The Killer Fees

Posted on: March 12, 2014 by Martin Curiel, CFA in The Efficiency Philosophy

This year, millions of Americans will spend countless hours looking for the best deal on cars, houses, TVs, detergent, bananas, and almost every other budget item imaginable. Companies like Groupon, Ebay, and Amazon have flourished partly due to our insatiable desire to find a bargain. When dealing with the topic of finance and investments, however, many individuals will not display the same level of intensity.  Getting the best deal on a mutual fund, insurance product, or financial advisor rarely spurs a Black-Friday-like line around the block.   But saving on investment-related fees could have a game-changing effect on one’s wealth over the long term. The chart below is a simple illustration:

As shown in the example above, a seemingly harmless 2% per year overpayment can wipe out nearly 50% of one’s ending wealth. For most individuals, such massive destruction of wealth is unlikely to happen by, say, overpaying for groceries every week or missing the Black Friday sale every year.

In this article, I present a framework for analyzing what I refer to as the “Killer Fees.” Although it is impossible to participate in the financial services industry free of charge, it is possible to fully understand the various expenses and opportunity costs incurred and to manage them effectively.

The Killer Fee Equation

“Beating the stock market and the casino are both zero-sum games, before costs. You get what you don't pay for.” – John Bogle, Founder of Vanguard

Let’s begin by developing a simple equation that attempts to capture all the fees that can be incurred when investing:

Total Fees =  

Advisor Fees
+ Product Fees
+ Underperformance Fees
+ Tax Inefficiency Fees
+ “Bad Behavior” Fees

Some of the components of the equation are explicit expenses, and others are opportunity costs. I refer to all of them as “fees,” since they have an equivalent effect on ending wealth. In the following paragraphs, I will summarize each component and provide some insight as to when an investor might be getting a bad deal. I will also share some best practices to manage each type of fee effectively.

Advisor Fees

Everyone needs to be paid for his or her time. Paying someone to help manage one’s financial affairs can be a wise decision, but overpaying that individual is always an unwise one. The purpose of an advisor should be to add more value than she costs in fees. That value could be in the form of minimizing an investor’s time, energy, or stress level spent on financial issues (so the investor can focus on other, more productive endeavors) or in helping minimize the other components of the Total Fee equation (so that total fees stay as low as possible). In our experience, we have seen many people blindly trust their advisor and never ask questions about how or how much is being paid for the service. Money is an emotional issue, and what is going on behind the scenes can appear rather technical.  Bottom lineAn advisor needs to earn his keep.

Signs of a bad deal.. Efficient Investors..
  • The advisor fees are “bundled” with other products and services.
  • The advisor fees are paid by the product provider, not the client, particularly through front-end/back-end loads.
  • There is never a straight answer when the investor asks, “What are you charging me?”
  • The advisor acts in a “Principal” capacity, charging a mark-up for the investments sold.
  • The advisor acts in an “Agent” capacity, making his or her money exclusively from trading commissions.
  • Hire fee-only advisors that only receive payment from the client or –avoid paying advisor fees by doing all the work themselves (assuming they have the time, expertise, and interest to do so).

Product Fees

Most individual investors participate in the financial services market through a mutual fund or similar product. At the basic level, a mutual fund will hire a team of smart, experienced, and talented professionals to invest money on behalf of many individual investors. The team members often make exorbitant amounts of money, which is not necessarily a bad thing if the team can deliver “abnormal” returns and can do so over the long term. However, as we have discussed in other articles, these teams (“Active Managers”) rarely beat their index-based counterparts, so the high product fees end up destroying value for most clients. Many financial advisors recommend actively managed mutual funds, for example, to show that they are diligent managers and strategists and/or because they get a commission from these product fees.  Bottom line: High product fees are not usually correlated with good long-term performance. 

Signs of a bad deal.. Efficient Investors..
  • Most of the investor’s mutual funds are actively managed funds.
  • The average product expense ratio exceeds more than 1%. (We prefer it not to exceed 0.2% unless there is compelling reason to do so.)
  • The financial advisor gets paid exclusively from the product fees.
  • select passive index funds (mutual funds and ETFs) that attempt to mirror broadly diversified markets.
  • use no-load funds

Underperformance Fees

Underperformance Fees represent the opportunity cost of investing in suboptimal strategies or products. For example, if an investor wants to buy into China’s growth potential, she has two basic options: a) invest in ALL Chinese stocks; or b) invest in a FEW Chinese stocks. The FEW option could mean selecting a mutual fund manager to pick a subset of Chinese stocks out of the larger universe of ALL Chinese stocks. The issue here is that when an investor is evaluating the mutual fund manager, she might only look at the total return to measure success. However, the most comprehensive analysis involves looking at relative returns; in other words, Did the FEW beat the ALL? In most markets and over the long term, the answer will almost always be NO, and thus the investor has incurred an Underperformance Fee. This category of fees is difficult to calculate and sometimes challenging to understand, but has an effect on wealth destruction equal to more explicit fees. Our detailed write-up on this subject can be found hereBottom line: A high return is not necessarily indicative of good performance. 

Signs of a bad deal.. Efficient Investors..
  • The advisor refuses to talk about relative performance, and emphasizes high absolute returns (like in 2013).
  • Investors/advisors buy the latest hot fund or product, citing high recent returns as the main reason.
  • The advisor recommends “combo” products that contain multiple asset classes and make it more difficult to calculate benchmark returns.
  • use passive strategies so that the Underperformance Fee is not an issue or is significantly minimized.
  • calculate Excess Returns (Underperformance Fees) at the strategy level and in aggregate.

Tax Inefficiency Fees

After-tax returns will always be more important than before-tax returns. The opportunity cost here is related to overpaying on federal and state taxes because of inefficient products, account structures, or decisions. Examples of inefficiencies include having all interest-bearing investments in taxable investment accounts (interest income is taxed at the highest marginal rates), holding all foreign investments in a 401(k) or IRA (where an investor cannot receive foreign tax credit), and not employing tax loss harvesting throughout the year. Our detailed article on the subject can be found here. Bottom line: The “Tax Man” is both your partner and your adversary in building wealth; you should understand how to manage him.

Signs of a bad deal.. Efficient Investors..
  • The investor gets a tax bill even though her performance was low — common in high-turnover mutual funds that distribute lots of capital gains at the end of the year.
  • The tax accountant doesn’t want to even bring up the topic of investing; the financial advisor rolls her eyes when the issue of taxes comes up.
  • The tax accountant only wants to talk about taxes once a year, when forms are filed and he can send an invoice.
  • integrate tax strategy with investment strategy throughout the year.

“Bad Behavior” Fees

Many individuals despise the idea of paying for a financial advisor. In some cases, we agree that it is most cost-effective to do everything yourself. However, there are instances when an advisor can be helpful. One of these is to prevent or at least manage what we term “Bad Behavior.” Even for those investors who have intimate knowledge of finance, taxes, and wealth management, it can prove difficult to do all that needs to be done. The investor might not have the time or might forget to do something critical. He or she might be susceptible to biases and other investor behavioral issues that can cloud judgment. Having a knowledgeable and objective third party who can execute the investor’s vision can minimize this bad behavior.  Bottom line: Doing nothing or doing something you are not supposed to can also be a destructor of wealth.

Signs of a bad deal.. Efficient Investors..
  • Cash has been sitting idle for over a year because the investor “doesn’t have time” to invest it.
  • The investor is constantly buying at the high and selling at the low (paying dearly for executing based on pure greed & fear).
  • The investor has over 20 diverse mutual funds and positions and has no idea what the overall return or allocation is.
  • understand themselves and when it is time to seek help.
  • have a few positions and understand how to evaluate their merits and risks.
  • outsource what they don’t have time and/or expertise to accomplish.

To summarize, fees are a necessary part of participating in the financial services industry. Whether the fee is an explicit expense (e.g., mutual fund expense ratio) or an opportunity cost (e.g., underperformance fee) is irrelevant when examining its ultimate effect on wealth. The goal should always be to minimize total fees as practically as possible. Understanding and managing investment-related fees will generally save more money and have a higher long-term impact on one’s wealth compared to other bargain-hunting activities, such as clipping coupons, bidding on eBay, or purchasing services on Groupon.

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.