Investing fees are not always easy to spot. Wall Street has done a good job burying these fees in the small print of hundreds of pages of prospectus. If they fully disclosed their compensation, investors might balk. This post will explain some of the hidden fees that investors don’t always see.
There are many types of hidden fees, many of which I haven’t even found yet. But some of the typical hidden fees include transaction fees (commissions), internal expense ratios, trading costs, and believe it or not, taxes.
Transaction FeesTransaction fees are different depending on where they are placed. A typical full service broker charges a commission to buy or sell an investment. Commissions range from 4.5% to 5.75% upon initial purchase, or 7.5%, in the form of a surrender fee, upon the sale of an investment by the client. Surrender fees usually diminish 1% each year the investment is held, giving incentive for the investor to hold the investment for 7 years. Annuity commissions can range from 7.5% to 15% upon purchase of the annuity. These HUGE commissions coupled with hefty internal expenses, more on that later, can devastate investment returns in the long term. It is large hidden fees like these that spawned discount brokerage firms like Schwab, TD Ameritrade, and Scottrade who charge between $7 and $30 a transaction, rather than a percentage of the amount buying.
Internal Expense RatiosInternal Expense Ratios range from 0.07% to 2.5% and up. Years ago, an investigation into 403b plans discovered internal expenses greater than 5%. That may have been why the 403b market is now more closely monitored. Your typical fee-based advisor will allocate in mutual funds with expense ratios of 1% or higher.
Trading FeesTrading Costs are costs that mutual funds and separate managed account managers pay in the form of brokerage transaction fees. These fees are typically paid by the investor, from interest or capital gains within the fund. It is almost impossible to get detailed information about the costs of these transactions. An article in the Journal of Finance (August 2000) found that the average aggregate mutual fund costs were 0.8% a year. This cost is from active managers employing stock picking in their investment style causing high turnover. Index funds had an average transactional cost of 0.07% over the same period. That 3/4 of a percent more goes in your pocket using index funds.
TaxesTaxes reduce the realized return of an investment outside a “qualified” or retirement account. Most investors screen funds based on pre-tax performance, with little regard to the impact of taxes on their portfolio return. This can lead to gross returns being lost to the IRS. An Alliance-Berstein study of 1201 U.S. large cap stock funds from 1998 to 2003 found that the average shareholder had an average annualized return of 10.0% pre-tax, and 7.7% after federal taxation of dividends and capital gains.
Equally important to investing in tax efficient funds is when you invest in these funds. An advisor buying before a large capital gain may encounter more tax than they expect, as is the case in this July 1999 Money magazine article entitled “Mutual Fund Tax Bombs”:
On Nov. 11, 1998, a physician in San Francisco invested $50,000 in a mutual fund called BT Investment Pacific Basin Equity. In January, scarcely seven weeks after he had bought the BT fund – he got the shock of his investing life. On his original $50,000 investment, BT Pacific Basin had paid out $22,211.84 in taxable capital gains. Every penny of the payout was a short term gain, taxable at Dr. X’s ordinary income tax rate of 39.6%. He suddenly owed nearly $9.000 in federal taxes. As a California resident, he was also in the hole for $1,000 in state tax.
The above example was taken from The Bogleheads’ Guide to Investing, an excellent read, if you are looking to get a good foundation in investing.
It is important to implement tax managed strategies to minimize federal taxes of capital gains and dividends, along with tax loss harvesting strategies to further reduce the amount of taxes paid.