Mutual funds: additional costs

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The cost of owning mutual funds is not limited to their respective expense ratios. An investor should be aware of the total cost of ownership, including the additional costs described on this page.

Transaction costs

In addition to fund acquisition and /or redemption charges, and the fund expense ratio, funds incur additional expenses that are not included in the fund's expense ratio. These expenses include fund transaction expense due to the buying and selling of fund securities. In general, these transaction costs closely track a fund's annual turnover rate: the higher the turnover, the greater the transaction cost. For equity funds transaction expense can be broken down into:

  • Brokerage commission expense: Brokerage commission expense is quantified and reported each year in a fund's statement of additional information. In a 2004 ZAG commissioned study,[1] authors Jason Karceski, Miles Livingston, and Edward S. O'Neal, found that in 2002, mutual funds paid an average commission of 0.38% and a weighted dollar commission (what investors actually held) of 0.19%. Lipper, in a 2004 study,[2], found that the average weighted commission paid by mutual funds measured 0.20% in 2003, with a range of expense between 0.01% and 8.73%.
  • Spreads: When a stock is bought or sold, there exists a spread between the purchase and selling price. This cost cannot be precisely quantified for mutual funds, but in general, spread costs are higher for small stocks than for large stocks; higher for illiquid stocks than liquid ones; and higher for international stocks as opposed to domestic stocks.
  • Market impact: A mutual fund making large transactions in a stock is likely to move the stock price before the order is completely filled. This transaction cost, similar to spread costs, must be estimated.

Total transaction costs are estimated to almost equal a fund's expense ratio.

  • Median mutual fund transaction costs have been estimated to measure between 70 and 85 basis points of annual cost drag (ranging from 55 basis points for large cap stocks up to 233 basis points for small cap stocks.)
  • Mean transaction costs are estimated at 144 basis points for the average fund, ranging from a mean of 77 basis points for large cap stocks to a mean of 285 basis points for small cap stocks.[3]

Transaction costs can be greatly reduced by the selection of passively managed, low turnover index funds. Brokerage expense for index funds measures to less than .01% for most large cap indexes, domestic indexes, up to .40% for emerging market stocks.[note 1]

Hidden costs

Mutual funds can derive investment services from soft dollars and directed brokerage practices. The SEC defines soft dollars as

... arrangements under which products or services other than execution of securities transactions are obtained by an adviser from or through a broker-dealer in exchange for the direction by the adviser of client brokerage transactions to the broker-dealer.

— SEC[4]

Directed brokerage is defined as:

In soft dollar arrangements, an investment adviser selects the brokers that will execute trades and provide research and other services to the adviser. In contrast, in a "directed brokerage" arrangement, a client asks its adviser, subject to the adviser's satisfaction that the client is receiving best execution, to direct commission business to a particular broker that has agreed to provide services, pay obligations or make cash rebates to the client.

— SEC[5]

As these costs are transaction costs, they are not a part of a fund's expense ratio. The sanctioned uses of soft dollar commissions are carefully defined:[6]

Section 28(e)[7] defines when a person is deemed to be providing brokerage and research services, and states that a person provides brokerage and research services insofar as he/she:

  • (A) furnishes advice directly or through publications or writing as to the value of securities, the advisability of investing in, purchasing or selling securities, or the availability of purchasers or sellers of securities;
  • (B) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy and performance of accounts; or
  • (C) effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required therewith by rules of the Commission or a self-regulatory organization of which such person is a member or person associated with a member or in which such person is a participant.
    — SEC

The SEC Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds[8] found the following:

While most broker-dealers provided only products and services which were clearly research, fully 35% of the broker-dealers that we examined paid for at least one product or service which appeared to be unrelated to research or execution.66 These products/services included, among other things: rent, computer hardware used for administrative or personal use, CFA exam review courses, AIMR membership dues, travel expenses, cable and satellite television for non-research areas, telephone service, employees' salaries, messenger services, consulting services, postage, parking fees, office equipment, word processing software, tuition and tax preparation services.

— SEC[9]

Harold Bradley, senior vice president of American Century Investments, estimates that fund companies do $10 billion annually in soft dollar business.[10]

Cash drag

Main article: Cash drag

Cash drag is a diminution of return caused by a cash position in a mutual fund. A mutual fund typically holds a cash position to facilitate redemptions and pending investments. Since underlying securities of a mutual fund, especially stocks, often have better long term returns than cash, a cash position tends to reduce the performance of the fund. Monthly reporting of mutual fund cash positions are posted at ICI: Trends in Mutual Fund Investing.[11]

Tax costs

Most mutual funds held in a taxable account have some sort of tax cost as they make one or more type of distributions, for which you have to pay tax even if you do not sell the funds. Tax cost comes from two sources - dividends and capital gains. In 2007, (the most recent year for which we have reported results) Lipper reports that shareholders in taxable fund accounts paid at least $23.8 billion in taxes on fund distributions of $418.5 billion, a cost amounting to 1.3 percent of assets.[12][note 2] Lipper estimates that over the past twenty years, the average taxable mutual fund investor paid taxes consuming 17 to 44 percent of fund returns.

Dividends are divided into two distinct tax categories: qualified dividends and non-qualified dividends. Some funds, typically taxable bond funds and REIT funds, tend to distribute non-qualified dividends. Equity funds tend to distribute some qualified dividends. Note that qualified dividends are taxed more favorably than non-qualified dividends under the current tax code.

Capital gains are also divided into two categories, namely short-term capital gains and long-term capital gains. Short-term gains are taxed at the marginal income tax rate; long-term gains are taxed at lower, tax-preferred rates. As the fund internally sells securities, the fund may realize capital gains. The gains that are not offset by the fund's loss carryforward must be distributed to the shareholders.

See also

Notes

  1. ↑ Vanguard brokerage commission data can be found in the following table
  2. ↑ Estimated taxes paid by investors on fund distributions for the 2005 -2007 are tabulated below:
    Estimated mutual fund tax cost on fund distributions
    Year Distributions Tax paid
    2007 $418.5 billion $23.8 billion
    2006 $200 billion $20 billion
    2005 $129 billion $15.2 billion

References

  1. ↑ Jason Karceski, Miles Livingston, and Edward S. O'Neal, "Portfolio Transactions Costs at U.S. Equity Mutual Funds"
  2. ↑ Mutual Fund Trading and Portfolio Transaction Costs
  3. ↑ Edelen, Roger M., Evans, Richard B. and Kadlec, Gregory B., "Scale Effects in Mutual Fund Performance: The Role of Trading Costs" (March 17, 2007). Available at SSRN: http://ssrn.com/abstract=951367
  4. ↑ Refer back to first
  5. ↑ Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds. September 22, 1998
  6. ↑ Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds. September 22, 1998
  7. ↑ Section 28(e)
  8. ↑ Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds. September 22, 1998
  9. ↑ Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds. September 22, 1998
  10. ↑ Investopedia: What are Soft Dollars
  11. ↑ ICI: Trends in Mutual Fund Investing
  12. ↑ Lipper Associates, 2007. "Taxes in the Mutual Fund Industry – 2007: Assessing the Impact of Taxes on Shareholder Returns", New York: Lipper Associates.

External links

Bibliography

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