4 Hidden Costs in Investing

Like most things in life, when it comes to your investments, you get what you pay for. In other words, if an investment costs less, it might not be the best product you can buy. When you go grocery shopping, do you try to save money by buying the store brand of toaster pastries that costs less instead of Pop-Tarts? They look the same on the box, but we all know Pop-Tarts taste better.

Don’t choose an investment just because it costs less, but make sure you’re not paying too much either. It may seem overwhelming to watch for costs when you’re choosing among the thousands of investments available, but it’s not that difficult. You just have to know what the different costs are.

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If you hire a financial adviser to manage your investments, a fee-based adviser usually offers the best value. Fee-based advisers charge a percentage of the dollar amount of your portfolio. You’ll pay more as the value of your portfolio rises, but the cost is well worth it if you’re reaching your financial goals. While the cost of managing your financial plan should be easy to determine, there are some hidden costs, which usually come in two forms: fees and taxes. Here’s a look at fees. (We’ll cover taxes in another post.)

Front-end loads. Brokers often get paid a commission, or load, for selling mutual funds. This fee does not go to the people picking the stocks or other securities in the fund. Loads come in different forms and are bad for investors because as soon as you purchase a front-end load fund, you’re already losing money. For example, if you invest $10,000 in a fund and the broker gets $500 in commission, you’ll have to earn $500 just to break even. By paying the load, you also lose the compounded growth on the amount of the load, which means it will take longer for you to reach your financial goals.

Another reason loads are bad is they can make you feel trapped in a bad investment. Let’s say you bought a load fund and market conditions change and the fund isn’t performing well. You want to sell it. The broker can look for a fund within the same family if you don’t want to pay another load, but staying in the same fund family can limit your choices and chances to find a better investment. If you switch to another fund outside of that fund family, you’ll have to pay another load.

Back-end and ongoing loads. When you’re choosing mutual funds, you’ll typically see them listed as A shares, B shares, and C shares. All of these share classes have some type of load, so don’t buy them.

A shares include a front-end load as discussed above. B shares come with a back-end load (or deferred sales charge). If you sell B shares within five to seven years, you’ll pay a penalty of 5 percent or more. You also have to pay higher ongoing operating expenses for B shares. Fund companies typically charge up to an extra 1 percent a year for B share operating expenses. C shares charge a back-end load of about 1 percent if you sell the fund within the first year. They also carry the same or higher expense ratio as B shares.

There’s no reason to buy a load fund. In fact, for every load fund there’s a similar no-load fund that performs just as well or better. It’s sort of like choosing where to get gasoline for your car. One gas station charges 10 cents more per gallon if you pay with a credit card. Another station across the street doesn’t charge extra for using a credit card. The gas is the same at both stations, but one doesn’t charge an extra fee. As you search for funds, look on Morningstar and other financial Web sites for no-load funds where fees and expenses are listed.

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12b-1 fees. It’s a good idea to understand why a broker or adviser is recommending certain funds for you. 12b-1 fees are a common fund expense used by fund companies to cover their marketing and distribution costs. They’re listed in a fund’s prospectus and on many financial Web sites. Keep in mind that fund companies may use revenue from 12b-1 fees to pay brokers or offer them incentives such as free trips for selling their funds. So make sure you have a good understanding of how revenues from 12b-1 fees are being used. Are you being placed in a fund because your broker is getting paid or receiving an incentive rather than because that fund is good for you?

Management fees. Some investment experts argue that management fees, which are included in a fund’s total operating expenses, are bad for investors. Management fees vary depending on the type of fund. Bond funds typically have lower management fees, while international equity funds have higher expenses because those fund managers have to travel all over the world to visit the companies they invest in.

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Higher management fees do create a larger performance hurdle for fund managers to overcome because their investments have to increase more in value to offset the fee. However, it’s worth paying more for a fund if it performs better than a fund that charges less. That’s why you have to look at a fund’s performance. For example, one index fund that mirrors the S&P 500 has a measly 0.15 percent management fee. One of the funds we own for many of our clients, Royce Low-Priced Stock Fund (symbol RYLPX) has a management fee of 1.49 percent. Net of all expenses, the Royce fund has returned an average of 10 percent per year for the last 10 years, much better than the S&P 500 Index’s return of 1.6 percent.

Let’s see how those returns add up. If you invested $10,000 in the Royce fund 10 years ago, you’d have $28,717 now, while you’d have just $11,766 from investing in the S&P 500 index fund (through Jan. 12, 2011). While past performance cannot guarantee future results, the example above illustrates that what’s important is how much the fund pays you, not what you pay the fund. Look for how long the manager has been running the fund and what his returns have been for that time period. If the manager has consistently beaten his peers, then it’s worth it to pay a reasonable management fee. But, if you have to choose between two funds with similar returns, choose the fund with lower expenses.

Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast-to-coast. He’s also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.