An important aspect that investors need to consider are fees and other costs related to investing. There are fees that are well disclosed and easy to understand (e.g., annual maintenance fees) and there are fees that are hidden inside investment products (e.g., expense ratio). One thing all fees have in common is that they can substantially reduce the return on investment, in particular over the long term.
Account maintenance fee
Account maintenance fees are the most basic form of investment fees. They are usually charged monthly or annually at a fixed price. A positive aspect of account maintenance fees is that they are predictable, which allows investors to easily evaluate the impact on their investment returns. Furthermore, because of their fixed-price nature, the impact on the overall return decreases with the increase of the account balance.
Most online self-directed brokerage accounts (taxable accounts and IRAs) do not charge account maintenance fees anymore. Today they can be mainly found with employer-sponsored defined-contribution plans (e.g., 401(k) and 403(b)).
Account management and advisory fee
Account management fees, or sometimes called advisory fees, are fees that are charged based on a percentage of assets under management (AUM) - that is, your account balance. In contrast to fixed-price account maintenance fees, the negative impact of percentage-based account management fees does not decrease with the account balance, but due to the effect of compounding even increases over time. We will discuss the effect of compounding later in this article.
Account management fees are mainly charged by brokerage accounts that are managed by a financial advisor, which can be software (robo-advisor) or an actual human. Robo-advisor-managed accounts usually charge a lower fee (less than 0.5 percent annually) than human advisor-managed accounts (around 1 percent). Some brokerage firms also offer a hybrid of both.
Note that some brokerage firms offer robo-advisor-based accounts that do not charge a fee, but they usually use certain financial tactics to still earn money on your assets that reduce your overall return on investment. We will discuss this in more detail later.
Transaction cost
Even if your brokerage account does not charge maintenance and management fees, there may still be certain fees being charged when making transactions in your account. Most brokerage firms that do charge transaction fees charge a fixed fee irrespective of transaction volume. For instance, when you buy stocks you may be charged a small fee (usually less than $10) no matter how many stocks you buy.
Very few brokerage firms charge transaction fees based on volume. For instance, a brokerage firm may charge a fee based on the number of stocks you buy. Such volume-based fees are usually very low and thus can still be more cost-effective compared to fixed-price fees (up until a certain transaction volume).
Most brokerage firms stopped charging transaction fees on stocks, most bonds, and ETFs. However, they still charge transaction fees on mutual funds from other companies.
In addition to transaction fees, there may be additional costs involved when making transactions.
Bid-ask spread
When trading stocks and other marketable securities at a stock exchange, the ask price (i.e., purchase price) and the bid price (i.e., the sales price) of a security at a certain point in time may not be the same.
For example: Let’s assume you own a stock that is currently listed for $100 on a stock exchange. This price usually only indicates the last price the stock was sold for. It neither indicates how much you would need to pay for the stock nor how much you would get when you sell the stock. Instead, you will need to look at the bid and the ask prices of the stock. The bid price is the current price someone is willing to pay for a stock and the ask price is the current price someone is willing to sell for. Let’s assume that in our example the bid price is $99 and the ask price is $101. The $2 gap between $99 and $101 is called bid-ask spread.
The bid-ask spread is an indicator of a security’s liquidity: the more liquid a security is, the narrower the spread. The bid-ask spread is considered transaction cost because you effectively lose money each time you trade a security.
Premiums and discounts on ETFs
Exchange-traded funds (ETFs) have multiple prices: The actual price based on the underlying securities called net asset value (NAV) and the bid and ask prices when you buy or sell an ETF at a stock exchange. Sometimes the ask prices are higher than the NAV, in which case you pay more for the ETF than it’s actually worth - sometimes the ask price is lower than the NAV, in which case you pay less for the ETF than it’s actually worth. The amount you “overpay” an ETF is called premium and the amount you “underpay” is called discount. The reverse is true when you sell an ETF.
There are various reasons why the bid and ask prices and the NAV diverge. The most common being that the underlying securities are relatively illiquid and thus their price discovery “lags” the ETF’s. Another reason may be that the underlying securities and the ETF are traded in different time zones.
Premiums are considered transaction costs because in such cases you pay more for the ETF than it’s actually worth.
Product-internal fees
Funds (mutual funds and ETFs) often incur a management fee that is known as the fund’s expense ratio (ER). It denotes the fund’s total cost as a percentage of the fund’s total assets averaged over a year:
ER = Fund total cost / Fund total assets.
Because the fee is automatically deducted from the fund’s return, it is not explicitly listed as a transaction on your account statement. You would need to look up the fund’s prospectus and reports to obtain the information on the exact costs involved.
For actively managed funds, the fee is often greater than 0.5 percent and can be up to 2 percent. For low-cost index funds, the fee is often less than 0.1 percent. Here are two examples to illustrate the difference:
If you would invest $10,000 in an actively managed fund with an ER of 1 percent, the annual cost of this fund would be $100. If you would have invested the same amount in an index fund with an ER of 0.05 percent, the annual cost of this fund would only be $5.
As can be seen from the previous example, the expense ratio can have a big impact on the long-term return of a fund, especially for funds with assets that generate a relatively low return (e.g., bond funds). For example, a bond fund with an ER of 1 percent where the contained bonds return 3 percent, the overall return of the fund would only be 2 percent. In other words, the fee would be equal to one-third of the bonds’ return.
Front-end load and back-end load
Some mutual fund brokers charge fees when buying and selling a fund. The fee charged when buying a fund is called front-end load and is typically around 5 percent of the invested amount. The fee charged when selling a fund is called back-end load and typically starts at around 5 percent of the amount to be sold and decreases over time until it eventually reaches zero. In other words, the longer you hold on to a fund, the lower the back-end load will be.
However, today the most popular funds are so-called no-load funds that don’t charge any purchase and sales fees.
Hidden cost
So far we have talked about fees and costs that are more or less clearly declared. But when investing there may be costs involved that are not always obvious.
One common cost that investors may face is what’s called a cash drag. A cash drag is caused by cash held in a brokerage account (or in any account for that matter) without being invested. This is very common for brokerage accounts that offer a cash position (often called settlement fund or core position) where investors keep a substantial amount of cash over a long period of time. Because cash doesn’t generate much of a return, any amount of cash that’s not invested will “drag” down the overall return of a portfolio.
Here is an example: Let’s assume you invest half your money in stocks that return on average 10 percent annually and the other half in cash that only returns 1 percent annually. The overall return of the investment will only be 5.5 percent instead of 10 percent if you would have invested all the money in stocks. This will have a major impact on the long-term return of your investment portfolio.
That being said, it’s still prudent to keep a small amount in cash for emergencies, which shouldn’t have a major impact on your return. From the previous example, if you would keep 10 percent in cash and 90 percent in stocks instead, the overall return will be 9.1 percent, which is not too far away from the 10 percent return on a 100 percent stock portfolio.
Some brokerage firms that offer free brokerage services that other brokerage firms usually charge a fee for (like robo-advisors), often require investors to keep a certain amount of cash in a low interest-bearing cash position. By investing that cash, brokerage firms can recoup their costs and often realize a profit - at the expense of your investment return.
The effect of compounding fees
When we talked about fees in the previous sections, we mentioned a couple of examples of common investment-related fees: on the one hand, low-cost funds charge less than 0.1 percent per year; and on the other hand, advisory fees and fund management fees can be as high as 1 percent per year. Still, 1 percent per year doesn’t sound that much, does it?
Let’s take a look at an example to see the difference between no fees, 0.1 percent per year, and 1 percent per year. Let’s assume we invested $10,000 in a stock portfolio that would return 10 percent per year if there were no fees and let it grow for 30 years. Here are the final account balances after 30 years for each of the three scenarios:
- No fees - $174,494.
- 0.1 percent - $169,797, a reduction of $4,697 (-2.7 percent) compared to the no-fee scenario.
- 1 percent - $132,677, a reduction of $41,817 (-24 percent), compared to the no-fee scenario; and $37,120 more than in the 0.1 percent scenario.
In other words, a 1 percent fee that has only a small impact on the return in the initial years, grows exponentially over time and eventually eats up a substantial part of your investment returns. In our previous example, a 1 percent fee reduces the portfolio size by almost one quarter over 30 years! - caused by the devastating effect of compounding fees.
Here is a graph to visualize the impact of compounding fees:
As can be seen in the graph, the blue line (no fees) and the red line (0.1 percent per year) are very close to each other, even after 30 years. However, the gap between the yellow line representing the 1 percent fee and the other two lines - despite being narrow in the initial years - is widening more and more over the years and is lagging the other two lines substantially after 30 years. And the gap will only widen from there on.