Jim'sMoneyBlog

Financial Opinion and Insights

Do You Know Your Mutual Funds’ True Costs?

Jim Lorenzen, CFP®

Jim Lorenzen, CFP®

 It’s a safe bet that most investors, and indeed even many financial advisors, have no idea how much they’re really paying for the investments they hold.            

This wasn’t something investors paid attention to when the stock market was roaring along at a double-digit pace and bonds were paying high yields; but times have changed, haven’t they?            

Since mutual funds might arguably be considered the most popular vehicle for individual investors, it might be worth looking ‘under the hood’ to see where your money is going.            

Most funds fall into one of three broad categories:  Stocks, bonds, or so-called `balanced’ funds – I say ‘so-called’ because these funds vary widely in characteristics and, frankly, I’ve always felt there are just too many variables to know what your allocations really are.            

For the sake of illustration only, let’s assume you have a stock fund with annual expenses of 1.4% – you can look in your own funds’ prospectuses to find yours.             

Is that 1.4% your total expense?  Not at all.  It does not include trading costs!  That’s right, the fund’s trading costs are not included in annual expenses.  They’re actually hidden in the price of the fund, it’s net asset value (NAV).  You see, when a fund manager makes trades, s/he pays commissions just like you do; and what the fund realizes after the trade are the ‘net proceeds’ of the transaction, which becomes part of the NAV.  John Bogle – is he still President of Vanguard? – estimated in his book, ‘Bogle on Mutual Funds’ that these hidden costs were probably around 0.6% per trade.   That ‘per-trade’ verbiage is important, as you’ll see.             

So, now we have a hypothetical 1.4% in annual expenses, plus 0.6% per trade.  Is that all?   Okay, like the broker in the Scottrade commercial asks, `What else?’             

 Have you ever heard of market-impact costs?            

Huh?           

As we know, fund managers rarely make ‘round-lot’ 100-share transactions.  They are known for moving large blocks of securities on a single trade!    Whether it’s a buy or a sell, it can affect the stock’s price when they trade.    Market-impact costs have to do with the effects a fund’s trading actually has on the price of a stock.    A BusinessWeek article I read ten years ago estimated that these costs range from 0.15% to 0.25%.   I doubt much has changed, but we can I think we can conservatively use the low-end.    Okay, our hypothetical fund has 1.4% in annual expenses, 0.6% in trading costs, and let’s say 0.15% in market impact costs.            

Now, let’s look at turnover.  How often does the manager turnover the portfolio?  Again, examine the data for your own funds; but, let’s assume our hypothetical stock fund has a turnover of 120% – not an unrealistic assumption for a growth fund, to be sure.  What does that mean?      

Annual Expense Ratio             

1.40%
Trading Turnover: 2.2 x 0.6% 1.30%
Impact Turnover:  2.2 x 0.15% 0.33%
Total 3.03%

           

Oops!  We’re not paying 1.4%; we’re really paying 3.03% – more than double what we thought!   And, it gets worse.  That percentage doesn’t go down as (if) you grow your assets.  The investor with $1 million is paying the same percentage as the new investor who’s beginning with an initial $1,000 deposit!             

Yes, I promised to come back to the importance of ‘turnover’ in the portfolio. Did you notice that the 120% turnover is computed with a 2.2 factor?  That’s because you have to `establish’ a position before you can turn it over.  That’s two trades.  The 120% turnover means that all positions are established and replaced, and it happens yet again to 20% of the fund’s portfolio!   Now, trading costs and market impact costs – all hidden in the NAV – become even more important.  As you can see in our hypothetical, the trading costs alone almost equal the fund’s annual expenses.             

Okay… we’ve got annual expenses, trading costs, market impact costs and then we’ve got turnover….  WHAT ELSE?     

How about 12B-1 fees?      I think this is when the broker drops his head in disgust.  12B-1 fees were, in my opinion, foisted upon the public by the industry claiming it would pay advertising and marketing expenses and help keep overall expenses down.   Yeah, sure, okay.  The truth is they primarily provide residual income to brokers – and if you have a good broker, there’s nothing wrong with that.  That compensation is what allows them to spend time on client service issues.  My issue with 12B-1 fees arises when an investor is paying them and isn’t using a broker.  The fund company is, in my opinion, just pocketing the money that would be going to a broker.     

Oh, yeah,   if you’re using a broker there are likely commissions.   Despite all the bad things you may have heard about commissions, they do have their place.   My own view is that the existence of commissions is what allows brokers to handle smaller accounts – people who otherwise wouldn’t be able to access professional help.   Fee-only planning and advisory practices like mine, for example, generally need higher asset-level  minimums to generate the revenue required to support the infrastructure our clients expect and deserve.   One might think you only need add more clients; but the reality is that service and manager oversight issues take time, and time is a finite commodity.  For this reason, many seasoned advisors – after nineteen years, I may fit that description – generally ‘cap’ their client list at one hundred in order to make sure no one is being neglected.  It’s simple math.  Financial objectives must be met within the 100-client cap.   But, I digress.   

Quick recap:   It’s not that any of these charges are necessarily good or bad; but, it’s important for investors to know what they’re paying in order to assess true net value – and to form realistic expectations.            

Hope this helps!

Written by Jim Lorenzen, CFP®, AIF®

July 13, 2010 at 8:00 am