No matter what kind of investment an individual makes–active, passive, automated– they’ll face some kind of fee that takes away from their returns.
Broadly speaking, investment fees are structured in two ways: recurring or one-time transaction charges. Recurring is when the charge is a portion of the assets you’ve invested, usually expressed as an annual percentage rate. One-time transaction charges work more like a flat fee, such as a certain number of dollars per-trade.
When investing, individuals may get excited about an opportunity or a long-term plan, making it easy to overlook the fine print. But over time, fees can make a profound impact on the returns an investor takes out of financial markets. Here’s a closer look at the types of fees investors may come across.
Common Types of Investment Fees
Every mutual fund charges a management fee. And other investment vehicles, such as hedge funds, do as well. This pays the fund’s manager and support staff to select investments and trade them according to the fund’s mandate. In addition to the manager, it also covers the administrative expenses of managing the fund.
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This fee is typically assessed as a portion of an investor’s assets, whether the investments do well or not. Some investments, such as hedge funds, charge a performance fee based on the success of the fund, but these are not widely used in most mutual funds.
Management fees vary widely. Some index funds charge as little as 0.10%, while other highly specialized mutual funds may charge more than 2%.
Management fees are expressed as an annual percentage. If you invest $100 in a fund with a 1% management fee, and the fund neither goes up or down, then you will pay $1 per year in management fees.
Hedge-Fund Fees: Two and Twenty
The classic hedge-fund fee structure is known as “two and twenty” or “2 and 20.” This means that there’s a 2% management fee, so the hedge fund takes 2% of the investor’s assets that are invested. And then there’s a 20% performance fee, so with any profits that are made, the hedge fund takes an additional 20% of those returns.
So let’s say an investor puts $1 million into a hedge fund, and the firm makes a profit of $500,000 in a year. That means the hedge fund would take a management fee of $20,000 plus a performance fee of $100,000 for a total compensation of $120,000.
Bear in mind, investors who are clients at hedge funds are typically institutional investors or accredited investors, those typically with a net worth of at least $1 million, excluding their primary residence. Hedge funds also tend to have higher minimum initial investment amounts, ranging from $100,000 to $2 million, although it varies from firm to firm.
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Due to lackluster performance and competition however in recent years, the classic “two and twenty” hedge-fund fee model has become challenged in many years. Many hedge funds now offer rates like “1 and 10” or “1.5 and 15”–a trend dubbed as “fee compression” in the industry.”
The Expense Ratio
The expense ratio is the percentage of assets subtracted for costs associated with managing the investment. So if the expense ratio is 0.035%, that means investors will pay $3.50 for every $10,000 invested.
The expense ratio includes the management fee, and tells the whole story as to how much of the fund’s assets go toward the people running and selling the fund.
In addition to management fees, a mutual fund may charge other annualized fees. Those can include the fund’s advertising and promotion expense, known as the 12b-1 fee. Those 12b-1 fees are legally capped at 1%. But when added to the management fee, it can make a fund more costly than at first glance. That’s one reason to double check the expense ratio.
Another reason is that the expense ratio may actually be lower than the management fee. That’s because some mutual funds will waive a portion of their fees. They may implement a fee waiver to compete for the dollars of fee-wary investors. Or they may do so as a way to hold onto investors after the fund has underperformed.
In the 2010s, some money market funds waived or reimbursed some of their fees after historically low bond yields wiped out any return they offered to investors. While mutual fund companies can reimburse part or all of a fund’s 12b-1 fee, it happens very rarely.
In addition to the annual management and possibly also 12b-1 fees, mutual fund investors may pay sales charges.
Typically, these charges only apply to mutual fund purchases that an investor makes through a financial planner, or an investment advisor. This fee, also called a sales load, is how the advisor gets paid for their service. It isn’t a transaction fee however. Rather it’s a percentage of the assets being invested.
While the maximum legal sales charge for a mutual fund is 8.5%, the common range is between 3% and 6%.
These sales charges can come in different forms. Front-end sales charges come out of an investor’s assets at the time of the sale. Back-end sales charges, on the other hand, are deducted from the investment when the investor chooses to sell. Lastly, contingent deferred sales charges may not come out at all, if the investor stays in the fund for a specified period of time.
When an investing professional–a financial planner, advisor, or broker–offers advice, this is how they’re paid. Some advisors have a business model where they charge a percentage of invested assets per year. Other advisors, though charge a transaction fee, in the form of a brokerage commission. Lastly, some simply charge an hourly fee.
Asset-based money management fees are usually expressed as a percentage of the assets invested through them. Typically, a hands-on professional will charge 1% or more per year for their services. That fee is most often deducted from an account on a quarterly basis. And it comes on top of the fees charged by any professionally managed vehicles, such as mutual funds.
But that fee can be much lower for automated investing platforms, also known as “robo-advisors.” Some of these robo-advisors charge annual advisory fees as low as 0.25%. But it’s worth noting that these platforms often rely heavily on mutual funds, which charge their own fees in addition to the platform fees.
Robo-advisors are famous for having rock-bottom fees. However, when investors are comparing robo-advisor fees, they’ll see that there’s a wide range. The minimum balances can also determine what sort of fees investors pay, and there may be additional fees like a potential set-up payment.
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Brokerage Fees and Commissions
When an investor wants to buy or sell a stock, bond or an exchange traded fund (ETF), they typically use a brokerage firm. Fees and commissions vary widely depending on the type of transaction and the type of broker. Those fees can be based on a percentage of the transaction’s value, or it can be a flat fee, or a combination of the two.
And when investing, that fee depends on whether an investor uses a full-service broker or a discount broker. While a full-service broker can offer a wide range of advice and services, their commissions per trade are far higher than a discount or online brokerage might charge.
Because discount brokers offer less in the way of advice and services, they can charge a lower flat fee per trade. In recent years, the biggest online brokerage firms have offered free trading, partly due to competition and partly because they instead get paid through a practice known as payment for order flow.
Payment for order flow, or PFOF, is the practice of retail brokerage firms sending customer orders to firms known as market makers. In exchange, the brokerage firms receive fees for that order flow.
While widespread and legal, payment for order flow has been controversial because critics say it misaligns the incentives of brokerage firms and their customers. They argue that customers may actually be “paying” for their trades by getting worse prices on their orders. Defenders argue customers get better prices than they would on public exchanges and benefit from zero commissions.
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No matter how an investor gets into the market, they will pay some kind of fee. It may be the quarterly deduction made by a financial advisor, or the trading costs and account fees of an online brokerage account, or the regularly deducted management fees of a mutual fund.
Those fees and commissions add up to the “cost of investment.” That cost is deducted from assets and represents a drag on any return an investor may earn over time. As such, investing fees require close attention, regardless of an investor’s strategy or long-term goals.
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