Investing Costs Are Not All Created Equal

All investors need to be aware of investment transaction costs, because they are not all created equal. Transaction costs come in many forms, the most incurred being clearing fees, brokerage fees, management fees, trail fees, contingent deferred fees and loads. Some of the fees are packaged together and given another name, such as expense ratio.

For the typical stock or bond investor, there are fees upon every transaction, whether it is a buy or sell. A Clearing Fee is accessed by the firm that makes the actual trade on the floor of a stock exchange, the New York Stock Exchange (NYSE) for example. There are a limited number of seats on the NYSE and only those having a seat are given the privilege of transacting business there. Many of the larger brokerage firms (Merrill Lynch, Shearson, Prudential, etc.) have their own seat on the exchange. There are hundreds of smaller brokerage firms that contract with other larger firms (National Financial, Mabon Nugent, etc.), which have a seat on the NYSE, to make transactions on their behalf. These larger firms and large brokerage firms are sometimes called Clearinghouses. They charge to make a buy or sell transaction for an individual investor, thus the name, Clearing Fee.

In addition to the Clearing Fee, an investor is accessed a Brokerage Fee. This is the fee that is charged by the actual brokerage firm and part of this fee is where the stockbroker/account executive derives income. Many times, the Clearing Fee and Brokerage Fee are referred to as the Commission. Beware that the Clearing Fee is not an optional cost but the Brokerage Fee is negotiable. The brokerage firm will usually allow the stockbroker some discretion as to the percentage discount allowed an investor. Unless the investor asks for this discount, it may never be offered. When one buys a house or car, there is always some haggling and horse-tradin' going on. Investing should be no different. Ask, and who knows, you may receive.

Mutual Fund investing has been and continues to be one of the most popular forms of investing around. There are, however, many fees that the mutual fund investor needs to be aware of and decide which ones to accept and not to accept. A mutual fund with a Load (sales charge) means that the company charges a fee on the amount invested. The fee may be as high as 8.5% of the amount invested, depending upon the size of the investment. These charges are accessed on every additional investment, declining as the account value reaches specific levels. The industry trend has been to lower the Load and raise other internal operating expenses. The vast majority of funds reinvest dividends and capital gains free of charge. Beware, however, there are some funds that attach a sales charge to reinvested dividends and capital gains. Inquire about this when purchasing and stay away from them. It is an unnecessary expense. The money arrived from the Load is divided first to the mutual fund company; second, to the selling firm; last, to the registered representative.

All mutual funds (load and no-load) have Annual Operating Expenses (AOE). The AOE usually consists of 3 categories: Management fees, 12b-1 expenses, and Other expenses. The AOE is also referred to as the Expense Ratio. This is a key ratio in determining the efficiency of operating the fund. Industry average ratios typically range from 1.0 to 2.5% of the fund's total value. A fund with a low ratio is less expensive to operate than one with a high ratio. For the investor, this ratio is key because it is an ongoing expense based on the account value. For example, a 1.0% AOE would cost a $250,000 account $2,500 annually. For the long-term investor, expense ratio is the biggest concern, not the Load. For example, in using the same account size and an additional investment of $1,000, the Load would be approximately $450, depending upon break-points.

Some funds have Contingent Deferred Sales Charges (CDSC). These have no initial sales charge upon investment, only upon liquidation within a specified number of years. One of the most popular fund types is the No-Load (NL). There is, however, a big misconception with NL investing. NL only means that there are no upfront sales charges on investment. There is always an AOE. Keeping expenses down will take more than just looking at the obvious charges. A prudent investor, whether working individually or through a broker, should inquire of an investment's expense. Always seek the best performance with the smallest cost. Sometimes, there is a trade-off, but the bottom line is what keeps you goin'. Good luck investing and don't forget to put on those horse-tradin' boots. If your broker doesn't want to haggle, tell him to hit the high road and find another who will.

Gary Ellis, MBA, CFP