As illustrated below, transaction costs can add substantially to the overall expense of an investor’s mutual fund. In addition to being substantial, these costs are nearly impossible to accurately quantify.
Tax Costs
Many investors pay more than their fair share in taxes when owning mutual funds. This problem is most transparent when mutual funds are owned outside of an IRA, Roth IRA, 401(k), or other tax-deferred accounts. An investor who buys into a mutual fund that is holding stocks that have appreciated prior to the purchase of the fund runs the risk of paying for these stocks’ capital gains taxes. Essentially, even if the investor did not benefit from the stocks’ gains, this investor will share proportionately in taxes due from the sale of these appreciated stocks when the mutual fund manager makes a change. Ultimately, one can end up paying taxes on investments that other investors profited from. Before purchasing an actively managed mutual fund in a taxable account, an investor should consider contacting the company to determine the level of embedded gains within the mutual fund. According to
Morningstar,
Cash Drag
Another cost of owning a mutual fund is cash drag. Cash is frequently held by mutual fund managers to maintain liquidity for potential transactions and potential redemptions by mutual fund owners. This may stifle the performance of a mutual fund if stocks increase in value greater than the cash held. According to a study by William O’Rielly, CFA, and Michael Preisano, CFA, the average cost from cash drag on large cap stock mutual funds over a 10-year time horizon was .83% per year (5). This cost results from investors paying the mutual fund’s expense ratio on 100% of the money invested despite the fact that not all of the assets are invested into stocks or other securities. Someone who holds cash in a bank savings or money market account on an individual basis generally does not have to pay these extra costs. Essentially, buy and hold investors are subsidizing other investors’ liquidity needs. It should be noted that cash held within a mutual fund could be beneficial during a time when stocks do poorly and incrementally more expensive when stocks perform well relative to cash.
Soft Dollar Cost
One of the most difficult mutual fund expenses to estimate is called soft dollar cost. This cost comes into play when mutual fund managers are buying and selling stocks within the mutual fund’s brokerage account(s). Frequently, mutual fund managers may direct the money being managed to brokerage companies providing them with research and/or other services, even if the brokerage companies are not providing the most cost efficient brokerage commissions involved with buying and selling stocks. Essentially, this is a quid pro quo arrangement. The mutual fund manager gets special services and/or research, and the brokerage company gets the brokerage business at a premium rate. This effectively keeps this cost out of the public’s eye, giving a fund the artificial appearance of lower than actual expenses. A research study by Stephen M. Horan suggested that U.S. soft dollar brokerage commissions may total $1 billion annually, or up to 40% of all equity trading costs (6).
Advisory Fees
The final cost is only relevant to individuals working with fee-based financial and/or investment advisors who select mutual funds for their clients. Many fee-based advisors will manage an investor’s portfolio for an annual fee commonly ranging from .25% to 2.50% of the portfolio’s balance. This fee is required to be disclosed on investors’ statements, and is charged in addition to the other mutual fund costs discussed.
Cost Summary
The following summarizes the average quantifiable costs described. Advisor and soft dollar costs are excluded due to the large range in advisory fees and the difficulty of quantifying soft dollar costs. When working with a financial advisor, it is important to add the advisory fee to the mutual fund costs listed below for an accurate depiction of total potential costs.
|
Non-Taxable Account |
Taxable Account |
|
Expense Ratio .90% |
Expense Ratio .90% |
|
Transaction Costs 1.44% |
Transaction Costs 1.44% |
|
Cash Drag .83% |
Cash Drag .83% |
|
– |
Tax Cost 1.00% |
|
Total Costs 3.17% |
Total Costs 4.17% |
As illustrated, hidden costs have infiltrated the mutual fund industry and are being paid by many unsuspecting investors. Despite potential drawbacks, investors can acquire broad tax efficient diversification at a fair price by utilizing mutual funds properly. In addition to potentially utilizing mutual funds, high net worth investors can obtain broad tax efficient diversification through direct ownership of securities or through privately managed accounts. These possibilities can increase transparency and eliminate many of the costs directly linked to mutual fund ownership. Cost considerations are one of many factors to analyze when allocating your portfolio and making investment decisions.
Ty A. Bernicke, CFP, is an independent financial advisor with Bernicke & Associates Ltd., in Eau Claire, Wisc. His research interests include portfolio theory and retirement income planning. He can be reached at questions@bernicke.com. Any opinions are those of Ty A. Bernicke and not necessarily those of Bernicke & Associates Ltd., or firms it is affiliated with.
(Quoted from http://www.forbes.com/2011/04/04/real-cost-mutual-fund-taxes-fees-retirement-bernicke.html on 7/14/13 @ 4:00pm.)
