You are paying too much for financial advice. At least, that is the conclusion from the latest Low-Cost Investing Survey from State Street. Do you know how much are you paying for financial and investment advice? Knowing the answer is the only way to determine the value of the services you receive. If you are unsure, the survey suggests you are not alone. It also reveals a persistent lack of understanding about investment costs and advisory fees paid by investors, despite the financial industry’s efforts to make advisory fees more transparent. Following are some of the more instructive issues revealed in the survey.
Mutual Funds and Exchange Traded Funds
Nearly half of investors believe the fees they pay their financial advisor include the costs of investment vehicles like mutual funds (MF) and exchange-traded funds (ETF). They do not. Fees for MFs and ETFs are charged separately from the fees charged by your advisor. They are deducted daily from your holdings and subtracted from the value of your shares. It is easy to misunderstand because it is an accounting entry we cannot see. Separately managed accounts (SMA) where the investment manager buys and sells specific securities fall in the same category. If the investment manager is a different entity from your advisor, chances are good there is an additional fee in those cases too.
If you pay your advisor 1.0% to manage $1 million for you, your advisor fees are $10,000/year. If they use MFs or ETFs that charge fees of 0.5%, your fees to fund managers are another $5,000/year. Notably, of those investors currently working with an advisor, nearly 60% agreed with this mistaken conclusion, while 37% of self-directed investors did the same. If the objective is to explain fees clearly, advisors are falling well short of the mark.
Expense ratios and basis points
Most investors indicate they are at least aware of what expense ratios and basis points are. However, less than one-third feel they completely understand each one. Expense ratios are fees based on assets under management and reflect the costs associated with investment vehicles like MFs and ETFs. Expense ratios include management fees, and they include administrative and other fees as well.
If you hold shares of a mutual fund worth $100,000 with an expense ratio of 0.5%, you will pay annual fees of $500. Part of these fees go to the investment manager, and the rest of these fees help cover administrative and accounting-related costs for the fund. Basis points are industry lingo, 1.00% is one hundred basis points, and one basis point equals 0.01%. The expense ratio example referenced above is 50 basis points.
A well-diversified portfolio is one with a variety of investments designed to reduced market risk. 85% of investors correctly agreed with this statement. However, 55% also incorrectly affirmed the following: a well-diversified portfolio has investments in various accounts at different firms. An example would be setting up multiple accounts at brokerages like Charles Schwab, Fidelity, and Merrill Lynch.
Spreading funds across platforms is not diversification because it only refers to where your money sits and not what kinds of investments you hold. The only diversification that matters is spreading your investments across multiple financial instruments, industries, and other categories. Doing so helps reduce risks by investing in different assets that react differently to market events. Merely spreading your investments across different platforms or brokerages will not achieve diversification in your investments.