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What Does a Mutual Fund Really Cost?

02/15/2019

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When comparing investment options, one important piece of information that investors tend to focus on is mutual fund cost. This makes sense as investment costs can seriously hinder the growth of a portfolio.
High costs require higher returns in order to make up for the costs. Plus, with the many other investment options available, high costs may end up not being worth it.
With that said, costs are an unavoidable reality of investing.
The most low-cost investments have some sort of associated cost. Even investments with higher comparable costs can still be worth it if they deliver returns that justify those costs.
For investors, the most important part of determining investment costs is having a full understanding of all costs associated. This article will help investors get a clearer understanding of all factors that go into determining mutual fund cost.

Management Fees

One of the most important costs for investors when choosing a mutual fund is the management fee. This is also probably the most well-understood mutual fund cost. These costs are shared as a part of the fund’s prospectus which can be reviewed by all investors. This cost is also one of the few costs that mutual funds are able to clearly anticipate.

As the name suggests, management fees are used to pay fund managers as well as the other staff that research and provide expertise for the fund. This is a standard cost with any mutual fund but the amount may vary from fund to fund.

Low management fees are certainly attractive when considering a mutual fund. However, management fees are just one part of the total fees that investors must consider.

Transaction Costs

Investors that do their own trading through a brokerage are subject to fees when they buy and sell stocks.

The same is true for mutual funds. When a mutual fund purchases or sells assets, it will be responsible for associated transaction costs. Since the mutual fund cannot absorb these costs, the costs must be passed on to investors.

Depending on the number of trades being done, this can be one of the most significant portions of overall mutual fund cost.

In some cases, mutual funds may be unable to control transaction costs completely. If a number of investors panic sell in a down market, for example, the fund may have to sell assets in order to pay out selling investors.

As a result, the fund could incur substantial costs as a result of the actions of individual investors. Even a passive fund may end up passing along transaction costs to investors.

Capital Gains Taxes

Taxes are another mutual fund cost that can arise when a fund sells assets. Much like transaction costs, a mutual fund cannot swallow the taxes incurred as a result of selling assets for a gain.

Consequently, the taxes must be passed on to the investors. For those that are in non-tax-advantaged accounts, capital gains taxes can sap away at total gains and stall portfolio growth.

A mutual fund that is more passive and less likely to sell off assets for gains may be preferable for investors concerned about taxes. However, it is unlikely that investors will find any mutual fund that completely eliminates any tax obligations.

Price of Assets

When a mutual fund looks to buy assets, they must buy these assets like any other investor. To do this, a buyer issues a bid that determines the price they are willing to pay. Sellers have an ask price. The difference is known as the bid-ask spread. Mutual funds, however, typically identify assets they would like to secure and purchase those assets at the ask price of sellers.

For stocks trading with a very narrow bid-ask spread, this price difference may not be significant. However, at the volume that we are talking about with large mutual funds, this price differential can prove to be costly. It is also not something that is regularly discussed when talking about mutual funds.

For fund managers that believe they have identified a winning asset, paying a little extra upfront to secure long-term gains is a small price to pay. However, this could be a major downside if their prediction turns out to be incorrect.

Cash Drag

Another lesser-known cost of mutual funds is called cash drag. Since mutual funds need cash on hand to pay out investors that are leaving or to buy new assets, this is money that is not actually invested. As a result, mutual funds are not delivering 100% of their true potential.

Some people refer to this cash drag as opportunity cost. The money that is sitting in cash, which could be invested, is unable to earn gains for investors. However, investors may be unaware of this cash drag and the potential they are missing out on.

Cash drag is a reality of almost all mutual funds. With that said, some funds carry more cash while some carry less, depending on how active the fund manager expects to be. A fund with less cash-on-hand will have lower cash drag than a fund with more cash-on-hand.

Better Awareness Leads to Better Investing

Ultimately, it’s important to understand that there is no perfect investment.

Every investment has its pros and cons. However, investors can make better decisions if they are more informed. By fully understanding the true details behind mutual fund cost, investors can make an educated choice about how to allocate their investment funds.

If you have questions about mutual funds and other investment options, please contact Linden Thomas and Company today.

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