Keeping Portfolio Costs Low Goes Beyond Fees And Commissions

by: David J. Waldron
Summary

Advisory fees and broker commissions are typically the primary targets when addressing the costs of managing a self-directed investment portfolio.

Keeping fees and commissions well below 1% are paramount to a cost-effective investment portfolio.

But Main Street Value Investor gauges at least four other significant threats to a portfolio’s total return.

The churning of fees and commissions is the Wall Street way to a beach house in the Hamptons. How about returns on capital invested? That is certainly an added benefit of the financial elite's output when it occurs.

However, the individual investor on Main Street must be wary of a myriad of other portfolio expenses that eat away at total returns.

Regardless of level, whether professional or personal, investing full-time, part-time, or in your spare time, all investors should focus on keeping portfolio costs as low as possible.

As defensive investors, we have developed a model to measure the real costs of managing and sustaining a profitable investment portfolio.

Here is Main Street Value Investor's primer on keeping portfolio costs as low as possible. Surprisingly, it involves more than just pursuing reasonable advisory fees or discount brokerage commissions.

The Promises and Perils of Self-Directed Investing

Long-view investing is the pursuit of the opportunity of total returns from compounding capital and dividends, market gyrations notwithstanding, against the perils of the inherent risks and costs of that pursuit.

For individual investors, the journey typically comes in one of two forms:

  1. An investor that is seeking to start a new or maintain an existing personal brokerage or retirement account, e.g., 401(k), IRA, or 529 Plan, utilizing the self-directed medium of a long-view buy-and-hold investment approach to personal money management.
  2. An investor that has retained professional money management, e.g., registered investment advisor, licensed broker/dealer, or certified financial planner, to oversee his or her brokerage or retirement accounts.

In either case, it is imperative to keep portfolio costs as reasonable as possible to maximize total returns from capital gains and dividends. Whether invested in individual stocks, bonds, mutual funds, or exchange-traded funds; cost management is as important as compounding capital gains and collecting dividend payments.

The primary difference is portfolio expenses are something we can control. Not so much for the fluctuating capital gains and dividend payouts from company and market gyrations.

But first, let's make sure those Wall Street bonus feeding fees and commissions are as low as possible.

The <1% Rule on Advisory Fees and Broker Commissions

Should you ditch your money manager? The short answers are yes, no, and maybe.

Perhaps a disclaimer that Main Street Value Investor is not about firing your investment advisor, financial planner, or broker, whether he or she operates on Wall Street or Main Street. In fact, I believe that many reputable, fee-only advisors or planners, as well as ethical discount brokers, exist and have the best interests of clients are at hand, especially financial professionals held to a fiduciary responsibility to investing clients by laws or regulations.

However, it is the advisory fees and broker commissions, as much as the advisors themselves that should be the focus of the individual investor. If you are paying more than one percent annualized in combined fees and commissions on your investment portfolio, you are paying too much. Frankly, 0.75% to 1.00% is on the high end of what is reasonable and possible.

If your advisor is charging you less than 1.00% annualized — with no high commissioned products — and you are happy with his or her performance and service then by all means stay the course. However, if you are like many individual investors inundated with excessive fees not supported by relative return then contemplating the alternative may be in order. Moreover, if you are already an independent, self-directed investor, focus your energy on keeping your portfolio fees and commissions as low as possible. Online discount brokers, low-cost mutual fund companies, and dividend reinvestment plans (DRIPS) are good places to start.

Main Street Value Investor's View on DRIP Plans

Value investors, regardless of whether working on Wall Street or living on Main Street, are often leery of automatic dividend and capital gains distribution reinvestment programs. We prefer to buy securities at our prices, and not on the whims of Mr. Market. The disciplined value investor allows dividend and capital gains distributions to settle as "cash" and then reinvests those funds when prices are attractive. The commission-free automatic reinvestment plans are appealing and may be the best course for the passive investor, but theoretically are more expensive than reinvesting on our terms of value, paying only modest discount broker commissions when reinvesting our precious dry powder.

How to Keep Advisory Fees and Commissions at Less than 1%

I use a discount broker when buying or selling stocks, ETFs, or mutual funds. My broker charges $4.95 per trade (there are probably discount brokers that charge less), and I invest only in ETFs and no-load, i.e., no commission, mutual funds that carry fees of less than 1% per year, although lower than 0.50% is best. Besides, one can readily find wonderful, actively managed ETFs and mutual funds that charge less than 1% in annual fees. Of course, index funds are the best opportunity to get below the 0.50% preferred threshold.

Limit Portfolio Turnover

Another solution to keeping investment expenses low is not to turn over a position — or portfolio for that matter — in less than three- to five-year increments.

Portfolio turnover is the measure of how frequently assets are bought and sold by the individual investor. We also gauge institutional portfolio turnover as it applies to actively managed ETFs and mutual funds. Low-cost active fund managers keep fees in check by limiting position churns or portfolio turnover.

Nevertheless, active trading produces excess fees and commissions as well as tax liabilities on short-term capital gains that may sabotage any actual gains from the speculative activity.

Let's take a peek at a self-directed investor's sample portfolio of $5,000 invested equally in five stocks and funds annualized over five years to demonstrate sensible fee management.

In the above chart, the investor is applying $1 each year in commissions on the stocks and ETF, i.e., $4.95 rounded up to include the ubiquitous penny service charges Wall Street throws into trades, divided by five years. We then add the management fees for the ETF and mutual fund to calculate the total annualized percentage. For simple illustration, the example assumes no capital or income appreciation in the assets over the five years which is obviously not the real-world desired result; nor any account value depreciation which is also not the objective, although certainly possible.

What About Bid/Ask Spreads or Slippage?

Some readers may be asking about the pitfalls of bid/ask spreads, such as hedging the price slippage from high-frequency trading with a limit order. As value investors of Main Street, we do not get caught up in the trader mentality and leave it to the individual investor on how he or she chooses to purchase or sell securities in the least expensive, lowest risk way. By using an online discount broker, these issues are minimal in the scheme of things.

For example, billion-dollar institutional portfolios are adversely affected by millisecond fluctuations in bid/ask spreads, and therefore the portfolio managers practice arbitrage and order limits to minimize price erosion when trading. To the contrary, we leave the pennies lost on a relatively small portfolio to the whim of an individual's principals believing the high-quality Main Street portfolio will suffer insignificant, often undetected damage from price fluctuations at the time of the trade.

Either way, the annual percentage cost is relative. However, despite not accounting for any capital gains or dividends, the above sample portfolio owns five quality positions for an annualized cost of around $2.30 per $1,000 invested, or 0.23%. That is far less than 0.50% per year, never mind 1.00%.

Vanguard Group's investment management legend, John Bogle, has famously demonstrated how annual fees do add up exponentially, but no investments are free of costs, so his valuable lessons are designed to keep yours as low as possible to limit the suction from the Wall Street fee machine.

Four Overlooked Threats to Your Portfolio's Cost Effectiveness

Although garnering most of the attention in the financial media, the cost of investing ventures far beyond just advisory management fees and broker commissions. Here are four often overlooked threats to your portfolio's cost-effectiveness.

401(k) Fees

Retirement consulting firms that market 401(k) plans or the similar non-profit and pension plans take, on average, a whopping 1.4% of your balance just for administering the program. Furthermore, the skim does not include the management fees deducted from the mutual funds or ETFs offered within the plan's menu of investment choices. Consequently, if an investor keeps fund advisory fees at a reasonable 0.60%, expense management becomes more challenging in a company plan than a self-directed one due to the consulting firm's fees.

Inflation

Dating back to 1913, the average annual rate of inflation in the United States is 3.18% as of 2016. Of course, annual inflation can be higher or lower going forward, but for the sake of argument, we use an average of 3% annually as our benchmark. Inflation is a significant erosion threat to investment portfolios.

Income Taxes

In the U.S., capital gains are taxed at 15%, and dividends are taxed as ordinary income. However, according to the Tax Policy Center, in 2014, American taxpayers were subject to effective tax rates including payroll taxes such as Social Security and Medicare of between 2.1% on the lowest income spectrum and 27.8% on the highest income level. Since the median effective tax rate was 15.0%, we use that figure for illustrative purposes.

Technology

Another overlooked, but significant cost contributor to investing is the technology we use to build and maintain our portfolio. Desktop computers, tablets or laptops, and smartphones are standard vehicles for investment research and trading. However, there are monthly fees from internet service providers and mobile telecoms to supply those connections. It is not unusual to pay upwards of $200 a month combined for a single device cell phone plan with mobile data plus a high-speed internet connection for the home or office where we do most of our investment research and online trades.

Of course, one must prorate costs directly tied to investing activity, and those costs plus eligible depreciation of equipment may be tax deductible. Same for fees and commissions.

Readers are encouraged to consult a tax advisor for details on his or her situation. Nonetheless, deductible or not, each is a cost to the portfolio.

Modeling the Annual Cost of Managing a Self-Directed Portfolio

Using the above cost drivers in a typical self-directed portfolio, we break down the real cost of being a value-oriented investor.

The median savings for American families is $60,000, so we use a rounded $50,000 total portfolio to measure overall costs to the investor.

Based on examples and national averages covered in this post, we assume the following parameters in calculating total portfolio costs:

  • Combined total portfolio of $50,000 of which half is in a self-directed brokerage or IRA account and half is in a 401(k) or similar employer-directed plan.
  • Brokerage and IRA fees are 0.25% annually.
  • Combined 401(k) or equivalent employer-directed account fees are 2.00% annually based on 1.40% administrator fees and 0.60% fund fees.
  • Average annual inflation is 3%.
  • Effective tax rate of 15%, after deductions, based on the average annual total return of 10% from dividends and capital gains.
  • We prorate technology costs directly tied to self-directed investing at about 10% or $250 of the estimated $2,400+/- annual total cost of mobile and internet fees, plus hardware depreciation if any.

Some readers may consider 10% average total returns as generous. However, if you take into account the historical total return for the S&P 500 is about 12% annually and assume cash and fixed income hedges comprise about 25% of the portfolio, we are looking at a minimum of a 10% average total return over a long-view horizon. Thus, we are sacrificing a mere two percentage points of the gain for the near-term safety or hedging using the cash and bond holdings.

A review of semantics may dictate that the portfolio balance is $55,000 if you figure the assumed annual total return of 10%, and thus the numbers need adjusting. But remember, our model is for illustrative purposes, and when factoring the several liabilities affecting a portfolio, the real cost may erode as much as 60% of the annual average gain, e.g., 6.00% of the 10.00%, respectively.

The sobering reality of our example is that a well-managed, cost-effective, self-directed portfolio is getting only about a 4% net total return on the investments, based on a 10% average annual total return on capital and dividends. Even more somber is if you add a 1% money manager to the mix, the sample portfolio is netting only a 3% average gain per year after factoring all direct and indirect costs.

That written, the self-directed 4% net average annual gain after expenses is better than nothing. That is why we invest in the first place: to beat nothing, the guaranteed return if you do not invest a portion of your earnings in the first place; or worse, three percent less than nothing if you factor the historical inflation rate.

Give Your Portfolio a K.I.S.S: Keep Investing Super Simple

To be sure, Wall Street will always overachieve the Main Street investor in overall investment-related income due to its knack for punishing clients with enormous churns of fees and commissions. As contrarians of the Wall Street Way, the mantra of the new value investor of Main Street is the absolute return of both capital and dividends with minimal fees and commissions.

We will never pay more than one percent of invested assets annualized in discount brokerage commissions and fund fees, combined. It is simply not necessary to pay more. In fact, we will likely incur significantly less than one-half of one percent in annualized fees and commissions on our investments.

Considering other, often overlooked costs such as 401(k) fees, inflation, income taxes on dividends and capital gains, and the technology used to research and trade those investments, keeping up-front fees and commissions closer to 0.25% becomes paramount to a low-cost portfolio.

Furthermore, we do not invest our hard earned dollars in any speculative, often high-cost investments such as commodities, high yield or distressed debt, currencies, or abstract derivatives enjoyed by the Type A personality Wall Street traders and speculators.

Also avoided are complicated, risky investment vehicles such as options or short selling. Perhaps we are entertained by observing such exhilarating and speculative activity, but only from the sidelines.

The bottom line is keeping portfolio costs reasonable also involves picking cost-effective investment vehicles such as dividend-paying common stocks, low cost mutual and exchange-traded funds; plus cash instruments to store dry powder from contributions, capital gains, and dividends. Be cautioned that some funds and brokers are charging inexcusable fees for money markets and sweep funds as well. The Hampton churn comes from virtually all investment categories.

As individual situations vary, I challenge readers to use the chart to plug in your investments and expenses to determine your overall cost of investing and your portfolio's real bottom-line net gain.

Nevertheless, like any business, work diligently to keep your investment costs as low as possible to make controllable contributions to your portfolio's bottom line.

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Comments are strongly encouraged and always welcomed. Please read the important accompanying disclosures.

Main Street Value Investor is a trademark, and Main Street Value Investor Model Portfolio (MSVI) and Main Street 20 Watchlist are servicemarks of David J. Waldron.

Disclosure: I am/we are long DIS, JNJ, MMM, VOO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Data is for illustrative purposes only. The accuracy of the data cannot be guaranteed. Narrative and analytics are impersonal, i.e., not tailored to individual needs or intended for portfolio construction beyond the contributor’s model portfolio which is presented solely for educational purposes. David J. Waldron is an individual investor and author, not an investment adviser. Readers should always engage in further research and consider (as appropriate) consulting a fee-only certified financial planner, licensed discount broker/dealer, flat fee registered investment adviser, certified public accountant, or qualified attorney before making any investment, income tax, or estate planning decisions.