No Percentage in Ignoring Fees

Anyone who has spent more than five minutes in a mall knows that different retailers often sell precisely the same merchandise for dramatically different prices. It’s smart to shop around.

The same holds true in the financial markets. Many investments are essentially identical no matter where you buy them. But the price of investment services, from trading costs to portfolio management fees, can vary dramatically.

It’s reasonable to pay extra for better service, of course, but investors should look long and hard at how much they’re shelling out. Fees can make a significant difference in your long-term performance.

If you trade actively or invest via mutual funds, you’ll be far more affected by fees than someone who only buys and holds individual stocks for long periods.

Investors must pay brokerage fees--called commissions--whenever they buy or sell stocks. The fee can range from a low of about $15 per trade at a deep-discount brokerage to hundreds of dollars per trade at a full-service brokerage.

What do you get for the higher commission? Theoretically, at least, a full-service broker should give you good advice. He or she should track the stocks you own, calling you when it makes sense to buy more, or sell. The broker should help you with any complications or transactions that need explaining (such as a merger involving one of your stocks).

The broker should also spend enough time with you and your portfolio to know the type of investments you like and the kind of investor you are--active or passive, conservative or aggressive. Given that knowledge, he or she should be able to recommend new investments that suit both you and your portfolio. And he or she should be able to back up any recommendation with research reports.

However, in cases in which you are mostly making your own trading decisions--researching stock and bond purchases yourself and determining how to divvy up your assets among different types of investments--it’s harder to justify the cost of using a high-fee brokerage.

In fact, some investors have two accounts--one at a discount brokerage and one at a full-service house. That way, they have access to the advice of the full-service broker and to the cheaper trading services of the discounter.

However you handle your investments, make sure you know the cost of trading before a trade is executed.

Most brokers--discount and full service--are willing to negotiate their fees, particularly with a good customer. If you find that your broker is charging more than others but you like him or her, ask if commissions can be lowered.

As for mutual fund fees, many investors don’t recognize how these fees can add up because the costs are usually presented as a small percentage of the amount you’ve invested, says John C. Bogle, chairman and founder of the Vanguard Group, a large mutual fund company in Valley Forge, Pa. But when you look at fund fees as a percentage of your investment return and consider how they affect the value of your portfolio over time, they are by no means inconsequential.

Consider two investors whom we’ll call Jane and John. Jane invests in a fund that charges only 0.5% in annual management fees. John invests in a fund that charges a 1% management fee and a 0.5% marketing fee known as a 12(b)1 fee--for a total of 1.5% in annual fees.

They both invest $200 a month, they both hold their funds for 30 years, and each of their funds earns an average of 10.5% a year before fees are deducted.

When Jane withdraws her money, she gets $452,098. When John withdraws his, he gets $366,149. A whopping $85,949 more of John’s account value was eaten up by fund charges.

“In any given year, a fee of 1 or 2 percentage points can be overcome” by strong fund performance, says Don Phillips, publisher of Morningstar Mutual Funds in Chicago. “But over time, pulling that much out each and every year takes a huge toll on investors’ pocketbooks.”

Mutual funds can charge three different types of fees: “loads,” 12(b)1 fees and management fees. All funds charge annual management fees. Some funds charge loads and 12(b)1 fees.

A load is a sales charge that is deducted either from your initial investment when you buy or from your proceeds when you sell, and is generally used to compensate the broker selling the fund. The kind deducted from the initial investment is called a front-end load; the kind deducted from the sales proceeds is a back-end load.

Front-end loads can amount to between 1% and 8.5% of your initial investment. If, for example, you invest $10,000 in a fund that charges an 8.5% front-end load, $850 will be deducted from your account and the remaining $9,150 will be invested in the fund.

Back-end loads are usually smaller percentages--rarely do they exceed 5% of the account value--but they can be substantial in dollar amount, because you’re paying the fee on whatever you initially invested and on your earnings. If you invest $10,000 for 10 years and your fund earns 10% per year, you’d pay $1,353 to sell at that point if the fund has a 5% back-end load.

A 12(b)1 fee is similar in purpose to a load. These are marketing fees, which pay for fund sales representatives and advertising. But you don’t pay the fee direct: It is deducted automatically from the fund’s assets, usually in small percentages--0.5% annually is typical. Because 12(b)1 fees appear so small, many investors see them as fairly innocuous. But over long periods they’re anything but, as John’s case clearly illustrated above.

Finally, a fund’s management fee, also automatically deducted, pays the investment advisors that pick and manage investments for the fund. Naturally, funds that attempt to beat market averages by choosing specific stocks (which requires research) charge higher fees than funds that merely mirror market averages such as the Standard & Poor’s 500 index. A so-called index fund will typically charge between 0.2% and 0.7% of fund assets in annual management fees, whereas actively managed stock funds may charge 1% or more.

Suppose you’re looking at a fund that charges relatively high management fees. Shouldn’t you get what you pay for? In other words, aren’t higher-fee funds charging more because they have better managers and thus better-than-average returns?

Sometimes. But many experts doubt that even a “hot” fund manager can beat the market averages time after time. Over long periods--and that’s how most wise investors invest--most funds’ returns are likely to be remarkably close to average market returns. Translation: The Jane and John scenario--where the only difference is the fees paid--is the rule, not the exception.

So what’s a reasonable fund management fee?

“I’ve always put my psychological barriers at 1.5% for international, 1% for domestic stock and 75 basis points [0.75%] for a bond fund,” says Morningstar’s Phillips. “The unfortunate thing is that mutual fund expenses continue to go up when by all rights, economies of scale and technology should have brought them down.”

Every mutual fund prospectus includes a summary of all the fees the fund charges. When you consider buying shares, make sure to take a close look at this chart and compare the expenses with expenses charged by other funds you’re considering. Your long-term performance might well depend on it.

Says Phillips: “Because all these fees are paid out of the investor’s pocket, you tend to find that the higher-priced funds underperform the lower-priced ones” over time.

Kathy M. Kristof writes about personal finance for The Times. She can be reached at Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or message Kathy.Kristof@latimes.com on the Internet.

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What a Difference a Fee Makes

Think fees you pay to mutual fund companies are too low to track? It may be worth a look.

If you could pay just 0.5% less in fees and earn the same return, the savings could be substantial. The chart below can help you figure out what small differences in fees make over time.

John Investor, for instance, plans to invest for 30 years. He traces the 9% return down to the 30 year box and multiplies his current account value of $10,000 by 13.27. At this annual rate, his $10,000 will be worth $132,700 when he wants it. What happens if pays 1% less in fees, and, thus, takes home a 10% average annual return instead? He has $152,200--$19,500 more.That’s the difference a fee can make.

Cumulative return table

Multiply figure by amount invested.

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Returns Years 8% 8.5% 9% 9.5% 10% 10.5% 11% 11.5% 12% 5 years 1.47 1.50 1.54 1.57 1.61 1.65 1.68 1.72 1.76 10 years 2.16 2.26 2.37 2.48 2.59 2.71 2.84 2.97 3.11 15 years 3.17 3.40 3.64 3.90 4.18 4.47 4.78 5.12 5.47 20 years 4.66 5.11 5.60 6.14 6.73 7.37 8.06 8.82 9.65 25 years 6.85 7.69 8.62 9.67 10.83 12.13 13.58 15.20 17.00 30 years 10.06 11.56 13.27 15.22 17.45 19.99 22.89 26.20 29.96 35 years 14.79 17.39 20.41 23.96 28.12 32.94 38.57 45.15 52.80 40 years 21.72 26.13 31.41 37.72 45.26 54.26 65.00 77.80 93.05

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