Investors Are Woefully Ignorant on Financial Adviser Fees: Are You Different?

Editor's Note: This story originally appeared on SmartAsset.com.

Investors don’t understand the fees they pay for investment products and advice especially well, according to a recent State Street Global Advisors survey.

State Street’s Low-Cost Investing Survey found a general lack of understanding when it comes to the management costs and advisory fees that investors pay. In fact, only 17% of investors who participated in the online survey knew that management costs associated with mutual funds and exchange-traded funds (ETFs) are separate from the fees that financial advisers and investment platforms charge.

The survey, which was conducted in June in partnership with A2B Planning and Prodege, collected data from 224 adults with at least $250,000 in investable assets.

Here’s what it found — and what you need to know to be smarter than they are.

What Are Expense Ratios and Basis Points?

While 87% of investors said they are at least “aware” of the term expense ratio, only 30% said they completely understand what an expense ratio is.

Likewise, 83% of investors reported being aware of basis points, but only 25% said they completely understand them.

So what do these terms mean and why are they important to understand?

An expense ratio is the percentage that a manager of a mutual fund or ETF charges to cover various costs associated with running the fund, like management, marketing and recordkeeping fees.

Those fees are bundled into a ratio that is expressed as a percentage of an investor’s total assets with the fund and automatically removed from their account each year.

The smaller the expense ratio, the more money an investor keeps to him or herself. Meanwhile, a heftier expense ratio can significantly eat into future returns.

A basis point, on the other hand, is simply equal to one one-hundredth of a percent, or 0.01%. This means if an expense ratio is 0.5%, the fund charges 50 basis points.

Financial advisers and traders use this term for several reasons, but primarily because it’s a quick way to communicate important information. Shortening the phrase “one one-hundredth of a percentage point” to “basis point” makes for easier and more direct conversations.

Advisory Fees vs. Fund Management Fees

It’s clear that much remains unclear when it comes to advisory fees and fund management costs. According to the State Street survey, nearly half of investors (47%) believe the fees they pay their financial advisers or investment platforms cover the management costs (expense ratios) that mutual fund and ETF companies charge for their products.

In fact, only 17% correctly said advisory fees do not cover the expense ratios of mutual funds and ETFs.

While financial advisers typically charge an asset-based fee for their services, this fee does not cover the cost of investing in particular funds. Like expense ratios, asset-based fees are usually expressed as a percentage of assets in a portfolio, but they go directly to your adviser.

By not understanding the distinction between an advisory fee and fund expense ratio, an investor may overestimate their expected returns.

What Constitutes ‘Low-Cost’?

The survey also found that investors are generally unclear about what constitutes a low-cost fund.

Investors who said they understand expense ratios and/or basis points consider funds with expense ratios of 0.60% or less to be low-cost.

However, State Street Global Advisors noted the asset-weighted average expense ratio of U.S. open-end mutual funds and ETFs are 0.51% and 0.20%, respectively. This signals that investors may be in funds that they incorrectly deem to be low-cost.

“From an ETF provider’s perspective, low-cost is generally considered funds with an expense ratio of 0.10% or less – this is six times lower than the threshold of investors in the survey,” said Brie Williams, head of practice management at State Street Global Advisors. “The bottom line is, when all other variables are equal, lower-cost investments can help investors keep more of what they earn in their portfolio.

Bottom Line

The State Street Global Advisors’ survey shows that a large percentage of investors remain hazy on the fees they pay.

Nearly half of the people polled said they thought fund management fees (expense ratios) were included in the advisory fees they pay their financial advisers.

Meanwhile, only a small percentage of investors fully understand what expense ratios and basis points are, the survey found.

There is also confusion surrounding what constitutes a low-cost fund. While investors believe 0.60% is the low-cost threshold, the average expense ratios of mutual funds and ETFs is actually less.