Democratizing Wealth: A Study on the Impacts and Efficacy of Low-Cost Investment Approaches
Investing is an essential financial strategy for individuals and institutions alike. It allows us to grow our wealth, achieve long-term financial goals, and secure our financial future. However, the costs associated with investing can significantly impact returns, particularly over long periods of time. Below, we will explore the importance of low-cost investing, highlighting its benefits and implications for investors. We will also examine strategies and financial instruments that enable us to minimize investment costs, thereby maximizing returns.
Understanding Investment Costs
To appreciate the importance of low-cost investing, it is essential to understand the different types of investment costs. These costs can be broadly categorized into three types: management fees, trading costs, and taxes.
Management fees: These are fees charged by financial professionals and institutions for managing your investments. They include expense ratios for mutual funds and exchange-traded funds (ETFs), as well as advisory fees for investment advice.
Expense ratio is the annual fee charged by a mutual fund or exchange-traded funds (ETFs) to cover operating expenses, such as management fees, administrative costs, and other expenses. It is expressed as a percentage of the fund's assets under management and is deducted from the returns earned by the fund.
The average expense ratio for funds can vary depending on the type of fund and the management style. According to Morningstar's 2021 fund fee study, the asset-weighted average expense ratio for mutual funds in the U.S. was 0.40%, which means that the average investor paid $4.00 for every $1,000 invested in a mutual fund. However, the fees can vary widely depending on the fund's objective, investment style, and management fees. Some mutual funds may charge fees as low as 0.03%, while others may charge fees upwards of 2% or more.
Some mutual funds may also charge "hidden" or "soft" fees, such as revenue sharing or 12b-1 fees, which are used to compensate brokers or financial advisors who sell the fund. These fees are not always apparent to investors, but they can add up over time and erode investment returns.
It can be challenging for investors to see mutual fund or ETF management fees because they are often buried in the fund's prospectus or other disclosure documents, which can be lengthy and difficult to understand. Investors may also overlook fees because they are not always presented in a clear and concise manner, often making it challenging to compare different funds on an apples-to-apples basis.
Trading costs: These are the costs associated with buying and selling securities. They include brokerage commissions and bid-ask spreads.
Brokerage commissions are fees that investors pay to their brokerage firm when buying or selling securities, including mutual funds, ETFs, stocks, and bonds. These commissions can increase trading costs because they are an additional expense on top of any fees charged by the mutual fund itself. For example, if an investor buys $10,000 worth of a mutual fund with a 1% commission, they will pay an additional $100 in commission fees for that purchase.
Over time, these commission fees can add up, especially for investors who trade frequently. For example, if an investor buys and sells mutual funds multiple times a year, they could be paying thousands of dollars in commission fees alone, which can significantly impact their overall investment returns.
In addition to potential commission costs, investors may also incur other trading costs more discretely through the bid-ask spread. The bid-ask spread is the difference between the price a buyer is willing to pay for a security and the price a seller is willing to accept. These spreads can be higher for less liquid securities and can also increase trading costs. Notice that these bid-ask spread can show up in accounts that offer commission-free trading.
Taxes: In most taxable investment accounts, taxes are levied on investment gains and can significantly impact returns. Income and net investment income taxes on capital gains, dividends, and interest can erode investment returns. The amount of taxes that investors pay on their investments can depend on several factors, including the type of investment, the investor's tax bracket, and how long they hold the investment.
These taxes over time can drag down the performance of an investment portfolio's after-tax returns. This drag on the portfolio is often referred to as tax drag. Tax drag occurs when an investor pays taxes on the income or gains earned by their portfolio, which reduces the amount of money available to reinvest and compound over time.
For example, if an investor earns a 10% return on their portfolio but is required to pay a 20% tax on the gains, their after-tax return would be reduced to 8%, which is the net return after taxes. Over time, this reduction in after-tax returns can add up and significantly impact an investor's long-term investment performance.
It’s important to consider which factors can increase the tax-drag on the portfolio, including the investor's tax bracket, the type of investments held in the portfolio, and how frequently the portfolio is traded. For example, if an investor holds a portfolio of actively managed mutual funds that generate high levels of taxable gains, they may experience a higher level of tax drag compared to an investor who holds a portfolio of tax-efficient index funds, traded less frequently.
The Impact of Investment Costs on Returns
The cumulative impact of investment costs on returns can be substantial, especially when compounded over the long term. Even seemingly small fees can dramatically reduce the overall returns on an investment portfolio. To illustrate this point, consider a hypothetical investor who has a starting portfolio value of $200,000 and expects an annual return of 7%. If the portfolio's fees and costs amount to 1% per year, the investment would grow to approximately $1,149,000. However, if the costs were 2%, the investor's portfolio would only grow to about $864,500 over the same period. In this example, the seemingly small difference of 1% in annual costs resulted in a significant reduction of $284,500 in the investor's final portfolio value or 25% of the final portfolio value. If the investor were to plan on utilizing this portfolio to fund retirement, this 25% percent reduction would significantly impact the kind retirement lifestyle of the investor.
Strategies and Financial Instruments for Low-Cost Investing
There are various strategies and financial instruments that investors can employ to reduce investment costs and enhance returns. Some of these include:
Low-Cost Instruments: When comparing investments, it’s important to look at a holding’s expense ratio relative to similar alternative investments. For example, there are countless investments that seek to track the S&P 500 with vastly different expense ratios. As of March 2023, there are S&P 500 funds that have management fees as high as 2.31% per year and other funds with fees as low as 0.03% per year. Note that the underlying holdings are almost identical but the performance over time will increasingly diverge. Different market sectors and investment strategies will also yield varying anticipated fees. It’s important to consider the cost of investments to similar peer investments when comparing costs.
Passive Investing: Passive investing involves tracking a market index or a specific segment of the market, rather than actively selecting individual securities. Passive investment vehicles, such as index funds and certain exchange-traded funds (ETFs), typically have lower management fees compared to actively managed funds. These funds typically forego the services of professional portfolio managers and are often competing with other index funds tracking the same or similar indexes, resulting in greater competition among fund providers.
A reduction in trading frequency can also reduce the bid-ask spread paid for trading stocks and ETFs. As mentioned above, the bid-ask spread is the difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller is willing to accept (ask) for a particular security in a financial market. Passive Investment strategies generally include a reduction in trading frequency which can ultimately lead to higher net returns.
Tax-Efficient Investing: Investors can minimize the impact of taxes on their investment returns by adopting tax-efficient investment strategies. These strategies include investing in tax-advantaged accounts such as IRAs and 401(k)s, holding investments for long-term capital gains treatment, and investing in tax-efficient assets such as municipal bonds and ETFs.
Choosing the proper account type for a client's investment portfolio is crucial to minimizing tax liabilities and maximizing after-tax returns. Various account types, such as taxable brokerage accounts, tax-deferred accounts including 401(k)s and IRAs, and tax-exempt accounts such as Roth IRAs, have different tax implications. By strategically allocating investments across these account types, clients can benefit from their unique tax advantages. For example, placing high-yielding, interest-generating assets in tax-deferred or tax-exempt accounts can help shield them from immediate taxation, while placing investments with a long-term growth orientation in taxable accounts can take advantage of lower capital gains tax rates. This careful account selection and asset allocation can help investors reduce their overall tax burden, preserve wealth, and ultimately enhance their long-term financial goals.
Furthermore, the type of investment is important in reducing the tax-drag on portfolios. Consider the differences between ETFs and Mutual funds. Exchange-traded funds (ETFs) offer certain tax advantages over mutual funds, making them the preferrable choice for tax-conscious investors. A key advantage is that ETFs are generally more tax-efficient due to their unique structure and the way they are traded. Unlike mutual funds, which calculate their net asset value (NAV) once a day and trigger taxable events when portfolio managers buy or sell securities to accommodate investor redemptions, ETFs are traded on stock exchanges like individual stocks. Furthermore, when ETF shares are redeemed, it is typically done through in-kind transactions, meaning the ETF provider exchanges the underlying securities for ETF shares, which minimizes the realization of capital gains. This tax efficiency can help investors retain more of their returns, contributing to better long-term investment performance compared to mutual funds in some cases.
Low-Cost Brokerages: Online discount brokerages offer lower trading costs compared to traditional full-service brokerages. Charles Schwab was one of the first to pioneer this in the mid-1970s and since then, many other discount brokerages have come to join them. Investors can take advantage of low-cost or even commission-free trading services provided by these platforms to minimize trading costs.
Management Fee Transparency: It is crucial for investors to be aware of the fees associated with their investment management. By understanding the costs involved, investors can make more informed decisions and select low-cost investment options.
Registered Investment Advisors (such as Selective Wealth Management) and brokers differ significantly in their fee structures, which can impact the services they provide and the overall cost of investing for their clients. RIAs typically operate under a fee-based model, charging clients based on a percentage of assets under management (AUM), hourly rates, or fixed fees for specific services. RIAs are required to provide clear and transparent fee disclosures to their clients as part of their fiduciary duty and regulatory obligations. These will always be presented in the client agreement and will also be clearly listed on account statements.
In contrast, brokers primarily work under a commission-based model, earning income through commissions on the securities and investment products they sell to their clients. Commissions for investment brokers can be difficult for investors to identify for several reasons. These commissions are often embedded in the cost of the transaction or the price of the investment product, which can make them less transparent to the investor.
Bundled costs: When brokers execute trades on behalf of their clients, the commission may be bundled into the overall transaction cost. Investors may not see a separate line item detailing the commission fee, leading them to underestimate the true cost of trading.
No explicit fee disclosure: Commissions may not be explicitly disclosed upfront or may be presented in a complex manner. This lack of transparency can make it challenging for investors to understand the exact fees they are paying.
Load fees on mutual funds: Brokers may earn commissions through sales charges or load fees on mutual funds. These fees are often built into the share price and might not be clearly visible to the investor. Front-end loads are paid when shares are purchased, while back-end loads are paid when shares are sold. The commission paid to the broker is typically included in these fees.
Hidden fees: Brokers might also receive indirect compensation from product providers, such as 12b-1 fees or revenue sharing arrangements. These fees are not directly paid by the investor but are included in the expense ratio of the investment product, making them harder to identify.
Due to these factors, commissions for investment brokers can be difficult for investors to see and fully understand. This lack of transparency may make it challenging for investors to compare the cost of different investment products and services, potentially leading to higher overall investment expenses.
Conclusion
Low-cost investing is a critical component of a successful long-term investment strategy. By minimizing management fees, trading costs, and taxes, investors can maximize their potential returns and achieve their financial goals more effectively. Moreover, low-cost investing encourages long-term investment horizons and facilitates portfolio diversification, both of which are essential for managing risk and building a robust investment portfolio.
In conclusion, low-cost investing should be a necessary consideration when building a portfolio and investment strategy. It plays a vital role in ensuring that investors can grow their wealth and secure their financial future. By understanding and minimizing the costs associated with investing, investors can significantly enhance their long-term returns, paving the way for a more successful and financially secure future.