Cutter Family Finances: Breaking Down Brokerage Fees
By: Jeffrey Cutter, January 13, 2014
One of the things I do when I meet with both new or existing clients is to look at the critical facts concerning their financial investment decisions. Critical means something significant, factual, important and relative that they must understand before making a financial decision such as taxes, fees, costs, risk, or a myth or a misconception.
This brings me to a recent meeting I had with a couple from West Falmouth (let’s call them Dick and Maggie) who were seeking some financial advice on their multi-million dollar portfolio, which consists primarily of mutual funds. In our discussion, they said that they only pay 1.25 percent in fees and expenses on their brokerage account.
Hmmmm . . . I’m not buying it.
I asked, “Would you be surprised to learn that you are probably actually paying 3 to 5 percent in fees?”
“Yes!” they said.
So, I pulled out my yellow pad and went to work.
Generally, the cost of owning a mutual fund is reflected in the Expense Ratio, which is charged yearly by the mutual fund. This is the only cost that many investors believe they pay when owning a mutual fund. The Expense Ratio is the percentage of the funds’ assets that are “needed” to run the mutual fund. It includes marketing costs, distribution costs and management fees. These can be found on websites such as Yahoo finance. Dick and Maggie are paying .95 percent. This is about average, I explained.
Transactional costs are the next one, and these tricky guys can be hard to quantify. They are not found in most prospectuses and are not included in the expense ratio. Transactional costs average 1.44 percent of the funds’ assets and include brokerage commissions and the cost of the bid/ask spread. Brokerage commissions are paid to the fund manager who buys and sells stocks for the mutual fund through the fund company’s brokerage account. The bid/ask spread is the difference between the best quoted ask price for a given stock (the price paid for the stock), and the best quoted bid price (the price at which the stock is sold to the fund).
Think of it like this, I explained to Dick and Maggie: “Stocks and bonds are bought by your brokerage firm associated with your mutual fund for a buck and they charge you $1.04 for the same stock.” That is the bid/ask spread, and it is a real cost.
Now don’t forget—Uncle Sam wants his money, too. Dick and Maggie have half of their portfolio held outside of their IRAs—in taxable accounts.
I explained that a new investor who buys into a mutual fund that is holding stocks that have appreciated prior to the purchase of the fund runs the risk of paying capital gains taxes on the sale of those stocks if they are sold while the new investor owns the fund.
Essentially, even if an investor did not benefit from the stocks’ gains, he or she could share proportionately in taxes due when the mutual fund manager makes a change in the assets held by the fund. Ultimately, one may end up paying taxes on investments that other investors profited from. I advised Dick and Maggie that before purchasing an actively managed mutual fund in a taxable account, they should consider contacting their broker/brokerage house to determine the level of embedded gains within the mutual fund. According to Morningstar, the average tax cost ratio (percentage of the assets in a fund that are sold, thereby resulting in capital gains) for stock funds is 1 percent to 1.2 percent per year.
Cash drain is yet another cost of owning a mutual fund that many folks do not think about. Fund managers often hold cash so they can have some liquidity for potential transactions and possible fund redemptions by owners. Potentially, this holds back fund performance. I gave Dick and Maggie an article showing them that the average cost from cash drain over a 10-year span was .83 percent per year. I explained to them how there may be costs they are not aware of. Investors pay an expense ratio on 100 percent of their investment. However, from our analysis, only 90 percent is actually invested within their mutual funds. So, in essence, their buy and hold investment strategy is subsidizing other investors’ liquidity needs. This is cash drain and it’s real.
In my opinion, the hardest cost to quantify is soft dollar costs. Essentially, this is a mutual arrangement between the fund manager and the brokerage house. The manager receives special services/research, in exchange for the brokerage house getting the manager’s brokerage business at an inflated rate. This approach gives an investor the appearance of lower expenses.
Lastly, we looked at Dick and Maggie’s brokerage statements. On the statement it shows an advisory fee of 1.25 percent. Dick and Maggie pay this to their broker for him to buy/sell their mutual funds on their behalf. This fee is common in the broker investment models and must be fully disclosed.
So, we added up all of Dick and Maggie’s expenses on my yellow pad; an expense ratio of .95 percent, transactional costs of about 1.4 percent, an estimated cash drain of .8 percent, and estimated capital gains tax of 1 percent. The fact is that they are paying approximately 4.15 percent in fees and expenses for their mutual funds.
Dick asked, “Does that include the advisory fee of 1.25 percent?”
“Nope,” I said. “That’s extra.”
Now Dick and Maggie know the critical facts.
Be vigilant and stay alert because you deserve more.
Jeffrey Cutter, CPA, PFS is the managing partner from Cutter Financial Group, LLC (www.cutterfinancialgroup.com) which provides private wealth and investment management. He can be reached at firstname.lastname@example.org.
Investment advice is offered by Horter Investment Management, LLC, a registered investment adviser. Insurance and annuity products are sold separately through Cutter Financial. Securities transactions for Horter Investment Management clients are placed through Pershing Advisor Solutions, Trust Company of America, Jefferson National Monument Advisor, Fidelity, Security Benefit Life and FC Stone. 1. http://tinyurl.com/nwvbep4