But at What Cost? … understanding investment expenses

Having spent the last two decades dedicating my professional (and sometimes personal) life to the financial services industry, it has always been interesting to me to see when/if people become cost conscious with their investments.  There is good reason to watch investment expenses closely when, on a $250,000 portfolio, a one-quarter percentage point difference can mean $625 less in your pocket.  Multiply that by 30 more years and compounding for natural inflation, you’d be giving away $30,000 of your money to a middleman.


People normally view the advisor sitting in front of them, trying to win their business, as the middleman whose fees may not be acceptable.  But, the culprit for higher charges goes beyond the difference among investment advisors; the investments available to you in your workplace retirement plan have costs not easily divined by the everyday investor.


Workplace retirement plans (under IRC 401 / 403 / 457) offer open-ended mutual funds for investment because they are, by leaps and bounds, easier to transact and to provide accounting for the custodial firm.  Being ‘open-end’ means that new shares are created when purchases are made or the fund company agrees to buy back all redeemed shares.  There is no negotiated market; the price at the close of business (also known as Net Asset Value) is the point at which buyers and sellers make their transaction.  It is due to the fact shares of these mutual funds are constantly being created or redeemed that there are usually extra costs associated with open-end mutual funds.


Many people doing their own research on the small group of mutual funds available to them through their workplace plans have found Lipper and Morningstar reports helpful in determining the relative risk of funds and their internal costs.  Users beware!  Sometimes, the expense ratios listed on these sites are telling less than half the story.  These services list the prospectus expense ratios of the funds; these are the costs known at the beginning of the year.  They include the budget for salaries of employees, the costs of paperwork and mailings, even advertising costs.  What they cannot possibly know at the beginning of the year: Trading Costs.  These fees are found in the Annual Report and are not part of the information Lipper or Morningstar covers.


As an example, Victory Sycamore Small Cap Opportunity Fund is shown on Morningstar as having an expense ratio of 0.96%.  According to Personalfund.com, there was another 1.35% of costs associated with trading the fund over the previous year.  This means the first 2.2% of the earnings go to middlemen and not the investor.


For complete disclosure, no investment offers cost-free investing.  But, there are Exchange Traded Funds which invest in a comparable fashion and have total expense ratios of one-quarter the fund mentioned above.  An ETF has a fixed number of shares and will not create new ones, nor will they contract, when people buy or sell throughout the day.  There are trading costs within this type of investment and they can vary by the passive or active involvement of the management team of the fund.  But, due to the finite number of shares available, costs are almost always lower than open-end funds.


These lower costs provide room to add an advisor to your investment portfolio.  Don’t get sticker shock by the 1 or 1.25% an asset manager will charge.  Quite often, he/she will be lowering your internal costs while adding a layer of professional management.  Future blogs will discuss the value an advisor can bring but, if cost savings are your primary aim, the reason you don’t get ‘sticker shock’ with your current investments is because you are not privy to the full story.


At this point, it’s typical to bring up the use of Index Funds.  Making use of mutual funds which are not actively managed will certainly lower your costs.  Nobody is making the decision to overweight in a specific investment or trying to buy at the absolute low and sell at the absolute high.  The progenitors of an Index Fund are just trying to approximate the performance of a benchmark.  But, can they really do that?  The answer is plainly: No.  It is impossible for a mutual fund mimicking an Index to have the same performance.  Granted, the costs associated with trading and administration of the fund are much lower than managed funds but, you will more than likely do slightly worse than the market by using these investments.


What about seeking guidance from people associated with your plan?  There are a couple of manners by which you can make use of other resources to have your assets managed, if you want to restrict your involvement to a bare minimum.  First, most plans offer Target Date or Lifecycle Funds.  These typically have a year in their title.  For example, Target 2025 means that, right now, the fund will hold significantly more stock than bonds and, as you approach 2025, each year, they will sell the more aggressive investments and get more conservative.  By 2025, the ratio should be something close to 50/50.  While it’s hard to argue with the glide path of getting slightly more conservative as each year passes, an investor should be aware of the following:

  1. The programming of the trades is not governed by anyone watching the market. If it’s the time of the year/quarter the fund sells stocks and buys bonds, it’s going to happen.  So, what if the stock market dropped 10% in the previous month and, correspondingly, the bond market saw a 1.5% increase?  The transactions are still occurring.
  2. There is an overlay fee for these investments. It may look like you are investing in one fund but, it’s really a fund made up of other funds.  You not only have the average expenses of each fund but, you’re also paying an additional cost for someone to oversee the transition of assets and internal re-balancing between funds.
  3. These funds are typically made up of investments from one company. Rowe Price and Fidelity offer some excellent funds but, what’s the chance that using all of their funds is advantageous?  When you go with this type of packaged product, you are losing the opportunity to find “best of breed” investments and there are opportunity costs for this.
  4. This one might be eliminated by the Department of Labor rule changes for retirement plans set to be in place by 2018 (a topic for another blog): Some custodians have created Target Date funds with their own generic mutual funds. Some of these mutual funds don’t have much of a track record.  This process is called “seeding.”  It doesn’t guarantee you’ll have a sub-par investment experience but, you probably would not have invested in fund by itself, if you were doing your own research.  So, why would you invest in it as part of larger group?

Second, and perhaps more sinister, many retirement plans have robo-investing embedded as an option.  Framed (incorrectly) as a “managed account” or “guided investing,” the investor will be asked questions about their goals, time horizon to retirement, and risk tolerance.  For a fee, a third-party contracted by the custodian of the retirement plan will adjust the asset mix in accordance with a score derived from the answers to the questions.  While eliciting thoughts/discussion on retirement goals is always a major positive and shouldn’t be overlooked as a benefit of this service, problems abound:

  1. The investments are usually limited to just what’s available in the plan. If the Mid-Cap Growth option in the plan consistently under-performs its competitors, it will still be used.
  2. The Data Gathering questions asked are open to interpretation and answers given to a computer program or hand-written form are often not reflective of the absolute truth of the situation.
  3. The costs of this type of assistance are often half to two-thirds of what it takes to employ a full-service advisor who will usually have access to the universe of investments instead of a couple of dozen choices made by a custodian who wanted to maximize their take from the fund rather than find the best performing, lowest cost alternatives. Industry professionals can lower costs and offer additional advice when needed; try asking your 457 Representative what your estate plan should include and how much it’s going to cost to put it together.  An independent advisor adds more than investment expertise.


If you’re judging an advisor by his/her stated charges, you aren’t seeing the full picture.  A 1% charge may seem high but, what if that advisor is keeping total costs below 1.6%?  Is that reasonable?  If you do-it-yourself with index funds and keep costs below 1% (note: index investing is not available for every asset class and, chances are, you will have to invest in some managed funds to get the correct balance) while accepting below-market returns, then it might not be.  If you engage the advice embedded in your plan, you might pay 0.5% to 0.75% plus the cost of mutual funds (both index and managed); your expenses might be in excess of 2% without any human interaction.  And, what about an advisor charging 1.25% but also using investments averaging 1.25% in costs?  Well, if this person regularly delivers extra value on a range of related topics, there might be solid justification.


Magicians aren’t the only ones using misdirection to bewilder audiences.  Ask your advisor or plan sponsor about all the costs you may incur.  If you feel you’re not getting the whole story or, worse yet, they refer you to a bunch of literature and websites, make your future planning about service and not just about cost.  Knowing the costs is just part of getting the Full Picture …