Attention, all day traders and long-term investors, brokerage account fees are important to understand for one reason: Fees can impact your investment returns.
Brokerage fees are charges that come from full-service brokers or discount or online brokerages for their financial activities to grow and maintain your account.
Regardless if you’re an active or passive investor, you should be aware of broker account expenses. Here is your guide to help you take control of fee management:
— Types of brokerage fees.
— Mutual fund fees.
— What is a spread?
— How do brokerages make money?
— The impact of brokerage fees on investment returns.
— Benefits and disadvantages of fees.
— Tips for minimizing fees.
Types of Brokerage Fees
In a stock market trade, transaction fees and expenses attached to various investment securities, products and services can have an impact on your investment portfolio, but being cognizant of these expenses can save you money in the long run.
The different types of brokerage fees you may encounter include:
— Mutual fund fees, including sales loads and 12b-1 fees.
— Trading spreads.
— Trading commissions.
— Assets under management (AUM) fees.
— Account fees.
Mutual Fund Fees
Brokers make money from buying and selling market investments. One type of asset that usually comes with fees: mutual funds. Mutual fund investors need to be aware of hidden fees. There are different mutual fund share classes, which are groupings of the same securities. However, the difference is the fees and expenses paid for each class of shares.
Class A shares charge upfront commissions called a front-end sales load. For example, if you fund your account with $50,000 and you receive a statement that shows a balance of $45,000, that $5,000 is stripped away from your investments and paid directly to the broker and is not invested. In other words, it is deducted from the initial deposit.
Class B shares don’t have upfront commissions, but there is a fee if the investor sells the security within a certain amount of time, which is called a back-end load. Investors are charged if they don’t hold the fund for the required time.
A Class B asset is subject to a 12b-1 fee, an annual fee charged to investors labeled as an operational expense tied to the expense ratio. This fee that investors pay is used to fund the marketing and promotion of the fund to interested investors.
Class C shares do not have an upfront charge, but the maintenance fees are higher, usually about a set fixed percentage for managing the asset, and it doesn’t tend to be reduced over time. So, this type of expense can eat at your returns.
Overall, investors need to watch out for both transparent and hidden fees, because the higher costs get, the longer time for your money to grow and ultimately realize returns.
What Is a Spread?
Another layer to the transaction includes the market maker, an individual or firm that provides the bids and asks, ultimately profiting from the difference between bid and ask prices of a stock. A market maker facilitates trades by setting the spread — that difference between the bid and the ask.
When a stock is traded, the market maker creates a market for the trade. Investors don’t normally get the market price when buying or selling a stock, and, as a result, the investor may either pay more than what the stock was purchased at or receive less when it is sold.
Most spreads on larger stock names are only pennies. Conversely, spreads on trades with small-cap company names could be as high as a couple of percentage points.
“With stocks, the main thing you want to watch out for is the difference in the spread between the bid and ask: The bid is the best price available where somebody wants to buy a security, and the ask is the best price available where somebody wants to sell a security” says Luke Lloyd, wealth advisor and investment strategist with Strategic Wealth Partners in Cleveland.
“If you want to buy at the market price, you will pay a premium to buy it. Some brokerages make money on that spread. It’s just something you want to look out for when placing an order with a broker,” Lloyd says.
How Do Brokerages Make Money?
It’s impossible to escape the costs of commissions; this is how brokerages stay in business. Fees can vary across different brokerages.
The pricing structure of brokerage fees includes commissions, assets under management, fees and account fees, which reduce your upfront amount invested and on which you will earn a return, says Christopher Mizer, president and CEO of Vivaris Capital in San Diego.
“For example, say you have $100,000 in an account that charges a 1% AUM fee and the underlying stock recognizes a 7% return for the year. Your effective return would only be 5.9%. You would earn 7% on $99,000 ($6,930), plus have the $99,000 principal amount, or $105,930 account balance after one year,” Mizer says.
Full-service brokers are licensed financial professionals who provide services that include retirement planning, investment research and stock recommendations and often perform portfolio analysis and help with putting an investment portfolio together based on an investor’s financial goals. Their fees are higher because they offer personalized investment advice.
Many online brokers, alternatively, offer commission-free online trading for stocks and exchange-traded funds, with sometimes a few caveats, depending on the broker-dealer. This can be a boon to traders who buy and sell frequently. But it’s important to recognize how these online brokers make their money.
The cost of trading is cents on the dollar per share, but with trade volume as much as more than a million shares per day, broker profits add up.
Another way online brokerages make money is by selling data to market makers. Robinhood, a discount brokerage known for its commission-free online stock trades, has a revenue model that sells customers’ orders and receives rebates from market makers, according to the company’s website.
Brokerages also make money from investors who buy shares on margin, which means borrowing money to trade. Brokers charge an interest rate for lending you money for your investments.
There is a stark difference between brokers and full-service financial advisors: The former won’t hesitate to sell you products for fees, while many of the latter have a fiduciary responsibility.
Broker agents are trying to sell you products and can even tag fees for conversations and meetings. After all, that’s how the agents and their firms make money.
For a traditional financial advisor, the industry standard is to charge a fee that is about 1% of the assets under management.
The Impact of Brokerage Fees on Investment Returns
Even small fees can have a big impact on your overall investment returns.
The U.S. Securities and Exchange Commission published a comparison of a $100,000 investment portfolio with a modest 4% annual return over 20 years with ongoing fees of 0.25%, 0.5% and 1%. After 20 years, the 0.5% fee account was $10,000 less than the 0.25% fee account. The 1% fee account was worth nearly $30,000 less than the 0.25% fee account.
That’s tens of thousands of dollars an investor could have kept in their pocket simply by keeping their overall fee load lower.
Benefits and Disadvantages of the Brokerage Fee Structure
While investors should in general opt for lower-cost investment options, just because a broker has higher fees compared with its competitors should not necessarily be a reason to turn away.
Though fees may be a sour point for some investors, active day traders may be willing to pay extra for access to expanded investments and trading tools.
The same line of thinking goes for long-term investors. You may be willing to pay extra for more comprehensive guidance.
An active investor may need a lot more tools for fundamental and technical analysis, including historical financial performance, earnings projections, research on competition and industry dynamics, Mizer says.
Fees and added expenses may cut directly into your principal, but if you’re paying for products that help you make better investing decisions, you likely end up coming out ahead.
Tips for Minimizing the Brokerage Fees You Pay
The best way to reduce your fees is by being financially educated. This way, you are aware of your costs and can better prepare for your financial future. Many don’t take the time to plan and get sticker shock when they see massive, unexpected fees on their financial statements.
Once investors have a better understanding of what fees are attached to their accounts and investments, they can make more cost-effective choices. Here are a few tips for minimizing the brokerage fees you pay:
— Choose lower-cost investment options: Many clients don’t realize mutual funds come with an annual expense ratio fee. An alternative investment to minimize this cost is exchange-traded funds, or ETFs, which tend to have lower expense ratios.
— Read the fine print: Brokerages are required to disclose all fee-related information, so be sure to read the fine print before investing.
— Use commission-free investments: Brokers may charge different commission levels on various investments. For instance, a proprietary fund offered by the company may be commission-free while a competitor’s fund comes at a cost. Whenever possible, opt for the commission-free option.
— Avoid investments with large spreads: While spreads can’t always be avoided, it’s good to keep an eye on them and it can help to choose investments trading at smaller spreads.
Luckily, hidden fees aren’t common anymore, says Kevin Boyles, vice president of business development at Millennium Trust Company in Oak Brook, Illinois, but he says you should still be seeking a broker whose rewards and compensation are focused on your success.
“There’s going to be a base fee that will likely go down once you have more money going into your account,” Boyles says.
More from U.S. News
Update 05/24/21: This story was published at an earlier date and has been updated with new information.