Funds vs Individual Securities: Part 2 - Hidden Fees

Intro

Narwhal Capital was founded on the principle that we add the most value for our clients through the selection of individual stocks and bonds rather than through the more common approach of investing in funds. We see three main advantages in this methodology that drive us to continue to implement it at our firm: tax efficiency, cost reduction, and performance. In part one of this series, we set the table for our discussion on this topic by explaining what funds are and why people hold them, while diving deep into the first of the three advantages of individual security selection, increased tax efficiency. If you would like to learn more about any of those topics, this link will allow you to jump back to that first post and get you up to speed. In part two of the series, we will explore the second advantage of individual security selection by examining the difference in the cost of holding individual securities compared to the cost of holding funds.

Why do fees exist?

I think it is important to frame our discussion before we dive into this topic. The word “fee” makes everyone a little wary in just about any scenario, but especially when it comes to the investment management industry, and rightfully so. Individuals within the industry have historically tried to sway what was an originally appropriate exchange heavily in their favor, and this dishonest practice has created massive distrust between clients and investment management professionals. I could dedicate multiple posts to the examination of the history of this type of practice within the industry, but we will leave that for another time.

With that short rant out of the way, we can address why there are fees in the first place. In a perfect world, fees exist to appropriately compensate investment professionals (advisors, fund managers, brokers) for the work that they carry out on behalf of their clients. These professionals provide a service that is not only valuable for the individual client but could positively impact that individual’s family for years to come. Receiving a service like that in exchange for compensation seems like a win for all involved. Sadly, as I alluded to above, we don’t live in a perfect world. That’s why it is important to be conscious of the amount you are paying in fees and where those fees are coming from to ensure that the exchange is justifiable based on the service you are getting in return.

That last thought is an important point to note. Determining whether or not a fee is too high can be a difficult task, but I would caution all investors not to compare fees “apples to apples.” This practice can be dangerous and doesn’t tell the whole story. As I said above, fees need to be justifiable based on the service you are getting in return. It would be easy to say that one investment opportunity charging a .5% fee is a better deal than another charging 1%. However, a surface-level examination of cost doesn’t give you any insight to the product you are receiving for the resources you are giving up. So, before concluding that the expense ratio (another term for a fee) on a fund is too high or the fee being charged by an advisor seems like a steal, be sure to examine the product you are getting in return for the cost you are paying. If that exchange is justifiable, you are off to a good start.

A quick note on the cost of trading

As convicted as Narwhal is about our approach to purchasing individual securities, there was a time that we couldn’t justify this approach for our smaller clients based on cost. Not very long ago, all brokerage platforms charged investors a commission on each trade made within a portfolio. The amount of commission depended on which brokerage service you were using to execute trades, but it typically ranged from $5 to $20 per trade, with some full-service brokers charging much more. Because of this commission, justifying a purchase or sale of a small position was difficult to do. Entering into a $100 position in a security with a commission of $10 would mean incurring a cost of 10% of the total position value. It would have been impossible to achieve sufficient diversification in smaller accounts without incurring major costs. As a result, Narwhal would purchase funds for these individuals until the account grew to a large enough size, where we could then begin buying individual securities. This was frustrating for us at Narwhal because we felt like those smaller clients weren’t able to realize the full benefit of our services.

Enter commission-free trading

Thanks to the disruption brought on by financial technology innovators, most notably Robinhood, the industry standard of commissioned trades changed quickly. In October of 2019, the brokerage firm Charles Schwab announced their decision to offer commission-free trading on all stocks and ETFs traded on its platform. That same day, many of the other big players in this space followed suit. This move was hugely beneficial to all investors, but especially those desiring to make trades at a higher frequency. This change allowed Narwhal to offer our full service to smaller accounts and maximize the value we provided, making active management an affordable option for all account sizes.

Fees within funds

As we discussed in the first part of this series, funds are pooled investment vehicles that hold an assortment of different securities. The specific securities that the fund holds, and in what quantity it holds them, are determined by a group of investment professionals called fund managers. These fund managers carry out the work of running the fund and are compensated through a fee paid by the individual investors. The cost realized by the investor for participating in a fund is known as the expense ratio. All funds have an expense ratio, but the amount that the fund charges is determined by the type of fund and how it is managed.

As a general rule of thumb, the more actively managed a fund is, the higher the fund’s expense ratio tends to be. Typically, an index fund (a passively managed vehicle that tracks a benchmark) charges a low expense ratio because, much like the benchmark that the fund is tracking, the holdings within the fund rarely turn over. Less work on behalf of the investment professionals correlates to lower fees paid by the investor. On the contrary, funds that are created to achieve outperformance of certain benchmarks must be actively managed in order to accomplish that goal. Because of the increased effort of these fund managers, and hopefully, the higher returns that they achieve, these funds warrant charging a higher expense ratio.

Are expense ratios bad?

There is nothing wrong with paying an expense ratio, but there are two scenarios surrounding the expense ratios on funds that investors should be mindful of. The first situation exists when an investor is paying a premium to participate in a fund that isn’t being managed like a premium fund. If an individual were paying an expense ratio that is considered reasonable for a high-quality actively managed fund (say a 1% fee), but is paying that on a fund that is passively managed, there is a mismatch in the resources given up for the product being received.

The second situation, and one that is far more common than the first, is the instance when an investor doesn’t know how much they are paying to participate in a fund, or worse than that, doesn’t realize they are even paying at all. That is the tricky part about an expense ratio; the charge isn’t mailed to your doorstep once a quarter. This fee is drawn from your total investment without any communication with the investor.

The good news is both of those scenarios can be addressed by using a quality fund research tool to determine the charges associated with funds. We recommend using Morningstar.com to do this research. This website allows you to search the name of any fund and examine the expense ratio, the strategy of the fund, its holdings, and its past performance. This is a great tool to utilize when comparing different investment options.

Load fees on mutual funds

There is another cost to be mindful of that exists outside of a fund’s expense ratio. Specific to mutual funds, there is often an additional cost of trading in and out of a fund called a “load.” This fee acts as a commission for the investment professional that is granting an investor access to a mutual fund. These loads can either be charged upfront at the time the investor purchases the shares of a fund (front-end load) or at the redemption (sale) of those shares (back-end load). Again, it is important to note that these load fees aren’t included in the quoted expense ratio of a mutual fund, but they are an added cost that an investor must bear. Not every mutual fund carries a load fee (those that don’t are cleverly called “no-load”), but it is certainly a factor that investors should consider before purchasing shares of a mutual fund.

Fee comparison scenario

To demonstrate the cost of holding funds within a portfolio compared to the cost of holding individual securities, assume two scenarios. In both scenarios, you are using the services of an investment advisor to manage your $1,000,000 investment account and are comfortable with the current price you are paying. In the first scenario, you are being charged a 1% asset-based fee to be invested in individual securities through a commission-free trading platform, and in the second, you are being charged a .75% asset-based fee to be invested in four popular funds.

Below is the layout of the funds and their expense ratios:

Invesco QQQ Trust (QQQ): 0.20% expense ratio

MassMutual Select Small company value (MSVZX): 1.00 % expense ratio

JPMorgan Mid Cap Value Fund Class A (JAMCX): 1.24% expense ratio

SPDR S&P 500 ETF: 0.095% Expense ratio

In scenario one, you are paying your advisor an asset-based fee of 1%, which equates to a $10,000 yearly fee (1% multiplied by the asset total of $1,000,000). Your advisor invests through a commission-free trading platform, so you incur no additional costs for investing. Your all-in charge for the year is $10,000 or 1%. As I mentioned in the first section of this post, that cost isn’t necessarily good or bad, it all depends on the quality of service you are receiving through the investment management and the customer service that the advisor provides. That cost is, however, transparent. The price you felt comfortable with initially is what you are paying, no more no less.

In scenario two, you are paying the asset-based fee of .75% to your advisor for the management of your assets, which comes out to $7,500 for the year (.75% multiplied by the asset total of $1,000,000). Additionally, however, you have to consider the hidden fees of participating in the funds that your advisor has you invested in. Assuming you are invested in the above funds in even chunks of $250,000, you would be paying an additional $6,337.50 for the year in fund fees (each expense ratio multiplied by the $250,000 invested in each fund). Combining the asset-based fee paid to your advisor with the fees hidden within the funds, your all-in cost of investing is $13,837.50 for the year, a fee of 1.38%. In this scenario, your true cost of investing was much higher than what you anticipated because of the added costs of holding funds. Again, is this cost too high? That question can only be answered by you as a client of this advisor based on the quality of service you are being provided, but clearly, you aren’t receiving those services at the price you felt comfortable with originally.

One quick caveat

You might read this example and think that you could bypass hiring an investment manager altogether and own those four funds yourself. I would agree with you that paying an advisor .75% to invest in funds that you could buy yourself doesn’t make much sense. You would have to weigh the other services provided by that advisor, outside of investment selection, to determine whether or not they are making up for the fees you are paying through those other means. In general, we have the conviction that clients pay advisors to invest for them, not to turn around and pass that responsibility off to another investment professional at a fund.

But what about bypassing the advisor charging 1% to have you invested in individual stocks and, instead, buying the funds yourself? I would encourage someone thinking that way to not solely consider the cost difference of the two options, but also to consider, along with cost, the two other factors being highlighted in this series, the tax implications of funds compared to individual securities and the conviction about the performance of individual securities vs funds. All three play an important role in determining the best method of investing.

Conclusion

Fees in and of themselves aren’t bad; they are in place to compensate investment professionals for creating value for their clients. But much like our last discussion on taxes, if you can reduce them through wise fund selection or avoid them altogether by purchasing individual securities and still achieve your desired result, it would be a mistake not to. There are some investors that favor the use of funds as an investment strategy, and that is okay, but it is important to be sure that you know the amount you are paying in fees and where those fees are coming from if you choose this approach. Fees within funds are often hidden from investors and can add up to large sums of money with very little warning, so knowing where to look is an important skill to have. In the final installment of this series, we will examine the third advantage (in our view) of holding individual securities, which is our conviction on performance.