When investing in financial products, investment fees play a significant role in determining long-term returns. Many investors are unaware of the various costs associated with mutual funds, variable annuities, and other investment vehicles. Some fees are clearly stated, while others are hidden within complex fee structures, reducing returns and benefitting financial advisors regardless of market performance.

This article provides a comprehensive breakdown of investment fees, distinguishing between internal and external costs, and examining how high fees can erode returns. Additionally, we compare two investor case studies: one using a high-fee financial advisor and another employing a low-cost, ETF-based strategy with dollar-cost averaging. For more insights into financial products, see my post on “10 Things Your Financial Advisor Is Not Telling You”.

Investment Fees in Mutual Funds

Mutual funds are popular investment vehicles, but they come with a range of fees that can significantly impact investor returns. Here’s a breakdown of common mutual fund fees:

1. Management Fees

• These fees compensate the fund manager for overseeing the portfolio.
• Typically range between 0.5% to 1.5% of assets under management (AUM) annually.

2. 12b-1 Fees

• Marketing and distribution fees charged by mutual funds.
• Can be as high as 1% per year.
• Often used to pay commissions to financial advisors.

3. Load Fees

• Front-end load: A commission charged at the time of purchase (usually 3% to 5%).
• Back-end load: A fee imposed when selling the mutual fund (declines over time, typically 5% reducing to 0%).

4. Expense Ratio

• Includes management fees, administrative costs, and other operational expenses.
• Actively managed funds have higher expense ratios (0.5% – 2%) compared to passively managed index funds (0.05% – 0.3%).

5. Redemption Fees

• Charged when an investor sells mutual fund shares within a short time (e.g., 90 days).
• Usually ranges from 0.5% to 2%.

6. Advisory Fees

• If a financial advisor is managing the investment, they may charge an additional fee (often 1% – 2% of AUM annually).

Investment Fees in Variable Products (Variable Annuities and Variable Life Insurance)

Variable annuities and variable life insurance combine investment and insurance features, but they often carry high fees that can erode potential gains.

Types of Fees in Variable Products

1. Mortality and Expense (M&E) Fees

• Charged by insurance companies to cover the cost of insuring the contract.
• Typically ranges from 1% to 1.5% annually.

2. Investment Management Fees

• Fees on the underlying funds within the annuity.
• Can range from 0.5% to 2%.

3. Administrative Fees

• Charged for record-keeping and account maintenance.
• Typically a flat fee ($30-$50 per year) or a percentage of assets.

4. Surrender Charges

• Fees applied when withdrawing money before a set period (often 7-10 years).
• Declines over time but can be as high as 7% initially.

5. Rider Fees

• Additional costs for optional benefits such as income guarantees or death benefits.
• Can add 1% – 2% annually.

Despite these high fees, variable products do not guarantee the protection of principal. If investors are taking on market risk, they may question whether the additional fees justify the insurance component. The whole point of using an insurance product is protection. If you are willing to take on additional risk, one may be better served to invest in regular stocks or ETFs.

Active vs. Passive Portfolio Management

A key decision for investors is whether to invest in an actively managed portfolio or a passively managed portfolio.

Actively Managed Portfolios

Actively managed portfolios involve a professional fund manager or a team making investment decisions in an attempt to outperform the market. These funds typically come with higher fees because of the costs associated with research, trading, and management expertise. The key justification for these higher fees is the concept of alpha—the ability of a fund manager to generate returns that exceed the market average after accounting for risk. If a fund manager consistently generates significant alpha, then their higher fees may be justified. However, research shows that many actively managed funds fail to outperform their benchmark index over the long term, making their higher fees harder to justify.

Passively Managed Portfolios

Passively managed portfolios, such as those composed of index funds or ETFs, are designed to track a market index rather than beat it. Because they do not require active decision-making or frequent trading, they have significantly lower expense ratios, often below 0.3%. Many investors prefer passive strategies because they offer broad market exposure at a fraction of the cost of actively managed funds. If an investor is paying for active management but not receiving above-market returns, they might be better off with a low-cost passive investment strategy.

Balancing Fees and Performance

The level of expertise and returns your manager generates should be commensurate with the fees charged. If you are paying a high fee for active management, the fund should demonstrate consistent alpha over time. If not, a passive investment approach may be the more cost-effective and prudent choice

Internal vs. External Fees

Understanding the distinction between internal and external fees is critical:

• Internal Fees: Deducted from fund performance before the investor sees returns (e.g., expense ratios, 12b-1 fees, mutual fund fees). This comes out before you see your return so it does not reduce your principal.
• External Fees: Taken directly from an investor’s account regardless of performance (e.g., advisor fees, wrap fees, insurance charges). These fees can directly reduce your principal. Unfortunately, I have seen advisors put clients in high fee products, only to see the clients lose money even in a bull market. In my opinion, these advisors should be fired and lose their license, especially when recommending these products to senior citizens.

Difference in Fixed and Indexed Annuities vs. Variable Products

Fixed and fixed index annuities, along with permanent life insurance policies, differ significantly from variable products:

• Fixed annuities have no investment risk, while indexed annuities provide returns based on a market index but with a cap. For a deeper dive into annuities, check out “A Guide to Annuities”.
• Fees in these products are often built into the structure, whereas variable annuities and variable life insurance have direct fees on investment accounts.
• Life insurance agents do not charge fees directly; instead, they are paid from the insurance company’s marketing budget, meaning investors do not see these costs deducted from their accounts.

Case Study 1: Advisor with Investment Fees

Investor Profile:

• Initial investment: $10,000 per year.
• Investment period: 30 years.
• Financial advisor fee: 2% of Assets Under Management (AUM) annually.
• Market return: 7% before fees.

Performance Calculation

Without fees, the investor’s portfolio would have grown to approximately $944,607 after 30 years. However, with a 2% advisor fee:

• The advisor collects fees every year, reducing the portfolio’s compounding potential.
• The final portfolio value is approximately $563,719—a reduction of nearly $381,000 due to fees.
• Even if the market drops, the advisor continues to collect their 2% fee, demonstrating the misalignment of incentives. This the ultimate example of why there is such a huge conflict of interest in the financial sector.

Case Study 2: Low-Cost ETF Investing with Dollar-Cost Averaging

Investor Profile:

• Same initial investment: $10,000 per year.
• Investment period: 30 years.
• ETF expense ratio: 0.1%.
• No advisor fee.
• Market return: 7% before fees.

Performance Calculation

With minimal fees, the investor’s portfolio grows to approximately $944,607, compared to the $563,719 in the high-fee advisor scenario.

Key Takeaways:

• Zero Fees makes a significant difference over long-term investing.
• The high-fee advisor scenario results in 40% less wealth at retirement.
• Using ETFs and dollar-cost averaging preserves more of the investor’s returns.

Conclusion

Understanding fees in financial products is crucial for maximizing investment returns. High fees, especially in variable products and actively managed mutual funds, can erode gains over time. By distinguishing between internal and external fees, investors can make informed decisions about where their money is going.

The case studies illustrate the long-term impact of fees. A high-fee advisor can dramatically reduce an investor’s wealth, while a low-cost ETF-based approach with dollar-cost averaging leads to significantly higher returns.

Investors should carefully evaluate the cost structures of financial products and consider whether higher fees provide sufficient value. If fees do not justify the benefits, low-cost alternatives like ETFs may offer a better solution. As always, conducting thorough research and seeking fee-transparent investments can lead to greater financial success.