Do You Really Know the True Cost of Your Advisor?
Many advisors fail to reveal the total costs to clients.
By Ric Edelman
Diversification. Asset allocation. Portfolio optimization.Sharpe ratios. Modern Portfolio Theory. The efficient frontier. The Fama-French Three Factor Model.
When it comes to making investment decisions, many consumers know they are ill-prepared to do it themselves. That's why you're smart to turn to a financial advisor for help. A talented, dedicated advisor can help you develop a portfolio that's suitable and appropriate for your situation, one that's designed to meet your goals and can generate higher returns at lower risks — and with less work — than you are likely to obtain on your own.
But how much does it cost to work with a financial advisor? This article will tell you.
As I explained in my book, The Truth About Money, you should always ask how advisors are compensated. Unfortunately, if that's all you ask, you might not be told the whole story. That's because there's often a big difference between what they earn and what you pay.
Therefore, instead of asking, "What is your compensation?" you should ask, "What are the total costs I will incur by working with you?"
You see, when your financial advisor provides you with a portfolio of funds, you'll incur not one cost, but three. So it's vital that you receive full disclosure — otherwise, you might end up paying far more than you should, and far more than you realize.
First, of course, is the advisor's fee. Known as an asset-management fee, it is generally expressed as a percentage of assets. At some firms, the asset management fee is as high as 3% per year. (The maximum fee for the Edelman Managed Asset Program® is 2%, and larger accounts pay a lower fee.) Instead of assessing the fee in advance (which would mean debiting your account on Jan. 1 for the Jan. 1 - Mar.31 period), the EMAP fee is collected in arrears, meaning you do not pay for our services until after you have received them. To learn the fees charged by other firms and how those fees are collected, you should ask advisors you are considering hiring for a copy of their Form ADV Part 2, a federal disclosure document that each advisor is required to provide to you.
But the asset-management fee is not the only cost you'll incur. In addition to paying for your advisor, you must also pay for the funds your advisor has recommended, and this is where you'll find two other costs: fixed expenses and variable expenses.
Fixed expenses are included in something called the Annual Expense Ratio. Every mutual fund and exchange-traded fund charges this fee — even so-called "no-load" funds. ("No-load" means there are no commissions when you buy or sell shares; it does not mean "no fee.") The expense ratio pays for the fund's recurring operating costs, from the manager's salary to the toll-free phone number investors call to talk to customer service representatives. As of 12/31/11, according to Morningstar, the average expense ratio for all mutual funds is 1.3% per year, although many are more than 2%. The highest in the industry, according to Morningstar, is a staggering 15.82%!
Although the expense ratio is expressed as an annual figure, it's actually debited on a daily basis. But the charge does not appear on monthly statements, making it hard for investors to notice it. To find it, you must look in the fund's prospectus, where the expense ratio is expressed as a percentage.
Many investors — and, astonishingly, even many investment advisors — think the annual expense ratio covers all fund expenses. But it doesn't. The expense ratio covers only perennial fixed costs — salaries, marketing, overhead, and the like. But there are many variable costs to operating a fund, and these are excluded from the expense ratio.
The biggest variable costs are brokerage commissions and trading expenses. When fund managers buy or sell a security, they pay brokerage commissions — just like you would, if you were to buy or sell a stock or bond. Of course, funds pay lower commission rates than you would pay. Even so, considering that funds trade millions of shares representing billions of dollars, their trading costs are huge — and the more the fund trades, the more it spends on brokerage commissions. Typically, funds spend tens of millions of dollars in trading costs per year, and these expenses are not included in the Annual Expense Ratio or even disclosed in the prospectus. To find these and other expenses, you must look in the fund's Statement of Additional Information.
Unlike prospectuses, advisors are not required to provide SAIs to you. As a result, many investors have never even heard of it, let alone ever seen or read one. In fact, after training financial advisors nationwide for years, I can tell you that some advisors have never heard of it either. Yet, according to Morningstar, the fees described in an SAI can equal or even exceed the Annual Expense Ratio. Until recently, you had to ask fund companies to mail you their SAIs. But thanks to the Internet, you can now find these documents at most fund company Web sites.
Trading expenses are difficult to determine, but in 2007, an analysis by researchers at Virginia Tech, the University of Virginia, and Boston College found the average fund, based on a sample of 1,706 U.S. equity funds from 1995 to 2005, incurred annual trading expenses of 1.44% per year during that period. This is in addition to the 1.23% that is the average Annual Expense Ratio according to Morningstar as of 12/31/11, based on all the mutual funds it tracks. These two figures put the total cost of the average mutual fund at 2.67% per year. (This calculation is based on historical data; current figures could vary.)
By adding this to a 0.90% advisor's fee, you can see how ordinary investors can incur a total annual cost of more than 3% per year.
So be careful when asking an advisor what he or she charges. If the answer is, "My fee is one percent," he might be omitting the Annual Expense Ratio and trading expenses that you'll also incur. So when you are interviewing potential advisors, make sure they tell you the total costs you'll pay to work with them.
1 1Based on data provided by 561 advisory firms for Rydex Advisor Benchmarking Research Study (2009). 2Based on all U.S. mutual funds and ETFs tracked by Morningstar (as of 12/31/11). 3Based on each mutual fund's Statement of Additional Information, according to a study by Virginia Tech, University of Virginia, and Boston College titled "Scale Effects in Mutual Fund Performance: The Role of Trading Costs," (March 2007). This research examined trading costs for a sample of 1,706 U.S. equity funds during the period 1995 to 2005. 4Edelman Financial (data as of 12/31/11). EMAP uses only no-load institutional funds and exchange-traded funds.
Note: This chart is for illustrative purposes only and does not represent the actual fees and/or expenses of any specific retail mutual fund or EMAP investment. The average EMAP mutual fund and ETF fees, expense ratios and trading expenses were based on all EMAP portfolios as of 12/31/11. The actual fees and/or expenses associated with a given mutual fund may be different. All figures are based on historical data; current figures could vary. This chart and the accompanying article refer to advisors who recommend mutual funds and exchange-traded funds to their clients. If your advisor recommends individual securities, such as stocks and bonds, a private money manager, or a separately managed account containing individual securities, you must be careful that you are being told the total costs of such arrangements, which can include management fees, brokerage commissions, trading expenses and other fees.
Ric Edelman is Chairman and CEO of Edelman Financial Services, a Registered Investment Adviser, and CEO, President and a Director of The Edelman Financial Group. He is an Investment Adviser Representative who offers advisory services through EFS and a Registered Principal of (and offers securities through) Sanders Morris Harris Inc., an affiliated broker/dealer, member FINRA/SIPC. Investment decisions should not be made based on information in this document. Investors should carefully consider the investment objectives, risks, charges and expenses of the recommended investment. This and other important information is contained in each fund's prospectus, which can be obtained from your investment advisor and should be read carefully before investing.