Here is a great article on Kiplinger’s by my friend Steven Goldberg. I have howled for years about the No Transaction Fee (NTF) platforms of the discount brokerages like Charles Scwab, TD Ameritrade, and Fidelity. In fact, I have some clients who have given me a limited power of attorney on their accounts at these brokerages, and they always question why I buy a Vanguard fund, which costs $50 to trade in most instances (and they often don’t have access to the Admiral funds – ugh). These NTF platforms actually drive up the cost of the funds. Each fund pays the discount brokerage 40 basis points or 0.4% per year to be on the platform.
The investor buys the fund because there is no upfront fee, but they pay a higher annual fee. Goldberg’s article does a great job of explaining the practice, but here is a good summation of the issue:
Funds participating in the NTF programs must charge the same annual expense ratio to all of their investors — whether they invest through Schwab, Fidelity and TD Ameritrade or buy directly from the fund. “You have to use the same expense ratio across the board,” says a fund manager who prefers not to be identified. Of course, the fund firms, not the brokers, pocket the entire expense ratio on money invested directly in their funds.
Here’s how the NTF programs work. Say the Gonzo Fund wants to be sold through Schwab’s NTF network — that is, be available to individual investors without those pesky transaction fees of $50, which are charged both to buy and sell the fund. The firm that sponsors Gonzo Fund must pay Schwab 0.40% annually of all Gonzo Fund assets owned through Schwab’s NTF network. Fidelity charges the same 0.40%, as does TD Ameritrade. “Brokerages demand these payments before they’ll put funds on their platforms,” says Niels Holch, of the Coalition of Mutual Fund Investors, a nonprofit advocacy group.
Online brokerages do perform services for that 0.40%. They take client phone calls, mail out statements and provide other client services. But these hardly seem worth 0.40% a year. “I think they should be paid,” says my fund-manager source. “But 0.40% is way too high. The value added isn’t that much. This is an enormously profitable business for the brokers.”
Forty basis points is a stiff fee for clerical work. If they manage ten billion in assets, that is a cool $40 million to be the middleman. The problem for investors is they are paying higher fees for a fund even if they don’t work with these discount brokerages. So buying a fund directly from the fund company won’t save the investor any money in the form of lower fees. As much as I would hate to see another type of share class, it might be useful to have a new share class that is sold through the fund companies directly. The fund companies could then cut out these middle man fees to be on the NTF platform. It would take more admin work on the part of the investor as the investor would have to set up accounts at each fund family, but it would be better than paying an exorbitant admin fee to Schwab, TD or Fidelity.
I think the better solution is to avoid mutual funds altogether. You can buy an Exchange Traded Fund (ETF) and save thousands in fees each year. These instruments charge a fraction of an actively managed mutual fund. As an example, the Vanguard Total Stock Market ETF (Ticker: VTI) charges 0.07% per year. So $100,000 invested in that particular ETF costs $70 per year. A typical actively managed fund charging 1% would cost an investor $1,000 annually. That is big money when compounded annually.
Even better, the vast majority of these index based investments outperform the actively managed funds each year. Several studies exist, but usually 70% of actively managed funds fail to match their benchmark annually. As this period extends to 10 years, that number climbs to over 80%-90% (again depending on the study).
If that isn’t enough to get you fired up about ETFs, then maybe this will help. ETFs are traded like a stock during the exchange day. This means you can get the lower trading commission fees that these firms advertise constantly. Usually, these fees are less than $12. If you bought a non-NTF mutual fund, the discount brokerages often charge $50. Buying the Vanguard Large Cap mutual fund (Ticker:VLACX), which is an index fund, costs $50 while buying the Vanguard Large Cap index ETF (Ticker: VV) costs you ten bucks. These are the same fund, just a different structure.
So if you are going to swim upstream to wealth, you need shun the NTF funds like most investors and start using ETFs. Or, you should just deal with the higher commission cost and buy a non-NTF fund – just make sure you hold it for the longer term to offset the cost of the commission.