Most Investors Don't Fully Understand Fees

Investors continue to lack a general understanding of the management costs and advisory fees they pay, despite the financial industry's efforts to make fees more transparent, State Street Global Advisors reported this week.

State Street's Low-Cost Investing Survey found that confusion exists about how investors pay for both investment products and the guidance they receive from an advisor.

A vast majority of respondents said they are at least aware of what expense ratios and basis points are, but few said they understand them completely.

"Comprehension of investment product fees — and fees in general — is low even among those working with an advisor," Brie Williams, head of practice management at State Street Global Advisors, said in a statement. "There's a clear opportunity for advisors to talk to clients about what they own, why they own it and how much it costs."

Consider that 47% of investors surveyed believe that the management costs of investments like mutual funds and ETFs are already included in the fee they pay their advisors or investment platform.

Sixty percent of investors currently working with an advisor agreed with this false statement, compared with 37% of self-directed investors. Younger investors were likelier than older ones to agree with it: 71% of millennials agree versus 51% in Generation X and 36% of baby boomers.

A lack of understanding also exists about the meaning of diversification. The survey found that 85% agreed that "a well-diversified portfolio is one with a variety of investments that reduce stock market risk," but 55% incorrectly believed that "a well-diversified portfolio is having investments in a variety of accounts at different firms or investment platforms."

State Street, in partnership with A2B Planning and its field partner Prodege, conducted the online survey in mid-June among a nationally representative sample of adults. For its custom "low cost" analysis, researchers analyzed 224 adults with investable assets of $250,000 or more.

How Low Is 'Low Cost'?

State Street noted that the overall awareness of costs at the investment product level seems to be high, but understanding of what the specific costs actually are is low.

Eighty-seven percent of survey participants said they are at least aware of what expense ratios are, and 83% were familiar with basis points, but less than one-third said they completely understand each one. More self-directed investors than advised investors said they have a complete understanding of what these terms mean.

Investors also seem to have a limited understanding of just how low "low cost" actually is when it comes to fund expenses. Among those who think they understand expense ratios and/or basis points, the average expense ratio they consider no longer to be "low cost" is 0.61%.

Meanwhile, the asset-weighted average expense ratio of U.S. open-end mutual funds is 0.51% and the average asset-weighted ETF cost is just 0.20%, the report said, citing Morningstar data as of July 19, based on SPDR Americas Research Calculations.

"Cost differences vary drastically across mutual funds and ETFs," Williams said. "From an ETF provider's perspective, low cost is generally considered funds with an expense ratio of 0.10% or less — this is 6x lower than the threshold of investors in the survey."

Williams noted, "The bottom line is, when all other variables are equal, lower cost investments can help investors keep more of what they earn in their portfolio."

When asked to rank order factors in terms of importance when evaluating investments like mutual funds and ETFs, respondents prioritized these:

Risk compared to return: 53%
Quality of stocks in the fund: 51%
Performance compared to peers: 46%
Performance compared to the benchmark(s): 42%

Management cost of the fund got a nod from 35% of investors. They ranked track record of the fund manager, market sectors covered in the fund and tax efficiency among the least important factors.

Inflation and Taxes Are Top Concerns

Asked about financial unknowns or variables they commonly worry about, 65% of survey participants cited rising inflation, 61% cited rising taxes and 55% cited saving enough for retirement. Younger respondents were more concerned than older ones about saving enough for retirement: 66% of millennials and 68% of Gen Xers versus 44% of baby boomers.

The survey also found high awareness of the negative effect taxes could have on overall investment returns. Sixty-two percent of investors said they consider how much taxes could deplete their returns when they think about investments.

Seventy-eight percent of millennials expressed concern about the bite taxes could take out of their returns, compared with 69% of Gen Xers and 51% of boomers.

"We expect to see record high flows into low-cost, tax-efficient ETFs, especially if tax rates increase and the low-yield interest rate environment persists," Williams said. "Investors should be talking to their advisor about strategies for minimizing the impact that cost, taxes and inflation can have on their overall portfolio."