Hidden Costs When Investing in Mutual Funds
Paul Tarins, RICP®,WMCP®,CSRIC™
Are actively managed mutual funds the perfect solution for people who want to own stocks without doing their own research?
Assembling a portfolio of mutual funds might seem like a great way to access the stock market for a fairly low cost. And in fact, according to Morningstar, the asset-weighted average expense ratio for active funds was 0.66% in 2019. But that’s just the starting point for understanding the true cost of owning mutual funds.
We break down some of the costs you should know about before you invest in actively managed mutual funds. Remember, not every fund prospectus will identify these expenses with full transparency so read your prospectus carefully.
Transaction costs occur when buying and selling shares as prices increase or decrease. The cost of these transactions isn’t actually paid for by the fund manager but is passed along to each of the fund’s shareholders.
Transaction costs can be difficult to determine as they are not found in most prospectuses. The turnover ratio within a fund will give you an idea of the amount of transactions. Morningstar’s definition of turnover:
Turnover rate represents the percentage of a fund's holdings that have changed over the past year, and it gives an idea of how long a manager holds on to a stock.
Fund accountants calculate a fund's turnover rate by dividing its total sales or purchases (excluding cash), whichever is less, by its average monthly assets during the year.
A fund that trades 25% of its portfolio every year has a turnover ratio of roughly 25%. However, if a portfolio's turnover ratio exceeds 100%, it does not necessarily mean that every single holding has been replaced. The ratio seeks to reflect the proportion of stocks that have changed in one year.
How does all this drive up your cost? UC Davis professor Roger Edelen and his co-researchers from the University of Virginia analyzed portfolio holdings and transaction data for 1,758 mutual funds from 1995 through 2006.
Edelen found that transaction costs, or costs for trading securities within a fund, can be higher than the expense ratio. The fees can vary by asset class. For example, investors in small-cap growth funds pay an average of 3.17% in transaction costs, and large-cap value funds pay 0.84% per year.
Also known as a sales load, this is a fee that you pay to buy into a fund. It is a commission for the firm each time you invest into the fund. It goes directly to the firm that your advisor works with. This fee is on top of the fund expenses and any brokerage fees.
Not all funds charge a sales charge and not all advisors work within this type of sales structure. There are many families of funds that have no sales charges. These are referred to as no-load mutual funds.
The load or sales charge of a mutual fund is included in the price per share an investor pays. The current share price of a mutual fund is referred to as the net asset value, or NAV. The share price, including the sales charge, is referred to as the public offering price, or POP.
When you purchase A shares, you are paying the sales charge up front. The maximum legally allowed load for a mutual fund is 8.5%. Most funds have a top sales charge much lower than the maximum. On average, you usually see a sales charge in the upper 4%-5% range.
B shares have a deferred sales charge that declines yearly. Usually their life is 6 year, after which they become A shares.
C shares usually charge 1% and vanish once the investor has held the mutual fund for a year.
The ongoing management fee varies among each share class, so again, read the prospectus and understand how these fees can erode overall returns.
Let’s say your fund manager had no transactions in a given year, no dividends were paid and you did not sell any of the shares you own. This could possibly be associated with zero capital gains and therefore no tax liability.
Now, consider a mutual fund with a 100% turnover. If it is a long-term investment in 2020, the capital gains tax rates are either 0%, 15% or 20% for most assets held for more than a year. Capital gains tax rates on most assets held for less than a year correspond to ordinary income tax brackets.
Taxes are no different than any other fund expense. They all erode your overall returns. You may experience a year of negative returns and still open your mailbox with a 1099 that creates a tax burden based on the turnover in the fund.
Not fun at all!
The most well-hidden costs in mutual funds include investor behavior, i.e., where your own actions can derail a well-intended long-term strategy. Although mutual funds are managed by fund managers, you have the ultimate say in when you sell your shares.
Investors, at times end up making a poor decision based solely on emotions. With the idea of buying low and selling high, your emotions may lead you to do the exact opposite; which is selling at the wrong time and getting back in after the overall stock market has made a large move upward.
This has historically led many investors to underperform the markets in five, ten- and twenty-year periods. When dissected and looked at closely, these expenses can put a major dent in your financial and retirement planning ventures.
Thinking it Through
Mutual funds can be a good way to build a portfolio that potentially meets your goals – but they may not be the low-cost alternative they seem. You may not want to research individual stocks to include in your portfolio – but you should research the mutual funds that hold them.
Paul Tarins is an investment adviser representative of and offers investment and advisory services through Portfolio Medics, a registered investment adviser. Nothing contained herein should be construed as a solicitation for investment advisory services. Sovereign Retirement Solutions and Portfolio Medics are not affiliated.