Very little in life comes without a price and investing is no exception. Before you enter the investment market, you have to understand how fees work. Even if you’re a self-service investor, you’re probably paying fees to somebody. If you’re not careful, these fees can steal a serious amount of profit from your portfolio.
In the prospectus, you’ll find these fees expressed as an expense ratio. If the ratio is 1.6%, for every $1,000 you invest, you pay $16 per year. The general rule of thumb is not to pay more than 1% in fees. Be careful, expense ratios vary widely between investment products. Vanguard’s Admiral Shares, an S&P 500 index fund has an average return of 5% each year with an expense ratio of 0.05%. You only pay $5 for every $1,000 you invest. That’s a great deal! Most funds don’t come with fees that low.
Don’t judge an investment on fees alone but keep them in mind as you make decisions.
Mutual Fund Fees
If you have a 401(k) through your employer, it’s probably full of mutual funds. A mutual fund is a collection of something—often bonds or stocks that are managed by a team of financial professionals that you’re paying for their time. The SEC wants you to keep a close eye on the fees.
Sales loads are commissions paid to brokers who sell the funds. They’re usually passed on to the investor. FINRA, a governing body for financial advisers doesn’t permit sales loads higher than 8.5%. Most don’t charge that much but these load fees can be substantial.
Some funds call themselves “no-load” funds but keep in mind that they may still charge other fees—redemption fees, exchange fees, account management fees, etc.
Because investors have become more aware of fees, it’s not hard to find well-performing funds that have a minimum amount of fees. Most 401(k) offer low cost index funds. If you can’t find a fund without reasonable fees offered in your retirement account, go for the index fund.
Exchange Traded Funds
ETFs have become one of the most popular investment products in recent years. Simply, an ETF is a basket of investment products that often aim to capture the performance of something—normally an index. They trade like a stock—in real time and with normal commissions unlike a mutual fund. Instead of paying a load fee of 6% to purchase a mutual fund, for example, you might pay $10 to buy $100,000 worth of shares.
But that doesn’t necessarily mean that ETFs have lower fees than mutual funds. Because there’s a team of professions managing many of these funds, there are expenses pulled from the returns of the fund. Like mutual fund, passively managed funds—an S&P 500 index fund, for example, will have lower fees than actively managed funds.
No Fees Isn’t Necessarily Better
If you want zero-fee investment products, stick with stocks. Other than the commission you pay your broker, there are no hidden fees. The only thing you have to track is the price. Some brokers offer ETFs managed by their company that have zero commission to purchase and very little expense ratio but that doesn’t mean they’re better.
Some of these ETFs are thinly traded and have subpar performance. If you can pay a minimum fee and get better performance, that’s probably a good move.
If it’s a “fund” it probably has a fee. Dig into the prospectus to find out how the fund is paying its own expenses and keep those fees to a minimum. The conventional wisdom is below 1% but below 0.5% is even better, especially if you have a broker that charges 2% of your total account balance to manage your account. Over time, fees can take a large bite out of your returns.