This article originally appeared in the Montecito Journal on September 5th, 2013.
Investment Fees or Investment Cost?
By Kevin Bourke
Are you old enough to remember the Pink Panther movie series starring Peter Sellers as Inspector Clouseau? In one famous scene, he sees a man sitting next to a dog. He politely asks, “Excuse me, but does your dog bite?”
The man replies, “No.”
So the inspector reaches out to pet the dog, and the dog promptly bites him. “I thought you said your dog did not bite,” says the intrepid Clouseau in his worst french accent.
“He’s not my dog,” replies the man…
It’s important to ask the right question, isn’t it?
Perhaps the most commonly asked question I hear is, “Kevin, what are your fees?” This is a good question, but not the best question.
Over the last fifteen years or so, the subject of investment fees has gotten much press coverage, which is a good thing for investors. Since this question of investment fees is important, let’s be certain we’re asking the right question to uncover the answer we’re really looking for. What is it you want to know?
When we discuss fees, we’re looking to get a sense of what we’re paying for our investments, right? Pretty simple. The challenge is understanding what all of the fees are that are embedded in our investments. What is the real cost? How much are you paying to have your investments managed and is it a reasonable fee?
A plane fighting a headwind will make slower progress than the same plane in still air. Higher fees amount to higher headwinds, all other things being equal. The problem with high fees is that the underlying investment has to perform well enough to cover the fee and provide a return to you as an investor. The higher the fee, the harder it becomes. But you know all this. This is why you ask prospective advisors, “What’s your fee?” You rightly want to know what sort of headwind you’re going to be facing with a new investment strategy. But we still want to get to the bottom of the fee question, so…
What, then, is the RIGHT question?
“Kevin, what is the total cost of the investment strategy you’re recommending?” See the difference?
Let’s look at two advisors, asked the same question, “What are your fees?”
Advisor A answers, “1% of assets under management.”
Advisor B answers, “1.5% of assets under management.”
Clearly Advisor A is cheaper, right?
Not necessarily. What if the internal fees of the investments offered by advisor A were 2% and the internal fees of the investments offered by advisor B were 0.25%? Which one offers a lower total cost?
Advisor A: 1% Advisory fee + 2% internal investment expense fee = 3% Total Cost
Advisor B: 1.5% Advisory fee + 0.25% internal investment expense fee = 1.75% Total Cost
You see? Asking the fee question is good, but it doesn’t give you the investment product portion of the total cost. If I was opening an investment account, I’d ask, “What are your fees?” Then I’d follow it up with, “What do the investment products you are recommending charge as a fee? What then is the total cost of the investments you’re suggesting?”
The cost of investments is not the only factor to consider when making investment decisions. Asset allocation, risk tolerance, time horizon, income, potential inheritances, job stability, health, the list goes on. Fees are not necessarily the most important question, they are however the easiest to quantify, so we hear much about them in the media.
Is there a “right” answer to the total cost question? Unfortunately, no. Some investment strategies, by their very nature, are more expensive to implement than others. There are no accurate ‘rules of thumb’ to determine whether a given cost is appropriate.
What to do…
I challenge you. Do you know what your investments cost? Not just the advisory fee, but the total cost including expense ratios, transactions costs and tax consequence? Advisors love this question. We don’t often get the opportunity to dig into the minutiae, something we enjoy. Go ask.
If you have an IRA, is your advisory fee tax deductible? There is a legal method to make this happen. Is it happening in your case? Also, might you be in investments that generate high taxes? A high tax hurts more than a low fee feels good. Does your advisory fee include tax planning?
Asking about the advisor’s fee is OK, but don’t forget to ask about the total costs of the investment products you’re considering.
Kevin Bourke is the founder of Bourke Wealth Management.