Financial Planning Blog

Posted on: 12/28/09

In Part 2 we discussed the direct, publicly disclosed costs of mutual fund investing. We discovered there are many ways that mutual fund companies are making money, even when we aren't. Unfortunately, the story doesn't end there. In this article the less understood, indirect costs of mutual funds will be explored. These costs are generally incurred as mutual funds buy and sell stocks or bonds for their portfolios. Although these costs are more difficult to quantify, and are not usually reported, they reduce the after-tax return to investors all the same.

Trading costs

The first main category of hidden mutual fund expenses is the cost of trading. Trading costs include brokerage commissions, spread costs, and market impact costs.

• Brokerage commissions: When mutual funds buy and sell stocks or bonds they incur commission costs, similar to those individual investors pay. Although mutual funds should get more favorable terms for their large volume trading, these costs are still significant, especially if the fund trades actively. Studies estimate annual brokerage commissions average 0.30% of fund assets, which are deducted from fund returns. Researchers found a big difference between the most efficient quintile of funds (0.08% brokerage commissions) and the least efficient quintile funds (0.56% brokerage commissions).
• Spread cost: Brokerage commissions are the most obvious cost of trading by mutual funds, but they not the largest. When stocks are purchased," market makers" take a small "bid/ask spread" between the sales price and the purchase price. In other words, the purchaser pays a slightly higher price than the seller receives--the difference providing the market maker compensation for keeping markets functioning smoothly. On average these spread costs amount to close to 0.47% of assets, according to the same researchers. Again, the range between the low and high cost quintiles funds was considerable-only 0.13% for the most efficient, and a whopping 1.23% for the least. Bid/ask spreads are relatively low for large, actively traded U.S. stocks, but can get significantly higher for small, less liquid stocks.
• Market impact costs: When mutual fund portfolio managers try to buy or sell large blocks of a stock they impact the market for that stock. When they buy large blocks, the initial purchases tend to bid up the stock price, making the average price they pay for the shares higher. The opposite occurs as a fund tries to unload a large position, driving down their average selling price. These market impact costs are hard to quantify*, but lower investor returns nonetheless. Market impact costs are higher for funds dealing in small cap stocks, where selling sizable blocks affect the market pricing to a greater extent. Also, market impact costs tend to be a bigger concern for funds with more assets, as opposed to small funds who trade in smaller blocks.

Costs of holding cash

Another overlooked cost is the impact of holding cash in a mutual fund portfolio. Most actively managed stock funds hold between 5% and 10% of their assets in cash, presumably to handle redemptions and to be ready to take advantage of new opportunities. (Passively managed index funds hold much less. For example, the Vanguard 500 Index Fund holds only about 0.4% in cash.) Over time, this cash is a drag on the portfolio returns. For example, suppose a fund holds a 10% cash position earns a 2% return on that cash. With the remaining 90% of the portfolio, the fund earns a respectable 10% return. Unfortunately, the investor makes a weighted average return of only 9.2%. This is a sizable dent in your returns, although it may work in your favor when stocks go down. To make matters worse, you are paying the full expense ratio (possibly over 1%) on this cash--in effect making those cash holdings a very expensive money market fund.

Taxes

If you are not investing in a tax-favored account (e.g. an IRA or 401K), then you also need to be very concerned about the on-going impact of taxes on your investment returns. In your taxable accounts, you will pay income taxes on the dividends and capital gains which are distributed each year by your mutual fund. The federal, state and local income taxes you pay on these distributions act as a not-so-small leak on your invested funds. They lower the amount of money you have working for you in your investment account, and will significantly lower your long-term return. Some funds do a much better job of minimizing these distributions and thus maximizing the amount of money you have working for you. Sure, you will generally need to pay taxes eventually, but delaying the taxes as long as possible will pay off in the long term.

How can you manage to minimize the "decompounding" effect of taxation? By using passively managed equity index funds and ETFs you can delay most, and sometimes all, of the capital gains taxation until you sell the fund. This is in contrast to actively managed funds which trade consistently, often realizing considerable long term, and worse yet, short term capital gains that must be distributed to shareholders. Recognizing the detrimental impact of taxation on investor returns, some mutual fund companies (e.g. Vanguard) have created special tax-managed funds. These are worth are certainly worth investigating if you are in a high tax bracket and investing significant amounts in taxable accounts.

Compare turnover rates

All these costs are depressing--financially and emotionally. It is all so complicated, how is the individual investor supposed to avoid incurring unnecessarily high levels of expenses? One clear indicator is comparing a mutual fund's turnover ratio with funds that have similar investment objectives. The turnover ratio is a measure of how much trading a fund has done in a given year. Although not a perfect predictor of trading costs within a fund, turnover ratios have been shown to be highly correlated with trading expenses. For more on turnover ratios, see this Morningstar article.

We'll let Burton Malkiel (A Random Walk Down Wall Street) summarize the lesson once again.

"I have performed many studies of mutual fund returns over the years in an attempt to explain why some funds perform better than others. As indicated earlier, past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance are expense ratios and turnover. High expenses and high turnover depress returns-especially after-tax returns if the funds are held in taxable accounts."

 

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*Back in 1996, Plexas Group estimated the market impact costs of large cap funds at about 0.40%/year, and about 1.5%/year for small cap stocks. This research is cited in Execution Costs of Institutional Equity Orders, by Jones and Lipson. 

 

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