Conduct a Cost Audit of Your Portfolio

Note: The following is part of Morningstar's 2018 Portfolio Tuneup week. A version of this article appeared on June 23, 2016.

To demonstrate how little most investors think about their investment expenses, run yourself through the following simple test (courtesy of director of manager research Russ Kinnel).

First, think about how much you're paying each year for cable TV and Internet services.

Now think about how much you're paying each year in investment-related expenses.

If you're like many people, the first question isn't tough to answer, especially if you're the bill-payer in your household. You probably wish the annual number were lower (and the exercise may prompt you to want to cut the cord), but it's a good bet you can come up with a pretty accurate figure.

The answer to the second question, on the other hand, is probably more elusive. For starters, you probably never write a check for your financial services, or even see an annual bill. That has the net effect of making you much less mindful of those expenses in dollar terms, even though those costs can be far higher than cable bills in households with substantial investment assets. For example, a household with $500,000 in investment assets paying 1% in all-in costs is shelling out $5,000 a year.

And unless you're paying very close attention, it's likely you're missing some investment-related costs altogether. One of the key reasons so many investors have gotten religion about watching out for high mutual fund expenses is that fund expense ratios are extraordinarily transparent and easy to track. Other costs, meanwhile, may be buried in fine print or not disclosed clearly at all. But just like fund expense ratios, they have the potential to drag on your take-home returns.

Here are some of the key questions to ask when checking up on your portfolio-related expenses.

Question 1: Are your mutual funds' costs as low as they can go? Mutual funds offer investors a good deal of transparency on the fee front: Expense ratios are right out in the open, which helps explain why investors have been gravitating toward very low-cost products in recent years. That's all for the better, as mutual fund expenses are one of the best predictors of whether a fund will be a good or poor performer in the future.

To check up on how your portfolio's mutual fund costs stack up, turn to Morningstar's X-Ray functionality. If you have a portfolio saved in Morningstar's Portfolio Manager, click on the X-Ray tab; if your portfolio isn't saved on the site, enter your holdings in Instant X-Ray and click "Show Instant X-Ray." Toward the bottom of the X-Ray page, look for the "Fees & Expenses" section. You'll see an asset-weighted expense ratio for your portfolio ("Average Expense Ratio"), as well as the expense ratio of a similarly weighted hypothetical portfolio composed of funds with average costs. Ideally, your portfolio's expenses will be well below those of the hypothetical portfolio.

For the "cable bill" view of what your mutual funds are costing you annually, you can see how much you’re paying in expenses to your mutual funds given your portfolio's current dollar value. That data point underscores why you should care about your funds' costs.

If your funds' costs are higher than you'd like them to be, click the "Holdings Detail" on the Fees & Expenses" header. You can then see your holdings' expense ratios alongside those of average expense ratios for the funds' categories; that can help you pinpoint the high-cost culprits in your portfolio. The Quote page for each individual fund includes the expense ratio as well as a one-word descriptor ("Fee Level") of how that expense ratio stacks up relative to category peers sold through the same sales channel.

For a more detailed look at a funds’ expenses, click on the "Expense" tab for an individual fund. You can see the historical trends in the fund's expense alongside those of its typical category peer and the peers sold through the same sales channel.

Swapping out of high-cost funds and into lower-cost options isn't a big deal within your company retirement plan or IRA, because you won't owe taxes when you make the changes. Exercise caution and consult a tax advisor if you’re making changes within your taxable account, however; you want to make sure any expense savings aren't offset by higher tax costs.

Question 2: Are your 401(k) fees reasonable? In contrast with mutual fund expense ratios, 401(k) fees can be opaque. While the expense ratios for individual funds in the plan aren't hard to track down, the administrative costs associated with the 401(k) can be buried. Generally speaking, smaller-employer 401(k)s carry higher administrative fees than 401(k)s fielded by very large firms, but that's not always the case. This article discusses how to dig into the administrative costs associated with your plan.

Question 3: Are you managing your equity and ETF trading costs? Brokerage commissions have come way down in recent years thanks to competition among discount brokerage firms. If you're using a full-service broker and paying higher commissions, just make sure you're getting your money's worth in the form of advice and other services.

And no matter what platform you're using to trade, bear in mind that commissions aren’t the only costs you'll pay to transact. If you're trading illiquid stocks, bid-ask spreads can inflate your total trading costs.

Bid-ask spreads can also jack up costs for ETF investors. In addition, the price of an ETF may stray from the value of its underlying holdings, drifting either higher (a premium) or lower (a discount). That's a particularly big issue for ETFs that traffic in securities that don't change hands frequently, as well as those that buy non-U.S. securities that aren't trading at the time the U.S. investor is buying or selling the ETF. Morningstar includes information on both bid-ask spreads and premium/discounts on each ETF's quote page.

Focusing on liquidity is the key way to reduce if not eliminate the drag of equity and ETF trading costs. The more frequently a stock or ETF changes hands, the narrower its bid-ask spread will tend to be. And the more liquid the ETF's underlying holdings, the less likely the ETF's price is to depart from its NAV. This article shares guidance on limiting costs while trading ETFs. Investors can also help reduce the drag of trading costs by trading infrequently themselves; even if they take a haircut when they make a trade, that amount will likely be small relative to the return they earn over a long holding period.

Question 4: Are you managing trading costs for your bond holdings? Investors in individual bonds also need to look alive when it comes to their trading costs, as bid-ask spreads can increase their transaction costs, too. (This explanatory piece discusses bid/ask spreads for bonds.) Moreover, in contrast with stock trades, securities dealers aren't currently required to disclose these transaction costs for bonds. (New disclosure rules go into effect this spring, however, as discussed here.) Thus, an investor transacting in individual bonds may be taking a haircut she's not even aware of. The smaller the investor, the more egregious these transaction fees are apt to be.

Large, institutional investors pay transaction costs, too, but those costs tend to decline for larger investors like mutual funds. Thus, even though an investor in a bond mutual fund has to pay an expense ratio, the savings in bid-ask spreads will often make the fund the more attractive choice than individual bonds for all but very large individual investors. Moreover, the further an investor ventures beyond government bonds, the better off she will be with a well-diversified portfolio and professional management that comes along with investing in a fund versus selecting individual bonds.

Question 5: Are you avoiding account-maintenance fees when possible? Account-maintenance fees are charges levied upon investors for holding their money at a given brokerage firm or mutual fund company. They're usually flat-dollar fees, such as $20 per year. That has the net effect of hurting smaller investors more than large ones. (On a $1,000 balance $20 is 2%, whereas a $20 account maintenance fee is 0.02% of a $100,000 balance.) Commonplace in the past, these fees have ebbed away with competition among brokerage firms; today, you're most likely to see them for very small accounts. Increasingly common, however, are charges for receiving paper statements; these fees don't frequently apply to larger accounts.

You don't have to venture too far to find firms that don't levy these fees. And even if the firm of your choice does charge such a fee on smaller accounts, you may be able to avoid it by amassing a larger balance or signing up for electronic document delivery. For example, Vanguard charges a $20 annual fee for each brokerage or mutual fund account with less than $10,000, but investors who sign up for electronic document delivery can avoid it. In a similar vein, investors at E-Trade can also avoid the firm's $2 fee for each paper statement by signing up for electronic document delivery.

Question 6: Are you sidestepping outgoing transfer fees? Outgoing-transfer fees, which apply when an investor transfers assets from one brokerage firm to another, are surprisingly commonplace. Fidelity and Vanguard do not charge these fees, but most other brokerages charge $50 to $75 to do so. Firms may also levy fees for closing an IRA.

If the firm that you're transferring assets from levies an outgoing transfer fee, ask the firm you're transferring the assets into if it can reimburse you for those expenses. (The leverage you have with a new provider is helpful to bear in mind whenever you're transferring assets from one entity to another--for example, rolling over a 401(k) into an IRA. The receiving entity has a vested interest in keeping you happy.) And in any case, it's worth bearing the big picture in mind when conducting such a transfer. If the new provider charges lower overall fees or offers a better investment lineup than your old one, you're likely to come out ahead in the end even if you do have to pay a one-time fee to make the switch.

Question 7: Are you keeping an eye on health savings account costs? Health savings accounts, or HSAs, carry extraordinary tax benefits: the ability to make pretax contributions, enjoy tax-free compounding, and enjoy tax-free withdrawals for qualified healthcare expenditures. But because HSAs haven't yet enjoyed widespread adoption or gotten much scrutiny, the playing field for HSA providers is nowhere near as competitive as is the case for, say, IRA providers. The net effect: layers upon layers of fees. Many HSAs carry setup fees, transaction fees when tapping the account for healthcare expenses (including when you use the debit card), transaction fees for getting the money invested, and annual account fees. Morningstar's Health Savings Account Landscape report takes an in-depth look at the largest HSAs, including their fees.

If you have an HSA through your employer, you may feel stuck because you need to use the employer-provided HSA to obtain a payroll deduction on your contribution. But there are no limitations on transfers out of the HSA. Thus, you can run your contribution through your employer-provided HSA, then periodically transfer the money out to the HSA of your choice--ideally one with lower costs. This article discusses the strategy and other HSA "saves" in greater detail. This blog post looks at the best HSAs for investors, and this one examines the best HSAs for people who are actively spending from their HSAs.