How much does it cost you to own a mutual fund? Probably a lot more than you think.
In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how much it costs to own a fund. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to the fund experts at Morningstar.
But that's not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.
"These trading and transaction costs are very real," says Stephen Horan, the head of professional education content and private wealth at the CFA Institute, a nonprofit association of investment professionals. "While it's very important to look at that expense ratio, it's just not going to capture" all of the costs, Horan says.
One reason trading costs go unreported is their complexity, which leaves the fund companies in disagreement about exactly how to calculate those costs. Trying to quantify a fund's trading expenses can be about as simple as brain surgery.
Most fund companies aren't exactly clamoring to disclose more information about these costs. The Securities and Exchange Commission seems to revisit this issue every several years without much happening. And investors are left trying to piece something together from snippets of information disclosed in a prospectus or other materials.
"The average investor can't really even begin" to get a strong grasp on these additional costs, says Richard Kopcke, an economist at the Center for Retirement Research at Boston College who co-wrote a recent study (.pdf file) about fees and trading costs of mutual funds in 401k plans. "There's just not enough information. Not even close."
Even experts come up with some very different estimates. Kopcke's study looked at the 100 largest U.S.-stock funds held in defined-contribution plans as of December 2007 and found trading costs for the funds that averaged from 0.11% of assets annually in the quintile with the lowest costs to 1.99% of assets in the quintile with the highest costs, with a median of 0.66%.
Horan, meanwhile, estimates that trading costs for stock funds total 2% to 3% of assets annually, though conservative estimates place them closer to 1%, he says.
Identifying costs
What exactly are these costs?There are four main components: brokerage commissions, bid-ask spreads, opportunity costs and market-impact costs.
The brokerage commissions a fund pays to buy or sell securities are the simplest piece to understand. The SEC requires three years of brokerage costs in dollars to be disclosed in a fund's statement of additional information. Putnam Investments, for example, reported commissions of $21.5 million for its Putnam Voyager Fund (PVOYX) for the fiscal year that ended July 31, 2009. That was equal to 0.69% of the fund's $3.12 billion in assets on July 31, on top of a reported expense ratio of 1.26%.
A Putnam spokeswoman notes that the fund outperformed its benchmark, the Russell 1000 Growth Index, by 17.1 percentage points, net of fees and expenses, for that period. Commissions for that period were also higher than normal, due to a new manager and volatile environment, she says.
A few fund groups, including Brandywine Funds and Selected Funds, do the math for investors by quoting their commissions costs as a percentage of assets.
But the SEC doesn't require commissions to be factored into expense ratios. The commissions tell only part of the story and so could be misleading, the SEC explained to Congress in a 2003 memo, and the agency has not revised this position.
Commissions typically make up less than half of a fund's total trading costs, Horan says. The other three components are much harder to quantify.
Bid-ask spreads deal with the difference between the lowest price at which a seller is willing to sell a security and the highest price a buyer is willing to pay. The gap between them, usually associated with thinly traded securities, is the spread. At any given moment, for example, a security may have a bid price of $96 and an asking price of $100. Say a fund bought that security for $100 and that the security's value later rises. If the fund decides to sell the security when the asking price is $110 and the spread has stayed the same, the fund will receive only $106. The spread thus cost the seller $4. Over time, spreads can be a significant cost for a fund that does a lot of trading in less-liquid holdings, such as very small stocks.
Market-impact costs, and the resulting opportunity costs, are often the largest component of trading costs -- as much as 1.5 times brokerage commissions, Horan says. These costs occur when a large trade -- say, unloading a big stake in a thinly traded stock -- changes the price of a security before the trade is completed.
Similarly, opportunity costs are when the impact of a trade keeps a fund manager from filling an order on his or her desired terms, resulting in either a less-favorable price or fewer shares purchased or sold, says Steven Stone, a partner and head of the investment-management practice group at law firm Morgan, Lewis & Bockius.
Funds do factor these costs into their returns, just like the costs stated in the standard expense ratios. So why should investors try to quantify these costs? Because the higher the costs are, the more value the manager will need to add in his or her security selection and trading decisions to make the investment worthwhile compared with, say, a passive index fund. And when the costs are not all broken out for investors to see, it's harder for investors to tell where that performance bar lies.
When a fund has high trading costs, that's "a higher hurdle to clear when coupled with the expense ratio," says Russel Kinnel, the director of fund research at Morningstar.
Continued: Debating disclosure
