Investment cost is the most predictable component of your future returns. The more you cut it down, the higher your future returns will be. But the notion of lower cost is so full of misconceptions and wrong comparisons that you should try to understand all the components of your total investment, and learn to compare apples to apples, before you make any drastic move.
Here is a quick checklist that you can follow:
First: Determine Price of Advice (POA). For mutual funds investors, POA is made of two components: 1)your fund’s annual expenses, largely accounted for by management fees paid to the portfolio manager and the fund company’s administrative costs, and 2) the fees that you pay to your investment advisor.
For load funds, advisor fees are typically embedded in the fund’s management expense ratio (MER) in the form of “trailer fees” (note: sales commissions are a separate item). In this case, your POA is equal to your fund (s)’ MER.
For funds that do not pay a trailer fee (typically no-load funds, or Class F funds), investors pay advisor fees separately, directly to the advisor, either in the form of a flat fee or as a percentage of the investment portfolio. In that case, POA is equal to the fund (s)’ MER plus the fees paid to the advisor.
Two: Compare apples to apples. Before you get too excited about how high your fund’s MER is, make sure you understand what it is made of. If it includes trailer fees, chances are your POA is not any higher or lower than the price paid by a no-load investor who works with a fee-based advisor.
As a rule of thumb, the majority of mutual fund investors who pay for investment advice can count on no less than 2.5% to 2.75% each year in terms of POA (annual fund expenses and advisor fees combined). So as long as your total cost is is within that range or reasonably close (and provided you are happy with the results, of course), you should drop the feel of guilt and stop resenting what you pay. This is the market price of advice.
Third: Do not ignore trading costs. Remember that MER does not include your fund’s trading costs, which can often be as high or even higher than MER. Trading costs include not only brokerage commissions, but also market costs and liquidity costs.
Fourth: Look at the overall picture. For any cost component, cheaper is definitely better, but always look at the overall picture. For example, a large cap fund that charges 2.5% each year may still be cheaper than a small cap fund that charges 1.5%. Likewise, a fund that reports a portfolio turnover of 300% and an MER of 1.5% may be more expensive than a fund with 30% turnover and a 3% MER.