Investing includes a variety of fees and expenses depending upon the investment approach and underlying investments being used. In general, fees refer to management costs that are deducted from an account, and investment expenses are internal administrative costs paid by those using funds. I refer to management fees as 'above the line' costs because they are listed in the transaction section of statements whereas investment expenses are 'below the line' internal costs that aren't shown on statements.
Management Fees
Above the line fees include management fees, advisory fees, and platform fees. These direct costs are periodically deducted from an account and based upon a % of the assets under management (AUM). You can find management related fees in the transaction section of account statements. Management agreements and investment policy statements should also disclose management related fees.
- Managementfees are charged by portfoio managers and advisors for managing your investments. Typical annual rates: .05% to 1% of assets under management (AUM).
- Advisory fees are charged by financial advisors to facilitate the investment management process. Typical range: 0.5%–1.5% annually.
- Platform/Account fees are maintenance or account service fees charged by brokerages or investment platforms. Typical range: .04%-1% annually.
- Combined Fees. Advisory, management, and platofrm fees are commonly combined as a single management fee that is deducted from an account quarterly. Typical range for a combine fee is 1% for passive core strategies and up to 2% for custom strategies.
Investment Expenses
Below the line investment expenses include the cost of investing in various types of funds. Fund expenses refer to operational costs expressed as an expense ratio, and trading costs. Both costs are reflected in the net asset value of the fund.
A fund's expense ratio represents the percentage of a assets used for administrative, operational, and management expenses. E.g. and E/R of .5% means the fund investor is paying the fund manager .5% a year to run the fund.
- Fund management costs include compensation for fund managers or team overseeing the portfolio.
- Administrative expenses include the cost of day-to-day operations, such as record-keeping and investor communications.
- Marketing/Distribution fees (12b-1 Fees) include costs for promoting the fund and servicing shareholders (common in mutual funds).
Lower expense ratios are generally found in passive investments like ETFs and Index Funds.
- Passive funds (e.g., index funds): 0.05%–0.25%
- Active funds: 0.5%–2%
Trading Costs are incurred by a fund or manager when buying or selling assets in the portfolio (e.g., brokerage fees, bid-ask spreads). Frequent trading (turnover) can increase these costs significantly. E.g a fund that trades (turns over) 100% of its positions every year has greater trading costs than a fund that only turnsover 20% of their investments each year. While difficult to find and even more difficult to calculate, trading costs are usually disclosed in a fund's Statement of Additional Information form that may accompany a fund's prospectus. Total Trading Cost may be estimated by multiplying the Turnover Ratio by the Bid-Ask Spread plus the Market Impact Cost. E.g. Total Trading Cost=Turnover Ratio×(Bid-Ask Spread+Market Impact Cost)
Indirect Costs
Management fees and investment expenses impact return but the total cost of investing also includes indirect costs that reduce your net return as much if not more than direct expenses.
Opportunity Costs: Cost-conscious investors often ignore the opportunity cost of inferior management. Ask yourself, hypothetically speaking, would you rather pay no fee and get a 5% net return, pay a 1% fee and get a 7% net return, or pay a 2% fee and get a 10% net return? Financial gurus will often imply that restricted management is best, but performance is a function of management. Savvy investors know that the opportunity cost of inferior performance can and often does dwarf the direct cost of management fees and investment expenses.
This is because investment statements don't document inferior results and investors are rarely provided the information needed to monitor the quality of their investment management process.
Tax Drag. Tax errosion is often ignored but can reduce taxable return around .
When evaluating investment options, investors typically look at pre-tax returns, net expense ratios, fund size, active share, portfolio turnover and similar statistics. But taxable investors tend to overlook the figures that have as big or bigger impact: the amount of return surrendered to taxes and the actual after-tax returns. The return lost to taxes is often a higher number than management fees and the stated expense ratio combined. You could say that it serves as an additional fund expense for the benefit of Uncle Sam.
Taxable accounts (borkerage, personal, joint, trust accounts) typically generate taxable gains, dividends, and interest. How much tax you pay affects your net returns. A 10% return, for example, may become a 7% net return after taxes are paid on the gains, dividends, and interest earned. Tax efficient investments can help to reduce your tax liability and tax management can further reduce your annual tax burden with tactical accounting techniques like loss harvesting.
Investment management is a process involving specific steps and practices, and if you skip steps or shortcut the process you reduce retuns and increase risk. Long term resuls are a function of effective process management, and prudent investors seek the highest quality management for the least cost possible. The fact is, restricting or inbiting management can reduce costs AND inhibit net results.
To do this an investor needs a basic understanding of the investment management process. Without this knowledge cost-conscious investors will find themselves steping over dollars to pick up pennies.