What does it cost to own a mutual fund? More than you’d like.

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How can investors know the real cost of a mutual fund?Executive Summary of article:

  • “… the average investor can’t begin to get an understanding of the costs due to the lack of information.”
  • Studies show that the average mutual fund costs between 2% and 3% per year.

According to Morningstar, Inc., most U.S. stock funds pay an average of 1.31% of assets to the portfolio manager each year in addition to other operating expenses. Other costs related to the buying and selling of securities are not reported in the expense ratio and those expenses can make a fund 2-3 times as expensive as advertised.

What exactly are the costs of owning a mutual fund?

There are four primary costs that affect a mutual fund’s price. These are:

  • Bid-ask spreads. These represent the gap between the lowest price at which a seller is willing to sell and the highest price the buyer is willing to pay. When the fund does a lot of trading on less-liquid holdings, such as small stocks, these costs can add up quickly.
  • Broker commissions. These are the commissions paid to the brokers who operate the fund. The SEC requires three years of these costs to be disclosed in a fund’s statement, but the SEC does not require them to be factored into the expense ratios.
  • Market-impact costs. These last two are often the largest component affecting trading costs. They occur when a large trade changes the price of a security before the trade is completed.
  • Opportunity costs. Opportunity costs occur when the impact of a trade inhibits a fund manager filling an order on their desired terms.

This results in either a less-favorable price or fewer shares transacted.
While it’s very important to look at the expense ratio before purchasing a mutual fund, it’s also important to understand that that number is not going to capture all the costs.

What do the experts say?

Richard Kopcke, an economist at he Center for Retirement Research at Boston College recently co-wrote a study about the fees and inherent trading costs of retirement funds, such as 401(k)s. Kopcke’s study reviewed the 100 largest U.S. stock funds held in retirement plans as of December 2007 and found that annual trading costs averaged from 0.11% in the quintile with the lowest costs up to 1.99% of assets in the quintile with the highest costs. The median was 0.66%. Kopcke’s conclusion was that the average investor can’t begin to get an understanding of these additional costs due to the lack of information.

Another study updated last year by Richard Evans, associate professor of finance at the University of Virginia’s Darden School, put the average trading costs of thousands of U.S. stock funds at 1.44% with an average of 0.14% in the lowest quintile and 2.96% at the highest. Evans’ conclusion was that high trading costs tend to have a negative impact on fund performance. On average $1 in trading costs decreased net assets by 46 cents in this study.

Stephen Horan, head of professional education content and private wealth at CFA Institute, a non profit association of investment professionals estimates that trading costs for stock funds total 2-3% of assets annually although conservative reported estimates put these costs closer to 1%. According to Horan, these transactional trading costs are very real and unfortunately, the expense ratio just does not capture all of the costs.

How can this be happening in these times?

One reason trading expenses are unreported is due to the complexity. That complexity leaves fund companies in disagreement about how to calculate the costs. Even fund experts have trouble coming up with estimates that are similar.

Of course, another reason is that fund firms aren’t all that anxious to disclose their costs either. The SEC tries to revisit this issue every few years, but it still hasn’t come to a conclusion or established a set of rules.

All of this leaves investors in the dark about the true cost of their mutual funds.

Where are we on the disclosure debate?

In 2003, the SEC indicated to Congress that trying to include all trading costs in the expense ratio would produce a number that was not comparable, and it would vary from fund to fund. There simply isn’t an agreed-upon methodology on how to quantify implicit transaction costs such as market-impact costs. Therefore, requiring fund managers to disclose total trading costs would result in investor confusion.

While nearly everyone agrees that investors are entitled to and should have that information, until the methodology is developed there will be a lot of larger companies who pay trading-cost consultants to estimate their trading costs, but midsize and small investment managers who can’t afford to pay accountants will continue to wait for the methodology to be developed.

Get Clues from the Turnover

Meanwhile, investors can get clues from a standard albeit imperfect measure of how much trading the fund is doing. This is called the turnover, and it shows at what rate stocks are being replaced in the fund. This is an imperfect measure because some stock funds that have a lot of new money coming in don’t have to sell to generate cash. In this case, their turnover rate would be zero even though the fund is likely buying a lot of stocks.

Last year, the SEC voted to require fund companies to disclose one year of turnover and move that information to the front of a prospectus. Turnover of more than 100% can indicate that the hidden trading costs may be on the high side. Of course, there can be a number of factors that impact turnover during a given period and turnover can vary over time. Still, it’s a clue as to the hidden trading costs that are undisclosed.

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