How Do Expenses Impact Net Performance Of Your Investments?

How Do Expenses Impact Net Performance Of Your Investments?

Most financial advisors talk about the gross performance that they produce for their clients’ assets. That’s because this is the highest number that they produce for their clients. For example, your rate of return for 2021 was 12%. 

However, knowledgeable investors want to know their rate of return after all of the expenses have been deducted. This “net return” is the number that actually benefits you. In the example above for 2021, let’s assume the various layers of expense added up to 2% or 200 basis points (1 basis point is 1/100th of 1%). The net return of the investor was 10% after all expenses were deducted—still an admirable “net” return, but not as high as the 12% gross return. 

This article answers these questions (and more):

  • How are net returns different from gross returns??
  • What is another type of expense that impacts your performance?
  • What are the total expenses that are deducted from your account?
  • Why do financial advisors charge custodial fees?
  • What is a sliding schedule of fees?
  • How many layers of financial fees are there?

How Are Net Returns Different From Gross Returns?

Gross returns are the total returns that are produced by your investments. You can look at the market value of your assets at the end of the year and deduct the market value at the beginning of the year to determine if you made or lost money. This simple calculation works if no expenses were deducted from your account, no cash was added to the account, and no money was distributed from the account. 

It is a simple calculation that determines if you have more or less money at the end of the year. The percentage change (plus or minus) is the gross rate of return. A more accurate measure would be to look at the change in market value minus the activity in your account. 

At the top of the activity list are expenses that were deducted from your account. This still presumes that you did not add any new money to your account or withdraw anything. Next, you calculate a net return (10%) that is the gross return (12%) minus all expenses (2%).

If your asset amount is $500,000 and your fully loaded expense ratio is 2%, then your expenses are $10,000 per year. Finally, compound $10,000 of expenses over 20 years, and you can see the impact of expenses on your financial well-being later in life.

How Is a Real Rate of Return Different From a Net Rate of Return?

We already know that a net return is a gross return minus all of the expenses that are deducted from your account. But, there is one more calculation that is also used by sophisticated investors: the real rate of return is produced by the performance of their assets. This is the gross return minus the impact of inflation. 

Why deduct inflation from the gross return? Expenses reduce the amount of money investors have available for their future use. Inflation reduces the future purchasing power of their money. Expenses and inflation can have major impacts on standards of living, particularly for retirees living on fixed incomes.

What Is Another Type of Expense That Impacts Your Performance?

The third form of expense is taxes, assuming your assets are held in personal or joint accounts and not inside a 401k plan or an IRA. Both of the latter types of accounts are tax-deferred, so there are no taxes on your savings until you start taking distributions.

Most investors are knowledgeable enough to maximize contributions to—and minimize withdrawals from—tax-deferred accounts until they are required by law. Doing this gives their assets more time to grow. Nevertheless, if your assets are held in taxable accounts and there are transactions with capital gains, there will be taxes to pay. The question is, “How much?”

The answer to this question will vary based on how and where your assets are invested. One simple illustration is the difference between investing in Exchange Traded Funds (also known as ETFs) and Mutual Funds. The management fees of the companies that manage the assets could be substantially different. 

How Many Layers of Financial Fees Are There?

Four types of fees could apply, depending on the recommendations of your financial advisor:

  • Financial planning and investment advisory fee
  • Third-party money management fee (mutual fund, ETF money manager)
  • Custodial fee
  • Transaction charges

What Are the Total Expenses That Are Deducted From Your Account?

Step one is to ask your current financial advisor to document every penny of expense that is being deducted from your accounts. Advisors should have this information at their fingertips. You should also ask your financial advisor to document this information on a quarterly basis, along with their performance report. 

Your current advisor has access to this information, but may not volunteer it. There is a good chance you may have to ask for it.

What Is a Sliding Schedule of Fees?

Most financial advisors charge a sliding schedule of fees that are based on your asset amount. The incremental fee goes down as the value of the assets goes up. An example of a frequently used financial advisory fee schedule might be:

  • First $1,000,000 1.00%
  • Next $2,000,000 .75%
  • Over $3,000,000 .50%

Advisors want to incentivize investors to invest as much money as possible with them. At the same time, they are acknowledging that their amounts of work are not increasing at the same rate as the asset amounts.

It is important to document exactly what services are covered by this fee. For example, it may cover financial planning, investment advice, performance reporting, and quarterly meetings. 

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Why Do Financial Advisors Charge Custodial Fees?

Generally speaking, most advisors choose to mitigate conflicts of interest by not coming into physical contact with their clients’ assets. The only exception is the financial advisor’s fee. This stipulation creates the need for a custodian that collects income (dividends and interest), processes trades, produces brokerage statements, and provides other services upon request. 

A custodian may charge 20 to 30 basis points for their services.

How Does a Wrap Fee Impact the Expenses That Are Deducted From Investment Portfolios?

A wrap fee consolidates some or all of the expenses that can be deducted from investor accounts into one asset-based fee. For example, the financial advisor, money manager(s), and custodian are all paid with one fee. 

The wrap fee can even cover transaction charges. The custodian is responsible for paying the expenses based on the instructions in the financial advisor’s service agreement. 

Your Net Growth

Happy senior older married couple discussing investing saving

As an investor, you may have control over inflation or taxes, but you do have control over the amount of expenses that are deducted from your account(s). Just as you want documentation for your portfolio’s performance, you want documentation for your performance. 

ViaWealth, your Kansas City financial advisor, can begin this process with an investment portfolio review. However, your gross returns, net returns, and the impact of taxes will all factor into our reports. Contact us today.

ViaWealth, LLC is a Registered Investment Adviser. Information in this article is for educational purposes only and is not intended to be an offer or solicitation for the sale or purchase of any specific securities or other types of investments. Investing in the securities markets involve risk of principal and unless otherwise stated, returns are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before making any financial decisions. Past performance is not indicative of future performance.

More about the author: Reid Larson

Reid is the Managing Member and Founder of ViaWealth LLC.

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