Mutual fund fees are often discussed, but not fully appreciated by many investors. The ultimate cost of owning a fund is far greater than what meets the eye. This is primarily due to two reasons. First, only about a third of the total cost is reported by the expense ratio. Other hidden fees can more than triple this explicit expense. Another factor often missed is the power of compounding fees, and even small changes in expense can become material over time.
For example, the average mutual fund expense ratio in 2013 was 1.25 percent according to Morningstar, which may not seem like much. However, that expense alone will trim a retiree’s nest egg from about $945,000 to $757,000, or nearly $190,000 (assuming a $10,000 investment compounded 7 percent annually for 30 years). Small changes in fees matter also. If we assume expense ratio is just 0.25 percent higher, expenses will be $30,000 more under the same assumptions.
Now here’s the kicker. Including all of the hidden fees associated with mutual funds, the total cost of ownership is estimated to be over 4 percent annually for a taxable account, according to a 2011 Forbes piece, “The Real Cost of Owning a Mutual Fund.” It’s no wonder so many active managers have lagged their benchmarks and retail investors have flocked to low-cost exchange-traded funds.
Cash. Finally, the amount of cash a fund holds in order to maintain liquidity creates a drag on performance of about 83 basis points per year, according to an ETF.com article,”Dealing With The Active.” The expense ratio applies to 100 percent of the fund assets. In other words, an investor is paying 1.25 percent on average for a fund manager to hold their cash. It is unlikely the fund would ever be 100 percent invested due to potential redemptions.
Transaction costs. A 2007 study by Edelen, Evans and Kadlec found U.S. stock mutual funds have an average transaction cost of 1.44 percent per year, which is not included in the expense ratio. These fees are not found in most prospectuses and can be difficult to determine. The first part of these fees is the commission paid to the broker. This alone costs investors roughly 0.25 percent, or 25 basis points each year.
It’s important to note most mutual funds don’t pay the rock-bottom, sub-$10 commissions you see advertised from online brokers. Rather, they pay a grossed-up commission, referred to as “soft dollars.” In return for paying this premium, mutual funds get access to research, analysts, management teams and even financial terminals and software.
Another factor is the bid-ask spread, which is the difference in price between what the dealer will buy and sell a stock. Even a spread of a penny allows the dealer to capture a fraction of a cent on every share traded. This tiny expense adds another 23 basis points each year. The final piece of the unreported transaction cost is a consequence of the fund’s size.
When a portfolio manager decides to trade a position, the large volume is enough to influence the market price. Before the entire order can be sold, the heavy volume drives down the price and a portion of the shares are sold at the lower price, or vice versa for a purchase order. This negative impact costs investors another 96 basis points on average.
Taxes. Investors with taxable accounts end up paying more than their share when investing in mutual funds. It is estimated that these cost investors an additional 1 percent per year (for equity funds), according to a 2010 Morningstar article by its fund analyst Katie Rushkewicz. Dollars typically flock to funds with the best performance. In order to build a favorable track record, the manager must have investments that increase in value, and thus have accumulated unrealized gains. When these gains are realized by selling the investment, owners of the fund must pay capital gains taxes. Unfortunately, this applies to the total gain realized by the fund, even if the investor entered after the stocks appreciated.
In total, these hidden expenses create an estimated all-in cost of 4.52 percent for a taxable investor or 3.52 percent for non-taxable accounts. The total cost of mutual fund ownership lowers the annual rate of return from a potential 7 percent to 2.48 percent, which results in only $437,000 at retirement. The seemingly small fees ultimately cost the investor $508,000 over 30 years.
This erosion of wealth does not even incorporate fees paid to a financial advisor. Some advisors pride themselves on having low fees, as low as 25 basis points. These low-fee advisors very commonly invest in mutual funds and often receive additional compensation.
Symbiosis between the advisor and the fund company is not too dissimilar from soft-dollar arrangements. If an investor uses a low-cost advisor, the ultimate investment would amount to $420,000, benefiting his advisor to the tune of $17,000. It is worth finding an advisor who invests in individual securities, even if the fee is higher. If the same investor chose an advisor who charged 2 percent but did not use mutual funds, after 30 years they would have $664,000 or $244,000 more than using a “low cost” advisor.
Brett Carson, CFA, is the director of research for CWM where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.