Mutual funds: additional costs

From Bogleheads

The cost of owning mutual funds is not just their respective expense ratios. You also need to be aware of the total cost of ownership, including the additional costs described in this article.

Transaction costs

In addition to a fund's acquisition and redemption charges, and its expense ratio, funds also have extra expenses not included in their expense ratios. These expenses include fund transaction costs from buying and selling fund securities. In general, these transaction costs are proportional to a fund's annual turnover rate: the higher the turnover, the greater the transaction cost. For equity funds, transaction expense breaks down into:

  • Brokerage commission expense: The fund's annual statement of additional information shows brokerage commission expense each year. 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%. In a 2004 study, Lipper[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 is 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.

Most estimates put total transaction costs as 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]

Choosing passively managed, low turnover index funds greatly reduces transaction costs. Brokerage expense for index funds measures less than .01% for most large cap indexes and domestic indexes, up to .40% for emerging market stocks.[note 1]

Hidden costs

Mutual funds can derive income from soft dollars and directed brokerage practices. The SEC defines soft dollars as:[4]

... 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

The SEC defines directed brokerage as:[4]

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

As these costs are transaction costs, they are not a part of a fund's expense ratio. The SEC carefully defines sanctioned uses of soft dollar commissions:[4]

Section 28(e)[5] 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[4] 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

Harold Bradley, senior vice president of American Century Investments, estimates that fund companies amass $10 billion annually in soft dollar business.[6]

Cash drag

Cash drag is an erosion of return caused by cash held by a mutual fund. A mutual fund typically holds cash for redemptions and for future investments. Because the underlying securities of a mutual fund, especially stocks, often have better long term returns than cash, holding cash tends to reduce the performance of the fund. The Investment Company Institute posts a monthly report of mutual fund cash positions.

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, 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.[7][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 split 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. You pay less tax on qualified dividends than non-qualified dividends under the current tax code.

Capital gains also split into two categories, namely short-term capital gains and long-term capital gains. You pay tax on your short-term gains at your marginal income tax rate; your long-term gains are taxed at lower, tax-preferred rates. As the fund internally sells securities, it may realize capital gains. The must distribute gains that are not offset by the fund's loss carryforward to its shareholders.

See also

Notes

  1. You can find Vanguard brokerage commission data in the following table
  2. The table below shows estimated taxes paid by investors on fund distributions for 2005-2007:
    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; Edward S. O'Neal (2004). "Portfolio Transactions Costs at U.S. Equity Mutual Funds" (PDF). Retrieved September 1, 2023.
  2. "Mutual Fund Trading and Portfolio Transaction Costs" (PDF). Archived from the original (PDF) on January 14, 2005.
  3. Roger M. Edelen; Richard B. Evans; Gregory B. Kadlec (March 17, 2007). "Scale Effects in Mutual Fund Performance: The Role of Trading Costs". Available at SSRN.
  4. 4.0 4.1 4.2 4.3 "Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and Mutual Funds". SEC. September 22, 1998. Retrieved September 1, 2023.
  5. "Section 28(e)". Archived from the original on January 6, 2002.
  6. "What are Soft Dollars". Investopedia. Retrieved September 1, 2023.
  7. 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