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The Hidden Costs of Mutual Funds

02/12/2019

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There are hidden costs associated with trading in a mutual fund, which are not reflected in the fund’s standard expense ratio. You may be paying a lot more with your mutual fund than you expected.
A basic rule to investing in mutual funds is to check the expense ratio, which is related to the buying and selling of portfolio securities, and is one way to measure the cost of a fund.
However, the expense ratio does not reflect all the costs to mutual funds. There are more than a few hidden trading and transactional costs, which can make the fund almost three times as expensive as advertised. And one of the key reasons why these costs are not advertised is that they are complex and can cost firms and managers some credibility.

How Complex Are These Trading Costs?

Trying to quantify these costs can be one of the most challenging endeavors for an investor.

One big obstacle is that mutual fund managers and firms are not willing to disclose information about these costs. Additionally, pressure from the Securities and Exchange Commission does not do much to change their behavior.

Investors depend on the information available in a prospectus, but it does not hold all the answers. The same investors also depend on other informational materials before choosing to invest in a particular mutual fund. Economists claim that this is not enough information to determine true costs and make an informed decision about buying into a fund.

The hidden costs associated with funds, including mutual funds, are difficult to determine for experts, who usually end up coming up with varying numbers.
An economist studied the 100 largest stock funds and found trading costs for the funds at the lowest quantile at an average of 0.11% while costs at the highest quantile at an average of 1.99% of total asset prices.

Expenses are an important element for investors to look at, including trading costs, which can have unfavorable impacts on fund performance.

What Exactly Are the Costs?

The costs are broken down into four parts: brokerage commissions, bid-ask spreads, opportunity costs, and market-impact costs.

Brokerage Commissions

Brokerage commissions are the most straightforward of the costs. This cost incurs when funds pay to buy and sell securities.
These commission costs are open source because the SEC requires three years of brokerage costs in dollars to be disclosed in a fund’s statement. However, the SEC does not require commissions to be factored into expense ratios.

Brokerage commissions make up less than half of a fund’s total costs, and the other three cost components are harder to quantify.

Bid-Ask Spreads

A Bid-ask spread is the difference between the lowest price a seller is willing to sell the security and the highest price a buyer is willing to buy the same security. The gap between the two price points is called the spread.

Spreads can cost funds a significant amount of money if a lot of trading with less-liquid holdings takes place. One example is with very small stocks in the fund.

Market and Opportunity Costs

These are the largest hidden costs associated with mutual funds. Market costs apply when a large trade can change the cost of a security before the trade is finalized.
Opportunity costs apply when the effect of a trade impedes a fund manager from filing an order on their desired terms. This leads to either a price less favorable, or to the purchase of fewer shares whether bought or sold.

Why Do Hidden Costs Matter?

While funds do not factor these costs into their standard expense ratios, they do factor the costs into their returns.
So why should you care about these costs?

Well, the higher the costs, the more value a fund manager will need to add to make an investment worthwhile. Additionally, when there are hidden costs, it is harder for investors to gauge where the performance of the fund ranks.

Funds that have higher trading costs associated with them usually end up having higher financial hurdles to clear on top of the expense ratio.
These trading costs are not required to be disclosed, and this was on the encouragement of the SEC in 2003 in front of congress. The reason disclosure is discouraged is that quantifying costs are based on estimates rather than hard figures.

However, the SEC has publicly stated that they are focusing on analyzing portfolio transaction costs and working on enhancing disclosures for investors.

Why Are Hidden Trading Costs Difficult to Quantify?

The main problem with quantifying hidden trading and transactional costs is that there is no agreed upon methodology, which leads to varying estimates on cost. Implicit transactional costs, like market-impact costs, are based on estimates that only lead to further cost guesses.

Fund managers say, and the SEC agrees, that disclosing total trading costs across funds would lead to market confusion among investors.

Additionally, quoting estimates in an informational prospectus to potential investors can lead to grey area conversations. Fund managers need to hold fast to the numbers they provide in a prospectus, and using estimates can lead to a loss of business and investor confidence.

Possible Solutions to Quantifying Cost

Nonetheless, many investors are entitled to information on hidden trading and transactional costs. And just because there is no standard cost breakdown yet, does not mean that stakeholders should not come up with one, according to economists and investors.

For example, Morningstar has been working on a trading cost ratio to complement the expense cost ratio for further disclosure of hidden trading costs.
However, this is a challenge for small and medium size firms to follow due to the additional expenses that would incur in hiring consultants to work on developing a trading cost ratio.

Meanwhile, while a trading cost ratio is still in the early stages of development, investors can use turnover percentage for clues.
There are a number of elements to consider that could impact turnover percentages during a given period. Remember that turnovers can vary over time.
Two other factors to consider in gauging a fund’s trading costs are size and style.

Small funds usually aren’t big enough to move markets, while big funds usually have high trading costs. Style is seen in terms of bid-ask spreads where aggressive growth funds have higher spreads, while income funds tend to have lower spreads.

Additionally, fund managers may buy and sell the same held securities over and over again when they believe them to be undervalued or overvalued. Funds and firms have tried to lower costs by switching to electronic trading systems and using other tools to lessen market impact.

Examples of Turnover Cases

Turnover percentages show the rate at which fund securities have been replaced. This gives investors clues into how much trading the fund is doing in interval periods. These clues are often expressed as percentages.

For example, a fund that sold half its securities and replaced them with an equal portion in value in new securities would have a turnover rate of 50%.
There are also extreme cases of turnover that take place.

For example, if there is a fund that’s getting a lot of new money coming from investors and it doesn’t have to sell anything to generate cash then the turnover rate would be 0%. This is despite whether or not the fund has been buying securities, so long as it is not selling any.

The SEC requires firms to disclose one year of turnover at the beginning of their prospectuses. Another disclosure is required somewhere in the prospectus that looks over the last five years.
Any turnover percentages of over 100% can mean trading costs are on the high side. In a Morningstar list of the 200 largest U.S.-stock funds, the funds with the highest turnover ratios were CGM Focus, at 504%, and American Century Equity Income, at 296%.

Final Points to Remember

When it comes to opting into an index fund, remember to do some digging to find what hidden costs are associated with the fund.
Trading and transactional costs will be part and parcel of various funds. It is important to understand that those costs are part of the overall price of opting into the fund. However, the costs are not reflected in the expense ratio, which is an important element.

Additionally, remember that quantifying trading costs is difficult. Ask the fund manager to break down what an estimation of those costs might look like.

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