The Investment Cost Savings That Add Up

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The pinch of higher fees and taxes can feel even more pronounced when stock markets have dropped in value or are in a slow-growth mode.

Investors who put large sums in the stock market tend to assess progress by performance, but the more accurate gauge of success is how much of a portfolio's gain they get to keep after factoring in investment fees and taxes.

“Investors often underestimate the fee and tax drag on their investments," says Dan Fasciano, Head of Portfolio Management at BNY Mellon Wealth Management. “It's not that they don't know that these costs are important, but the magnitude of their impact isn't always appreciated."

Paying a little more for a mutual fund or overlooking an opportunity to offset capital gains with losses to minimize taxes may not seem like a big deal in any given year, but over the long term the cumulative effect can result in significantly lower investment outcomes.

Consider the effect of just a half a percentage point fee difference. Assume a $100,000 investment in a mutual fund with a 7% average annual return. If the fund charges 0.5% annual expense ratio, after 20 years the initial investment would grow to about $350,000. If it charged 1%, the total would be $316,500, and with a 1.5% expense ratio, just $286,000.

The pinch of higher fees and taxes can feel even more pronounced when stock markets have dropped in value or are in a slow-growth mode. “When you're trying to eke out returns in tough markets, every percentage point lost to costs can be painful," Fasciano says.

While Fasciano urges investors to pay more attention to fees and tax implications, he is careful to note that investment decisions shouldn't be selected based on fees and taxes alone. “The important questions are, 'What are you getting for the fees you're paying?' And, 'Is there a solid rationale for incurring a tax bill?'"

Get What You Pay For

Before paying a premium for an active mutual fund manager, you should be asking if the extra expense is worthwhile when you can buy an indexed mutual fund or ETF for a fraction of the cost. In most cases, it's not. Numerous industry studies find that a minority of active managers beat their benchmarks over both the short and long terms after factoring in fees.

There are certain asset classes where analyst coverage is lower and opportunities to outperform higher “where we think it does make sense to pay more for active management," Fasciano says. Emerging markets are one example. Other research has shown that managers in foreign markets—particularly emerging markets—have a much stronger record of beating their benchmarks even after fees than in U.S. markets.

Similar assessments of a manager's value should be made in alternative investments, Fasciano adds. For example, while hedge funds have lowered management fees in recent years, they still range around 1.5% (and performance fees run as high as 20%). Hedge funds of funds tend to be even more costly, because layered fees are the norm. "It can often be really hard to justify the costs," Fasciano says. “Chosen wisely, a single hedge fund manager might actually be more additive."

Tax-Minimizing Strategies

In addition to higher fees, many mutual funds spin off capital gains annually to shareholders—and the gains are taxable in the year they're distributed, even if investors haven't cashed out of the fund.

To help avoid or minimize capital gains taxes, advisors to wealthy clients can create customized tax-managed portfolios of individual stocks. The tax savings on such accounts through active tax-loss harvesting can be significant, particularly in volatile markets, and can more than compensate for active management fees. These custom portfolios can be a small batch of stocks with exposure to a particular sector, or they can replicate the exposure of a broad index fund or ETF.

For example, BNY Mellon Wealth Management runs a portfolio of individual stocks for qualified clients that replicates the exposure and diversification of the S&P 500. The manager has the flexibility to trade out a stock to lock in a loss and then quickly buy a similar stock in the same sector so that the investors' exposure isn't interrupted. (To avoid a wash sale, an investor cannot sell or trade a security at a loss, and within 30 days before or after, buy or trade a security that is substantially similar).

And some of the biggest tax savings can be achieved simply through wise portfolio construction: by paying close attention to the types of accounts where you locate assets. Asset classes such as bonds and dividend-paying stocks that kick off investment income—which is taxed at income tax rates of up to 37%, compared to capital gains rates of up to 20%—are best held in tax-deferred accounts like IRAs or a 401(k). Meanwhile, tax-efficient investments such as tax-exempt municipal bonds and stock index funds held for the long term are best parked in taxable accounts.

Still, as investors accumulate assets over many years and add additional accounts, it's important not to let perfection be the enemy of the good. Maybe you have a bond fund in your taxable account or one of your most tax-efficient stock funds in your IRA. Fasciano cautions not to act rashly to try to solve the problem. Whether it makes sense to reshuffle investments depends on a number of factors such as investment time horizon, after-tax returns and accumulated gains. Quips Fasciano, “Nothing is simple when there are a lot of moving parts and taxes are involved."

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