Understanding the difference between what your advisor charges and what you pay


You should always ask your advisor how he or she is compensated. Unfortunately, if that is all you ask, you might not be told the whole story. That is because there is often a big difference between what advisors charge and what you pay. Hence, instead of asking, “What’s your compensation,” you should ask, “What are the total costs that I will incur with this strategy?” For example, when your financial advisor provides you with a professionally advised portfolio of mutual funds, you may incur not one fee, but three. It is vital, therefore, that you receive full disclosure; otherwise, you might end up paying more than you realize. I am not suggesting, in any way, that you should not pay these three fees. Instead, I simply want you to be aware of how it works from a cost standpoint. In other words, let us go for full transparency so you can make an informed decision.

The first fee is the advisor fee. This annual fee is generally expressed as a percentage of the account value. With some firms, the advisory can be as high as 3 percent per year. Depending on the amount of assets being managed, however, a reasonable asset management fee could be in the area of .50 percent to 1.25 percent per year. (Fee-based programs are generally not designed for excessively traded or inactive accounts and may not be suitable for all investors).

The second fee is the operating expense cost of the mutual fund: In addition to paying your asset management fee, you must also pay for the mutual fund’s expenses that your advisor has recommended. The operating expenses are expressed in the fund’s “annual expense ratio.” Every mutual fund has an annual expense ratio (a measure of what it costs an investment company to operate a mutual fund, expressed as a percentage of the fund’s net asset). According to a report published by the Investment Company Institute (ICI) titled Trends in the Expenses and Fees of Mutual Funds, 2012, the average stock fund expense is 0.77 percent. Included in fund operating expenses are management fees, 12b-1 fees, shareholder mailings and other expenses. (The fund company takes 12b-1 fees out of the fund’s assets each year for marketing and distribution expenses, which may include compensating financial advisors or other investment professionals).

Operating expenses are not paid directly as a fee, but they are deducted from the fund’s assets, so they reduce investment returns. This fee is “hidden” as it does not appear on client’s statement. To determine your fund’s expense, either ask your advisor or look in the fund’s prospectus.

The third fee is the operating of the mutual fund: Most investors, and surprisingly even many financial advisors, are not aware of the third fee: the annual variable cost. The largest variable cost of a mutual fund is its trading expense. For instance, when your stock fund buys and sells stocks, they pay commissions for the transaction. Often times, these commission costs are in the tens of millions of dollars. To find this fee and other expenses, we must look in the funds statement of additional information (SAI).

Many studies that examine the average trading costs of mutual funds do not arrive at the same conclusion. For example, Richard Kopcke, an economist at the Center for Retirement Research at Boston College, reviewed the 100 largest U.S. stock funds held in retirement plans as of December 2007 and found that annual trading costs averaged from 0.11 percent to 1.99 percent. The median was 0.66 percent. Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals estimates that trading costs for stock funds total 2 to 3 percent of assets annually although conservative reported estimates put these costs closer to 1 percent.

One way that investors can control their investment expense is to employ the services of a separately managed account (SMA). With an SMA, your fee structure will most likely be in the form of a single asset-based fee that generally covers investment management, transactions, ongoing expenses and the advice of your financial advisor. Please note that separately managed account programs can vary therefore additional fees may be charged including but not limited to 12.b.1 fees, minimum quarterly account fees and manager’s fee that is separate from the financial advisor fee and is based on the manager’s stated fee schedule on the contract billed separately for the outside money manager’s advisory services. You should carefully review all Advisory Disclosure Documents associated with the program for a full description of services, fees and expenses and those fees or expenses that may be excluded. Most SMA strategies typically require a minimum account size of $50,000.

Remember, fees should only be an issue in the absence of value. In other words, lower costs do not imply better performance, while higher costs do not suggest lesser result. The important take-away is for you to understand the arguably confusing fee arrangement of a typical, professionally managed portfolio of mutual funds. Far too often, when financial advisors are asked what the fees are, they only reference the advisor fee. Now you know better!

Advisory products are not designed for excessively traded or inactive accounts and are not suitable for all clients. Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges and expenses carefully before investing. The prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read the prospectus carefully before you invest.

Harry Pappas Jr., CFP®

Managing Director-Investments

Certified Estate and Trust Specialist

Pappas Wealth Management Group of Wells Fargo Advisors

1000 Sawgrass Village Suite 103

Ponte Vedra, Florida 32082