Nickels and Dimes

January 2016

There’s an intersection close to where I live with two gas stations facing one another across the street. One regularly charges about five cents per gallon of gas less than the other—sometimes as much as a dime. As you’d expect, there’s always a buzz of activity at the less expensive station, and far fewer customers at the more expensive one.

Nobody likes to be nickeled and dimed at the pump—or most other places for that matter—but for some reason, we don’t seem to scrutinize pricing in the investment arena the same way we do other expenses. For example, some investors buy stocks and bonds without realizing the full cost of those securities. Likewise, many investors unknowingly buy high-cost mutual funds or exchange-traded funds (ETFs). And some investors overlook fees entirely. Why?

The obvious answer is that investment costs are not always clear. At the pump, we can’t miss the price per gallon. Those numbers stare down at us from a gigantic placard. They are listed on each individual pump. We watch as the numbers scroll by and add up. Investment fees, by contrast, are listed as line items in the fee table of a prospectus and on various monthly or quarterly performance summaries. They can be hard to find. They can be hard to understand. And they might not tell you the whole story.

Understanding expenses

Investment fees come in different forms and sizes and can be significantly corrosive to your returns—especially over long periods of time. There are commission fees for buying and selling stocks. For bonds, transaction fees can either be a per-bond fee or a percentage of your overall trade, and can vary widely.

Some funds charge a “sales load,” the money paid to a broker on the purchase (called a front load) or sale (the back load) of the fund. In some cases these can amount to more than 5% of the purchase or sale price of a fund, which erodes returns.

But not all funds charge loads (there are many “no-load” funds), so let’s spend a moment on an expense that all fund holders face: total expense ratio. The total expense ratio, or operating expense ratio (OER), is the cost of owning a fund and covers the fund’s operating expenses—portfolio management, administrative and other operating costs.

Fortunately, average total expense ratios have been falling. According to the Investment Company Institute1, in 2014 (the last year of available data), the average total expense ratio for mutual funds fell to 70 basis points (0.70%) from 99 basis points (0.99%) in 2000. Many investors prefer ETFs because they are a relatively inexpensive way to gain exposure to a diverse array of stocks or bonds (or commodities and other asset classes). According to ETF.com data2, the average net operating expense ratio for traditional passive, open-ended equity and fixed income ETFs is 44 basis points (0.44%), with some stock ETFs as low as 3 basis points (0.03%).

While the gaps between these numbers are miniscule, you’ll find that what appear to be small, insignificant differences in total expense ratios can erode your long-term earnings potential over time in a meaningful way.

A $24,000 haircut

For example, if you invest $100,000 in an ETF with an annual OER of 0.10%, after 20 years, you would have $314,359, assuming an annual return of 6% and no other fees. Invest the same amount in an ETF with an annual OER of 0.50%, after 20 years you’ll have just $290,120. In other words, the higher fees would have shaved more than $24,000 off your investment. That’s a pretty sizable haircut.

"...because investment fees aren’t beckoning from 100-foot poles like gas prices, we as investors have our work cut out for us. It begins by asking questions—a lot of them."

But because investment fees aren’t beckoning from 100-foot poles like gas prices, we as investors have our work cut out for us. It begins by asking questions—a lot of them.

Advisers need to play their part too, helping their clients lift the veil. For starters, every investor should understand the OERs on their funds. In addition, every investment decision should include a discussion about mark-ups, commissions, settlement costs and loads. Here are a few questions to ask:

—What fees are being paid to get into, or out of, this investment, and how do they impact returns? Who gets paid with those fees?

—What amount is paid annually in total expenses in order to be invested in the fund?

—Is there a contractual limit on the total expenses that can be charged?

Whether you’re an investor or an adviser, these conversations are certain to create stronger relationships. Tell me there’s a place where I can get my gas cheaper, and I’m going to thank you for it. Tell me there’s a way to potentially save tens if not hundreds of thousands of dollars over the lifetime of my investing career, and I’ll be grateful forever.


Marie Chandoha
President and CEO, Charles Schwab Investment Management


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