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Paying Less In Management Fees
Category :- Investments

Author :- Warren Mackenzie 
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Posted on July 4, 2014, 3:26 am
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Find out what you are really paying in fees and commissions

You may or may not be paying too much in fees and commissions, but if you don’t know how much you are paying, you have no way to make a fair judgment.

During the bull market between 1982 and 1999, many investors considered a 12% rate of return to be the minimum acceptable. They were paying high management fees on their mutual funds but most did not object to the fees because they were satisfied with the net return they were receiving.

Now, things are different. Many industry experts predict that during the next decade, investors should not expect more than single-digit returns on equity investments. Fees, therefore, become a more important consideration. When the gross return on your investment was 12% and you paid a 3% management fee, you were in effect paying 25% of the gross return in fees. That was bad enough. But if the gross return is only 6% and you are still paying a 3% management fee, you are now paying 50% of your gross return in fees. Obviously, paying half your income in fees slows down the growth of your retirement fund.

One difficulty in determining actual fees is the number of types of fees, some of which are hidden or buried in the fine print. For most investors, it is difficult to know how much you are actually paying. This is especially true with hedge funds, which may have hidden fees, particularly if there are capital guarantees attached. In many cases, the only way to determine the amount you are paying in fees is to ask your financial advisor for a full report.

The commissions you pay on stock trades are obvious. When you buy or sell a stock, the commission charged is shown on your transaction slip. With mutual funds, segregated funds, and hedge funds, however, there may be two fees. The first is the transaction fee, which may be paid either as a front-end fee, which you would see, or as a deferred sales charge, which you would not see.

Buried in the fine print is the ongoing management fee. This fee is included in the management expense ratio (MER). It includes the management fee, and other costs, such as legal and audit, stationery, and costs related to guarantees and to operating the fund. The MER does not include trading costs incurred by the mutual fund. Published rates of return for mutual funds are always the net return after management fees have been deducted, and this is usually, but not always, the case with hedge funds.

You may be paying reasonable fees. If so, you should be grateful to your advisor. But you may be paying excessive fees. The solution: Find out how much, both in percentage terms and in actual dollars, you are paying for your investment advice.

Don’t ask your advisor for a detailed account of fees that you’ve paid for the last five years. The advisor will know what you are paying currently but it is too much to request an analysis of how much you paid in previous years.

Your advisor can tell you, for example, how much the “spread” or commission is on your bond purchases. The fee on a bond purchase is hidden. You purchased the bond out of the inventory of the brokerage firm. In effect, the firm buys wholesale and you buy the bond as a retail customer. A commission charge will increase the cost of the bond and you have a right to know the cost of the charge.

Fees are necessary and investors would have very limited choices without the help of the professionals who make up the industry. It works both ways: professionals must be able to charge fees and you must be willing to pay reasonable fees. What is an overall appropriate level? It will vary depending on the size of the account and the level of service, but the normal range is between 1% and 1.5%.

Bottom line: You can’t make any judgment about fees unless you know how much you are paying in fees. Fees should be clearly spelled out, ideally in the Investment Policy Statement.

What you can do now: Ask your financial advisor for a complete picture of what you are paying in management fees and commissions.

Don’t miss out on F-class mutual funds

If investors are in a fee-based account and they are not using F-class investments, they may be paying too much in management fees.

Most mutual fund and hedge fund companies offer their products in two versions. These are identical in every respect except for the percentage charged as the management expense ratio (MER). The lower the MER, the higher the return to you.

The amount of MER depends on the level of costs the fund company incurs in paying the fund managers to operate the fund and in paying the investment advisor a trailer fee. In many cases, the largest component of the MER is the trailer fee paid to the brokerage firm. A trailer fee is an ongoing fee paid by the mutual fund, or hedge fund, to the financial advisor to compensate him for the service provided. The fee is usually paid either monthly or quarterly. The typical trailer fee is between 0.5% and 1% of the assets under management.

It follows that when the fund company eliminates the trailer fee paid to the financial advisor, the management fee is reduced by the same amount. The version of the fund that does not pay a trailer fee is called the F-class version. In this version, the MER is usually about 1% lower than in the regular version and the fund’s return is therefore higher by that amount.

Trailer fees are an important source of revenue for most investment advisors and brokerage firms. Because of this, the mutual funds that do not pay trailer fees can be purchased only when you are invested in a fee-based account. A fee-based account, sometimes called a WRAP account, is where an annual fee is paid based on the size of the account and you do not pay commissions on each transaction.

Where possible, when you are in a fee-based account, the mutual funds or hedge funds you purchase should be the F-class units. If you are in a fee account and don’t have this class, your advisor may be receiving two service fees for looking after one investment. Most brokerage firms will not allow this double dipping, but others do. You may have to ask to discover how much you are really paying.

When you own F-class shares, the management fee that the brokerage firm deducts each month is really not as high as it seems because: (1) the MER on the mutual funds or hedge funds you own is lower than it would otherwise be and (2) it is immediately income tax deductible (if not in an RRSP account).

Bottom line: If you are in a fee-based account, be sure that you are invested in F-class funds so that you are paying one management fee rather than two.

What you can do now: If you are in a fee-based account, find out if your mutual funds are F-class units. If they are not, ask if the management fee is being charged on these funds. If it is, you should complain.

Don’t just accept fees; negotiate them

Low-maintenance investors, especially those who provide referrals, can often negotiate lower fees. Over a lifetime, a lower fee may improve your net return enough so that you will be able to retire a few years earlier, or have more money to spend when you are retired.

The price of just about everything can be negotiated. Many investment advisors will negotiate fees. It is not uncommon that some of their clients are receiving discounts while getting the same attention, advice, and service as full-fledged payers.

If you are paying for services by way of a front-end fee, or if you are in a fee-based or WRAP account, the fees are generally negotiable. A WRAP account is one where a bundle of services are wrapped together in an all-inclusive fee. WRAP accounts do, however, have a minimum fee, set by the brokerage firm, and you cannot negotiate lower than this minimum. The minimum fee is usually in the $2,000 to $2,500 range per year.

The best time to negotiate fees is before you have signed the papers to move your account to the new financial advisor. At this point you have the greatest leverage because the new advisor wants your account. You can likely get a better deal by telling your new advisor you will be a low-maintenance account.

Smart investors are low-maintenance investors. They don’t do a lot of trades and they don’t need to see their financial advisor often. The advisor will be pleased to hear that you need to meet her or him only once a year. And, if your accounts are properly set up, one meeting per year will be enough. You also could mention that you will be making few phone calls, perhaps one every six months.

It will also help if you tell your advisor that you understand the importance of referrals and that you will be glad to provide them. Some financial advisors send a small gift to show their appreciation to clients who give them a number of referrals. Tell the advisor what you would most appreciate is a reduction in the annual fee.

It is useful to know that the financial advisor can usually negotiate fees, even though any reduction would have more impact on the firm than on the advisor personally. A $1,000 reduction in fee will save you that amount but may only cost the financial advisor about $250 in after-tax dollars. The cost to the financial advisor is lower than the benefit to you because, in a full-service brokerage firm, the fees are split between the firm and the financial advisor who handles your account. An experienced advisor probably gets to keep about 45% of the total fee you pay and the brokerage firm gets to keep 55%. A financial advisor who is new in the business, and is generating less income for the firm, may only be getting about 30% of the fee.

Let’s assume that you are dealing with an experienced advisor and your total account is $400,000. If you could negotiate a 1/4 of 1% annual fee reduction, it would save you $1,000 per year. The financial advisor receives 45% of the fee and the reduction costs him $450. Since he pays income tax on all earnings, the true after-tax cost is about $250. Most financial advisors would willingly give you a 1/4 of 1% reduction in fees if you provide some referrals.

While an advisor has some flexibility in negotiating fees that are above the minimum fee level, he or she has almost no flexibility in negotiating fees if they are below the firm’s minimum fee level. Below a certain level, it becomes too costly for the finanical advisor to give any futher discounts.

Bottom line: You can negotiate fees, and the best way to get lower fees is simply to ask for them. Financial advisors are always looking for new, good quality, referrals. Nothing will make your financial advisor more receptive to your request for lower fees than the promise of such referrals.

What you can do now: Find out how much you are now paying in fees and ask your financial advisor for a fee reduction based on the fact that you are going to be a low-maintenance account and/or you are going to send referrals. If you make these promises, be sure to follow through on them.

Don’t underestimate the impact of a 1% improvement in net return

Investors do not pay enough attention to fees and they do not know the benefit of even a 1/4 of 1% reduction in the fee rate. When you add in the benefit of compounding, even a small reduction in fee may mean you will be able to retire years earlier or spend more in retirement.

If investors knew the long-term results of even a 1/4 of 1% fee reduction they would pay more attention to the fees that are being charged.

Imagine someone who starts saving $1,000 a month at age 35. They save $12,000 a year for 25 years and retire at age 60. They use this capital over the next 25 years and they die at age 85.

If you do the math, you will find that in this example the savings of 1/4 of 1% in a lifetime amounts to almost $380,000. With the same basic spending and the same income from investments, this 1/4 of 1% fee savings could mean either spending and enjoying another $380,000 or leaving that additional amount to your heirs.

This example also points out the impact of compounding over the long-term and of the amazing benefit, therefore, of starting to save at an early age.

Bottom line: It is great to live in, and enjoy, the present moment. However, you should also be aware of the long-term result of lower fees. For many middle-aged investors, a 1/4 of 1% fee reduction will allow them to retire as much as one year earlier.

What you can do now: First find out what you are paying in fees, then try to negotiate a small fee reduction.

Understand the benefits of exchange traded funds

Many investors are paying higher fees and more in income tax, as well as taking more risk than necessary. However, they are not getting any better return than if they bought an exchange traded fund that earned the same return as the related stock market index.

“Pioneers on the investing frontier know costs matter. ETFs are key ammunition in the shootout over high fees,” according to Jonathan Chevreau, Financial Post columnist.

The best way to explain an exchange traded fund is to say that it is like an index mutual fund in that it represents a basket of securities designed to mirror the performance of a stock index, such as the Toronto Stock Exchange (TSX) or the Dow Jones Industrial Average (DJIA), or almost any other exchange in the world.

Here, however, are some arguments for using an ETF rather than traditional mutual fund or index fund in order to capture market growth.

• Evidence shows that the majority of equity mutual fund managers do not perform as well as their benchmark index. Over time, most Canadian equity managers will have a lower annual return than the TSX stock market index. Since the return on ETFs will be almost the same as the index, buying an ETF instead of an equity mutual fund may be one way to improve your return.
• ETFs can help you save money on the management expense ratio (MER). The average Canadian equity mutual fund has an MER of about 2.5% while an ETF has an MER of about .3%. This saving of more than 2% per annum is meaningful when looking at single-digit returns.
• ETFs make security changes only infrequently and are, therefore, more income tax efficient than most mutual funds. ETFs defer capital gains for a longer period than usually happens with regular equity mutual funds.
• When you buy an ETF, you are getting an almost exact mirror of the underlying index on which it is based. By comparison, when you buy, for example, a Canadian large cap growth fund, it is likely that you will also find cash, medium-sized stocks, and US stocks within the fund.
• An ETF can be purchased or sold during the trading day, in the same way an individual stock can be bought or sold. Index funds can only be bought or sold at fair market value at the end of the day after the markets are closed. If you see movement in the market at 10 a.m., you could buy or sell at the price at that time rather than the price at end of the day.

ETFs do not pay your advisor any trailer fee. This is one reason why the MER is so low and why most advisors choose not to recommend ETFs unless their client is in a fee-based account. If you are paying your advisor a fee, based on assets in your account, there is no reason why he should object to using ETFs instead of private equity managers or mutual fund managers.

Another reason why investors might not hear about ETFs is that many finanical planners are not licensed to sell them. In these cases an investor could get most of the same benefits by purchasing an index mutual fund, which the planner would be licensed to sell.

There’s an added problem for investors who buy regular mutual funds in the hope that they can guess which managers will outperform the market over the coming year. Even if you are lucky enough to pick next year’s best-performing manager, there is no evidence that she will continue to outperform. In fact the evidence shows that after 10 years, only a small percentage of first quartile managers continue to be ranked in the first quartile of their peer groups.

There is one disadvantage of an ETF compared with an index mutual fund. When you are on an automatic savings program, you can make regular and periodic investments into an index mutual fund without incurring a transaction cost for each reinvestment. With an ETF, if you are dealing with a full-service brokerage firm, you will have to pay a fee each time you make an investment.

Another disadvantage of the ETF is that with an ETF you have no possibility of beating the market. With an ETF you are going to get the return of the market, no more and no less.

Bottom line: Most of the large financial institutions, such as pension funds, foundations, and endowment funds, use “passive” or index investing for a significant portion of the assets they allocate to the equity markets. These institutions seek exposure to equity markets but do so in a way that minimizes fees. An individual investor can have the same low-cost exposure to the market by buying one of many types of ETFs.

What you can do now: Get a better understanding of how ETFs really work by reading Howard Atkinson’s book, The New Investment Frontier II.

Beware of the hidden costs of deferred sales charge mutual funds

The real cost of buying deferred sales charge funds is often greater than is anticipated at time of purchase. In practice, what frequently happens is that the deferred sales charge (DSC) either gets triggered by an early sale, or an opportunity is lost when the investor hangs on to a bad fund in order to avoid triggering the DSC fee.

When investors buy deferred sales charge mutual funds, instead of front-end funds, their main motivation, obviously, is to save on fees. In fact, however, in my experience at least, investors who hold these funds pay more, not less, in fees.

An investor who buys a mutual fund on the deferred sales charge method pays no transaction fee at time of purchase. And if the fund is held for up to seven years the fee can be totally avoided. There is a cost, however, if the fund is sold before the end of the DSC schedule.

At the time of purchase, this waiting period never seems to be a problem. The investor is optimistic about the fund’s potential, or he wouldn’t buy it, and at this point he cannot imagine any reason to sell it before the DSC fee expires. Paying no fee sounds more attractive than paying even a relatively low 1% or 2% up-front fee. In this case, the certain cost of 1% or 2% seems greater than the possibility of having to pay 5% or 6% in the unlikely event that the fund is sold before the deferred sales charge period expires. The thinking is that the DSC fee doesn’t matter because it will never be applied.

This thinking frequently turns out to be wrong, however, because many investors do sell before the DSC fee expires. The problem is that new and better products are always becoming available, mutual fund managers leave the fund they were managing, and sometimes fund managers go into a slump. For these reasons, investors routinely make a decision to sell the fund before the end of the DSC schedule. The fee is usually about 5%, if redeemed in the first year, 4.5% if redeemed in the second, and so on. The fee for early redemption is now based on the purchase price. In times past it might have been based on either the purchase price or the market value at the time the fund was sold.

From the financial advisor’s point of view, selling on a DSC basis is initially more attractive than charging a front-end fee. With a DSC purchase, the financial advisor makes a commission of about 5%, which obviously is more attractive than the 1% or 2% he would earn on a front-end sale. The bottom-line reason for the DSC fee is that the advisor gets paid by the fund company as soon as you buy the fund. If you don’t keep the fund, the mutual fund company needs to get its money back. They do so through the DSC fee.

Investors might be interested to know that the trailer fee earned by the advisor is generally higher on the “front end” version of a mutual fund. Typically, the trailer fee on a front end fund is 1% per annum, while the trailer fee on a DSC fund is 0.5% per annum. The management expense ratio (MER) is generally the same for both the front end and DSC versions. Over the long term, therefore, the advisor actually earns more by selling front end funds.

In some cases, the mutual fund owner effectively becomes a prisoner to the DSC fee. Often, to avoid triggering the DSC fee, the opportunity to purchase improved investments will be lost. A person who had invested almost $1 million in NASDAQ-based technology funds once came to me for advice. His investments had fallen in value to about $300,000. The funds had been purchased on a deferred sales charge basis and the redemption fee was still at 5%. It would have cost him $50,000 to liquidate his investments. He felt he had no choice but to hang in for a few more years until the DSC fee expired – and to keep hoping that the markets would improve.

If your account is small and you want professional advice from a full-service brokerage firm, you should not totally reject the idea of DSC funds. A financial advisor has to earn an income. In many cases, DSC mutual funds are a sensible choice for both client and advisor. Today, however, if your account size is, say, more than $200,000, you probably should not be purchasing on a DSC basis. Five years ago it was standard practice to use DSC funds and therefore if you still have some of these funds you should not be concerned. You should be concerned, however, if you have a large account and are still buying mutual funds on this basis.

Bottom line: Most investors with large accounts can do better than to purchase their investments on a DSC basis. It is usually cheaper in the long run to pay up front. Financial advisors commonly sell funds with a front-end fee somewhere between zero and 2%. If you are paying more than 2% for a front-end-fee mutual fund, you are paying too much.

What you can do now: If you are going to purchase mutual funds, rather than buying the funds on a DSC basis, offer to pay a 1% or 2% front-end fee.

Focus less on fees and more on your investment strategy

Investors can lose much more by acting on bad advice than by paying too much in fees.

Fees are, for the most part, easy to understand. Every investor knows that low fees are better than high fees. When it comes to comparing the merits of two widely different investment proposals, however, a greater level of knowledge is required. While fees are important, it is the investment strategy that is paramount to an investor’s success. If you have a good financial advisor, the fees you pay are a good investment.

I have known many potential clients who only wanted to discuss fees. They were emphatic that their business would go to the advisor who offered them the best fee schedule, or the greatest percentage discounts. For these investors, nothing seemed to matter except the fees. As a result, they often saved on fees but lost more by working with a less skillful financial advisor. Such investors are penny wise but pound foolish or, in the other well-known description, they know the cost of everything but the value of nothing.

Focusing entirely on fees and/or commissions can backfire. An unethical advisor can quickly make up in volume what he loses in the percentage rate simply by recommending more trades than necessary. Even a highly discounted fee will, in the long run, result in higher costs compared with what you would pay with a financial advisor who charges a higher percentage fee but seldom makes a trade.

Bottom line: You should understand fees, but do not focus on fees to the exclusion of all other matters. The investment strategy is more important.

What you can do now: Find out how much you are paying in fees. Focus on fees only if they seem high in relation to the advice you are receiving.

Don’t buy new issues to save on commissions

It is often a mistake to buy new-issue offerings. History shows than within a few months, the new issue frequently winds up trading at a discount to the initial offering price.

At first glance it appears that the buyer of a new issue avoids paying a brokerage commission. That makes new issues a popular buy. Yet, fee-conscious investors would often be better off by paying a commission and buying the new issue at a later date. Frequently the new issue can be purchased at a lower cost, even after taking commissions into consideration, after it has been trading on the open market for a few months.

There are different types of new issues. The most common type is shares sold to the public when a major corporation is raising capital. Another example would be shares sold to the public by owners of a business who have decided to go public by converting the business to an income trust and selling the income trust shares to the public. A further example is when mutual fund or hedge fund companies create new closed-end funds that are offered to the public as a new-issue offering.

New issues can only be purchased through a brokerage firm. The financial advisor and the brokerage firm get their selling commission from the company raising the money rather than being paid directly by the investor. You might reasonably wonder where the company gets the money to pay these commissions. Usually, the bulk of the money comes out of the proceeds raised from the new issue. So, indirectly, the investor still pays the commissions. Financial advisors like selling new issues because the commissions on new issues are usually higher than those earned on a normal stock purchase.

The total cost of getting a new issue to the public is generally quite high. Costs include legal fees, commissions, consulting fees, brokerage fees, guarantee fees, and banking fees. These costs are normally all paid out of the proceeds of the new issue. As a result, the net asset value of the shares often goes down in value as soon as the shares are available to trade.

For example, in the case where a company creates a new closed end mutual fund or hedge fund, assume that 10 million shares are to be sold at a price of $10 per share. In theory, this company should be trading at $10 per share because the company now has $100 million in cash. With 10 million shares outstanding, each share should be worth $10. In reality, however, the first thing the company has to do with the money is to pay the expenses that they incurred. After paying the costs, the company might have only $95 million in cash. With $95 million in cash and 10 million shares outstanding, the net share value will be $9.50 per share and that is where the shares could be expected to trade.

Although this investment should trade at the net book value of $9.50, in practice it often trades at a discount to even the true net asset value of $9.50. It would not be unusual for this security to trade at a 5% discount to the true net asset value. Thus, the shares might actually trade at about $9.

If you have confidence in the company’s long-term prospects and want to buy in, you could then buy the shares trading on the open market for $9.00 to $9.50. Even if you pay a commission of 2%, you would be further ahead than having bought the new issue at $10.00 without paying a fee. There is, of course, a possibility that the shares could go up, and stay up, immediately after they begin trading. It is equally likely, however, based on the history of new issues, that the shares will trade at a discount.

Bottom line: If your main objective is to save on fees, don’t be in too big a rush to buy new issues. In many cases, you will be able to buy more shares of the new issue for the same amount of money by waiting until they have been trading for a few months.

What you can do now: Buy new issues if you want to own the security. Avoid this move if you’re just trying to save on brokerage commissions.

Beware of hidden costs when you buy bonds

It is a mistake not to know the hidden costs you pay when you trade bonds. When interest rates are low, and you pay a 1% cost to switch bond positions, you have to make exceptionally good calls in order to be further ahead after the trade.

You don’t see the fee that you pay when you purchase government or corporate bonds. If you want to know the cost, you should ask your advisor.

Government or corporate bonds are usually purchased out of the inventory that the brokerage firm owns. In this case, the brokerage firm is acting as a principal rather than as your agent. It is like going into a store and purchasing goods from the store’s inventory. The brokerage firm makes money by buying bonds on the open market at a wholesale price and then selling to you at a retail.

By way of comparison, when you purchase stocks, the brokerage firm usually, but not always, is acting as your agent. In this case, the firm is buying the shares on your behalf in the same way that a real estate agent helps you buy a house owned by a third party.

The cost or spread (the difference between the wholesale price and the retail price) is built into the retail price. You do not see how much you pay. The financial advisor involved in the trade enters into the computer the level of fee that will be charged and you are told what the yield will be based on this charge. A typical fee is 0.5% to 1% but discounts may be available if you ask. Sometimes the “cost” is referred to as the “spread,” i.e., the difference between the wholesale market value and the retail market value, and at other times it is referred to as a commission.

The fee or commission is generally calculated on the face value, or maturity value, of the bond. The commissions on a long-term strip bond can therefore be huge. If you spend $10,000 for a strip bond that will mature at $35,000 in 25 years’ time, and you pay a 1% commission on the maturity value of $35,000, you are effectively paying a 3.5% commission on the actual purchase price. (See note on strip bonds below.)

Occasionally, it may make sense to alter the makeup of your bond portfolio to anticipate changes in interest rates. However, if your portfolio is properly diversified, you are generally better off holding the bonds to maturity.

Your financial advisor and the brokerage firm make excellent commissions when there is a lot of trading activity in bonds. For you to make money by trading bonds, your advisor needs to make consistently accurate predictions – in advance of other professionals – as to where interest rates are heading. I would question why an advisor with this level of skill is working in the retail market and not running a fixed-income arbitrage strategy for a hedge fund.

Note: Strip bonds do not pay interest but are purchased at a deep discount to their face value. The return you receive from strip bonds is the appreciation in price from the time you make the purchase until the time you sell or the bond matures. Strip bonds are suitable for registered accounts but usually not for non-registered accounts. Strip bonds are not practical for non-registered accounts because the increase in value is taxed as interest even though no interest payments have been received. It is also sometimes difficult to try to work out the amount that should be included in taxable income.

Bottom line: When you trade bonds, unseen fees or commissions can have the effect of reducing the rate of return that you might otherwise earn. Over the long term, because of the hidden costs, most investors will find that using an active trading strategy does not improve the net return over a buy and hold strategy.

What you can do now: Ask your financial advisor for the details on the spread, or commission rate, on your bond purchases.

Don’t try to make capital gains on your bonds

When investors try to increase their total after-tax return by actively trading bonds, they will certainly increase commissions paid, but it is less likely that they will also be able to increase the total net return.

When investors own government or corporate bonds, they see the market value of the bonds constantly changing. The changes in market value are primarily, but not entirely, in response to changing interest rates.

An increase in interest rates by the central bank brings a decrease in the market value of bonds. A bond with an existing fixed rate of interest – whatever it might be – is less attractive in a higher interest rate environment. Conversely, when interest rates decrease, the bonds that you already own will increase in value.

Investors are sometimes tempted, or encouraged by their financial advisor, to sell the bonds that have risen in value to realize the accrued profit. They may see an opportunity to increase their profits by following a strategy of buying bonds when interest rates in the economy are high and selling them when rates are lower. By buying low (when interest rates are high) and selling high (when interest rates are low), capital gains would be earned in addition to interest that is earned each year.

The strategy rarely works because of commission costs, our inability to consistently predict where interest rates will go, and the need to reinvest at prevailing rates. If you buy a bond and hold it to maturity, you will earn the rate of return you expected to earn when you first bought the bond, regardless of how interest rates have changed in the meantime. When investors understand this, it is easier for them to ignore the monthly or quarterly fluctuations in their bond portfolio because they know their bonds will almost always mature at their face value.

Given that interest rates rise and fall over economic cycles, the chance for capital losses or gains are about equal. Extensive studies have shown that over 90% of all the return earned by investing in bonds comes from interest payments. The other 10% is from capital gains. In other words, if the average return from investing in bonds was 8%, then 7.2% was earned from the interest coupons and 0.8% was earned from trading bonds.

Some people may believe that this average improvement of the expected return is worth its active trading. I believe there is almost no chance that the average investor will benefit by actively trading bonds. Consider that the professional traders expect to improve the rate of return by only about 1% per annum, and they buy wholesale rather than retail and buy and sell with lower commissions than the average investor. However, I suggest that if an investor wants to try to increase the return on bonds, he or she should use a bond mutual fund with a very low MER.

It is also questionable whether it makes sense to sell a bond at a profit, trigger the tax immediately, and then take the money and invest in bonds with a similar term to maturity but at a lower interest rate. Some see a benefit in earning a capital gain, as opposed to interest, but this benefit is partly offset by the disadvantage of paying tax sooner than necessary and by paying commissions.

There are two occasions when the sensible thing might be to sell bonds that have risen in value: when you want to move out of the bond asset class altogether, or when you want to make a significant shift in the “duration” of your bond portfolio.

Duration is a more precise way to measure the average term to maturity of your bond portfolio. Duration takes into consideration not only the number of years before the bond matures but also the interest payments that you will receive. When the coupon interest rate is high, your cash flow is higher, which means you receive that portion of your money sooner. The faster your capital is returned, the shorter the duration of the bond.

Bottom line: Professional bond traders and fixed-income arbitrage specialists find it difficult to make capital gains by trading bonds in anticipation of interest rate changes, and they pay almost nothing in commissions. Given the high commissions that you pay, you are generally better off holding your bonds to maturity.

What you can do now: If your financial advisor suggests that you sell a bond to take a profit – but then have to invest the proceeds in a bond with a lower yield – ask for a calculation that compares the total after-tax return of the bond that you now have with the expected total after-tax return for the new bond that you will purchase with the proceeds.

Understand the costs of buying or selling thinly traded stocks

Why this is important: Some investors trade too much for their own good because they are unaware of the hidden costs of trading, particularly if they are trading in stocks that move on low volumes (thinly traded stocks).

You should be aware of three trading costs on stocks that trade on low volumes.

The commission is the first and most visible of these three costs and it is therefore the focus for most investors. Although less visible, the other costs are often greater and can result in a penalty for frequent buyers or sellers of low volume stocks.

The second cost is the difference between the bid price and the asking price for a stock. Assume that the last trade on a stock was $10. The new bid price – the price someone is willing to pay to buy the stock – might be $9.80. On the other side, the price asked by someone who is willing to sell or “offer” the stock – is $10.20. This difference is called the spread and represents the potential profit for the market maker. The market maker is the person or firm taking the responsibility of buying and selling as necessary to create a ready market for the stock.

In effect, the market maker gives the offering price to the seller, and charges the asking price to the buyer. On thinly traded stocks, the spread might be 2% to 5% of the purchase price. In this instance, the buyer at $10.20 is paying 40 cents more for the shares than he could get for them if he resold them immediately. A frequent buyer or seller of thinly traded stocks loses the amount of the spread every time he or she buys or sells.

The third cost is the amount by which your trade moves the market. For example, assume that you want to purchase 10,000 shares of a thinly traded stock trading at $10, with bid price of $9.80 and asking price of $10.20. Placing an order to purchase 10,000 shares is likely going to cause the share price to increase. You might be able to buy 1,000 shares from the first individual who was offering to sell his shares at $10.20, but to get the rest of the shares that you want, you will have to increase the price in order to interest the other shareholders in selling. In effect, it is your buying that is causing the share price to move higher, and this is an added cost to you.

The hidden cost of the spread, and the cost of the movement in the market, is generally greater than the cost of the commission that the brokerage firm receives. These costs are not a factor, however, when you purchase large capitalization companies that are traded on the New York Stock Exchange (NYSE). With large-capitalization, high-volume stocks, there is usually only a very small difference between the bid and the ask price, and your order has no impact on the movement of the price.

Bottom line: Do not focus entirely on the commission being charged each time you trade stocks. This is only one of the costs you pay and it may not be the largest. A skillful financial advisor who understands the market can do a lot to reduce the other costs of trading in low-volume shares.

What you can do now: The next time you make a trade, note the difference between the bid and the ask price before the trade, and then again after the trade has been filled. You should also ask your advisor to check the bid and ask price and the volume being traded before you place your order.


Source: http://www.teamstart.ca/Library/PersonalFinances/PayLessFees.htm

Comments : With our roots in the economic development community, Teamstart core mission is to provide resources to Canadian business owners to help them do the right things right. The core value is to only provide know how that comes from objective, independent, experienced, knowledgeable, and reputable sources.
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