As John Bogle, the venerable founder of Vanguard, whom I recall being referred to by a panelist at a Securities Industry and Financial Markets Association conference as Mr. Goody Two Shoes, famously observed, investment performance will be profoundly affected by transactional costs. Bogle believed that a mutual fund invested over a long period of time in a broad equity index with minimal management fees would ultimately outperform managed portfolios charging higher fees.
Cost to Equity Ratio
The cost-to-equity ratio is a measure of the impact of transactional costs on the performance in an investment account. Simply stated, the cost-to-equity ratio measures on an annualized basis the percentage of transactional costs, including fees, commissions and margin interest, incurred on the equity in account. For instance, if the annualized cost-to-equity ratio in a particular investment account is 2%, the account holdings will have to appreciate by 2% in a year before the investor will receive a positive return. If the account holdings decline by 3% in a year, the investor will realize a loss that year in the account of 5%.
Think of the financial markets as a casino. If the S&P Index on average over extended periods of time appreciates by 7%, the odds are ultimately weighted in favor of the investor. These odds are reduced, however, by transactional costs. If the annual cost-to-equity ratio is 10% because of high commissions incurred by active trading and substantial margin interest incurred in a heavily leveraged account, the odds in the casino are weighted against the investor.
Advisor Fees and Commissions
In selecting a financial advisor, it is critical that the fees charged the investor are commensurate with the service provided. Financial advisors typically charge a flat annual or quarterly fee or commissions charged for the purchase or sale of securities. Flat or wrap fees typically range from .5% to 1% per year varying by the customer’s assets under management or the type of securities held. If you are holding a bond portfolio in a low interest rate environment, 1% fee can eat away about 20-25% of your likely return, and, if the value of the portfolio begins to drop as interest rates rise, you may be lucky to break even. If an account holding equities or mutual funds is not actively managed, you may pay less in a commission based account. The problem with commission based accounts is that they incent the financial advisors to trade the account and sell the investor high commission products. The use of margin results in more commissions and margin interest.
The investor should be mindful of the effect of trading costs is having on the portfolio and whether the cost structure is efficient for the investment strategies employed and the investor’s objectives. The investor should also be mindful that, except with discount brokers offering very low commissions often between $7.95 to $9.95 per trade, the financial advisor has discretion of reduce trading commissions. Financial advisors also often have discretion to reduce wrap fees. Every investment you select may not be a winner, but you can control your account performance by making sure that you are overpaying for the management of your account.