Mutual Fund Costs (--> Wiki)

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Mutual Fund Costs (--> Wiki)

Post by Barry Barnitz » Mon Sep 17, 2007 10:46 am

An expanded version of this page is available at The Bogleheads Wiki.


[contributions welcome]

A simple fundamental tenet of investment theory is that the net return of investment is reduced by the costs of investment.

Gross mutual fund returns are reduced by the following investment costs:

1. Management and Administrative costs
2. Distribution Costs

These charges are reflected in a fund's expense ratio.

The following charges are not reflected in the expense ratio.

3. Sales commissions (on broker sold "load funds")
4. Mutual Fund Transaction Costs. These include brokerage commission expense, spread expenses, and market impact expenses.

Vanguard illustrates the corrosive effects of investment costs:

Suppose you have $50,000 to invest. Let's say you invest half of it in Fund A with an expense ratio of 1.3%, and you put the other half in Fund B with an expense ratio of only 0.3%. Assuming an 8% rate of return, see what can happen to your investment in 20 years.


Image

Investing in Fund A could cost you $19,751


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John Bogle and Vanguard on Mutual Fund Costs

Post by Barry Barnitz » Mon Sep 17, 2007 11:00 am

John Bogle and Vanguard have much to say about mutual fund investment costs.

1. The Relentless Rules of Humble Arithmetic by by John C. Bogle
Founder and Former Chairman, The Vanguard Group
Financial Analysts Journal; November/December 2005
CFA Institute's "Bold Thinking on Investment Management: The FAJ 60th Anniversary Anthology,"; 2005

The overarching reality is simple: Gross returns in the financial markets minus the costs of financial intermediation equal the net returns actually delivered to investors. Although truly staggering amounts of investment literature have been devoted to the widely understood EMH (the efficient market hypothesis), precious little has been devoted to what I call the CMH (the cost matters hypothesis). To explain the dire odds that investors face in their quest to beat the market, however, we don't need the EMH; we need only the CMH. No matter how efficient or inefficient markets may be, the returns earned by investors as a group must fall short of the market returns by precisely the amount of the aggregate costs they incur. It is the central fact of investing.


2. In Investing, You Get What You Don't Pay For by John C. Bogle
Founder and Former Chairman, The Vanguard Group
The World Money Show
February 2, 2005
Orlando, Florida
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Academic Studies on Mutual Fund Costs

Post by Barry Barnitz » Mon Sep 17, 2007 11:41 am

Academic studies on mutual fund costs:

1. Mutual Funds Fees Around the World by Khorana, Ajay, Servaes, Henri and Tufano, Peter, (July 23, 2007). HBS Finance Working Paper No. 901023
Using a new database, we study fees charged by 46,580 mutual fund classes offered for sale in 18 countries, which account for about 86% of the world fund industry in 2002. We examine management fees, total expense ratios, and total shareholder costs (which include load charges). Fees vary substantially across funds and from country to country. To explain these differences, we consider fund, sponsor, and national characteristics. Fees differ by investment objectives; larger funds and fund complexes charge lower fees; fees are higher for funds distributed in more countries and funds domiciled in certain offshore locations (especially when selling into countries levying higher taxes). Substantial cross-country differences persist even after controlling for these variables. These remaining differences can be explained by a variety of factors, the most robust of which is that fund fees are lower in countries with stronger investor protection.


2. The Use and Abuse of Mutual Fund Expenses by Houge, Todd and Wellman, Jay W., (January 31, 2006)
Prior research shows that mutual fund investors are often aware of up-front charges like sales loads, but they are less mindful of annual operating expenses, even though both types of fees lower overall performance. This study documents the historical trend and recent abuse of annual mutual fund expenses. As the industry becomes more adept at segmenting customers by level of investment sophistication, we claim that load mutual fund companies take advantage of this ability and charge higher expenses to their target customer: the less-knowledgeable investor. No-load fund companies, who tend to attract the more sophisticated investor, offer lower expenses. For example, over 2000-2004 the average annual expense ratio of load equity funds was 50 basis points higher than no-load equity funds. We show evidence of this widening cost disparity since the early 1990s among new and existing equity, bond, and index funds. We also document a growing abuse of sales distribution or 12b-1 fees among funds that are closed to new investors, almost all of which are load funds. Thus, load fund investors are more susceptible to paying higher expenses and receiving lower returns over time.


3. Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transactions Costs, and Expenses by Wermers, Russ, THE JOURNAL OF FINANCE • VOL. LV, NO. 4 • AUGUST 2000
We use a new database to perform a comprehensive analysis of the mutual fund industry. We find that funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent. Of the 2.3 percent difference between these results, 0.7 percent is due to the underperformance of nonstock holdings, whereas 1.6 percent is due to expenses and transactions costs. Thus, funds pick stocks well enough to cover their costs. Also, high-turnover funds beat the Vanguard Index 500 fund on a net return basis. Our evidence supports the value of active mutual fund management.


4. Scale Effects in Mutual Fund Performance: The Role of Trading Costs by Edelen, Roger M., Evans, Richard B. and Kadlec, Gregory B., (March 17, 2007)
Berk and Green (2004) argue that investment inflow at high-performing mutual funds eliminates return persistence because fund managers face diminishing returns to scale. Our study examines the role of trading costs as a source of diseconomies of scale for mutual funds. We estimate annual trading costs for a large sample of equity funds and find that they are comparable in magnitude to the expense ratio; that they have higher cross-sectional variation that is related to fund trade size; and that they have an increasingly detrimental impact on performance as the fund's relative trade size increases. Moreover, relative trade size subsumes fund size in regressions of fund returns, which suggests that trading costs are the primary source of diseconomies of scale for funds.


5. An Analysis Of Mutual Fund Trading Costs by Chalmers, John M.R., Edelen, Roger M. and Kadlec, Gregory B., (November 23, 1999)
We directly estimate annual trading costs for a sample of equity mutual funds and find that these costs are large and exhibit substantial cross sectional variation. Trading costs average 0.78% of fund assets per year and have an inter-quartile range of 0.59%. Trading costs, like expense ratios, are negatively related to fund returns and we find no evidence that on average trading costs are recovered in higher gross fund returns. We find that our direct estimates of trading costs have more explanatory power for fund returns than turnover. Finally, trading costs are associated with investment objectives. However, variation in trading costs within investment objectives is greater than the variation across objectives


6. Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry by Bergstresser, Daniel B., Chalmers, John M.R. and Tufano, Peter, (January 16, 2006)
Many investors purchase mutual funds through intermediated channels, engaging and paying brokers or financial advisors for fund selection and advice. This paper attempts to quantify the benefits that investors enjoy in exchange for the higher costs they pay in order to purchase funds through the broker channel. We focus on five measurable potential benefits to consumers of brokered fund distribution: (a) Assistance selecting funds that are harder to find or harder to evaluate; (b) Access to funds with lower costs excluding distribution costs; (c) Access to funds with better performance; (d) Superior asset allocation, and (e) Attenuation of behavioral investor biases. Exploring these dimensions, we do not find that brokers deliver substantial tangible benefits. In short, while brokerage customers are directed toward funds that are harder to find and evaluate, brokerage customers pay substantially higher fees and buy funds that have lower risk-adjusted returns than directly-placed funds. Further, brokered funds exhibit no better skill at aggregate-level asset allocation than funds sold through the direct channel. This analysis implies that any benefits that exist must be found along less tangible dimensions.
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