Fees vs. Expenses: Understanding all the costs of investing
Cost is a top priority when we consider most things in our life. We ask ourselves, “Is this the best deal we can get?” “What’s the cost of ownership after the initial cost?” “Does the cost change over time or stay consistent?” However, finding the true cost is not always easy. This is true when it comes to investing. In this blog we will break down different costs associated with investing and the difference between fees and expenses.
We will not go through the specific fees and expensive of all investment products. We will focus on the difference between a fee and an expense and how to assess both before deciding.
A fee, in the investing world, is an actual subtraction from your capital. For example, a mutual fund may have a front-end fee of 5% for your initial investment in the fund. If you invested $10,000 into the mutual fund your initial investment would start at $9,500. The 5% fee or $500 is subtracted from your principal and you can see the fee on your statement.
An expense, in the investing world, is the cost to operate a specific investment. Each investment product has an expense and are typically easy to find. Expenses, unlike fees, are not visible on statements or reports. For example, let’s assume a mutual fund has an expense ratio of 0.75%. If that mutual fund made 10% in year one, they would only credit your account 9.25%. The 0.75% was the cost the company kept, to manage the investment. You will not see the deduction of the 0.75% on any statement and the expense will continue for the life of the investment.
In order to understand the true cost of an investment you must look at the fees and expenses together. Using the examples above you’d have the following costs for the first year of investing: $10,000 initial investment would decrease to $9,500. The $9,500 would have produced $950 in growth without expenses. Total expenses on $10,450 for one year would be $78.38. This leaves the investment with an ending balance of $10,371.62 and total cost for the first year of $578.38.
It is important to consider both fees and expenses when selecting an investment. In the example above the 5% is a high fee but it is only assessed in the first year. If the investment is a long-term investment it may be best to pay an upfront fee in exchange for a lower expense. If the investment is shorter term it may be best to avoid an upfront fee for a higher expense.
Fees are not always one and done. In the past ten years; wrapped, managed, or fee-based accounts have continued to grow in popularity. These accounts charge a consistent fee. For example, a managed account may charge 1% of the account balance, annually, for the life of the account. In a managed account the underlying investment expenses are important to track. If your underlying investments have a combined expense ratio of 1.25%, plus the 1% annual fee, your total cost is 2.25% annually. These costs can add up over long periods of time and have an adverse effect on your financial plan.
Lastly, don’t be cost wise and return foolish. Fees and expenses vary based on the investment product and investment sector. Emerging market equities will have a higher cost than US fixed income investments. Be sure to compare an investment to other similar investments, for a true cost comparison. Some investments may be worth a higher total cost. When comparing money managers with similar portfolios one may charge a higher expense and outperform the competition. i.e. It may be worth paying 0.2% more in expenses if the fund historically returns 1.0% higher in growth. Keep in mind past performance does not guarantee future performance.