When assessing investment fees, a critical question arises: Are these fees enhancing your returns, or are they merely eating into them? In the first two articles of this series on evaluating returns, I explored risk-adjusted returns and values-adjusted returns. Now, let’s dive into how fees impact your portfolio performance.
Investment Fees: A Food Analogy
As a foodie, I often compare investing to the decision to either cook at home or dine out. Let’s say you decide to stay in and eat spaghetti. Should you use a pre-packaged jar or make it from scratch? If so, you’ll need a recipe, which in investing is akin to an asset allocation. This means carefully selecting and buying your “ingredients”—stocks, bonds, mutual funds, etc.—based on the portfolio allocation you’re following.
Let’s say you are going to use mutual funds. You can buy a single type, such as a large cap fund. You might buy the generic, in investing this is called passive. Passive investing seeks to replicate, not beat a benchmark. The Standard & Poor’s 500 (S& P 500 is a widely referenced benchmark. Alternatively, you can buy the brand name that tries to beat the returns of the passive alternative. Some versions may even incorporate considering some social value, like being fossil fuel free. Active investing adds expenses that increase their cost over their passive alternatives
Mutual Fund Fees: Breaking It Down
Mutual fund fees can vary significantly. This webpage from the Financial Industry Regulatory Authority Mutual Fund Fee Analyzer highlights the various types of fees, beyond just what your financial advisor or investment adviser representative charges.
The Importance of Share Classes
Fund companies create mutual funds for different distribution channels and investors. These classes impact your returns based on their respective fee structures. Here’s a quick sampling:
· Class A Shares: Sold by financial advisors (also known as brokers), they come with an upfront commission. There may also be ongoing fees.
· Class C Shares: Also sold by brokers, but without the upfront commission. Instead, these funds often have higher annual expenses.
· Class Investor Shares: Reserved for investors using investment adviser representatives and typically carry lower fees than the A and C shares. Typically, Investment adviser will add an annual advisory typically starting at 1-2%.
· Class I Shares: Reserved for institutional investors, these are often used by investment adviser representatives and typically carry lower fees. There is usually a minimum investable amount, such as $250,000 that may also have a trading fee. Typically, Investment adviser will add an annual advisory typically starting at 1-2%.
Share classes can vary based on location and who is delivering the item. I liken this to knowing that the same role of toilet paper costs more at a convenience store than the grocery store than at a big box retailer. To illustrate the effects of fees on the same investment, I chose Fidelity as they sell through many distribution channels. The Fidelity Advisor Asset Manager 60% is an asset allocation fund that is 60% stock and 40% fixed (bonds and cash). Fidelity creates various share classes: A (FSAAX), C (FSCNX), I (FSNIX), M (FSATX), Z (FIQAX), and (FSANX).
Using the Mutual Fund Fee Analyzer, let’s take a deeper dive into the A, C and I share classes of The Fidelity Advisor Asset Manager 60% Fund. After selecting your funds, you are given options for expected return, investment amount and time horizon. I accepted FINRA’s defaults- 5% return for each fund, $10,000 investment and a 10-year time horizon. We will look at the actual annual average returns in the second part of the analysis.
The Class A is sold by a Registered Representative aka financial advisor aka broker. There is a commission of $575 when you invest. The advisor also may receive an ongoing fee from the annual operating expense. The C Class is also sold by Registered Representatives. These representatives also receive a portion of the annual operating expense. The Class I is used by investment adviser representatives. Their employer typically charges anywhere between .5 to 2% for a specified minimum, that usually decreases on a tiered schedule. I input .75% for this analysis. You can use the provided Mutual Fund Fee Analyzer link to do your own what-if analysis.
Further down the page, the fund fee analyzer shows you the actual average returns from each of the funds over the past 10 years. You will see that the Institutional performs the best, with the A Share following.
Passive vs. Active vs. Values-Based Investing
A constant debate in the investment world revolves around active versus passive management. Passive managers track market indices like the S&P 500 or MSCI, leading to lower fees. On the other hand, active managers charge higher fees because they aim to outperform these indices. Some active funds also incorporate values-based considerations, like excluding fossil fuel investments.
But which approach yields better returns?
Using the Fund Fee Analyzer, I compared three different funds: Vanguard’s LifeStrategy Growth Fund (Investor Shares), Fidelity Advisor Asset Manager 60% Class I, and Green Century Balanced Fund Class I. All three aim for a 60% stock and 40% fixed allocation.
Once again, I accepted FINRA’s defaults- 5% return for each fund, $10,000 investment and a 10-year time horizon. We will look at the actual returns in the second part of the analysis. In this case, the LifeStrategy Fund has a significant advantage: more than $700 less than the Asset Manager and $1200 less than the Balanced Fund. However, the funds did not have a 5% return over the last 10 years.
When one looks at the average annual returns, the Green Century Fund has had better average annual returns over the past 5 and 10 years. Over the last 1 and 3 average annual returns, Vanguard was top and Green Century was number 2. These are average annual returns which don’t show the effects of compounding returns.
When evaluating performance, I recommend focusing on funds with at least a 10-year track record. This provides a better idea of how the fund performs over time, hopefully moderating the effects of just luck.
The Danger of Looking at Fees in Isolation
A client once questioned why my advisory fees were higher than what they were paying elsewhere. The assumption was that all advisors deliver the same returns, which made my higher fee seem unjustified.
Think of it like hiring a chef. You’re paying for more than just ingredients and a recipe—you’re paying for skill and experience, which can make a significant difference in the final result. Similarly, a knowledgeable adviser can select the right investments, strategies, and tools that might not be accessible to a DIY investor or investors working with advisors with a limited investment options and asset allocations (recipes).
Conclusion: Is the Fee Worth It?
Many investors get caught up in comparing fee percentages. Lower fees don’t always translate into better returns. In fact, we’ve seen that the highest fee can results in the highest return.
The key question is whether the portfolio’s performance and value justify the fees. Could the right Registered Representative or investment adviser representative give you access to better research, tools, or investments that you wouldn’t otherwise have?
I recommend asking your advisor to run a portfolio analysis, comparing their proposed strategy with other alternatives, ensuring that the results are net of fees. In my next article, I’ll explore how adjusting gross returns for taxes should play into your investment decisions.
(This Part 3 of an ongoing series – you can read Part 1 here and Part 2 here)