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CHAPTER 7: BEWARE THE FEES

As fiduciaries, it’s our duty to be transparent about the fees that we assess and that our clients pay. Such transparency often is lacking in our industry. One of the reasons that we do not advocate the use of mutual funds is their lack of transparency about the variety of fees charged within them.

Layers of hidden expenses lie inside the typical mutual fund. A 2011 study conducted by Forbes found that the average mutual fund costs in a taxable account totaled 4.17 percent per year. In nontaxable accounts, the industry average was 3.17 percent.

Compare those figures to the average expense ratio proclaimed in a mutual fund prospectus, which is 0.9 percent. As you can see, there is a major disparity between what the prospectus tells you that you are paying and what you are actually paying.

There are five main types of hidden costs associated with mutual funds, but let us focus here on some that people rarely
know about.

Transaction cost: A big attraction of mutual fund investing is that you do not need to research individual securities and decide, for example, whether to buy IBM or sell AT&T. A professional management team does that for you. What may not be clear to you is that the buying and selling produce expenses that the managers pass on to you. They do not have to tell you what those costs are, however. The plan prospectus explains that the transactions produce commissions and that those commissions are not reported in the total annual operating expense. Those transaction expenses are the number-one hidden cost in most mutual funds. The Forbes study found that the average transactional cost in funds is 1.44 percent.

Cash drag: Because mutual funds are pooled investments in which millions of people participate, some of those investors on any given day will be liquidating all or a portion of their portfolios. The mutual fund must honor those liquidations, so it keeps cash on hand for the payouts. What does that mean to you? The fees that you pay are based upon 100 percent of the account value—including the portion that is sitting in cash doing nothing for you. This is what is known as cash drag, and it’s a hidden expense that you will not find in a prospectus. The Forbes study found that the average cash drag expense in mutual funds is 0.83 percent. For every dollar you invest, you are losing nearly a penny to cash drag, each and every year. It adds up, particularly over the course of thirty or forty years.

Tax cost: One Forbes study estimated tax costs, on average, to be 1 to 2 percent.4 These results are from the phantom tax on mutual funds, as I explained earlier. You might have owned a fund only for a month, but you end up paying taxes on it as if you have owned it for the entire year. Or perhaps you did own it for a year, but you discover that on December 31 the fund is worth less than when you bought it on January 1.  You experienced a loss. Nonetheless, the fund manager took some positions during the year that had gains and produced dividends. You are liable for your share of those gains, even though you lost money on the fund.

Soft-dollar costs: Some mutual fund companies have third party arrangements with brokerage firms that actually place the buys and sells for them. They make those transactions above market cost, in exchange perhaps for research that they provide to the mutual fund management teams. In essence,
that means you are paying above-market transaction costs for an arrangement behind the scenes.

Market-impact cost: Most funds have billions of dollars that they are required to invest somewhere. Th ere are only so many securities available. So when the fund buys and sells securities, often the sheer volume can move the price of that security. Because funds try to avoid this, they can only buy or sell so much of one security at a time. In part, this is why we compare mutual funds to a huge, slowly turning wheel. Sometimes it can take months for a fund to become fully invested or divested from a particular security, not allowing them to be as reactive as might be necessary to get into or out of positions.  It’s because of the massive amounts of money they have to invest that mutual funds are not always as efficient or effective as other investment solutions.

TIP OF THE ICEBERG
None of those costs that we just described are transparent. The only cost that’s transparent are the fees that they disclose in the prospectus, such as the marketing or distribution fee that you pay at the close of each market day. Nonetheless, despite what you are shown, you are paying all those other expenses. Few people understand that. In fact, few advisors know about all the hidden costs.

Mutual funds are well marketed and therefore quite familiar to the public. The marketers try to get the consumers to focus on what they think they are paying in costs. Mutual funds typically are sold as A, B, or C shares. For example, an A share would have a front-end commission of 3 to 5 percent, depending on the fund family, type of fund and how much you invest. Th at makes it relatively easy to identify the cost to invest in the fund: on a $100 investment with a 5 percent sales load, you would see $95 actually invested. The $5 might seem pretty expensive. Then, once you invest that money, who manages the shares? A lot of funds have worked to reduce the management fees, so people will look at the prospectus and see a management fee of 0.5 percent, which might seem reasonable.

But that’s just the tip of the iceberg. The expense that people don’t know about lies in the construction of the mutual fund. A small-cap or mid-cap fund manager, for example, will be buying two thousand to three thousand positions. If you were making that many trades in a self-directed brokerage account, you would be paying a significant cost to build that portfolio. And yet that is exactly what happens inside mutual funds. You’re not just paying the front-end commissions and management fee. You must consider the purchasing of every individual security within the portfolio. And you must consider the turnover ratio: How often are all those positions bought and sold throughout the year? That’s where the major hidden expenses show up in the mutual fund portfolio. That might be three times higher than the management fee, and it’s not transparent.

It’s not that the mutual fund is trying to mislead: if you asked the fund manager what the turnover ratio would be, he or she would say that’s hard to tell, it all depends on what is happening in the stock market in the next twelve months. You can’t precisely anticipate those costs, but you can see what transactions were made in the last 12 months and add that cost to all other fees that we outlined to get a sense of the total cost of investing in that mutual fund, including what is happening behind the scenes.

OVERLAP AND HANDCUFFS
People often will own five, ten, or fifteen mutual funds within their portfolio. Those funds could include thousands of securities, with a lot of overlap. After all, the mutual fund companies are not about to share information on what they are buying and selling. One mutual fund in your portfolio might be buying AT&T stock and another might be selling it—and you are paying transaction costs both ways. The lack of communication between management teams leads to excess
transactional expenses in your overall portfolio.

Another big risk to the mutual fund portfolio is that the manager is more or less handcuffed. Let’s say you are buying a mutual fund that deals at all times in large-cap stocks. What happens to that mutual fund if large caps are going south, as happened in 2008–09? The fund still has to keep buying that particular variety of stocks regardless of market conditions. That is what the fund prospectus requires the manager to do.

What that underscores is that the construction of the mutual fund can limit the ability to truly manage the portfolio, resulting in a lack of diversification. In the planning process, we evaluate your mutual funds and the fees within them. We use a third-party software system to highlight hidden fees. We can see how the fees compare to the industry average of 3 or 4 percent. Not all funds have a high cost, but it is not uncommon to see fees at 4 or 5 percent. We have seen them as high as 8 percent. If you have one like that, you probably will want to dump it right away. You probably should get rid of the ones at 4 or 5 percent as well. You won’t know what to do, though, unless you can identify the hidden costs.

INSTITUTIONAL TRANSPARENCY
We conduct a portfolio analysis to identify the specific costs within each of your mutual funds, so that you can decide whether they are acceptable. As a consumer, you need a clear picture of what you pay for services received. If you have a $500,000 portfolio, and you’re paying 3 percent on that investment, that’s $15,000 a year. In ten years, that’s $150,000 of investment expenses. If you can reduce that to any degree, you put money in your pocket—as well as the additional amount you can make by putting those savings to work for you.

Our advisory fees are always transparent to our clients. We put them in writing and discuss them, and we all sign off on them. Whenever you invest money in equities or bonds or any type of market-driven investment, there always will be some expenses. Th e question is how much are they, and can you see them all?

As a fiduciary firm, we use a transparent model of institutional investing. This is the type of investing employed by large pension plans, foundations, and endowments—some of the biggest pools of money out there. The advisory fee and transactional costs must be fully disclosed and transparent.  Institutional pricing is among the lowest in the industry. At a penny a share, you would pay a dollar if you bought a hundred shares of IBM, or $1.36 if you sold 136 shares. You would see that cost right on the statement.

TO BE TRULY DIVERSIFIED
The institutional approach also allows us to truly create a diversified portfolio, custom-built around your risk tolerance.  It is up to the institutional management team to create a diversified portfolio that is not bound by a prospectus. With this approach, the client becomes the prospectus. For example, if the aim is to achieve a 5 percent return, there is no prospectus saying we have to use large-cap companies. We might use international companies. We might use bonds, treasuries, or small-cap. We can use whatever investment is out there to seek that 5 percent return with an acceptable amount of risk.

By getting rid of that prospectus, we can truly build a diversified portfolio based on risk tolerance and investment objectives. Some investments might seek the 5 percent while others focus on companies known to do well in inflationary times. Others might hedge commodities. The risk tolerance is specific to each portfolio and what you are trying to accomplish. The buying and selling is not based upon what some prospectus requires.

This type of institutional portfolio also can promote tax efficiency. A mutual fund manager doesn’t generally have as much flexibility in mitigating the impact of taxation in the portfolio. A custom portfolio, however, can be designed to minimize the amount of capital gains that are incurred. Such tax strategies can play a significant role in adding to your net worth.

We’re not saying that mutual funds are all bad. If you are twenty or thirty years old and are just trying to stockpile as much money as you can in a 401(k) plan, mutual funds can get the job done. You will not need that money for a long time, so you can ride out the ups and downs of the market. But as you near retirement, you need to maximize the efficiencies of your investment. At that stage of life, mutual funds are normally not the best place to invest due to their higher expenses, inefficient construction, and inability to be proactive and reactive in the management of resources.

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