We've hammered home the importance of rock-bottom fees for maximizing your returns.  Remember, banks and fund managers often have different motivations than you do! Now, it's time to dissect fee structures and expose those sneaky hidden fees lurking within complex financial products. Think of it like this: you want to know exactly where your money is going.  There are three main types of fees to watch out for, categorized by who's charging them: (1) Investment management fees (what you pay for the expertise), (2) Brokerage fees (the cost of executing trades), and (3) Admin & depositary fees (the behind-the-scenes costs of keeping things running).  For funds, all this crucial fee information should be summarized in the Key Information Document (KID).  This document, thankfully, is usually short and sweet, giving you a clear overview of the fund's essentials so you can make smart investment choices.

Investment Managers

If you're not hand-picking individual stocks and bonds through a broker, chances are an investment manager is calling the shots for you. These are the companies responsible for the daily grind of managing investment portfolios, whether they're funds, sub-funds, ETFs, or even personalized managed accounts. Now, here's a crucial point: while investment managers have a fiduciary responsibility to their clients (meaning they're legally obligated to act in your best interest), it's absolutely vital to remember they're a service provider, not your new best friend. The misalignment of incentives we've talked about makes this clear: your goals and theirs might not perfectly align. So, treat them with professional respect, but always keep a watchful eye on how they're handling your money.

To operate legally, investment managers need authorization from a national regulatory body. Think of it like a license to operate in the financial world. These bodies, like the Securities and Exchange Commission (SEC) in the US, the Financial Conduct Authority (FCA) in the UK, or CONSOB and Banca d'Italia in Italy, exist to protect investors, especially everyday investors like you and my mum (known as "retail investors"). They impose a lot of rules and regulations on investment managers, which, as you can imagine, adds to their costs. Additionally, managers need sophisticated (and often expensive) software to analyze investments and execute trades. So, how do they cover all these expenses and still turn a profit? The answer, plain and simple, is fees.

• Management Fees are usually charged as a percentage of the assets under management (i.e. the size) of the portfolios. In other words, the fee is calculated based on the total value of the investments they're managing for you;

• Performance fees, also known as incentive fees, are a percentage of the profits the investment manager generates in the portfolios they manage. These fees should only be charged if the manager exceeds a certain benchmark or hurdle rate. 

• Entry / Exit Fees (also known as front-end load and back-end load) are one-off fees charged to investors to subscribe / redeem money from a specific instrument (typically a fund); and

• Other operating fees.

It's important to recognize that these fees are not simply a rip-off. As we've discussed, investment managers, particularly smaller firms, face significant regulatory costs and, like any business, need to charge clients to cover their operating expenses. Since many of their costs are fixed, smaller firms may need to charge higher fees to remain viable.  Each fee has a specific purpose. Management fees cover the day-to-day costs of running the business. Performance fees incentivize top portfolio managers to achieve exceptional returns and stay with the firm. Entry and exit fees help cover marketing and sales expenses associated with acquiring new clients. And other operating fees may apply when investment managers make specialized purchases, such as software tailored for managing a particular portfolio, with the costs passed along when necessary.

In the past, a common fee structure for investment managers was the 2-20 model: a 2% annual management fee and a 20% performance fee. Today, we see ETFs with Total Expense Ratios (TERs)—the sum of all direct fees divided by your investment—as low as 0.20%. So, why are some firms still charging TERs of 2% or more? One valid reason, as we've touched on, is that smaller investment managers may need higher fees to cover their operating costs. This is perfectly acceptable if you have complete trust in their expertise and management.

However, consider this scenario: as a retail investor, you want to invest in a product that mirrors the returns of the MSCI World index, previously discussed in our article “The Foundation of Wealth”. Instead of paying a low fee of 0.20%, you choose to pay 2% because your banker is a trusted friend, and you're comfortable with the difference. There's nothing inherently wrong with that, but let's break down the financial impact. If the MSCI World returns 11.24%, and you subtract the higher fee of 1.80%, your net return drops to 9.44%. Instead of accumulating over €1 million, your bank account will hold €702,622.34. Adding a 20% performance fee, your effective return becomes 7.55% (9.44% * (1 - 20%)). If there's also a 3% entry fee, your monthly investment of €350 effectively becomes €339.50. With these combined fees, your final balance would be €462,248.59. Now, here’s the key takeaway: out of €1,034,419.34 of your own money, you keep only €462,248.59, while the investment manager earns €572,170.75. Did your friend mention that 55% of your returns would go to their employer? Always be aware of the real cost of fees before making investment decisions.

Attilio and I both still work with investment managers, and we know there are plenty of honest professionals out there. There are legitimate reasons to pay higher fees. For example, some investment managers have access to exclusive investment opportunities that might require a larger initial investment than you can make or are simply not available to the general public. Others have dedicated teams of analysts who can thoroughly research financial products and potentially identify opportunities for superior returns. Consider Jim Simons' Medallion Fund, one of the best-performing funds in history (though, sadly, not open to everyone). It charged hefty fees (4% management and 44% performance), but also delivered a net annual return of 39% to its investors for decades. The bottom line? There's nothing wrong with paying higher fees for superior performance, just like there's nothing wrong with buying an Hermès bag instead of one from Zara. But, in both cases, you must understand (1) the quality you're getting and (2) the price you're paying. Otherwise, you risk overpaying for something that's not what it seems.

The key takeaway here is to make sure you're getting value for your money. You need to be comfortable with both the returns you are achieving and the overall costs you are incurring. This is crucial for maintaining control of your finances, even when delegating investment decisions to professionals.  If you do not fully grasp how much you are paying and how much you are earning, you risk allowing someone else to profit from your investments while you bear all the downside risk.  Don't let that happen: stay informed, ask questions, and take charge of your financial future.

KID & Factsheets

When it comes to understanding fund fees, a crucial tool is the fund factsheet. These short documents, usually just two or three pages long, contain all the essential information about a fund, including its costs. To illustrate, we'll examine a factsheet from Azimut, a well-known Italian asset management company. Please note that we have no affiliation with Azimut and we are not making any judgments about them. We are simply using publicly available data for illustrative purposes and the same analysis can be applied to factsheets of other companies.

Suppose you have €1,000 to invest and after reading our newsletter you want a global exposure similar to the MSCI World Index. Based on this, you are recommended  something like AZ Fund 1 - AZ Equity - Global Growth - A - ACC (ISIN: LU0804221488), for which you can find the factsheet here. While it's in Italian, the numbers are easy enough to follow. This particular fund has a 2% entry fee, a 4% annual management fee, a 0.2% transaction fee, and a performance fee. The performance fee is 20% of the difference between the fund's performance and its benchmark, plus 0.1% of your initial investment. The fund's benchmark is 90% MSCI World and 10% bonds, but to keep things simple, let's just compare it to the MSCI World. 

Please note that in 2022, when the fund lost almost 38% (whilst the index declined just 17.63%), they still charged a 0.10% performance fee! We mentioned that 2% management fee and 20% performance fee for equity funds may sound anachronistic, so what obscure securities is Azimut buying to justify these very high fees? Surprisingly, as you can verify on the fund’s website, the top holdings include well-known names such as Apple, NVIDIA, Microsoft, and Amazon.com. These are hardly obscure investments! These are hardly obscure securities! This raises an important question: what justifies such high fees when the fund’s investments appear to be fairly standard? Investors should critically evaluate whether they are truly receiving value for these expenses.

So, let's look at the numbers. If you had invested €1,000 in this fund, after five years, your net amount would be €1,129. However, if you had simply invested in an MSCI World ETF, your net amount would have been €1,689. That's a significant difference! The gap arises from both the fund's underperformance relative to its benchmark and the high fees  paid to Azimut. To put it in perspective, you earned just €129 on your investment, while Azimut made €234.31 from your money. Even in cases where you lose money, the fund manager still profits. As you may have guessed, this is nowhere near the level of performance we saw with Jim Simons' Medallion Fund.

Brokers

There are mainly two types of fees that brokers may charge: fees per transaction and bid-ask spread. The former refer to a fee that is charged for each executed trade, which can be a lump-sum or a percentage of the total size of the trade. For example, on Interactive Brokers and you want to buy a French stock you will end up paying:

Hence, if you want to purchase 1 share of LVMH it will cost you max(€683 x 0.05%; 1.25) = max(€0.3415; €1.25) = €1.25 on Interactive Brokers. 

The bid-ask spread instead is an indirect cost that you will pay as the purchase price (bid) and the sell price (ask) usually differ. Continuing the same example, if we buy and sell immediately 1 share of LVMH on top of the transaction fees I may spend €0.10 on Interactive Broker. The less a security is traded (usually called illiquid securities) the bigger will be the bid-ask spread.

Administrators and Depositary

Banks and other financial institutions, including some brokers, might charge investors a fee for holding their securities and reconciling them daily. These are typically called depositary or custodian fees and administration fees. When you buy individual stocks and bonds through online brokers, you might not encounter these fees. For example, both Interactive Brokers and BG Saxo generally don't charge them. However, it's always a good idea to double-check their terms and conditions, as fee structures can change.

When you buy a fund, like a UCITS fund in Europe, additional behind-the-scenes costs are often involved. For regulatory reasons, these funds must have a depositary and a fund administrator. These entities charge fees, calculated as a percentage of the portfolio's value, which are included in the fund's Total Expense Ratio (TER). So, even if you buy a UCITS fund through a platform like Interactive Brokers, the fund itself might hold its underlying securities at a large bank (like State Street), and that bank will also charge fees for its custodial services. This is why paying close attention to the TER is crucial. The TER gives you a comprehensive overview of all the direct costs the fund incurs, allowing you to make a more informed investment decision.

Matryoshka

Unfortunately, understanding the fees you're paying can be tricky. Let's go back to our Italian asset manager example. They also offer "fund-of-funds," which are funds that invest in other funds. As you can imagine, the fees charged by each underlying fund add up, creating a layer of complexity. Take, for example, AZ Fund 1 - AZ Equity - Global FoF - B-AZ FUND (ACC); you can find the factsheet here. 

You don't need to be a math whiz to see that a combined 3.5% entry/exit fee and a 5% management fee should raise some red flags. But it gets worse. Looking at the top 10 holdings, which make up 55.5% of the portfolio, we find other funds, like Allianz Best Styles Global Eq WT EUR, that tack on an additional 0.50% in TER. So, the fees are piling up, and when you look at the ultimate exposure you are getting, by analysing the underlyings of these funds, guess what securities you find? From its website, you may have guessed already that Allianz Best Styles Global Eq WT EUR main exposures are once again Apple, Microsoft, NVIDIA, etc… “But AZ Fund 1 - AZ Equity - Global FoF - B-AZ FUND (ACC) is diversified, it is invested in other funds as well!” Like JPM Carbon Transition Global Equity (CTB) UCITS ETF - USD (acc) (EUR), whose main exposures are Apple, NVIDIA, Microsoft, Alphabet, and Amazon.com, or DNB Fund - Technology Institutional A (EUR), whose main securities are Microsoft, Alphabet, Samsung, Nokia, or Amazon.com. You see? You have the illusion of being diversified, but most of these funds ultimately invest in the same companies. 

Negative Compounding

Even if you follow the recommended holding period (seven years in these examples), they still seem to cost you roughly 5% per year. We’ve previously discussed the power of compounding and how it can generate impressive returns over time. But always remember that costs compound too, and their impact grows exponentially, eroding your returns. Unfortunately, the bad news doesn't end here and it's often the case that these high-fee asset managers also underperform compared to low-cost ETFs.

Until financial literacy becomes more widespread, many people will likely continue to trust their banks and advisors blindly, without fully understanding the fees they're paying. That's precisely why we felt it was so important to give you this overview.