"What does it cost?"
It’s no secret that effectively managing your wealth requires an intentional approach to selecting your investments. But what many don’t realize is the importance of identifying and considering the costs associated with certain investment vehicles.
Investment fees can be a big detractor from the net returns you end up realizing in your portfolio. Therefore, it’s crucial to understand your total investment costs and minimize unnecessary expenses—those that are not intentional and strategic.
Certain costs incurred when buying, selling, or holding an investment can go un-published – and these “hidden” costs can make it very challenging to understand the true expense of your wealth management.
Fixed Income Commissions
Fixed income commissions are paid to a selling broker, but are less transparent than equity commissions. Typically, the expense is hidden in the bid/ask spread—the difference between what you pay for a bond and what you could sell that same bond for. The greater the discrepancy between these two prices, the more compensation that goes to the selling broker (and less to you).
These commissions can be especially high and opaque in municipal bonds. In 2013, according to the Wall Street Journal, the average spread in municipal bonds was 1.73% for the retail investor.
Fund Trading Costs
Fund trading costs are “invisible” costs that have been researched extensively in academia. These are the costs that your fund bears (which in turn reduce the returns you receive) when buying and selling shares due to bid–ask spreads and commissions.
In a 2014 article for the Financial Analyst Journal, John Bogle estimated this cost is 0.50% annually for actively managed funds—$500 per $100,000 investment.
Fund Cash Drag
A second “invisible” cost of investing in funds is known as cash drag. Because cash has a lower expected return than stocks or bonds, any funds held in cash act as a drag on returns over time. This is an opportunity cost (incurred when you forgo the chance for gain on a cash investment) but it is a very real cost, as it reduces your returns over time.
John Bogle estimates that actively managed funds hold around 5% of the fund in cash while index funds typically are fully invested. The estimated impact of this cash drag is 0.15% annually—$150 on $100,000 investment.
Fund Tax Drag
The last “invisible” cost is known as tax drag. A fund generates a tax bill due to income, dividends and capital gains. Higher turnover funds (which trade more frequently) tend to generate a higher tax bill due to the difference in tax treatment of short-term vs. long-term gains, and from a quicker realization of gains.
Bogle estimates the tax drag to be 0.75% annually on actively managed funds and 0.30% on index funds.
Another study published in 2000 by Rob Arnott et al. looked at equity mutual fund performance relative to the S&P 500 index. They found that over a twenty-year period starting in 1980 the average mutual fund underperformed the S&P 500 benchmark by 1.75% before taxes and by 2.58% after taxes—implying a tax impact of 0.83% annually.
How much are you paying in investment expenses?
Being intentional about your investment costs is critical to optimizing your portfolio and managing your wealth. Download our whitepaper, “The Costs of Wealth Management” to learn more about the key characteristics of these “hidden” expenses, as well as different classifications of investment costs and how to minimize unnecessary fees.
In this whitepaper, we provide an overview of industry fees, and a case study that shows how understanding these costs can significantly impact your standard of living.
Interested in learning more about how Cordant helps its clients avoid unnecessary costs and optimize their investment portfolio? Click here to download the whitepaper, or give us a call at 503.621.9207.
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