Where Are The Customers' Yachts?
Fred Schwed's iconic 1955 book "refers to a story about a visitor to New York who admired the yachts of the bankers and brokers. Naively, he asked where all the customers' yachts were. Of course, none of the customers could afford yachts, even though they dutifully followed the advice of their bankers and brokers."
Since then, how much has changed?
Do you know what your investments are costing you? If you’re not sure, you’re not alone. It’s not like you’re handed a menu of charges to choose from when it’s time to place your order. Even when you know where to look for financial costs, the information can be difficult to digest.
Let’s fill in some of the blanks by covering three significant sources of investment costs: fund management fees, (trading) costs, and advisor costs.
Fair Fund Management Fees
We typically invest in a mix of funds towards efficiently capturing global returns without having to juggle thousands of individual securities at a time. With most client portfolios holding tens of thousands of individual securities, what a task that would be!
Cost-effective diversification is a common strategy, and the basis for many popular investment options, including Vanguard's LifeStrategy Funds and more concentrated funds including the iShares Core S&P 500 ETF. In exchange, the Vanguard or iShares managers seek reasonable compensation for their services.
What’s “reasonable”? To discover how much fund management is costing you, start by looking for each fund’s expense ratio. You can find this information in the fund’s prospectus, or by searching online for its name or ticker symbol. Many broad market index mutual funds or ETFs have annual expense ratios of 0.02% (2 basis points) or less. If a fund’s annual expense ratio approaches 1% (100 basis points) or more, we advise caution - almost certainly, you should think twice about investing in it.
Some fund managers also pile on extra fees, or loads, beyond the ones reflected in their expense ratios. These should also be disclosed in the fund’s prospectus, and can include:
- A one-time front-end load when you buy shares of the fund
- A one-time back-end load when you sell shares of the fund
- Similar contingent deferred sales charges (CDSCs) and other redemption fees
Hiding and Seeking Fund Fees
Because fund management fees are typically bundled into each fund’s share price, you’ll barely notice they’re there. But they still cost you real money.
For example, in a recent working paper, “Obfuscation in Mutual Funds,” academics from the University of Washington, MIT, and The Wharton School at the University of Pennsylvania compared the 2019 costs and performances of two S&P 500 Index mutual funds. Before fees, their gross returns were nearly identical at 31.46% vs. 31.47%.
But one fund manager charged a lean 0.02% (2 basis points). The other one charged up to an all-in 5.08% (508 basis points). Once you know that, it’s easy to tell which fund will leave more money in your pocket after fees.
Are you having trouble finding a fund manager’s fees to begin with? Consider this central finding from the same paper:
“...we find evidence consistent with funds attempting to obfuscate high fees.”
In other words, the study found that lower-cost funds usually provided short, easy-to-understand fee disclosures; the higher-cost funds often buried their costs in lengthy and complex legalese.
Why complicate things? When searching for a particular type of investment, there are almost always funds available that do not charge loads and similar add-ons, and do clearly disclose their costs.
Low costs are important. But they’re not the only reason to favor one fund over another. Some investments cost more to manage because it’s more expensive to participate in their target market.
For example, an investment in a U.S. market fund will usually have lower expenses than an investment in a non-U.S. market fund. So, first, identify available investments that fit your unique investment goals. Compare their expense ratios, apples to apples. Weed out any funds that charge loads, or bury their fee disclosures in long-winded blather. Then select suitable funds with the lowest costs.
In addition to your fund management costs, custodians, brokers, and trading platforms also make money off your investment activities. Take a step back from the mutual funds, ETFs, or other holdings you decide to invest in to consider where these holdings live and reside—and what does it cost to buy, sell, and hold them?
An Account of Your Accounts
First, let’s define a few terms:
It’s easy to answer where your holdings live. They live in two main types of investment accounts:
- Individual accounts, which you set up and manage on your own (along with your advisor).
- Employer accounts, such as 401(k) or 403(b) plans, which your employers set up and may manage for you.
There are two places where your individual and employer accounts typically reside:
- Traditional custodians, like Schwab, Vanguard, or Fidelity.
- Online platforms or “robo-advisors,” like Robinhood, Wealthfront Advisers, or Schwab Intelligent Portfolios®.
All of these "places" are known as custodians. Just like a bank holds your cash, a custodian holds your investment assets.
Your custodian uses brokers to execute your investment trades. Some custodians double-duty as the broker; others contract with third parties.
The Cost of Doing Business
So far, so good? Now that you’ve got a lay of the land, here’s an important insight …
It really doesn’t matter which types of accounts you’ve got, or where your holdings reside. You’re not the one trading in the market. You (or your advisor) places trading orders. Your account custodian takes it from there.
Therein lies additional costs: the costs of holding and trading everything you’ve got.
Those “Free” Frills Can Cost You
Until a few years ago, brokers would almost always charge a commission whenever they executed a trade for you. In a more recent “race to zero,” many providers are now touting commission-free trading. But is that trading really free? If you take one thing from today’s piece, here it is:
As an investor, whenever you’re being led to believe you’re getting something for nothing, your best bet is to assume exactly the opposite.
It stands to reason: Custodians and brokers must be profitable, or they’d go out of business. If they’re not charging a commission on your trades, they’re still making money somehow. It’s just not where you’d expect to see it, nor can you tell how much it’s really costing you.
Tricks of the Trading Trade
Unfortunately, hidden costs usually mean higher costs. Following are a few tricks of the trading trade that often replace or augment more transparent pricing.
Cash Sweeps and Lending Practices:
Ideally, you actually invest most of the money you’ve earmarked for investing. But you probably also hold a little or a lot of cash in your investment accounts. Some custodians have been profiting handsomely by quietly sweeping this cash into their in-house, low-rate bank accounts, instead of paying you market-rate interest. They can then reinvest your cash in higher-rate holdings, or lend it out and earn interest on it—and keep the difference for themselves. Add everyone’s cash together, and the profits can pile up.
To illustrate, a 2018 San Francisco Chronicle piece reported average money market rates were around 2% at the time, while average bank sweep accounts were paying closer to 0.27%. The article described these practices as “similar to the way many airlines have cut fares and made up for it with fees for baggage, seat assignments and overpriced food.”
Payment for Order Flow:
As described above, your custodian arranges for your trades to be executed. In theory, they’re required to seek “best execution” for your trades. In practice, one common technique is to use payment for order flow to seek competitive trading bids from third parties. Sometimes, this can generate more competitive pricing that benefits you. But it also can create conflicting incentives if an entity offers your custodian more payment (for them), without also ensuring best execution (for you).
Platforms have been under scrutiny on this front, including a 2020 U.S. Securities and Exchange Commission (SEC) charge that Robinhood was misleading customers about the true costs of their trades. Neither admitting to nor denying the charge, Robinhood paid a $65 million fine and agreed to review their payment for order flow and other best execution policies and procedures.
If you’re trading in individual bonds, there are usually significant hidden costs known as markups and markdowns. When bonds are bought and sold, there is the equivalent of a “wholesale” versus “retail” price. The markup/markdown is the difference you pay above the “wholesale” price. This undisclosed difference typically goes to the broker, in addition to any disclosed commissions paid.
According to Investopedia, "The commission can range from 1 to 5% of the market price of the bond."
Before we wrap, let’s talk about our own advisory costs.
These days, you don’t need an advisor to manage everything we just discussed. You can look up fund expense ratios on your own, and watch for loads and other fees. You can set up and fund your individual accounts, and decide how you’d like to invest your retirement plan assets at work. You can be diligent about minimizing uninvested cash in your investment accounts.
That's why we suggest nine different commission-free options in the Costs section of our website at www.openwindowFS.com/costs.
As an independent, fee-only, fiduciary advisor, we certainly help our clients with all these logistics, and more. But more than that, we provide professional, objective advice on everything related to your total wealth:
We advise you on managing your wealth across your total investment portfolio, wherever your accounts may reside. If your only advice comes from a custodian or trading platform, it’s likely to only apply to your investments with them, without considering assets you hold elsewhere. Plus, if you could do better elsewhere, don’t expect to hear about it from them.
We advise you on your total wealth interests. Do your investments best reflect your personal financial goals and risk tolerances? How should you use insurance to protect your wealth? How can you spend safely in retirement, and which accounts should you spend down first? What about Social Security? Are your estate plans up to date, with accurate beneficiaries across your various accounts and policies? How can you effectively draw personal wealth out of your business? What about those corporate stock options? How can you integrate your charitable giving with optimal tax planning? These are just a taste of the areas we advise on.
We advise you according to your highest financial interests. Even “free” trading can be horribly expensive if it runs counter to achieving your greatest financial goals. In our fiduciary relationship with you, we’ll show you how to minimize hyperactive trading, make the most of the market’s available returns, and manage the very real risks involved. A commission- or fee-based advisor representing others’ interests is unlikely to do the same.
When you hire Open Window as your independent, fee-only advisor, you are purchasing our all-in fiduciary advice. Our costs are clearly disclosed and are our sole source of compensation. Our clients know the exact cost, with no commissions, no kickbacks, no surprises. Helping families illuminate and eliminate excessive investment costs is one way we strive to "pay our own way" as an advisor.
When done right, our cost is a small fraction of the value we offer:
- By helping you make better decisions, make them earlier, and by avoiding costly errors.
- By seeking a long-term investment return that exceeds other comparable options.
- By seeking a lower lifetime tax burden, and the benefits of tax-efficient wealth transfer and charitable giving.
- By helping to provide peace of mind while saving you time and energy.
If you’d like to explore further how we can enhance your own financial experience, please be in touch with us today at www.openwindowFS.com/connection.