With the economy in difficult straights and the financial markets leaving investors wondering when the next shoe will drop, many do it yourself investors are rethinking whether or not to hire an investment advisor. For years investors have turned to investment representatives at large brokerage firms. Lately though, informed investors have begun looking for greater options and in growing numbers they are turning to smaller independent firms which tout fee transparency, a fiduciary relationship, lower advisor to client ratios and lower costs. A diligent and capable advisor can help develop an investment strategy that may fit the investor’s needs, improve returns, manage risk and reduce the work-load and stress level.
One of the primary reasons that investors are reluctant to hire an advisor is perceived cost. Interestingly, investors are unaware of some of the more punitive hidden costs. When we think of cost, the first one that comes to mind is commissions. Commissions are fees paid to investment sales professionals for selling you an investment. We will limit our focus to mutual funds for the sake of this article. Five percent (5%) is a typical commission for the purchase of a retail mutual fund. Sometimes commissions are hidden in the form of surrender charges and 12b-1 fees but they are present nevertheless. Of course do-it-yourself investors buy “no-load” mutual funds. These are mutual funds that are sold directly by the mutual fund company without the help of a sales representative so no commissions are charged.
When considering whether or not to hire an investment advisor, you should always ask how the advisor is compensated. Where possible you should opt for an advisor who is paid a fee for advice rather than a commission, that way you will know that the advisor won’t be tempted to move you in and out of investments for the sake of generating commissions. Keep asking questions. There is often a big difference between what the advisor is paid and what you actually pay in costs. The better question would be “What are the total costs of the investment strategy?”
There may actually be three different costs associated with an advisor managed investment portfolio. The first is the advisor’s fee which is generally quoted as a percentage of assets under management. At many of the larger firms this fee may be as high as 3% per year. One way to determine an advisor’s maximum fee is to consult their Form ADV (Part II and Schedule F). This is the disclosure document required by the federal government for all Registered Investment Advisors.
The advisory fee is just the tip of the iceberg though. In addition to paying the advisor, you will pay the mutual fund company, even if you are buying no-load mutual funds. The mutual fund costs paid by the investor typically include the fund’s internal expense ratio which according to Morningstar averages 1.32% per year and the mutual fund’s trading expenses which according to a recent study by Virginia Tech, The University of Virginia and Boston College averages 1.44%. Total investment costs could easily top 4%.
You will want to make sure you get a clear answer to your question about costs. Amazingly, many investment advisors are unaware of a fund’s trading costs and this component of expense can be a big one. If the advisor doesn’t know they exist he/she is unlikely to quote them to you. Trading costs are the variable costs paid by a mutual fund to brokerage firms which place securities trades on behalf of the fund. One of the reasons that so many advisors and investors are unaware of these costs is that they are not usually disclosed in the prospectus. You will find them only in the fund’s Statement of Additional Information (SAI).
So when you ask an advisor what his/her fee is, be sure you get the complete answer, not just “My fee is one percent”.
