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In 1999, $12 billion of exchange traded funds (ETFs) were issued.  Net issuance of ETF shares rose to $177 billion in 2008.  From year end 1998 through 2008 ETFs issued $661 billion in new shares.   The rise in demand came from both institutional and individual investors, according to the Investment Company Fact Book. (www.ici.org) 

Why the passive approach?

Passive investment vehicles include index mutual funds and exchange traded funds (ETFs).  Both track the performance of a basket of securities included in an index.

For instance, the Russell 3000 Index measures the performance of the broad U.S. equity market.  The Ishares Russell 3000 Fund (IWV) is an exchange traded fund that holds a representative sampling of the securities in the Russell 3000 index.  The sample has an investment profile similar to the index, and may or may not include all of the securities that are included in the index.

As of 10/31/2009 the Russell 3000 index included 2,968 securities.  The Russell 3000 Fund (IWV) held 2,964 of the securities included in the Russell 3000 index. (source:Morningstar)

An index does not invest in the securities, it simply tracks their performance.  Therefore there are no fees included in the index returns. 

Funds, however, invest in the securities and the performance is reduced by transaction costs and other ongoing costs, such as management fees and other fund expenses. The net annual expenses, ongoing costs, for the Russell 3000 Fund are .20% (1/5 of 1%), according to the 2009 annual report.

A fundamental reason investors choose a passive approach is because they are aware that the majority of actively managed mutual funds are not able to out perform their benchmark index over an extended period of time.  The high expenses associated with active management such as transaction and ongoing costs,  reduces the fund’s performance by an average of about 1.5% per year, according to http://www.icifactbook.org/fb_sec5.html

That means if the index posts an 8% return, the average active managed fund would have to achieve a 9.5% return in order to net 8% after costs. If the fund’s returns are less than 9.5%,  it under performs the index. 

Relatively efficient pricing of stocks and bonds along with costs associated with active management makes beating the index a daunting task.  According to a Standard and Poors study, Indices Versus Active Funds Scorecard, Year End 2008, less than 50% of active managers beat their indices over a 5-year period.

An analysis of two – five-year periods of performance; 2004 to 2008 and 1999 to 2003 revealed the following for…

…Large-Cap Active Managed Funds: 72% under performed their S&P 500 index in 2003 to 2008 period, 53 % under performed in 1999 to 2003. 

…Mid-Cap Active Managed Funds: 79% under performed the S&P MidCap 400 benchmark in 2004 to 2008 period, and 91% under performed in 1999 to 2003.

…Small-Cap Active Managed Funds: 86% under performed the S&P SmallCap 600 benchmark in the 2004 to 2008 period, 69% under performed in 1999 to 2003.

According to the study, one consistent investment myth has been that active managers have an advantage in bear markets due to the ability to move quickly into cash or defensive securities.  The study analyzed the performance of active managers during the past two bear markets, 2008 and 2000-2002.   The report illustrated over 50% of the active Large-Cap funds under performed their benchmark, over 70% of the Mid-Cap and Small-Cap funds under performed their respective indices. 

The under performance of active managed international equities and bond funds were similar to U.S.  stock funds. 

To view this study you may have to copy and paste this url  http://www2.standardandpoors.com/spf/pdf/index/SPIVA_Rerpot_Year-End_2008 

In conclusion

Exchange Traded Funds and Index Funds offer low cost ownership of both stocks and bonds.  The high cost of active management is one stumbling block that is difficult to overcome for most active managed funds.  Even in bear markets, the majority of active managers fail to beat their benchmark index.

Golden Hills Financial Group is an independent investment advisory firm utilizing exchange traded funds and index funds in portfolio construction.

Striking the Right Balance

The most important decision an investor makes is the allocation of their money between stocks, bonds, and cash. Some research has shown that 90% of your long-term return comes from this asset allocation decision. Many, maybe most, people jump right into buying stocks and mutual funds before they have crafted their stock/bond/cash strategy. They end up with too much in the stock market, making them susceptible to larger losses than they can tolerate.

The stock market over the long term has provided higher returns than bonds because investors demand a premium for accepting the higher risk in stocks.  Why do stocks pose more risk to investors? The brief answer is when you buy shares of a company, you become part-owner in the firm. There are no guarantees of dividends or that you will ever get your money back. If you buy a bond issued by the government or a corporation, you become a creditor. You have lent them money. They in turn will pay you interest over the life of the bond. Upon maturity you get your principal back. Regular payments and your money back. Not much risk in that. Oh, if a company you lent money to goes broke, you get paid before stockholders get a dime. Common stockholders get paid if there’s any money left after bond holders and preferred stock holders are satisfied.  It’s not unusual in bankruptcy cases for common stockholders to receive $0.   

Points to consider.

There are three major considerations when deciding on how much to invest in stocks. How comfortable you are with market ups and downs, called risk tolerance, how long your money needs to last, called time horizon, and the size of your financial base relative to your financial needs.

Risk tolerance. Investors familiar with the stock market have a better idea of how they’ll react if the market drops. If you have been in the market the past few weeks, you may have decided you want less risk than you have. This market is putting every investor through a risk tolerance test. But if you aren’t sure how much risk you will be comfortable with, you can take a smaller bite of the stock market than would be recommended based on your time horizon. You can always add to that position as you learn through experience.

Time horizon. Too often individuals consider the years up to retirement as their time horizon. Not so. You could be in retirement for 15-30 years. Let’s say you are 45 years old with plans to retire at age 65. You are healthy and expect to live to be 90. Your time horizon is 45 years. The goal is to accumulate enough funds by retirement, the pre-retirement years, that will last throughout retirement, the retirement years. Generally, it is recommended that about five years before retirement the investment in stocks is reduced and bonds and cash are increased. But your money needs to last a long time, and it’s the stock portion of the portfolio that provides growth.

Financial base. The larger the difference between your portfolio size now and where you want it to be at retirement, the larger the allocation to stocks. Stocks are the growth engine of a portfolio. Bonds and cash protect the downside risk and provide income.

Let’s say Madeline wants to have $750,000 in her 401k when she retires in 20 years. She has $50,000 today with plans to add $6,000 per year. To achieve her goal, Madeline needs to earn 11% annually. Stock market returns over the long term have averaged 12%. Therefore, Madeline would need to have a 90 – 100% allocation to stocks to achieve a 11% return.

If Madeline had $100,000 in her 401k, instead of $50,000, she could reduce her allocation to stocks because she only needs an 8% annual return to achieve her goal of $750,000.

Sample Portfolios

Here are some examples of portfolio allocations during different stages of life according to Richard A. Ferri, author of the book All About Asset Allocation.

Mid-life Allocation Range

 Pre-retiree and Active Retiree Allocation Range

REIT = Real Estate Investment Trust
Fixed Income = Bonds

Each investor has an allocation that is unique to his or her situation.  The above examples may or may not be appropriate for you. 

A risk of NOT investing a portion of your portfolio in the stock market is that you will outlive your money.

A risk of investing TOO MUCH in the stock market is you will not have time to recover large losses. In addition, fear may cause you to sell in a panic when stocks are at their lowest prices.

Now is the time for rational decisions. “This time is different” is the phrase that pops up each time the stock market takes a precipitous fall. It may or may not be true this time. What we do know is what has occurred in the past. History demonstrates that markets recover and eventually move up.

An exodus to cash will leave you with the daunting decision of when to re-enter the market.  Investors who run to the side-lines often wait too long to buy back in, missing some of the best days’ in the stock market. This is one of the reasons the average investor significantly underperforms the S&P 500. The other reason is that investors chase performance, buying last years’ winners. For most people the best action is no action for now.  You may want to consider making adjustments to your portfolio later, after the market had recovered.

Creating a portfolio is like putting the pieces of a puzzle together.  Portfolios are built by assembling pieces of stocks, bonds, and cash, with possible additions of real estate, commodities, & alternative investments.  Modern portfolio theory taught us that by combining securities that don’t follow each other, when one leans left the other right, we are likely to achieve a more stable return.  Bonds tend not to move in tandem with stocks.  In finance terms, they have a low correlation to stocks.  So if stocks drop 15%, bonds may decline but less than 15% or they may even rise.  Bonds are the pieces that reduce short-term, gut wrenching swings in the portfolio’s value. 

A recent example.  From October, 2007 to March, 2008, the S&P 500 had lost around 16%.  The Lehman Aggregate Bond Fund, used to represent the broad U.S. bond market, was up about 4%. A portfolio split 50/50 between the S&P 500 & the Lehman Bond Fund, would have returned -6%.  

2) Bonds protect the downside.

While similar to #1, protecting the portfolio’s value is of special importance to retirees who are withdrawing funds regularly to supplement their income.  When cash is withdrawn from a 100% stock portfolio during down markets, the distribution takes a larger piece of the portfolio than if the markets were up, and that piece is gone so it can’t come back when the markets climb.  

For simplicity let’s consider a portfolio made up 2,000 shares of an exchange traded fund, IWV, that represents the U.S. stock market.  The price per share has plummeted to $78.  Each month the retiree withdraws $1,000 for living expenses.  13 shares are sold at $78 to provide this month’s withdrawal.  Next month IWV has risen to $95 per share.  Only 11 shares have to be liquidated in order to withdraw $1,000.  The two additional shares that had to be sold at $78 are no longer in the portfolio and able to come back with the market.

In a declining stock market, cash and bonds can provide the income needed.  When the stock market comes back, (yes it will rise again) the stock portfolio will not have been depleted so will take full advantage of the rising prices.

3) Bonds provide income.

Bonds pay interest, which makes up most of their return.  The other portion of the return comes from the change in the price.  Individual bonds typically make interest payments every 6 months.  Bond funds generally distribute interest monthly.  The interest payments provide stability to a portfolio, and dependable cash distributions to investors.  When the markets are performing poorly, during a bear market, interest payments are a stable source of income.

If you rely on distributions from your investments to supplement income.  If you do not have other income streams to use when the stock market is declining.  If your financial position is such that you are concerned you may outlive your money.  Then investing a portion of your portfolio in bonds is wise.

The portion you allocate to bonds could vary from 15% for the aggressive investor with a time horizon over 20 years, to 85% for an investor more concerned with preserving their portfolio and has a life expectancy less than 5 years.

We all want to enjoy our retirement years with as much vigor and as little stress as we can muster. While I can’t help much with the vigor, a few financial tips on how to live in retirement may help to reduce the stress.

Tip #1: Invest wisely.   Allocate your investment portfolio across stocks, bonds, cash in proportions that reflect both your tolerance for risk and your financial position. For instance, you may have a very low tolerance for taking risk with your money. Based on that alone, you might be comfortable with a very small or no portion of your retirement money in the stock market. Now review your financial position. Based on your current spending habits, you plan to spend, or are currently spending, 8% of your portfolio annually. That mean in order to maintain the principle balance your portfolio needs to earn 8% + some inflation factor of let’s say 3% per year, or 11% annual rate of return. That won’t happen invested in cash and bonds.  Over the long term cash has returned about 3%, bonds 5%, and stocks 10%. In the short term, returns vary dramatically from year-to-year, putting stress on you and your finances during retirement. So what do you do? You might start by reducing your spending habits. But that’s not my point in Tip #1. Find the right balance in allocating your money between stocks, bonds, and cash so the volatility in your stock investments will be offset by the more conservative and stable investments in bonds and cash. Stocks add a long-term growth element to the portfolio which is needed to increase the probability your money will live has long as you do. The following are some sample retiree portfolio allocations to consider:

Preservation Portfolio: This is probably best for retirees who stay awake at night worrying about losing money. It’s more appropriate for people with a shorter time horizons–say less than 10 years. By “time horizon” I mean life expectancy.
15% Stock
60% Bond
25% Cash

Conservative Portfolio: If you expect to live at least 10 years and you don’t like taking a lot of risk.
30% Stock
55% Bond
15% Cash

Moderate Portfolio: Retirees who expect to live more than 10 years and have an appetite for some risk, may want to consider a larger allocation to stocks.

60% Stock
35% Bond
5% Cash

Aggressive Portfolio: Do you expect to live 20 years or more? Is your spending flexible enough that you could reduce expenses during down markets? Do you have another source of income, such as a pension, that you can rely upon if the markets are negative for two or more years? If so, you may be a candidate for the Aggressive Portfolio.
75% Stock
20% Bond
5% Cash

Even the most aggressive portfolio does not have 100% stock. Some retirees may have a level of wealth that no matter how they invest they will never run out of money, think Bill Gates. Most retirees should not be risking their entire nest egg in the stock market. You will also notice that the portfolio with the least risk includes some stock. That is to maintain some potential for growth. There is uncertainty in knowing how long we will live. Even a preservation portfolio may need to last longer than we initially thought. You want living longer to be considered a good thing.

Tip #2: Minimize your fixed costs.
Flexible spending during your retirement years will put you in control. If you have the control to reduce expenses and draw less from your portfolio when the stock market is doing poorly, then your dollars will last longer. Wait until the markets have plumped up your funds with good returns before buying those cruise tickets. For many, the mortgage is their largest monthly fixed cost. Focus on paying it off.  Or downsize to a smaller, less expensive house.  If there’s equity left over, invest it.  Pay off your credit card debt.   

Tip #3: Don’t retire….. recreate your life.
For many retirees working after retirement will not be a choice.  It will be necessary.  Living in retirement for maybe 20-40 years is a very long time.   If there’s a pretty good possibility you may outlive your finances, take a year or so to live the retirees dream, then create your next life phase.  This could be your opportunity to do something you are good at but couldn’t make enough money from it to support yourself and your family.  Now the financial need isn’t as great, so go for it.  Take Dick and Nancy.  Dick taught painting before he retired and Nancy worked in art museums.  In their 70s now, they live 6 months in Italy where Dick paints the landscape and sells his art work to tourists.  Nancy authors books on artists and writes travel guides of Italy that include Dick’s art work.  How about Steve, a man who can fix anything.  He has fun socializing a few hours each week at a hardware store where he helps make home and landscape projects less daunting for those with lesser experience.  The extra cash, social enjoyment, and mental activity keep him young so he can continue to enjoy four days a week at a lake home with family and friends.

Recreate a life that makes you happy! 

                                                              April 2008                YTD 4/30/2008

U.S. large stocks                                       5.1%                             -4.9% 

U.S. small & mid-sized stocks                 4.2%                              -6.1%

Foreign developed country stocks           5.4%                              -4.0%

Foreign emerging country stocks             8.1%                             -3.8%

U.S. broad bonds                                      -.2%                               2.0%

U.S. municipal bonds                                1.5%                                .3%

We’ll look at the broad equity (stock) and fixed income (bond) markets. 

The U.S. Stock Market:  The Russell 3000 Index represents approximately 99% of the U.S. stock market.  The largest 1,000 stocks make up the Russell 1000 Index.  The next 2,000 stocks make up the Russell 2000 Index.

The Russell 1000 Index, large U.S. companies, achieved a positive total return (dividends plus price change) of 5.1% in April.  That wasn’t enough to erase the losses in the 1st quarter.  Year-to-date April 30 returns still posted a negative 4.9%.     

The Russell 2000 Index, small & mid-sized U.S. companies, posted a return of 4.2% in April with a negative 6.1% return year-to-date.

Foreign stock markets did better than their U.S. counterparts.  The MSCI EAFE Index, representing developed countries, returned 5.4% in April with a negative YTD return of 4.0%.  Countries characterized as emerging economies posted 8.1% return in April but still lost 3.8% YTD.

If you had an allocation to bonds in your portfolio they helped buffer the losses experienced in the U.S. and Foreign stock markets in the 1st quarter.  

Bonds

The Lehman Aggregate Bond Index represents the U.S. investment grade bond market.  It includes U.S. government bonds, corporate bonds, mortgage pass-through securities, and asset-backed securities.  Returns for April were -.2%, achieving a 1.95% return YTD. 

For investors in a higher tax bracket who may have municipal bonds in their portfolio the S&P National Municipal Bond Index posted April returns of 1.5% and YTD returns of .3%. 

2008 has been a challenge to investors.  For those with an allocation between stocks, bonds, and cash that is suited to their risk tolerance and goals, it has been less stressful.  If you have found yourself waking up during the night with your heart palpitating wishing it was morning so you could see how the markets are doing, I suggest you revisit your asset allocation because you could be too heavily invested in stocks. 

If you want me to talk about how to determine an asset allocation that is right for you in a future blog, let me know.  Or, if there is another topic of interest, send a comment to me.

Good investing!

If you plan to sell your business, then understanding what creates value will help you focus on value-creating aspects of the company.   Buyers look at the history of a business as support for today’s value.  Wouldn’t you rather buy a business with revenue and profits trending upward?  That means timing of the sale will be important to you.  If your interest is waning, the industry is stagnating, competitors are multiplying, your health is declining, you may find sooner rather than later will bring in the best offer.  Managing the business with an eye to its sale, will allow you to pick the best time to sell.   

An experienced, serious buyer will spend considerable time on due-diligence.  That is the process of scrutinizing your markets & marketing strategy, financial operations, property & equipment, and business operations & personnel.  Your preparation will reduce a buyer’s concerns and increase their willingness to make an offer. 

Manage the following aspects for creating value.

Maintain excellent records.  Lowering the buyer’s risk will increase what they are willing to pay.  Help the buyer feel confident that what they see is what they’ll get.  Keep good documentation for inventory control, payroll, financial statements and other key business processes. 

Buyer’s thinking:  A buyer has to continue to run the business when you are gone.  Having up-to-date written processes means the transition will go smooth even if some employees leave after the sale. 

Have a clean balance sheet.  Write-off or negotiate payment of old accounts receivable items.   Take care of the accounts payable items that have been on the books because of disagreements.  Focus on paying down debt, cleaning up the inventory, and minimizing liabilities. 

Buyer’s thinking:  Old receivables show an unwillingness for customers to pay.  A buyer will think there are unsatisfied customers.  Then the question is raised as to the quality of the product and service, the level of customer service provided,  and the overall customer experience and attitude. 

Focus on profit.  The concept is simple… increase revenue, reduce expenses, increase profits.  At least it’s simply stated.  To get the highest dollar for your business will require you to manage the income statement.   Are there opportunities to increase sales that have been overlooked or put on hold because you’ve concentrated on serving the current customers?   Have you reviewed contracts on real estate, property insurance, employee benefits, and so on to see if you can get the same or better service for a lower price.  Does the company lease vehicles?  Can you cut your lease expense?  If your income statement reflects accelerated depreciation, which is used to reduce profits and lower the tax liability, a different method for income statement purposes may reduce this expense, increasing the bottom line.  These are some general ideas for you to consider.  

Buyer’s thinking:  A  trend of increasing revenue and profitability shows that current management and processes are performing well.  The buyer can focus on growth with the expectation the current profits will be maintained after the purchase.   

Be sure the facilities, machinery & equipment are in good general condition.  Curb appeal is important.  Present a clean, organized facility.  Have the furniture & fixtures, vehicles, machinery & equipment in good condition.  

Buyer’s thinking:  If the seller maintains the property and equipment, then there is reason to think other parts of the business are well managed.  The buyer may be using these assets to collateralize the loan to finance the purchase.  The better the condition of the assets the more value the banker will assign to them resulting in a larger loan.

Have the right personnel.  A good management team and employees with the right skills need to be in place. 

Buyer’s thinking:  Adequate personnel keeps business disruption to a minimum during and following the transition.  A buyer can be more confident that sales will be maintained and impact on cash flow will be minimal.

Get a valuation analysis: It’s difficult to value your own business.   The personal attachment after years of hard work and personal sacrifice tend to inflate the value to a seller.  An ouside expert can give you a range of value developed from sound valuation practice and experience.  

Getting the highest price for your business may take 3 to 7 years of preparation.   The payback comes when you get the best price possible for the firm.  And, knowing the business you have worked so hard to create will continue into the future serving your customers and providing jobs for your employees. 

You may hear that if your company isn’t profitable you have nothing to sell.  Not always true.  In 1993 I sold a management training firm that I had started three years earlier.  The company was just building name recognition and had achieved marginal profitability when my husband’s multiple sclerosis forced him into early retirement at 44 years old.  We decided the best option for the family was for me to sell the business and take a corporate position that would provide more security (health insurance) with less risk for the family.

It was a traumatic time.  I gained weight as I ate my way through hours of ‘coming to grips’ with the decision.  The business was serving the needs of the business community.  Three years of hard work were starting to provide the payback I had worked so hard to achieve.  Now, I was thinking of closing the doors.  That was the advice of a CPA who said the firm wasn’t profitable enough to get an interested buyer.

At first I took that advice as gospel.  Then I started thinking about the companies we had been serving and thought someone must see the gains we had made over the three years, with companies returning to buy additional services.

I decided to build a history of the firm, showing profit and loss statements with a trend of increasing revenue.  Following that, I built a spreadsheet that listed each customer.   After each company I included the invoices, dates, and dollars spent with us to show repeat business from satisfied customers.

It’s interesting, as the owner I knew this was taking place but I had never compiled the data in this way before.  Now I had a positive financial trend with repeat customers to share with potential buyers.  It was starting to look like we had something to sell.

I didn’t stop there.  In the files we had kept notes from customers.  Some had written comments of appreciation on the surveys that were sent with each product or service. Some were unsolicted notes from individuals we had worked with who just wanted to say ‘thank you’ for helping them find the best training book, video, or speaker to fit their training need.

The final step was gathering marketing pieces we had developed, newsletters, magazine articles written about us, and training material we helped companies to create.  Contracts with trainers & suppliers were added to round out all of the important business documents.

A three-ring binder was put together, creating an impressive picture of what we had to offer a buyer.

At that point I started making phone calls to companies that might be interested in buying the firm.  Within six weeks I had three interested parties, one of which owned grocery stores.  They bought the firm.  A rather unusual buyer you are probably thinking.  They had two reasons.  They wanted to increase the employee training within their stores and owning the firm would make that more cost effective.  The other reason was that one of the owners wanted to create and sell her own workshops, something we outsourced to professional speakers and trainers.

The company I sold was called An Open Mind Company and I recommend you keep an open mind when you plan for the sale of your firm.

The Securities and Exchange Commission (SEC) lists how investment advisors get paid.  http://www.sec.gov/investor/pubs/invadvisers.htm

Q:  How do investment advisers get paid?

A:  Before you hire any financial professional-whether it’s a stockbroker, a financial planner, or an investment adviser-you should always find out and make sure you understand how that person gets paid. Investment advisers generally are paid in any of the following ways:

• A percentage of the value of the assets they manage for you;
• An hourly fee for the time they spend working for you;
• A fixed fee;
• A commission on the securities they sell; or
• Some combination of the above.

In Part 1 of this article I talked in more detail about a percentage of the value of the assets they manage for you.  Now I will describe the remaining ways investors pay their investment advisers.

An hourly fee for the time they spend working for you

This is pretty straightforward.  An advisor may choose to charge for services by the hour.  They charge an hourly rate for time spent on communication through phone, personal contact, email, and managing your assets.  I find this fee schedule is more common with advisors who provide both financial planning and investment advisory services.    In some instances, there may be an hourly rate for the advisor’s time and a lesser rate for the time an administrative person works on a client’s account.

A fixed fee:

An advisor may assess the services required and estimate the time required to complete the work.  They will set a fixed fee.  The fee may be split, a portion up front with the remaining at the completion of their work, all up front, or all at completion.  Fixed fee for financial planning is quite common, with $2,000-$5,000 being a common range.  Of course, the complexity of your situation will determine this rate.  If the financial planner is going to manage your investments, they may charge for that service using one of the fee schedules above.

A commission on the securities they sell:

Each transaction, the purchase or sale of a stock, generates a sales charge called a commission.  The commission is calculated as a percentage of the transaction or as a flat fee.  These charges change from brokerage firm to brokerage firm, and even within the same brokerage firm.   A firm may have commission rates based on the size of the transaction and client’s portfolio size.

There are significant fee differences between discount brokerage and full-service brokerage commissions.

Full-service Broker:  If you rely on a broker to recommend stocks to buy and sell and to make the trade, commission charged for each transaction may start at $35 and go higher.   Let’s say your broker recommends you sell $1,000 of ABC company and buy $1,000 of XYZ company.  Let’s also assume the commission is $40 per trade.  The commission charged to your account will be $80.  $40 to sell ABC and $40 to buy XYZ.  Commissions amount to 8% (80/1000).  The stock has to rise 8% before you begin making any money.

Discount Broker: If you decide what stocks you want to buy and sell, you can use a discount broker.  Online trades range from $4 – $20 and you either make the trade yourself (cheapest) or call the broker to make the trade.   If we use the same example from above except use a $10 commission, our cost is $20 or 2% of the stock value.  You keep 6% in your account.

Sales Charge (Load) on Purchases

A sales load is like a commission investors pay when they purchase a security through a broker.  Mutual funds that use brokers to sell their shares typically compensate them by imposing a fee on investors, known as a “sales load” (or “sales charge (load)”), which is paid to the selling brokers.

There are two general types of sales loads-a front-end sales load investors pay when they purchase fund shares and a back-end or deferred sales load investors pay when they redeem their shares.

Front-end Sales Charge (Load) on Purchases

The Front-end Sales Charge (Load) on Purchases is the amount investors pay when they purchase fund shares. The key point to keep in mind about a front-end sales load is it reduces the amount available to purchase fund shares.

Example: if an investor writes a $10,000 check to purchase mutual fund shares, and the fund has a 5% front-end sales load, the total amount of the sales load will be $500. The $500 sales load is first deducted from the $10,000 check (and typically paid to a selling broker), and assuming no other front-end fees, the remaining $9,500 is used to purchase fund shares for the investor.

Deferred Sales Charge (Load)

The Deferred Sales Charge (Back-end Load) investors pay when they redeem fund shares (that is, sell their shares back to the fund).

Example: if an investor invests $10,000 in a fund with a 5% back-end sales load, and if there are no other “purchase fees,” the entire $10,000 will be used to purchase fund shares, and the 5% sales load is not deducted until the investor redeems his or her shares, at which point the fee is deducted from the amount redeemed.  Back-end loads may decline over time.  A 5% charge may decrease by 1% each year.  Example: year 1 a 5% fee is paid if an investor sells the fund, year 2, 4%; year 3, 3%….. year 6, 0%.

A fund with a contingent deferred sales load typically will also have an annual 12b-1 fee, a portion up to .25% is typically paid to the broker.

To learn more about mutual fund expenses and fees go to  http://www.sec.gov/answers/mffees.htm#distribution

Some combinations of the above.

Some advisors charge a percentage of the assets value and receive commissions.

There are advisors who charge an hourly fee or a flat fee for certain services plus a percentage of the portfolio value for managing your investments.

There are certainly other combinations, so be sure to read the agreement or contract and then ask the advisor to explain “how do you get paid?”.

How do investment advisers get paid?  This is the Securities and Exchange’s (SEC’s) answer found at  http://www.sec.gov/investor/pubs/invadvisers.htm

A:  Before you hire any financial professional—whether it’s a stockbroker, a financial planner, or an investment adviser—you should always find out and make sure you understand how that person gets paid. Investment advisers generally are paid in any of the following ways:

• A percentage of the value of the assets they manage for you;
• An hourly fee for the time they spend working for you;
• A fixed fee;
• A commission on the securities they sell; or
• Some combination of the above.

I’ll describe each fee structure.   They are general descriptions so expect variations.   

A percentage of the value of the assets they manage for you; 

Let’s say the advisor states they will charge 1% of the value of the assets.  That means if you have a $500,000 portfolio your estimated fees will be $5,000 per year ($500,000 x .01).  It’s an estimate because the fee is charged quarterly based on the value of your portfolio during or at the end of each quarter.   Let’s assume the portfolio value doesn’t change throughout the year.  Fees may be charged ’in arrears’ or ‘in advance’.   They will be calculated based on the value of the portfolio on the last day of the quarter or on the average value of the portfolio during the quarter.   One quarter of the $5,000 annual fee, $1,250, will be the assets under management fee for the quarter.  This fee is generally withdrawn directly from the account, unless you and the advisor agree to another payment option, e.g. check.  The advisor will send you a statement showing the quarterly fees that are being withdrawn.  The advisor may also charge a fee for setting up the account or a fee may be charged if you discontinue using the advisor, like the 2 quarters of fees assessed in the above example.   

The assets under management fee is to compensate the advisor for managing the portfolio.  The advisor will work with you to determine the correct asset allocation (we’ll discuss that term in another commentary) and make buy and sell decisions or recommend securities to buy and sell.  In addition, the advisor will provide quarterly and annual reports that show the retuns compared to appropriate benchmarks.  For instance, if your portfolio is 50% U.S. large company stocks and 50% intermediate term bonds, the report will show the quarterly return of the stock portfolio and the bond portfolio along with a U.S. large company index such as the Russell 1000 Index and the U.S. bond index such as the Lehman Aggregate Bond Index.   By relating the portfolio returns with the index returns an investor can determine whether their advisor is doing a good job of managing their investments.  If the portfolio consistently posts returns less than the benchmarks, meet with your advisor to find out why and if the answer isn’t satisfactory find a new one. 

You will often see the words “fee-only” advisor.  This means the advisor receives compensation exclusively through advisory fees.  They are not paid commissions.  The fee may be as a percentage of assets, hourly rate , or fixed rate. 

A note about me:  I am a registered investment advisor in Colorado.  I receive my compensation from a percent of the value of the assets.  Other rules may apply in other states.  This description is meant to give a basic understanding of how fees are charged.  You may find variations due to your state’s rules or advisors’ business models. Variations might be monthly fee calculations, rather than quarterly,  a higher percentage charged when a minimum return is achieved and a lesser fee when the portfolio return is below the minimum.  Read the agreement and ask the question, “how to you get paid?”   

Part 2 of this topic explains the other types of fees.