Understanding Investment Fees
The first step in determining if you’re getting value is to know how and what you’re paying.
The second step is to assess alternatives to decide if you’re using the best fee model for your situation.
Work towards separating what you pay for investment management from what you pay for financial planning and advice.
You may pay the same person for both investment management and financial planning and advice, but it is essential to separate the two very different jobs, to know how your fee is split between the two jobs, and to assess value received separately for each job.
This article summarizes the four main ways you pay fees: commissions, annual fee, Management Expense Ratio (MER), and spreads.
First, make sure you understand the basics of each model. Next, have a conversation with your advisor about how the investment management job is split from the financial planning and advice job – ask for specifics and see what you get.
Use your best judgment to assess the answers and give me a call and I’ll help you translate!
MER (Management Expense Ratio):
The MER-model of compensation is just like an annual fee, but it’s ‘hidden’ because it is deducted straight from the fund in which you’ve invested. Both mutual funds and Exchange Traded Funds charge MERs annually to cover their expenses. The MER is calculated based on a percentage of the money you have invested in the fund and it is taken directly out of the money you have invested in the fund, so it is easy to forget how much you’re paying annually in fees.
You will not get an invoice from the fund company to pay the fees directly, so you will not have a frequent reminder of what you’re paying the fund company for managing your investments. These fees are charged annually for as long as you own the fund.
Your advisor may receive a “trailer” from the fund company that charges this MER. The trailer is a certain amount of this MER you pay and is the compensation the fund company pays the advisor for selling their fund. In theory, the trailer is the compensation your advisor receives for doing the research to pick the most appropriate fund for you and provide you with other financial planning advice.
You need to know that some mutual fund companies pay higher trailers to advisors than others, and sad to say, but some advisors are incentivized to recommend that you buy the fund that pays them the highest trailer. By the way, the advisor will in most cases continue to receive this trailer every year that you own the fund, even if you never hear from that advisor again…
Of course, you want your advisor to be able to earn a reasonable living and be appropriately compensated for the advice they give you, but at the same time, there is absolutely nothing wrong with you asking and continuing to ask what portion of the MER they receive as a trailer from the fund you own.
Commissions:
A commission-based compensation model is one in which you pay a transaction fee when you buy and when you sell. The commission is either split between the human advisor and the firm, or it goes straight to the firm it there’s no human facilitating or advising the trade. The amount is usually calculated based on a percentage of the dollar amount of the trade. There is often a minimum size of the commission in this case. A commission may also be a flat fee that you pay regardless of the size of your trade.
You can conceptualize the commission model as the fee that pays for advice and service leading up to and after the transaction, including compensation for access to the trading system. People who like commission-based compensation models like the idea of paying when they take action, paying for someone to do some specific research on a trade for them, or who don’t need advice at all so are happy to simply pay the commission charged to make the trade.
There’s uncertainty in your annual investing costs with commissions because it depends on how often you trade.
Annual Fees:
An annual fee model is one in which you pay an amount of money every year calculated as a percentage of the size of your investment account. There are usually no additional costs throughout the year if you pay an annual fee. Robo-Advisors charge an annual fee (go to the Resources page to learn more about Robo-Advisors).
You can conceptualize the annual fee model as the fee that gives you access to advice that is not linked to whether you make the trade or not. The advice you get could be more objective because of this fact since there are no incentives to convince you to act. The annual fee model is good for people who like the relative certainty of the annual cost of investment advice rather than the unknown commissions.
After a few years on the annual fee model, you’ll want to look back and assess how many trades your advisor did for you and how much advice you got to make sure this is the right model for you.
Spread:
When you invest in products that pay you an interest rate return, the institution selling you that product takes a ‘spread’ as compensation. This means that if the bank knows they can take your cash and turn around and invest it themselves for 5% interest, they are confident offering you, say, 4% interest on the product. In this case, you buy the product, happy with your 4% interest, and the bank turns around and invests your money for 5% and takes the 1% spread (profit).
Nothing wrong with this, it just sheds light on the often-repeated mantra that there are no fees associated with certain products like GICs (Guaranteed Investment Certificates) at the bank. It is fair for you to ask the bank salesperson for the spread they’re charging on products such as GICs, just for your information.
