The (Hidden) Costs of Mutual Fund Investing

Updated: September 1, 2015

We humans focus on what we are shown. This tendency makes magic work. The magician fools our eyes by making large and dramatic movements designed to distract us from the small, unobtrusive motions that are the action (hiding extra rope, concealing coins to be “pulled” from volunteers’ hair and ears, etc.).1

The main findings of this article:

  • Most people don’t know how much they spend on mutual funds
  • Many mutual funds are very expensive
  • Expensive mutual funds impose a significant “tax” on their investors’ profits
  • High cost mutual funds deliver lower returns to investors
  • Paying less will probably raise your investment profits

Suppose I asked you the size of your mutual fund portfolio, and then I asked how much you pay the fund company to manage your money. You might say $25,000, or $50,000 or $100,000 or even $1,000,000 for your portfolio’s size (count your retirement assets, too!). Regardless of the size of your portfolio, I bet you’ll say one of two things about how much you pay. My guesses are:

  1. Nothing; and
  2. I don’t know.

The first answer is unfortunately wrong, and the second is just unfortunate. You probably spend much more than you would if you knew what the costs were. Since I’m guessing, I’ll guess that the right answers for those portfolios are at least $250, $500, $1,000 and $10,000 respectively.2 Those are sizable sums – not as much as you spend on your house, or your car, or food and clothing – but quite possibly one of your top ten spending categories.

Why do some of us think that mutual fund companies manage our money for free, while most of us who think it must cost something aren’t sure how much?

Think back to what I said about magic. Most mutual fund companies make lots of noise about their performance but say very little about their fees.3 In many cases, you have to dig to find their fee structures.

Even when you find the fee structures, you have to figure out for yourself what it costs you. The ICI (the mutual fund managers’ trade association) has vociferously opposed recent proposals that fund managers should provide shareholders with an annual personalized statement of their fees, ostensibly on the ground that it would be too expensive. Sensible Financial finds this argument laughable – many fund companies already provide statements that report personalized asset allocation and returns. Personalized statements of fees and expenses would be easy to calculate and easy to report.

We believe their true reason is obvious. If you received an annual bill from your fund company, you’d be able to look for the best deal, just as you do when you buy a car, or take out a mortgage. Most importantly, you’d definitely be able to answer the question at the beginning of this article: How much do you pay for mutual fund management?

So, how much do you pay? To give you an idea, we’ll look at the full costs of the largest mutual funds that invest in large US companies. It’s likely that you own shares of at least one of them – certainly you know someone who does.

Shareholder mutual fund costs have four parts, and only one is easy to find. One part is so well hidden our best cost information source doesn’t report it.

  • The expense ratio4 is easiest to find. Fund companies must present this in the prospectus as the cost of a $1,000 dollar investment over 1, 5 and 10 years. Morningstar also provides this information, shown in basis points or hundredths of a percent – 100 basis points is one percent.
  • Your fund pays trading commissions whenever its portfolio manager buys or sells securities. Figures for these costs may be in your fund’s annual or semi-annual report (sent to you by mail, and frequently discarded without opening) or its Statement of Additional Information (SAI). Calculating your share of these costs is real work – you must divide the fund’s costs by the assets in the fund, then multiply by your assets.5
  • The last two costs are also related to trading. No fund reports or measures them, but they are important nonetheless. We can estimate them based on the types of securities each fund holds, and the amount of trading each does.
    • Spreads are the difference between the “bid” and “ask” prices in the stock market. The most aggressive buyer offers the bid price, while the most eager seller demands the ask price. The bid price is lower than the ask (otherwise the bidder and the asker would trade). Anyone buying or selling a stock pays the spread. You pay the spread every time your fund trades. For large-cap, frequently traded stocks, the spread is small, but for small-cap, infrequently traded stocks, the spread can be large.
    • Market impact costs are stock price changes associated with large orders. A large buy order tends to drive up the price, a large sell order drives it down. After the order is filled, the price tends to return to its original level. The difference from the market price is the market impact. This cost will be larger for funds that trade more and for funds that hold less liquid securities – small-cap and emerging markets are good examples.

Fortunately, analysts are paying more attention to costs. Recently, economists Jason Karceski, Miles Livingston, and Edward S. O’Neal studied mutual fund costs for 40 large mutual funds.6 I’ve summarized their results below, focusing on mutual funds that invest in large US companies. [These figures are for 2004. While the numbers are different today, the direction is the same.]

Karceski and his colleagues worked hard to identify the commission costs paid by various mutual funds and estimated the spreads the funds would have incurred. The variations among the funds are striking. I’ve divided the mutual funds into five groups, with index funds at the low cost end and funds with high expense ratios and high transaction costs at the other. The index funds have the lowest expense ratios and transaction costs. Their total costs are 60% lower than the next lower group. Imagine being able to buy bread or gasoline at a 60% discount! Their advantage is even more striking when compared to the highest cost funds.

The middle three groups have very similar transaction costs and differ substantially in expense ratios. The highest cost group has expense ratios no higher than the next lower group and transaction costs three times those of the other managed mutual funds (fifteen times the index fund transaction costs!).

You may be asking, “What difference does it make? The percentages are small, how could the dollars be large?”

First, the dollars are large. Most people would jump at the chance to save 50%-80%, which is the difference between the typical managed fund and the typical index fund, as we’ve shown. You can do the math in your head or on the back of an envelope. Very roughly, you are probably paying at least 1% of your assets ($100 for $10,000 in assets, $1,000 for $100,000, etc.). You could save 50-80% or more of that, every year.

Second, the costs are a large portion of your total possible return. Real returns (after inflation) on US equity have been 8% over the last 80 years, more or less. Investment costs of 1% are thus one-eighth (12.5%) of your return. Let me say that again, with emphasis: on average, you are paying more than 10% of your profit to the mutual fund company. In years when realized returns are high, the “tax rate” imposed by the fund company is lower. When realized returns are low, the “tax rate” gets large very quickly.

If you’ve ever wondered why your investment results lag the market, here’s one striking possibility. Imagine taking a 10% salary cut, or paying 10 percentage points more in income tax rate. The impact on your paycheck would be about the same.

In fact, it’s even worse, because returns compound over time. The next table shows how the “fund tax” grows as the time horizon gets longer. For example, as your investing time horizon increases from 1 to 10 to 30 years, the “tax rate” increases from 13% to 17% to 27% for a fund with a 1% expense ratio.

Investment companies whose funds are expensive might argue that the comparison isn’t fair. They might say that high cost funds have higher returns before expenses, so investors actually net higher returns after expenses. Fortunately for investors, Standard & Poor’s (S&P) has just published an analysis of precisely this assertion. Unfortunately for investment companies with expensive funds, S&P found that funds with higher expense ratios return less.

S&P looked at the performance of funds investing in US stocks over the last 10 years. To make the comparison fair, they grouped the funds according to the kinds of companies they invest in – large, medium, or small sized companies; growth, value, or a blend of the two styles.

S&P calculated how much an investor would have earned by investing $1,000 for 10 years in either low expense ratio funds or high expense ratio funds for each size/style asset class. As the table indicates, in almost every case, the investor would have been much better off investing in the low expense ratio fund. For example, for Large-Cap Growth funds, the investor would have added $341 dollars more after 10 years in the low expense ratio funds than in the higher cost ones.

Additional Return to $1,000 Investor After 10 Years
Low Expense Ratio Fund vs High Expense Ratio Fund

For investors investing other amounts, we’ve included the results in percentage terms. For that same Large Cap Growth asset class, the investor would have added 17% more after 10 years in the lower expense ratio funds.7

Percentage Advantage to Investor After 10 Years
Low Expense Ratio Fund vs High Expense Ratio Fund

We haven’t yet answered a key question raised at the beginning of this article. How much are you really paying for the mutual funds you hold? Here’s how to find the answers:

First, the expense ratio is readily available. It’s in the prospectus, and is also readily available on Morningstar, both for the fund you hold and for direct competitors. Multiply the expense ratio times your assets for each fund. That’s the best you can do with readily available information, even though it will be a significant underestimate for funds that trade a lot.

Second, although commissions and other trading costs are hard to find, it’s easy to assess which funds probably have lower trading costs. Those costs are proportional to the amount of trading the fund does, and that’s measured by the turnover ratio. The turnover ratio is a bit harder to find than the expense ratio, but Morningstar reports this statistic, too.

To compare costs of similar funds, compare the expense and turnover ratios. If one fund’s expense and turnover ratios are both lower, it’s almost certain to have lower total costs. If one fund’s expense ratio is lower, and the turnover ratios are close, the fund with the lower expense ratio will be less expensive. If the expense ratios are similar, and one fund has a much higher turnover ratio, that fund is likely to be the most expensive. Only if one fund has a much lower expense ratio and the other a much lower turnover ratio is it difficult to judge. Fortunately, these cases are pretty unusual.

How can you be sure that buying the lower cost fund will produce better returns? In short, you can’t be certain. The difference in performance between high and low expense ratio funds will vary over time, and the low cost funds won’t always win (in Mid-Cap blend, they lost over the time period S&P studied). However, the odds are with you. Costs are predictable, returns are not. To modify an old saying a bit, the low cost fund doesn’t always outperform the high cost fund, but that’s the way to bet!

If you have questions about the costs and performance of the mutual funds in your portfolio, contact me at Sensible Financial, either by phone at (617) 444-8677, or by email at rick.miller@sensiblefinancial.com. Lower cost funds are a good route to more money in your pocket!