The maze of fees and expenses that you pay to manage your financial situation is complex and opaque, and sometimes even unknown. Our mission is to simplify things and make sure that whatever cost you incur provides some sort of return either financially, or mentally, while still making sure that you are getting all the services that you require to make good decisions and have a sound financial situation.
Dear Family, Friends, and Clients:
Investment costs are a subject of high contention in personal finance these days. It appears that the entire industry is in a race to zero, and some cynics still chide that even at this rate, you would be overpaying. Recently the major brokerage and custodial firms reduced commissions to $0 on most trades. In fact, there are now several Exchange Traded Funds that are temporarily paying investors to invest in their funds; I seriously doubt the efficacy of any advice that I am compensated to accept. It is important, however, to minimize unnecessary expenses, and to be certain that what we pay is rewarded either tangibly, through a higher net worth, or intangibly, in the form of peace of mind. In other words, what we pay should either help us eat better or sleep better.
The unfortunate fact of the matter is that investment costs and related expenses are extremely complex, and in some cases completely hidden. This is a repercussion of operating in a fragmented industry. There can be multiple layers of fees to compensate brokers, advisors, mutual fund managers, custodians, insurance companies, tax advisors, and government agencies. The call to simply cut costs indiscriminately is hard to resist; however, a thorough understanding of what you get for what you pay can help put into perspective necessary fees and superfluous costs. At Basepoint Wealth, transparency is a requirement on which we are unwilling to compromise.
In order to unwrap the esoteric package of fees involved in modern day wealth management it is important to first classify and define the various categories of fees typically encountered. Some of these fees may be relevant to your financial situation, and some may not. Questions regarding which fees are applicable to you should be directed to your Wealth Advisor. This is a good long look behind the curtain and I will spare no details out of shame or modesty.
Financial Advisory Fees:
The most apparent fee is the fee charged by your Wealth Advisor for advisory services because this fee is deducted monthly and is clearly shown on your statement. This fee compensates your Wealth Advisor and your Wealth Advisor’s firm, and covers costs associated with providing financial advisory services.
Some of the fee is your Advisor’s compensation, some of the fee covers the cost of rent, technology and insurance, and some of the fee goes to help Basepoint expand the business infrastructure to offer more services to you. Oddly enough, since the financial advisory fee is the most transparent, it is the one that gets the most scrutiny. As we peel away the layers, I hope it becomes clear how increasing our fees a little can decrease the total fees that you pay significantly. Every time we move an operation in-house it is because we think that we can do it for significantly less cost, or because we feel that we can add significant value to the process. Remember that giant financial firms can provide cheap services because they deal solely on scale, not on quality. They develop systems that are approximately right for most people, but individually right for almost none. If you have ever read our opinion on “average” you will understand why this may not be in the best interest of anyone.
Basepoint is relentlessly transparent about the fees we charge, but unfortunately that is not typical throughout the financial advice industry. It always gives me a little smile when a prospective client tells us that their advisor works for free. If your advisor has an office, a computer, glossy brochures, and spends the winter in Palm Beach, she is getting paid. Unfortunately, for a large part of the industry, advisor compensation is buried deep within the costs of the products that are sold. It is a relatively reliable rule of thumb that the deeper the compensation is hidden within the product, the more likely you are dealing with a salesperson, the more complex and difficult it will be to replace the product, and the more expensive the product is over time.
Mutual Fund Expenses:
When we invest your money in a mutual fund, we are hiring a team to manage a portion of your assets within a certain strategy. The mutual fund is simply an investment company that holds passive (non-controlling interest) securities and is regulated under the Investment Company Act of 1940. Hedge funds seem more exciting because they are esoteric, and they use leverage to increase potential returns. The problem with leverage and lack of transparency is that we can hardly see what we own at any given time, and that leverage amplifies both returns and losses. In addition, they are not always appropriate for IRA and Roth IRA assets due to the leverage they use, and they are limited to accredited investors, which may not include all our clients. Our investment strategy is simple enough that using mutual funds satisfies most of our needs and is significantly less expensive that the 2% of assets and 20% of profits that the hedge fund and private equity wizards “earn”.
Research by Dr. C. Thomas Howard has shown that diversification by strategy is more important than diversification by asset class. While we do stratify our allocations by market capitalization, we try to access different strategies in each of our funds. The average portfolio that we encounter from outside Basepoint contains too many funds, all pursuing the same strategy, and many times even owning the same stocks. The biggest problem with most modern mutual funds is threefold: they are too large in terms of assets, they are over-diversified, and they buy and sell too often. Our mutual fund selection criteria specifically attempt to limit these three follies. We try to invest in small, concentrated funds, with low annual turnover.
While we pay a higher fund management fee because our funds are small, we pay lower internal transaction fees because the cost of trading is reduced. This makes logical sense because fixed expenses like rent and other operating expenses are a higher percentage of assets under management in a $500 million fund than they are in a $50 billion fund. In addition, hiring 13 analysts is more as a percentage asset in a similar way. Would you rather have a fund without adequate resources that costs .50% of assets, or a really well managed fund with adequate research capabilities that charges .80%? On a $100,000 holding, this $300 annual cost can mean the difference between a fully staffed investment team and a team struggling to gather and analyze information. What you give up in terms of focus and flexibility in a behemoth of a fund is well worth the $300 to remain small and nimble, in our experience.
Every time your fund manager buys or sells a security a commission is earned by a brokerage firm, a bit like an angel earning his wings when a bell rings. An industry rule of thumb is that round-trip commissions (selling something, then buying something) is about 2-3% of the total trade amount. If your fund has 100% turnover, you can estimate that they are paying somewhere around 2-3% of total assets in trading commissions. Likewise, if your fund has 10% turnover, you can estimate that the total cost of trading is around .30%. This is a big incentive for us to limit turnover, assuming that the fund manager makes good decisions to begin with. I always take pause of a manager who replaces his entire portfolio 3 times a year.
With this in mind, since an average fund used in the industry may cost 1% a year, and have 80% turnover, an investor could assume that they are paying somewhere between 3-4% on average for fund management and trading. Most of our funds should be significantly less than this due to our policy of using funds with low trading activity, even though the published expense ratio looks a little higher than other funds. However, our goal over time is move more of the investment management functions in house to start chipping away at this cost. Some investment strategies are easier to implement than others, and we will only take over strategies that we feel fully competent in managing. Some strategies require many years of experience, and that may force us to outsource these strategies indefinitely. But each time we move assets in-house there are significant savings that accrue to your account. It is very important to remember that we are better off paying the additional costs than doing things outside of our circle of competence. Be wary of the broker who spends half his week at the golf course bragging about his stock picking skills. It is always important to remember the immense chasm that sometimes lies between confidence and competence.
The information above holds true except in the alternatives funds we use. The expense ratios listed for our merger arbitrage and long-short portfolios are higher than average mutual funds. This usually comes down to the fact that they must pay interest on shares they borrow in short transactions. This is included in the expense ratio and skews the fees higher. If you have questions about this point, your Wealth Advisor can provide further details on the funds you own.
Trading, Execution, Account Maintenance Fees and Custody Expenses:
There are trading costs associated with the investments in your accounts. Basepoint covers these expenses as a part of your advisory fee. The rationale for having the firm cover the cost of the trades is that when Basepoint Wealth was established, many of our clients were following us from the Broker/Dealer model in which trading costs were being absorbed by the advisor. Basepoint Wealth is aware that many RIA fiduciary firms pass these costs through to their clients, and in some cases, this may be better for them in the long run.
Let us assume that there are two mutual funds that look similar on the surface but are very different in reality. One has a very diligent manager who has a core philosophy that he never deviates from, and he spends his time managing the assets in his fund, not out marketing to investors. The other fund has a manager who is less diligent in his investment duties but has gotten very large because he spends a lot of time having expensive dinners with prospective clients, courtesy of the fund’s shareholders. Part of his size advantage is that he can afford to pay a fee to brokers and custodians to be on the “no transaction fee” platform that makes it free to buy and sell the fund for investment advisors. Instead of paying per transaction, the fund simply gives a few million dollars to the custodian each year and it gets buried into the cost of managing the fund.
Now put yourself in the shoes of an investment advisor, and imagine you are trying to pick a fund in the category in which these two funds reside. On the one hand, you have a decent fund that should perform well over time with a high degree of confidence; on the other hand, you have a fund that is fine, but also free to trade. If you are in control of 2,000 accounts, and the fund will need to be added to each of these accounts at a $15 fee, the cost to the advisor is $30,000. If another fee has to be paid to sell the fund being replaced, the total cost is $60,000. But as an individual, the cost to you would have only been $30 to make the change in each account. A small price to pay to eliminate conflicts.
There are dozens of different trading charges and costs that we pay for trading in your accounts. Our agreement with our custodian on these various charges runs 14 pages. There are also account specific fees that we do not pay on your behalf like exercising a tender offer, retitling some assets, holding non-tradable investments, etc. In addition, there are account closing fees if an entire account is liquidated.
Some brokerage firms may have annual “account maintenance” fees, or IRA fees to cover costs associated with your accounts. These charges can be as high as $125 per year and provide very little in the way of benefits to you, or even your financial advisor. They were always hated by the advisor force at our previous Broker/Dealer, and a subject of high contention whenever they were raised or added to new types of accounts. Our current custodian does not charge maintenance fees or IRA fees right now, and we would seriously consider our options if they did implement them and a similar custodian were available without them, all other things being equal.
One final custodial charge that remains relatively unknown is the costs they charge relating to holding your cash. Every brokerage account has a money market account built in, called a “sweep account”. Many custodians mandate that their own internal sweep account be used on which they take some percentage of the assets over what you would earn in a normal money market account. Imagine having $100,000 in cash in an account that is mandated to use an option that is just .30% higher than the best alternative in fees, does not sound like much. In fact, it totals $300, and given the amount of cash we have at Basepoint it would be somewhere around $150,000 in additional charges to our clients for no extra benefits; this is a cost that we should strive to avoid. Our preferred custodian provides high flexibility in sweep options and we move back and forth between the FDIC Insured account and Government Securities account, depending on which one pays the highest interest rate.
Annuity and Insurance Charges:
Most people cringe at the word annuity; but just like any tool, in the wrong hands they can be dangerous, and in the right hands they can be productive. If your situation is improved by using an annuity contract, an entirely new layer of fees is added. A deferred annuity contract is an account with an insurance company that can be converted into a stream of income at a later date. The assets can be invested in subaccounts that resemble mutual funds, the insurance company general account (fixed account), or they can track some sort of index, usually subject to caps and floors. Since you are handing over some or all of the risk of loss to the insurance company, an additional fee is charged on top of the fund management fees. Sometimes these “Mortality and Expense Fees” and “Rider” charges can be as much as 2% of the account value on top of the other fees for management.
The reason that annuities get such a bad name is mostly due to the excess cost, but also due to the fact that they are proposed most often by salespeople. Sometimes the commission percentages can reach double digits. The drive to put $100,000 into a complicated annuity contract when a $10,000 paycheck is on the line can be difficult to resist. Especially when no further work is really required since the contract is inflexible anyway. But just like cicadas, the annuity salesman emerges when the surrender charges have expired to boast the new and improved contract that you simply must upgrade to, courtesy of the new commission. In addition, a lot of fancy and costly features can be added to the contracts, sometimes with additional commission accruing to the salesman. Clearly this is not a proper alignment of incentives.
The annuities we use at Basepoint are specifically designed for use by fee-only advisors. There are no commissions paid and the M&E expenses are very low. Interest rates are higher on fixed annuity products because there is no agent to compensate. We simply bill the annuity account just like any other account and that is the only revenue paid to Basepoint on the contract. There is no conflict of interest because it is the same fee regardless of whether or not we use an annuity for your situation. This means that we can stay in the same contract for many more years accruing benefits and achieving liquidity. Some of the available products are liquid immediately without a surrender charge from the first day.
Insurance is another tool that can be used unwisely, for the very same reasons. We have a similar suite of insurance products, but they get very little use because in most cases term insurance is the best option. There are, however, some situations where a permanent insurance policy is most appropriate. Your wealth advisor will work with you in these cases, but the same policy stands on insurance, we use fee-only products that we bill directly instead of products that pay commissions.
Commissions, Loads and 12b-1 Fees:
Some brokers still make their living charging commissions. This may be a wise arrangement when you want to buy a stock and hold it until the sun rises in the West, and further, have no cares if anyone is watching it. In fact, you may be better off just putting it in the lockbox at the bank and forgetting that you own it. In most other situations, paying commissions creates a conflict of interest between the salesperson’s paycheck and your goals and dreams. A person working on commissions has to start over every year to earn a living. This is not to say that the vast majority of salespeople who collect commissions are not entirely ethical, it is simply a fact that they have a conflict of interest. The main problem with commissions in investment accounts is that there is an incentive to overtrade. In the industry it is called “churning”, and it involves buying and selling at a furious pace to maximize the charges for transactions. As mentioned earlier, the longer the holding period the better in terms of both costs and taxes. In addition, commissions can sometimes be hard to track.
Sales loads on mutual funds are a relic from the past that may have outlived their usefulness. Originally, the maximum sales load was 8.5%, but most funds are lower than this today. The more money you put with a single fund family, the lower the initial sales charge. The 8.5% sales charge that old-school brokers earned was fair compensation for driving door-to-door to collect $50 or $100 every month to put away a little something for a future wedding, or for retirement. These accounts were meant to be held for decades, and the charges paid for the very labor-intensive process of collecting handwritten checks before computers and the internet was fair at the time. When I first started in this career 20 years ago, the last few of these grizzled veterans were rapidly approaching retirement. Many of them did not consider themselves financial advisors at all, they were simply in the business of collecting checks to put into mutual funds.
The biggest sin that I have seen with sales loads, is the spreading of assets among multiple different fund families to maximize the sales charge on the entire amount. If the maximum sales load of an account with less than $100,000 is 5.75%, and a client is moving over $500,000, which only pays 2%, imagine the bigger paycheck if you happened to use five different fund families instead of just one. In addition, I have seen instances where a salesperson will use a loaded product and then move the funds to a managed account immediately after, specifically for the purposes of maximizing their compensation. In other words, they collect 5.75% upfront, and then move to a different account in which they make 1.5% per year. Luckily, most of these practices are against compliance policies today.
12b-1 fees are another cost that can be difficult to find or calculate and are becoming a relic of a bygone era. They are for “marketing and distribution” and charged directly by the fund and passed through to the salesperson. Different fund share classes may have different 12b-1 fees typically ranging from .25%-1%. This compensates the broker for keeping you invested and it was a good bridge between sales loads and managed accounts as the industry was moving from sales to advice. The sneakiest use of 12b-1 fees is using a fund with a distribution charge in a managed account to hide the true cost of the account; charging 1% on assets but then also collecting .25% on the side from the fund companies without accountability. Basepoint does not recommend 12b-1 fee funds. If a Basepoint client does own a 12b-1 fee fund (transferred in from an outside account), any 12b-1 fees collected from our clients is retained by the custodian and not passed through to Basepoint or any of our advisors.
Regulatory Fees and Taxes:
Ronald Reagan said: “The nine most terrifying words in the English language are, ‘I’m from the Government and I'm here to help’”. But that never stopped them from trying. The Securities Exchange Commission was founded June 6, 1934 in response to the terrible things that people did to each other’s money before the stock market crash in 1929. There are several good books on the time, “The Battle For Investment Survival” and “Reminiscences of a Stock Operator” among them, that lay out just how wild it was to be involved in securities trading before the current regulatory regime was installed. That being said, good intentions do not always translate into good outcomes. There is currently a very small SEC fee of $20.70 per million dollars in trading activity. In addition, Basepoint is charged annual fees by regulatory agencies to register, monitor, and review certain documents that we provide as disclosure.
The second certainty (taxes), in the words of Ben Franklin, is most people’s least favorite charitable cause. We try very hard to minimize the tax bill from your account by limiting trading to necessary activity, taking long-term capital gains when feasible, balancing IRA distributions with non-qualified sales at capital gains rates, carefully using insurance and annuities, using municipal bonds where appropriate, and using other tax planning techniques to minimize your lifetime tax bill. This is part of our core competency increases your total Net Wealth over time, as discussed later in the section on “Advisor Alpha”.
Tax Preparation and Legal Fees:
As you may know, Basepoint is now providing tax preparation services. As part of this we may also begin providing other accounting services to make your life easier, like bill pay and check writing. The main purpose here is to simplify things for you and to have the return prepared at the source of most of your documents and activity. Being able to walk down the hall and talk to your tax preparer is an invaluable benefit to your Wealth Advisor. In addition, proactive collaboration is much more likely. While we will still be charging separate tax planning and investment advisory fees, a long-term goal is to figure out the regulatory and legal hurdles to combine the fees. We will keep you posted on our progress toward simplification.
Currently we are in the process of adding the capability of creating simple wills and trusts using a third-party service. More complex estate plans will still require the use of a local attorney to ensure that all the components of the estate plan are sound. We plan to pilot this program later in the year, and the process will involve a data discovery meeting and a review of your existing estate plan before suggestions are made. Once again, in the early stages, a separate estate planning fee will need to be charged, but over time, we hope to be able to combine this service with our other bundled services, on our mission to provide all your financial needs in one place for a single, simplified fee.
Advisor Alpha
I want to very briefly cover a topic that probably deserves an article of its own. While this piece talks about what you pay, an even more important component is what you get. Vanguard pioneered a concept called “Advisor Alpha” in 2001. This is an attempt to measure, in annual percentage terms, how much working with a sound advisor adds to your returns by implementing strategies that individuals without advisors normally miss.
Their research shows that, on average, an additional 3% in net returns is added by implementing the following planning and investment management techniques: suitable diversification, cost-effective implementation, rebalancing, behavioral coaching, asset location strategies, withdrawal order strategies, and total-return vs income investing. Keep in mind this does not include all the other things we watch for you like minimizing costs on cash, in-housing some asset management, tax planning strategies, estate planning strategies, maintaining adequate liquidity, monitoring your insurance policies, and the full scope and breadth of the financial planning process.
Conclusion:
The maze of fees and expenses that you pay to manage your financial situation is complex and opaque, and sometimes even unknown. Our mission is to simplify things and make sure that whatever cost you incur provides some sort of return either financially, or mentally, while still making sure that you are getting all the services that you require to make good decisions and have a sound financial situation.
We will continue building Basepoint into an organization that provides the highest value advice at the most reasonable total cost. Keep in mind that does not equate to the lowest price. If we are attempting to eliminate multiple layers of fees while still providing the diligence and service to ensure your success, there will always be corner cutters who can do things “cheaper”. When it comes to finding advice for your family’s financial success, I hope you shop the way you would for a neurosurgeon, and not the way you shop for socks. If “30% off!” is ever painted in our front window, it should raise an eyebrow about why it cost so much before.
As always, your Wealth Advisor is available to answer any questions that arise from my inability to keep a secret. I am also available to answer any questions. We have made a firm commitment to you to charge a fair price and not cut corners that are likely to lead to financial calamity.
Warm Regards,
Allen
Allen Wallace, CFA, CPA/PFS, CFP®
Chief Investment Officer