While the focus in investing is often on returns, it’s important for investors to understand the impact of expenses on their investing results.

An investor bulletin published by the Securities and Exchange Commission (SEC) shows the effect of higher expenses on investment returns. They looked at the impact of expenses on a hypothetical $100,000 investment held for 20 years. The SEC assumed a 4.00% annual rate of return, with annual expenses at 0.25%, 0.50% and 1.00%.

Here is the impact of these expense differences on returns:

• Over 20 years, incurring annual expenses of 0.50% reduced the end value of the portfolio by about $10,000 versus if the annual expenses had been 0.25%.
• Over 20 years, the portfolio incurring 1.00% in annual expenses had an ending value that was $30,000 less than the same portfolio with 0.25% in annual expenses. According to the SEC’s analysis, this difference in expenses over the 20 years adds up to an additional $28,000 in expenses over this time period. If that money had been available for investment, the investor might have earned an additional $12,000 in returns over this time period.

As you can see, a relatively small difference in the level of expenses incurred by an investor can really add up over time.

There are numerous added costs that investors need to be aware of. These eight common fees and expenses can easily eat into your returns.

1. Expense ratios

Mutual funds and ETFs carry expense ratios that pay for expenses such as administration, trading costs to buy and sell securities held in the fund, and other costs to operate the fund. The expense ratio is calculated by dividing the total operating expenses of the fund by the fund’s total assets.

The returns that investors receive from mutual funds and ETFs are net of expenses. For example, if a fund’s gross return was 10% for the year and its expense ratio was 1%, your net return would be 9% for the period. This is a simplified example as things like your holding period for the fund, investments and distributions during the holding period, combined with the fact that mutual fund accounting is a bit complex all factor in.

What this means is that all things being equal, if you are looking at two funds in the same asset class, the fund with a lower expense ratio would start with an advantage. In the case of an actively managed fund, you will want to look at many other factors beyond expenses. In the case of an index fund, you will want to be sure to compare funds that track the same index such as the S&P 500 or the MSCI EAFE (EAFE stands for Europe, Africa and Far East) index.

2. 12b-1 fees

Some mutual funds carry a 12b-1 fee, which is lumped in as part of their expense ratio. This is considered a marketing fee and is used to compensate brokers, registered representatives or advisors for selling or recommending the fund. These fees are sometimes also used in a 401(k) plan to cover a portion of the plan’s administrative costs and/or to compensate the plan’s outside advisor.

The higher the 12b-1 fee, the higher the fund’s expense ratio will be.

3. Sales loads

A mutual fund load is essentially a sales commission tied to certain mutual funds. Mutual funds with a sales load are usually associated with stockbrokers or registered representatives who are compensated through commissions.

There are two types of loads.

Front-end loads

Front-end loads are a charge assessed at the time that the fund is purchased. They are typically associated with A-shares. The front-end load is deducted from the amount of your money that is ultimately invested in the mutual fund.

As an example, assume the initial investment in a fund is $10,000 and the front-end sales load is 5%. The amount of the sales load would be $500 and the amount invested in the mutual fund is $9,500.

The front-end load goes to compensate the brokerage or advisory firm selling the fund. You may pay these loads in addition to any other fees you are paying for advice. The load reduces the amount invested and ultimately the amount of money you accumulate over time from investing in the fund.

For example, $10,000 invested in a fund on January 1 that earns 10% for the year will grow in value to $11,000 by the end of the year. If only $9.500 was actually invested, the amount you’d have at the end of the year would be $10,450. This would multiply itself over time and the discrepancy in the value of your investment would grow over time.

Back-end loads

Back-end loads have been typically associated with B and C share class mutual funds. B shares have largely gone by the wayside in terms of new sales, but there are certainly some shares out there held by investors.

In the case of B shares, there was no upfront sales charge or load, but the back-end load serves as a surrender charge instead. This means that if you sell the shares prior to the elapse of a set time period, the net proceeds to you from the sale would be reduced by the amount of the back-end load. Typically, these back-end loads decrease over time and disappear altogether at the end of the surrender period.

As an example, if the back-end load was 3% when the shares were sold after holding them for four years, selling $20,000 worth of fund shares would only net you $19,400 after the back-end load was assessed.

C-shares use another form of the back-end load which becomes a level load over time. A typical C-share mutual fund will include a 1% back-end loan that works as follows:

• There is a level load in the form of a 12b-1 fee, which is generally 1% on the fund. This is part of the expense ratio and typically never goes away as long as you hold the fund.
• If you sell during the first year after investing, the 1% turns into a surrender charge that is assessed on the proceeds of the sale of the fund.

4. Surrender fees

Surrender fees may be assessed on some annuities and mutual funds. A surrender fee is a percentage of the proceeds if the investment product is sold within a certain period of time.
A surrender period may last for a number of years, with the surrender fee decreasing over time. The purpose of the surrender fee is to discourage investors from selling the annuity or the fund prior to the end of the surrender period.

If a surrender charge of 2% is in place at the time an investor sells shares of a variable annuity worth $30,000, then the proceeds of the sale will be reduced by $600 in this case. This is a direct reduction of the overall return on this investment.

5. Financial advice fees

Fees for financial advice will vary depending upon the type of financial advisor that you work with. There are three basic advice models. However you pay for financial advice, it is still a cost and one that you need to understand and manage.

Fee-only advisors

Fee-only advisors charge a fee for the advice they render. There are no commissions or sales of financial products. Fee-only advisors will typically charge in one of three ways:

• Assets under management (AUM): Under this scenario, the advisory fee will be a percentage of the investment assets for which the advisor is providing advice. A typical fee might be 1% of assets. If you have $250,000 under advisement with the advisor, then your fee would be $2,500 annually. Typically, the fee would be charged based on the total assets under advisement at the end of each calendar quarter based on the annual percentage. In our 1% example, this would be 0.25% per quarter. Often advisors will scale their AUM fees to be lower for clients with higher levels of assets and vice versa for clients with smaller accounts.
• Flat retainer fees: Some advisors will charge a flat fee that is not based upon an asset level. They may have different fee levels based on the complexity of your situation or other factors.
• Hourly or project fees: Some fee-only financial planners and financial advisors provide advice on an as-needed or on a project basis. Their fee may be hourly or on a flat-fee basis for a specific project such as a financial plan or a review of your portfolio.

Commission-based advisors

Commission-based advisors are compensated through commissions from the sale of financial products. This might include sales loads from mutual funds or commissions from the sale of insurance products like annuities. These advisors must sell investment and financial products to get paid. Often the true cost of commissions is buried in the expense structure of the product being sold.

Commission-based advisors have the duty to propose suitable investments to their clients, this is a lower standard than acting in their client’s best interest. Therefore, a hidden cost might be that the product sold to you is not the best one for your situation.

Fee-based or fee-and-commission are both names for advisors who are compensated by a combination of fees and commissions from the sale of financial products. An advisor might produce a financial plan for you for a set fee, then implement their recommendations made in the plan through the sale of products that pay them commissions.

Fee-based and fee-only may sound alike, but they are decidedly different compensation methods and investors should understand how they differ. Fee-based has gained a level of popularity in recent years with the advent of the now ill-fated fiduciary rules.

6. Brokerage wrap fees

A brokerage wrap account is a managed account offered by brokerage firms. They will invest your assets in a fashion that is in line with your situation. The assets in the account are often mutual funds but could include ETFs or individual stocks as well.

Wrap accounts have gained in popularity during recent years as many brokerage firms have moved towards offering fee-based type products.

The wrap-fee is a management fee paid to the brokerage firm for managing the account. Wrap-fees can vary, but a typical range is 0.75% to 3% of the assets invested in the account. On top of that, the account may use mutual funds that pay a fee to the brokerage firm either through their 12b-1 fees or another method.

7. Transaction fees

Transaction fees are fees assessed for buying and selling investments. In addition to front-end loads and surrender charges discussed above, there are other types of transaction fees to be aware of.

• There may be a cost to buy or sell shares of a mutual fund. This may be assessed at certain custodians for certain funds. For example, Vanguard charges $20 per trade for certain non-Vanguard funds if bought or sold online and $50 if bought or sold by phone.
• There may also be a transaction fee to buy and sell exchange-traded vehicles such as ETFs or shares of individual stocks. For example, Fidelity offers $4.95 trades for many ETFs and stocks.

Note that transaction fees can vary widely from custodian to custodian, so it is wise to investigate. There are also a number of funds available on an NTF basis meaning there are no transaction costs to buy or sell.

8. 401(k) fees

In some cases, the fees and expenses associated with a company’s 401(k) plan might be assessed all or in part against the plan participant’s accounts. This could include costs for administration, recordkeeping and fees associated with an outside investment advisor for the plan. These costs do have to be disclosed, but make no mistake they are real, and they do reduce your returns within the plan.

Bottom Line

The fees and expenses discussed above are paid in a variety of ways, some not always transparent.

• Advisory fees may be paid directly by check, they may be billed to your investment account and taken from the assets in the account or they may be paid from 12b-1 fees that are part of the mutual fund expenses.
• Advisors may be compensated directly from the investments they sell or recommend to you using trailing commissions or other means.
• Expense ratios directly reduce the net return you realize from investment vehicles like mutual funds, ETFs and variable annuities.

It is important that if you are working with a financial advisor or a broker that you fully understand ALL costs related to working with them and how they will be compensated for the advice they provide.