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What You Don't Know

The Real Costs Associated with Index Funds

02/13/2019

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The real cost of index funds is often unclear to investors.
Investment costs have become heavily scrutinized in recent decades due to academic research, technology and competition. Indexing and other passive strategies have rapidly transformed capital markets in recent decades, and with good reason.
The alpha generated by active managers may not always justify the associated fee for portfolio management, according to numerous research reports over recent decades. It can be very expensive to hire a team of analysts, traders, and managers with the talent required to outperform a tight market.
Instead, investors can reap the benefits of capitalistic economic growth through broad equity market exposure.
However, the rush to eliminate management fees has seemingly obscured the analysis of other expenses that determine the real cost for investors. Some of these costs are apparent, but many are hidden.

Visible Costs – The Expense Ratio

Mutual funds and ETFs charge fees to shareholders each year, and these are commonly measured by the expense ratio. These fees cover fund administrative expenses, 12b-1 and fund management fees.

The expense ratio is published in a fund prospectus, meaning it is generally subject to scrutiny. Actively managed mutual funds can have expense ratios as high as 1.5%, but lower-cost passive index funds are often as low as 15 basis points.

The impact of management fees is well-documented and generally understood by investors. Exceptionally high expense ratios can reduce investor returns by as much as 40% over a 25 year period. High expense ratios are not inherently bad, especially for proponents of active management. However, investors must determine if active managers are able to create more value than they extract.

Trading Cost – An Important “Hidden” Expense

Index funds also incur expenses to transact securities, and these costs are passed along to shareholders. Funds pay brokerage commissions and fees to clearing houses. The bid-ask spread can erode value, especially if trading volume is high.

Very large funds can actually influence market pricing by selling large blocks of securities while rebalancing. In that event, the quantity supplied increases rapidly, driving the value of the security down, though this theoretically should be a temporary impact.
Even the most passive funds must periodically rebalance to track benchmarks. This can be caused by changes to the index constituents or simply to keep exposure to a given security aligned with the fund’s stated allocation rules. This dynamic is significant enough that some hedge funds have developed strategies around pricing securities likely to be sold in blocks during rebalancing.

Trading cost is difficult to estimate and is not disclosed in the fund prospectus. However, investors can research portfolio turnover, which measures transaction volume. That data is not a strong predictor of fund quality, but it can be very helpful when estimating the cost of investing.

Studies indicate that 100% turnover generates trading expense ratio of approximately 1.2%. High portfolio turnover increases the real cost for investors. For perspective, some of the largest passive index funds have turnover below 5% during low-volatility periods.

Commissions

Commissions, loads and transaction fees charged by the mutual fund are additional expenses for investors that are not captured in the expense ratio. Unlike the trading costs that are incurred by the fund and passed through to shareholders, these fees are charged directly to the holder at the time of share purchase or redemption.

Such fees have come under scrutiny as competition continues to cause pricing pressure in the financial industry. These are often considered “dead weight”, meaning they simply reduce net asset value in a portfolio.

Good advisors and funds can justify these costs by creating overall value that would otherwise not be realized.

The Bid-Ask Spread

Investors who directly hold securities or ETFs in a brokerage account have encountered the bid-ask spread. When a transaction occurs, there is a gap between the price paid by the buyer and price paid to the seller. The difference goes to the market maker, who is compensated for taking the risk of providing liquidity to the market. The spread is modest for highly liquid securities, but it can be significant for less liquid assets.

The moment a stock or ETF is purchased, it cannot be resold for the same price. The spread must be closed before gains are generated, creating an obvious drag on results.

Investors can minimize this cost by holding liquid securities and minimizing trading frequency.

Taxes

Tax liability for investments depends on the types of securities held, the investment strategy, the availability of tax loss harvesting in the portfolio, and the investor’s activities outside of the investment portfolio.

Investors must also pay capital gains tax. Assets held less than a year are taxed as ordinary income, whereas realized returns on assets held for more than one year are subject to long-term capital gains rates. Interest and dividends are taxed as regular income. These expenses must be factored into individual returns.

Taxation is also important at the fund level for ETFs and mutual funds. The funds themselves must pay taxes when they realize gains on sold securities. Mutual funds generally must sell securities to produce cash for shareholders who are redeeming shares. These are often taxable events, and those expenses are passed along to the remaining shareholders. ETFs have gained popularity in part because they do not create taxable events at the fund level when shares are liquidated.

High redemption volume under the right market conditions can hold significant expense ramifications, and these costs are not captured in a fund prospectus.

Opportunity Cost

Opportunity cost is an essential concept in finance, though it is not a cash expense like fees would be. Capital dedicated to any use necessarily precludes those dollars from being deployed elsewhere.

The return that those dollars could have generated in an alternative allocation is a real cost to investors.

It is not practically possible to minimize opportunity cost with every decision. Future returns are uncertain, and liquidity needs, or risk tolerance could disqualify some investment options for some investors. However, investors can make an educated decision about their best options based on individual needs and principles.

Many active managers fail to create enough value to justify the costs associated with their strategies. Nonetheless, there are some talented professionals working at sufficient scale who have driven their associated opportunity cost above their compensation.

DISCLOSURES

Linden Thomas and Company and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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