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Rekenthaler Report

Upfront Investment Fees Are (Almost) No More

The evolution’s winners and losers.


Wasting Away
Once upon a time, retail investors paid large entry fees.

In the 1970s, the average stock transaction, as measured by brokerage commission plus half the bid-ask spread, consumed about 1% of an investor’s stake. That percentage began to fall in 1975, when the SEC deregulated commission prices, but it did not disappear. When the 1990s began, for example, the average transaction was 0.50%.

Not so much today. As I write this article,  Apple’s (AAPL) bid price is $205.58 and its ask is $205.60. Charles Schwab and Fidelity charge $4.95 per trade. Buying 200 shares through them would cost that $4.95 commission plus two dollars for the stock’s bid-ask spread (0.50 x 200 x $0.02). That makes for a total of $6.95, on a $41,120 purchase--2 basis points. The deregulators’ dream came true, and then some.

Mutual fund loads have come down even further, from an initial standard of 8.5%, to 5% by the early 1990s, to effectively zero today. Either investors purchase exchange-traded funds; or they buy no-load mutual funds; or they use load-waived shares, which forgo the official sales charge. The first option costs the same as with stocks, and the other two options nothing at all.

Power to the People
The people led the revolution. The government assisted, first by removing the price controls on stock trades, and then by permitting the use of 12b-1 fees in mutual funds (which eventually proved to be a mistake, but which did help to lower front-end sales charges), but ultimately the general public made the difference. It resented paying upfront fees, and rewarded investments that charged otherwise. The marketplace had no choice but to follow.

One can wonder whether investors are as better served as they believe by the new pricing model--an item that I will discuss shortly--but not whether they like the switch. They clearly do. In six years of writing this column, I cannot recall a single investor bemoaning the disappearance of front-end sales charges. Nor, of course, of the invention of online brokerages.

Their reasons are both cosmetic and real. The cosmetic effect is hiding that which was once apparent. Brokerage firms continue to receive revenue, as do financial advisors. And that revenue continues to come from their clients. It sometimes feels as if retail investing has become just about free, but not so for most shareholders. They merely pay their bills in other ways.

The real effect was the transformation of incentives. Pay people according to how many trades they generate, and they will probably suggest more trades. Investors understood that principle just as well as economists, and it made them eternally suspicious. Even if financial advisors hadn’t adjusted their practices by churning portfolios less--which some certainly did--their customers would have been happier under the new compensation scheme. It became easier to trust the help.

Disconnecting revenue from trades also made brokerages more creative. If commissions had stayed high, perhaps they would have aggressively improved their technology and services anyway, to increase market share. But the pricing revolution removed their choice. No broker dines on stock commissions alone, and few (if any) on mutual fund loads. To survive, they must innovate.

But the other side must be spoken. As previously mentioned, financial-services costs still exist. Online brokerages don’t receive hidden payments for their stock trades, as neither the company nor the stock exchange reimburses them for the activity. But they are compensated by fund sponsors for offering funds through their No Transaction Fee program, and their money market funds profit from cash sweeps, and they may have other funds that they wish to sell. One way or another, they will be paid.

The same holds for financial advisors, although their approach is relatively transparent. Their trade suggestions are free--solicit as many as you like, the price will not change--but their availability costs an annual fee, typically 1% of assets under management. For that amount, a stock investor in the 1970s could turn over an entire portfolio, once per year.

(Today’s pricing scheme is more competitive with mutual funds, as the average holding period must approach a decade for those in funds with 8.5% load charges to outdo those who pay annual 1% advisory fees. Such investors do exist. Periodically, I hear from financial advisors about clients who bought funds from them when Richard Nixon was president, and who have not since traded. Such fund shareholders are not, however, the silent majority.)

These changes are not necessarily bad. Those who understand where brokerage firms now make their money, and who appreciate the math of financial advisors’ fees, can make informed decisions. There are far more financial-service models than in the past; one for every flavor of investor. The danger lies with the uninitiated. They may not realize what they are paying. That did not happen in the old days, with upfront fees that could not be missed.

The incentives for financial advisors have improved, but they remain imperfect. True, advisors no longer are directly rewarded for inducing trades. Indirectly, though, they face pressure to do something. Investors generally dislike paying 1% per year for their advisors to make no recommendations whatsoever, even if sloth proves to be the best investment advice. In time, perhaps, clients will learn to be more patient, thereby permitting financial advisors to operate without fussing over their activity levels.

None of these are outright problems. Although I have some concerns with today’s pricing model, I would not exchange it for what came before. The only outright loser has been the mutual fund industry, because under the new system, one of the best ways for financial advisors to justify their charges is to show their clients how much money they saved on fund fees. In a sense, what once went to fund companies now goes instead to financial advisors.

Bad news for fund companies, but immaterial for investors. They have little reason to mourn the past.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.