fidelity Brokerage Services. “Getting good value for your investment services can help improve your performance and ensure that more of your return ends up in your pocket.”
The fee structure of investment products varies, from annual percentage charges based on assets under management to sales loads, fees for service, and annual fees. All of them vary by provider, and all can have an impact on your returns. This article looks at a few different types of investment and cash management fees to show how they can affect you—but this is just a sampling. You should consider the costs of all your investment products.
Mutual fund fees
Mutual funds come in lots of different flavors. Fidelity’s brokerage platform offers more than 10,000 funds, including passive index funds and exchange-traded funds (ETFs) that attempt to track a basket of stocks found in an index, and actively managed funds that attempt to outperform the market. Just as the different funds offer different types of services, so, too, fees can vary widely.
Virtually all 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 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 companies, and ongoing portfolio construction, and may charge higher fees. But even within the universe of actively managed and index funds, there are significant cost differentials.
Expense ratios, however, 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 advisers 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 annual 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.
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 pay when buying stocks or ETFs.
These fees tend to be small in dollar terms, so you may simply accept them as a cost of doing business. But if you trade frequently or tend to trade small amounts, these costs may have an effect. For example, if you trade 150 times each year, the difference between a $7.95 commission and a $9.99 commission could total more than $300.
Like all these costs, commissions need to be weighed against value. When it comes to stock trading, one of the key differentiators is price improvement. 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. Many brokers will talk about price improvement and imply that a large percentage of shares receive price improvement. However, the detail you want to know is the dollar value per share of that price improvement. Some brokers are able to achieve a greater dollar value of price improvement than others by accessing dozens of competing market centers, among other factors. Along with commission, price improvement is an important consideration for traders.
Bonds aren’t traded on open exchanges the way stocks are, and compared with stock trades, they may have some less transparent charges. When you buy a bond on the secondary market, you pay the asking price as well as the markup—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. With new-issue bonds, the broker’s compensation is included in the face value, so you do not pay a separate transaction cost. But if you are buying a bond on the secondary market, it is important to consider the impact of bond markups on performance.
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 $300,000 across 300 bonds. Comparing a 1%-per-bond markup with a 0.1%-per-bond ($1-per-bond) markup equates to a saving of $2,700.
“Understanding bond markups 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 two percent and you’re charged a one percent markup, it could erase a significant portion of your income and total return.”
When investing on margin, you borrow money, using your portfolio as collateral, and invest it. The leverage created by the borrowed assets affects your performance either positively or negatively. But 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). Say you buy $20,000 of stock on margin, and hold it for 90 days. A difference of 0.675 percentage points on your margin rate—for example, a 7.25% rate rather than a 6.575% rate—would cost you more than $100 more over that three-month time frame.
Most banking fees may seem pretty minimal, but those costs can pile up. For example, the average ATM fee is close to $3; if you go to the cash machine every week, that could add up to more than $150 a year. A checking account may charge $10 a month, which quickly adds up to more than $100 a year, and when you add in minimum account balance fees, bank wires, and other service charges, cash management fees can quickly reach hundreds of dollars per year.
This is why it’s important to look at the fees you pay and make sure they are competitive.
It is also important to consider the credit cards you are using for purchases. Annual fees can rack up expenses, whereas rewards credit cards can offer important benefits—including saving on everything from airline travel to cash back for savings.
“Cash management products are increasingly competitive, with many brokerages and banks offering free ATM withdrawals, no account fees, and other discounts,” observes Subramaniam. “It makes sense for consumers to shop around for good prices on these services.”
Managing the risk of paying too much
Diversification is sometimes described as the only “free lunch” in investing—a way to 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 performance, service, and strategy 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 real goals.”
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917