A FEW YEARS BACK, a fellow named Wylie Tollette faced uncomfortable questions as he sat before the public oversight committee of the California Public Employees Retirement System (CalPERS). Tollette, the pension fund’s Chief Operating Investment Officer, was responsible for updating the committee on the status of its massive $350 billion portfolio.
But when a committee member asked about the fees CalPERS was paying to a particular group of investment managers, Tollette did not have a ready answer. “It’s not explicitly disclosed or accounted for,” he said. “We can’t track it.” CalPERS, the largest pension fund in the United States, was being kept in the dark by some of the money managers it had hired.
In his defense, Tollette noted that CalPERS was not alone in its inability to know what it was paying. “It’s an industry challenge,” he said.
It is indeed a challenge. Still, when you are trying to build wealth, it is critically important to understand and manage the fees that you are paying. According to multiple studies by the research firm Morningstar, fees are “the most proven predictor of future fund returns.” With that in mind, here are four steps you can take to audit your investment costs:
1. Check your mutual fund “expense ratios.” That represents the percentage of a fund that investment managers deduct to compensate themselves. For mutual funds holding domestic stocks, look for an expense ratio under 0.1% (that is, one-tenth of 1%), which is what the lowest-cost index funds charge. For a fund holding international stocks, expect to pay more, but no more than 0.15%. If a fund is charging much more than that, you want to be skeptical. You can find out a fund’s expense ratio on the fund company’s own website or at Morningstar.com.
2. Look for other mutual fund fees. A fund may also levy two other costs, both of which are cloaked in jargon and difficult to spot. The first is called a “12b-1” or “marketing” fee, which is included in the expense ratio and may explain why it’s unusually high. This is a fee that the fund company may pay to the advisor who sells you one of its funds. What makes these fees particularly distasteful is that they are not simply one-time commissions. Instead, they are subtracted from your investment every year.
The other type of fee to watch out for is called a “load.” This is similar to a 12b-1, except that it is a one-time payment. Unfortunately, however, loads can be sizable, eating up maybe 5% of your investment before you even get started. I would unequivocally advise against any fund carrying either of these fees.
3. Pay attention to “turnover.” This represents the percentage of a portfolio that is bought and sold each year. Whether you are looking at a mutual fund or at an advisor who manages a portfolio of stocks for you, turnover is important because it not only represents an additional investment cost, but also it can have a serious impact on your tax return, as winning investments are sold, triggering capital gains taxes.
If you look at a simple index fund like Vanguard Group’s S&P 500 fund, you will find turnover of perhaps 4%. Look at actively managed funds and you’ll often see turnover of 50% or 100%. If you are unsure of the tax impact of turnover, check your tax return or see if your accountant can help you.
4. Ask about “soft dollars.” If you work with an investment advisor, does the firm have any “soft dollar” arrangements with its brokers? Soft dollars are an opaque practice whereby a brokerage firm charges an investment advisor’s clients more to trade and the investment advisor then receives benefits in return, such as help paying for “research services.” The result is that you could end up—indirectly and invisibly—paying your advisor more than you realize.
Does all this sound like a lot of homework? If you want to hold down investment costs, here’s the best strategy: Opt for simplicity in your investment life. Yes, complex investments may pay off. But in my opinion, you put yourself in a much better position to succeed when you keep it simple.
Adam M. Grossman’s previous blogs include About That 22%, More for Your Money and First Things First. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.