Most financial advisors report gross performance because the number is always higher, perhaps two to three percent higher. And, most investors accept the numbers because they do not know they should be asking for performance reports that are net of all expenses. The higher the expenses, the more likely the advisor is to report gross results.
There are several layers of expense that you should be aware of. If you know all of the expenses, you can add them up and deduct them from your performance yourself. Or, you can use a free tool that resides on the Investor Watchdog website (http://www.investorwatchdog.com/) that will obtain expense data for you.
The first layer of expense is the one charged by your financial advisor for investment advice, recommendations, and ongoing services. It could be a fee or a commission. If it is a fee it is usually asset-based, for example, you pay $5,000 to invest $500,000 of assets with an adviser who charges a 1% fee. If the advisor is compensated with a commission, the fee is collected by the product company (mutual fund) and paid to the advisor. In this case, the advisor’s expense is included in the investment product expense.
The next layer of expense is the money manager that could be a Separate Account Manager, mutual fund, ETF, or hedge fund. These are the firms that invest in the securities markets. They also charge asset-based fees that are in addition to your advisor’s fee. There are two scenarios if your advisor is compensated with commissions. If the product has a front-end load (commission) the amount is deducted from your assets. If the product has a back-end load the product company pays the amount to your advisor and your assets are subject to a seven-year penalty for early withdrawal. Money managers increase their fees to offset amounts that are paid to advisors.
The custodian that has physical possession of your assets charges a fee. The custodian could be your advisor’s firm or a third party. The custodian receives dividend and interest payments, processes transactions, and produces brokerage statements. This service provider also charges an asset-based fee that is a percentage of your assets.
Your advisor may charge a separate fee for a financial plan that is based on an hourly or fixed fee schedule. Planning is not an investment expense, but the cost of the planning service may be deducted from your assets. In some cases, planning expenses are covered by the advisor’s asset-based fee. Commissions from product sales may also cover the planning expenses.
The last fairly common expense is transaction charges. The expense is primarily associated with the purchase and sale of securities. However, other types of investments may also have transaction charges. Some advisors offer blocks of trades for an asset-based fee or a fixed fee.
As you can see, there are layers and layers of potential expenses. Some of these expenses may not apply to your situation depending on the service provider and your advisor’s employer. On the other hand, you may be exposed to additional fees for the same reasons.
Two or three percent in annual fees may not sound like much, but they are a big number when they are compounded over time. They are also a big number if you are experiencing negative or flat returns. For example, your gross investment performance is 3% and your expenses are 3% so your net performance is 0%.
You should always require full disclosure for all expenses and net returns on your performance report.