by Erin Lowry
How Would You Rate Its Website and App?
I’ll be honest: a few of the websites out there are not the streamlined experience most Millennials are used to. Hopefully that changes soon, but if a particular kind of user experience on a website or app is important to you, then you should test-drive both before picking a brokerage.
How Hefty Are the Fees?
Always determine what your potential brokerage firm will charge you to be a customer. Does the brokerage charge you a fee for “assets under management” (AUM)? For example, a 2 percent fee on your portfolio of $10,000 means you’ll be paying $200 annually, which could be in addition to other trading fees. Are you receiving $200 worth of guidance and value? Later on in this chapter, we’ll overview various fees you may experience and how to decode the almighty expense ratio we defined in chapter 2.
Does It Uphold Suitability or Fiduciary Standards?
Perhaps you’ve decided to pay for investing advice. That’s perfectly okay, but you should know what type of advice you’re receiving. Is your advisor being held to the suitability standard (i.e., the recommendations are suitable for you) or the fiduciary standard (i.e., the recommendations are in your best interest)? You should also know if and how your broker receives any commissions on products he or she puts in your portfolio.
Okay, Okay—I’ll Name Some Names
I know you’re still wondering, “BUT WHERE DO I GO?” I hear you, so I’ll overview different kinds of brokerages and list some actual options. Please be aware that I’m in no way endorsing these particular options, but simply acknowledging their existence in the space.
Full-Service Brokerage Firms
With a full-service firm, you’ll have an advisor helping you build and manage your portfolio, but you’ll pay higher fees. This might sound like the better option for a novice investor because an expert is helping you out. The issue: a full-service brokerage may not want to work with you. You often need to be bringing some serious money to the table to have an actively managed portfolio of this nature. This isn’t always the case, but there’s a reason the stereotype of needing double commas (aka $1 million or more) in order to be taken seriously exists.
Still, with some competition in the marketplace, plenty of firms have much lower asset minimums than $1 million, but the level of guidance and advice you get may vary based on your account balance. You’ll need to do your research if you plan to go with a full-service brokerage firm.
Examples of a full-service brokerage firm include: Morgan Stanley, UBS, Edward Jones, and Merrill Lynch. There are also investment banks like J.P. Morgan Private Bank and Wells Fargo that offer investment advice and financial planning services.
Discount Brokerage Firms
With the discount brokerage firm, you’ll be taking the DIY approach and therefore will save more in fees. Plenty of both rookie and seasoned investors utilize the DIY approach to investing, including yours truly. There is a lower barrier to entry than with a full-service brokerage, because you only need a little money to get started. Some, but certainly not all, funds at a discount brokerage may have minimum initial investments, often $1,000 to $3,000.
Similar to the full-service brokerages, some discount brokerage firms also offer access to financial advisors, but you usually need to have a certain amount of money invested with the firm in order to unlock that feature. For example, if you have $50,000 in investments, then you gain access to investment professionals for general guidance. If you have $500,000 in investments, then you get to consult with a certified financial planner (CFP) for no additional fee if you have a specific question. Just because you go with a discount brokerage firm doesn’t mean you’ll be without personalized guidance.
If you don’t have the amount of money invested that’s required to unlock the personalized advisor features, then you can always call customer service for general help.
Examples of discount brokerages include Vanguard, Fidelity, Charles Schwab, TD Ameritrade, T. Rowe Price, and Ally Invest.
Online Financial Advisors (aka Robo-Advisors)
Robo-advisor is the term often used to refer to digital platforms for investing. Robo-advisors are typically perceived as having little to no human interaction and relying on an algorithm, but that’s not entirely correct.
“Robo-advising, the term is too narrow,” says Alex Benke, CFP®, Betterment’s VP for financial advice and planning. “People think of Betterment as a robo-advisor, but we have an offering that involves people, too. We [Betterment] think online financial advisor is more accurate. It implies use of technology, but it doesn’t pigeonhole in terms of how you’re getting that advice.”
Robo-advisors or online financial advisors are marketed to Millennials as a digital solution for the often intimidating process of investing. You’re asked some questions online and given recommendations on about how to best build your portfolio. They can be quite helpful to a novice investor who wants either a little more hand-holding or to take advantage of other offerings, like frequent rebalancing and tax-loss harvesting. There will be more information about robo-advisors in chapter 9.
One potential downside to the online financial advisor route is paying a higher fee for access to funds you could purchase directly through the discount brokerage firms like Vanguard, Fidelity, and Schwab. However, that fee could be worth the value you’re receiving. It’s up to you to decide. It should also be noted that some brokerage firms have tried competing with the online financial advisor by adding on a robo option. You should critically evaluate whether those add-ons provide the same value. Some do and some don’t.
Examples of online financial advisors include: Betterment, Swell, Personal Capital, Wealthfront, Wealthsimple, and Ellevest.
Apps
Yes, there is most certainly an app for that. Robinhood, Acorns, and Stash are all examples of apps with which you can invest via the touch of a button on your phone. Chapter 8 will overview using apps for investing.
PICKING YOUR INVESTMENTS
Yet again I’ll have to disappoint you a bit. I can’t give you a definitive answer because I don’t know anything about your goals, risk tolerance, or time horizon. But I can tell you this:
First, you’ll need to decide if you want to go the actively managed mutual fund route or the passively managed index fund or ETF route. Both are valid, but don’t forget that “actively managed” means you’ll pay more in fees.
Second, you’ll need to reflect on the goal for this money and the kind of risk you want to take. (Refer back to chapter 4 for setting actionable goals.)
Third, you’ll need to diversify as you build your portfolio. You don’t want to just pick one stock in one sector. Investing in mutual, index, or exchange-traded funds gives you exposure to a variety of sectors and companies, and is a good first step. Examples of funds that do that would be the S&P 500, Total Stock Market, and Total International Stock Market, but notably those are all on the high-risk end of the spectrum. Total Bond Market would be more conservative, while a Balanced Fund offers an approximately 60/40 split on stocks and bonds and is medium on the risk spectrum.
UNDERSTANDING THE FEES
Now it’s time to add one more important factor when choosing your brokerage firm and investments: fees. I mentioned earlier that fees need to be a critical part of the decision-making process, so let’s do a deep dive into the fees you may encounter and how to decode them.
Expense Ratios 101
You’re going to pay fees on your investments. The brokerages aren’t nonprofit institutions, and at the bare minimum, they need to cover the administrative costs of running a fund. Even if your app or trading platform says “no fee,” that usually means it doesn’t take a commission on your trade, but the stock you buy or the ETF or mutual fund does have an expense ratio. In 2016, the average expense ratio across funds was 0.57 percent, according to a Morningstar study of US funds.3 This cost is generally deducted from the fund’s averag
e net assets.
That being said, fees range significantly from modest to hefty. As Colleen Jaconetti, CFP®, a senior investment analyst for Vanguard Investment Strategy Group, mentioned in chapter 4, the more you pay in fees, the more those fees eat away at your growth potential as well as the amount of money you’ll have in the future.
Where to Find the Expense Ratio
Expense ratios are (or should be) prominently displayed under the details or facts about the fund. You could download the fund’s prospectus and look for it there. Or just go to the brokerage’s website, search for the fund, and then hit Control-F and search for “expenses” or “exp ratio” or “expense ratio” to hunt it down.
If you can’t easily find this on a brokerage’s website, go to Morning star.com and search for the name of the fund. Morningstar analyzes and provides data about the stock market.
But What Does the Expense Ratio Mean?
If, right next to an index fund, it says “0.14 percent expense ratio,” what does that mean?
“They’re going to charge you $4 for every $1,000 you have invested,” says Jaconetti.
What’s a Reasonable Expense Ratio?
“I would say at least somewhere below 50 basis points would be reasonable,” explains Jaconetti. “It’s still a little on the high end relative to what you could be getting, but obviously anything above 50 basis points, I would say is on the higher end.”
What the Heck Is a Basis Point?
Pretty much just a fancy way of expressing the expense ratio. A fund charging you 50 basis points charges you 0.50 percent. One basis point = 0.01 percent.
Why an Expense Ratio Might Be on the High Side
The way your fund is managed will impact the expense ratio. Passively managed funds are going to be cheaper than actively managed funds.
Investing in international funds is another reason you may encounter a higher expense ratio. Global diversification (investing in funds outside the US stock market) is part of a balanced portfolio because it spreads out your risk, but it does often result in a higher expense ratio than investing in the US market. For example, you might get 0.26 percent on an international fund compared to 0.14 percent on a US market fund.
What Should I Expect If I’m Paying a Higher Expense Ratio?
“People shrug their shoulders at 1 percent, but we know how that adds up,” says Alex Benke, CFP®, Betterment’s VP of financial advice and planning. “But at some point, you get down to it and think, ‘Yeah, even a quarter of a percent is costing me a bunch of money over time,’ so the struggle there is to evaluate the payment for the value that you’re getting.”
Benke points to the various online financial advisors (aka robo-advisors) and suggests being highly critical about whether the one you plan to use is balancing cost and value. Evaluate if you are receiving value for the cost, or if it’s just setting up a portfolio for you without any added benefit. For example: is there tax-loss harvesting, rebalancing, or a streamlined user experience?
“When considering the value you’re getting out of something, you want to look at the dollars-and-cents value,” says Benke. “Is it squeezing out as much from your money as it can in terms of funds you get put in and taxes it can save you? But also, is it actually making your life easier in terms of the time that you’re investing?”
Similarly, Jaconetti recommends thinking about your “why”: are the fees for advice or just for the fund or product? “Some people are willing to pay a fee because they think the manager will have outstanding performance going forward,” she explains, but she warns you to keep in mind that past performance is not indicative of future performance. Assuming your fund manager does outperform the market, you should still do the math to see if you received a higher return after fees.
Paying for advice is a personal decision, but this could justify a higher expense ratio, especially if it helps you create a tax-advantaged strategy for your investments.
Can I Lower the Expense Ratio?
Investing more is an easy way to reduce an expense ratio. Well, it’s “easy” in the sense of being simple, not that you can magically come up with more money to invest.
Slow-and-Steady in Action
When I first started investing, I was woefully ignorant that investing more could lower my expense ratio. I picked a fund with a minimum investment requirement of $3,000 and diligently contributed monthly. The expense ratio was 0.15 percent. A few years later, I made my monthly contribution and received a prompt that I could convert to a new fund and reduce my expense ratio to 0.04 percent. What?! Turns out, once my investment hit $10,000, the brokerage offered a reduced expense ratio for the same investment. I converted to the new fund and saved myself 11 basis points, which also meant keeping more in my pocket for future growth.
Other Fees
Not all brokerage firms charge these fees, and fees also vary by fund. You can find more details about fees by downloading its prospectus. A prospectus is a document that overviews the investment to potential and current investors. It’s a legal document and required by and filed with the SEC. A prospectus generally includes information about what the company does, its strategy, its financial details, the risk involved, and fees. It should be readily available on any webpage detailing information about the fund. Here are some of the fees you may see on a prospectus. Notably, the expense ratio may be referred to as “management fees” and/or “total annual fund operating expenses” on a prospectus.
ASSETS UNDER MANAGEMENT (AUM): A flat-rate fee is paid to your advisor based on the size of your portfolio (i.e., your assets under management). For example, a 2 percent AUM on your $100,000 portfolio means you’re paying $2,000 to your advisor for his or her services.
COMMISSION: Your advisor or broker receives a commission for opening an account on your behalf or selling you particular products. Your advisor isn’t necessarily acting in a nefarious manner if he or she receives a commission, but you should be aware if that’s the case and ensure the product matches the fiduciary standard and not the suitability standard, because fiduciary ensures it’s in your best interest, not just suitable. You don’t want a subpar product in your investment portfolio just because your advisor gets a commission off the sale.
TRADING OR TRANSACTION FEE: A commission or trading fee is usually charged when you buy or sell shares of stocks through an ETF or buy individual stocks through your brokerage. A transaction fee may also be charged when you buy a mutual fund. The cost of the fee can vary by the type of transaction, how many transactions you make, how much you have in assets under management, and even how you make it (i.e., online or via phone). Plenty of commission-free ETFs exist.
ACCOUNT SERVICE FEE: This is similar to the monthly service fee a bank charges on a checking or savings account. It’s often an annual fee and may get waived if you hit a certain threshold for assets under management or if you waive paper statements and elect for electronic-only communication.
FRONT-END LOAD OR BACK-END LOAD: You pay a fee for the purchase (front-end load) or sale (back-end load) of your mutual fund investment. The fees for load funds usually pay the broker or advisor who researched the fund, advised you to purchase it, and placed the buy order for you. Back-end loads may be reduced or phased out depending on how long you hold the fund. DIY investors typically avoid investing in a load fund.
REDEMPTION FEE: This is separate from the back-end load fee, but also gets charged when you sell your shares in a fund. This fee is charged to offset the cost the brokerage may incur when selling your shares.
PURCHASE FEE: A fee you’re charged when you buy shares in a fund. This is separate from the front-end load fee because, like a redemption fee, it is used to cover the cost of the transaction.
NO-LOAD FUNDS: There is no fee to buy into or sell your investment in a mutual fund. The expense ratios on no-load funds are typically lower than that of their load-fund counterparts. The fewer
and lower the fees, the more you pocket.
12B-1 FEE: Another fee your brokerage may charge to offset the operational costs of running a mutual fund. It is baked into the expense ratio, so you may not notice it at first, but it will push the overall cost of the expense ratio up. The 12b-1 fee is capped at 1 percent by FINRA (the Financial Industry Regulatory Authority). One percent may not sound like much, but that can really eat away at your returns, so check to see if a fund comes with a 12b-1 fee before making the purchase.
IS MY MONEY PROTECTED?
Well, that’s a bit of a tricky question, with an answer of both yes and no.
“Definitely safe, as long as the firm is SEC and FINRA registered and has SIPC* [Securities Investor Protection Corporation] insurance, which all the firms basically are required to have,” says Alex Benke. “The common worry is that the firm is newer and will fold, and then what happens to my money? It’s different than a bank folding because you’ll get the shares back and will then just have to put them in a less fancy account.”