With the rise of ETFs (Exchange Traded Funds) investors are now realizing the benefits of low cost index fund investments. For the majority of investors, mutual funds are very much a part of their investment mix. But until recently, the average investor was unaware of the total costs associated with owning mutual funds and the negative impact to achieving long term investment success.
John C. Bogle from Vanguard did a very telling study on “The Arithmetic of “All-In” Investment Expenses.” In his research report, John establishes the drag on mutual fund returns by estimating the investment expenses associated with them. Identified below are an illustration of the real costs of mutual funds including costs considered ‘hidden’.
Real Costs of Mutual Funds
Expense Ratio
This is the disclosed expense ratio the investor will see in the prospectus. The average large cap mutual fund charges 1.12%. As a comparison the expense ratio for the Vanguard Total Stock Market Index is 0.06%. Why such a difference in cost? Mutual funds are what we call actively managed investments. The fund charges for their active management, the premise being their expertise will lead to the fund outperforming its benchmark.
An Index fund is referred to as a passive investment and is not actively managed by a manager. An index fund seeks to replicate the movements of a particular index. However, research has shown the average Mutual Fund doesn’t outperform; hence an investor is over paying for under performance. For a 20 year period ended 31 December 2012, actively managed funds underperformed index funds by an average of 1.80% per year.
Transaction Costs
This is the first “hidden cost” not reported in the expense ratio. Transaction costs are the trading costs the mutual funds incur in active management. Every time the fund buys or sells a security they incur a fee. As an additional expense, transaction costs can add on average 0.50% per year.
Cash Drag
Active funds are rarely fully invested and consistently hold an estimated cash position of 5%. On average the equity premium for stocks over cash is 6% per year, leading to an estimated additional cost of 0.15% for holding cash.
Sales Loads
Retail investors often pay a front-end sales charge directly to the Mutual Fund for fund distribution. The typical sales load is approximately 5%, which results in an additional estimated sales cost over the holding period of the fund of 0.5% per year.
Additional Items To Consider
Tax Inefficiency
Index funds are highly tax efficient compared to an actively managed mutual fund. When a manager of a mutual fund sell securities to capture gains; the gains are passed through to their investors and taxed as reinvested capital gains. This causes the Mutual Fund investor to pay more taxes overall on their investment than a holder of an index fund.
Harmful Investor Behavior
Over a 15 year period ended 30 June 2013, large-cap blend funds achieved an average annual return of 4.5% – for the funds that survived. While, as reported by Morningstar, asset-weighted returns of individual investors over the same period earned only 2.59%, a ‘behavior gap’ of 1.91% per year.
Statistically, the average mutual fund incurs on average 2.27% per year in expenses or 2.21% more when compared to an average index fund charge of around 0.06%. Over time this expense difference significantly impacts the investment return to the individual investor.
If you are interested in learning what your “all in” Mutual Fund costs go to PersonalFund.com. It is a tool I use to research the cost of client’s current investments and show them comparative costs when proposing index fund investing as an alternative.
So what does this all mean for you and your long-term investment success?
The average investor should focus on developing a strategy with the help of an advisor to build an investment process around low cost passively managed index funds. By utilizing index funds an investor can easily diversify their holdings with low cost options; removing unnecessary reported and unreported costs from their portfolio.
Just as important, they need to partner with an advisor to eliminate the “behavior gap” and the associated emotions that lead to poor investment decisions. Harmful investor behavior of buying high and selling low can be resolved by sticking to a long term passive strategy. By incorporating an annual rebalance, investors can keep their portfolio inline with their acceptable risk tolerance. By systematically rebalancing your portfolio, you are able to take advantage of market gyrations; enabling the investor to take advantage of volatility rather than being paralyzed by it.
Author Bio: Brad is the President and Chief Compliance Officer of Kattan Ferretti Financial L.P. He is responsible for the day-to-day management and oversight of client portfolios. He is a CERTIFIED FINANCIAL PLANNER™. In addition his role as an investment manager he is Vice President of Kattan Ferretti Insurance an insurance brokerage firm offering business, personal, life, and health insurance solutions.
Outside of Kattan Ferretti, Brad is a partner at NewEra Fund Management, which is currently incubating a hedge fund strategy that focuses on algorithmic and quantitative analysis to generate investment returns in excess of the market on a risk adjusted basis.
[Editors Note: To help understand the true cost of mutual funds you invest in, be sure to read up on Personal Capital. It’s a free service that will show you just how much your investments are costing you.]
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One of the first things I look at when investing in mutual funds is the expense ratio. I feel the higher the expenses are, then that might mean less dividends for all shareholders. Overall I stay away from any funds with expenses higher than .75%. To many options with lower fees and equal returns.
Great write up! There really is no good reason I can find to invest with mutual funds these days… The funds will just eat you alive!
Thank You!! We are doing our best to educate.
Very informative — I haven’t really looked much into mutual funds but this article gives a me good understanding about it. After all, there’s a reason Warren Buffett prefers low-cost index funds.
Great list, Jon.
Mutual funds days are numbers with the option of investing via ETFs. Articles like these help in getting the word across and educating others about the pitfalls of mutual funds.
Best wishes
R2R
Fees can be crazy high with mutual funds. I prefer the low cost of good index funds. I have noticed a few things about regular mutual funds though:
1. If you want to attempt to beat the market with a mutual fund, you will probably have to look at a fund with more fees, thus usually counteracting the higher earnings.
2. Mutual funds with low initial investment minimums generally have higher fees, but it can still be worth it if that’s the only way you can get started.
I prefer index funds to keep my expense ratio super low! Great post!
@Kalen @ MoneyMiniBlog: Kalen: Actually there is a correlation between higher cost and worse performance. Since investing is a zero sum game, the higher fees charged, the less likely you are to outperform. In fact an expense ratio is a greater indication of long term performance than the Morningstar fund rating (lower expense, better performance). I believe the statistic is something like over a 10 year period, accounting for survivorship, 82% of active funds underperformed their benchmark. I would like to do another post about active vs. passive historical long term results, there are some unique findings.
@Brad Roth: Thanks for responding, Brad! That’s exactly right. The higher costs end up eating away any higher returns. That is, if they even have the higher returns. I have noticed a few funds with a return that has beat the market, but only for a few years and the fees were so high that it ultimately underperformed. I prefer low cost index funds all the way. Actively managed funds are largely unnecessary. I would personally rather invest in individual stock, as to actively manage my own stocks. As far as funds go, index funds for me. Thanks for the reply.