Watch Your Fees

NEW YORK (TheStreet) --One truth that is too often overlooked is that the fees that investors pay for investment management services are, on average, the most consequential factor in their performance.

The moral of the story is that the most important thing retail investors can do when weighing their investment options is to compare them based on fees and make sure they're getting the cheapest option for the service they're getting.

Most people approach investing with a very different attitude. They want to know how the stock market is going to do over the next year, and whether or not they should invest in international funds because overseas markets will perform well, or whether small-caps will outperform large-caps or vice-versa.

I, too, think it would be great to have a crystal ball or a time machine but, unfortunately, even the experts aren't very good at predicting the future, let alone translating predictions into an effective investment strategy. We can predict death and taxes, as the old saw goes, and as investors, we can predict that we'll be charged fees.

The importance of fees was laid bare by a 2010 Morningstar study that concluded that expense ratios in mutual funds are actually a better predictor of performance than Morningstar's own star-ratings system that it uses to rate funds.

Fees are important and over time they can be very costly. An initial investment of $100,000 that grows 8% over 25 years would, at the end of that period, be worth $734,017.60. However, if management fees reduced the returns by 2% annually, the investment would only be worth $446,496.98, reducing the value of the investment by almost 40%. Many people don't realize that a fee that sounds as innocent as 2% can result in such a large cost over time.

Most fees paid by the average investor are mutual fund expenses, investment adviser fees and brokerage commissions, the per-transaction trading fees for buying and selling individual stocks. Brokerage commissions can be avoided by making few trades.

Excessive trading, in most cases, is counter-productive for investors anyway, so they should make smart initial decisions on where to invest their money and hold those positions for a long period of time to maximize their returns.

Mutual funds are often expensive -- they charge management fees and marketing fees that are too burdensome for the performance they typically deliver. There are some exceptions to this, but people like John Bogle, the founder and former CEO of the Vanguard Group, have made a very convincing case that low-cost, passively managed index funds are a far superior investment for most investors than actively-managed, high-cost mutual funds. The majority of fund managers under-perform major market indices, after all.

Investment advisers are a good option for people who want help and guidance with their investments, but the customer needs to make sure the adviser is truly independent. As The New York Times recently reported, former J.P. Morgan Chase ( JPM) advisers say they were encouraged to funnel customers into the bank's mutual funds even when the advisers knew it was not in the best interest of the client.

"I was selling J.P. Morgan funds that often had weak performance records, and I was doing it for no other reason than to enrich the firm," Geoffrey Tomes of Urso Investment Management told the Times about his tenure at the bank, which ended last year. "I couldn't call myself objective."

That's a damning indictment of the quality of J.P. Morgan's commitment to serve its clients, but once again, it comes as no surprise in this era of financial malfeasance and overwhelming public distrust of major financial institutions, like J.P. Morgan, Goldman Sachs ( GS) and Citigroup ( C).

It also underscores an important point about investment advisers. They collect their own annual fee but if all they're doing for clients is shoveling money into funds and other vehicles, which charge their own set of fees, the real cost to the client is in fact much higher -- and it's very damaging.

So, investors that are evaluating advisers to manage their investments should question them carefully on their independence. Are they incentivized in any way to put clients into one type of investment as opposed to another? And how expensive are the investment vehicles that the adviser would prescribe?

If an adviser is less-than-forthcoming on such questions, I would find someone else.

At the time of publication the author had positions in JPM and C but not in the other stocks mentioned.

Follow me on Twitter @NatWorden

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

This contributor reads:
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The Baseline Scenario
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Zero Hedge
Gregor Macdonald
Chris Martenson
On Twitter, this contributor follows:
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