"There is no free lunch."
Every product or service has a fee associated with it. Investment fees are often embedded in the cost of the product in such a way that people may think it’s free. The truth is... it’s anything but free. We’ve all the heard the saying "you get what you pay for", but as Jack Bogle, the founder of Vanguard, put’s it, "you get what you don’t pay for." In other words, any money you save on fees and expenses is yours to keep and goes straight to your bottom line.
Understanding fees requires some basic understanding of the types of fees typically found in the investment management and advisory world. Here are some examples:
Flat, Fixed, or Hourly Fees- A small, but growing number of advisors and financial planners are compensated by fixed fee agreements which are not based on the size of a portfolio or the purchase of a product. Instead, these fees are based on the amount of time and/or complexity of the advice arrangement. (Hint: We think this is best!)
Assets Under Management (AUM) fees are typically a percentage of total investments paid to an advisor or manager of those funds. Often around 1%, this fee is paid each year and varies depending on the value of the portfolio being managed.
Commissions were at one time the most common way an advisor/broker received compensation. A portion of the amount being bought or sold in stocks, bonds, mutual funds, etc., was deducted from the trade amount and provided to the broker and the firm he works for. These fees can vary significantly but a commission of 5% on the purchase of mutual fund "A" shares is common.
Expense Ratios- These fees, deducted from any mutual funds you own, are paid to the mutual fund company to cover their expenses. All mutual funds have fees and they vary widely from company to company and fund to fund. The average mutual fund expense ratio is often quoted to be 1.2% per year.
12(b)-1 Fees- Deep within the prospectus of many mutual funds is a controversial fee arrangement between some mutual fund companies and the financial advisors who sell them. Named after the section in the "rule book" that allows the fee, the 12(b)-1 is the portion of a fund's expense ratio that is routed back to the advisor that sold the fund and his firm. In other words, it’s an increase in the normal mutual funds expense ratio to compensate an advisor for the marketing and sale of the fund. Like a commission, but ongoing every year instead of being paid once. These fees can range from less than .25% to as much as 1%. It should be noted that there are lots of mutual funds that do not charge 12(b)-1 fees, and not surprisingly, an advisor who has built a practice around collecting these fees will rarely recommend non 12(b)-1 funds.