A new study shows that mutual fund investors pay substantial expenses they don’t even know about. In some instances these expenses are larger than the easily obtained “annual expense ratio” figure— so it is possible that some of your fund choices cost twice as much as you think.
No, this is not a call for Eliot Spitzer.
The central issue here isn’t moral turpitude. It is the long-term impact of expenses on fund performance. (Needless to say, better disclosure would help.)
The study, “Portfolio Transaction Costs at U.S. Equity Mutual Funds” by Jason Karceski and Miles Livingston at the University of Florida and Edward S. O’Neal at Wake Forest University, deals with one of the big grey areas of mutual fund costs— transaction costs. Brokerage commissions can be objectively known but are not readily available. They are mentioned in some fund prospectuses, but not in others. To have regular access to brokerage expenses you need to access a little-known SEC filing, the SAI (for Statement of Additional Information).
Even then, your knowledge will be incomplete because an important part of transaction costs can only be estimated. It is the bid-ask spread on any trade— the difference between the market maker’s bid/ask prices. For mutual funds, whose transactions can affect market prices, this looms larger than direct brokerage commissions.
The researchers found that brokerage commission costs averaged 38 basis points (0.38 percent) as a percentage of fund assets. This amount was smaller than the bid-ask spread cost, which averaged 58 basis points or 0.58 percent of fund assets. The 96 basis points total, or 0.96 percent, is higher than the expense ratios of many large mutual funds. Add that to the average domestic equity fund expense ratio of 1.26 percent and the average fund carries a total cost burden of 2.22 percent. Many, of course, have higher expenses and many have lower expenses.
The researchers also found that transaction expenses consistently declined when dealing with larger funds, large cap funds versus small cap or foreign funds, and index funds versus managed funds.
There are some very uncomfortable messages here for those seeking performance from active management.
- Small-Cap Investing May Be Self Defeating. According to Ibbotson Associates, small cap stocks returned 12.7 percent annually over the 1926-2003 period, a 2.3 percent annual advantage over the 10.4 percent annual return of large cap stocks. Small cap growth funds, however, had expense ratios averaging 1.28 percent annually and their annual trading costs were greater than their expense ratios. One implication: a low cost large cap index fund is likely to do as well with about 2/3rds the risk.
- Small “Unknown” Funds Have a Major Cost Dis-advantage. One of the staples of media reporting on mutual funds is to find little known funds that have done well in the last three months to one year and “discover” them. Unfortunately, recent performance can be a flash in the pan while the cost disadvantages of smaller funds can weigh down long term-performance. While the average domestic fund in the study had combined transaction costs of 80 basis points, an asset weighted calculation of the same costs cut the burden to only 38 basis points. Larger funds tend to have lower costs.
- Over Long Time Periods, Index Investing Has A Major Cost Advantage. As I’ve pointed out many times, when you buy a major index fund with a 1 percentage point cost advantage over the typical managed fund, it’s hard for the managed fund to catch up. In fact, the advantage is even greater. While the average managed domestic fund has total transaction costs of 80 basis points, a large index fund has total transaction costs of only 7.5 basis points, less than 1/10th as much. That makes the total cost difference over 172 basis points, or 1.72 percent a year. Recently, the difference between being in the bottom 25 percent and the top 25 percent of all large blend funds was only 1.57 percent annually over a 15 year time period.
What does it all mean?
Costs matter. All costs matter. Without clear demonstrated management superiority, we’re better off index investing than choosing managers. And if we do get into the manager picking game, we should have a bias toward those who run the large funds with limited portfolio turnover.
On the web:
The Mutual Fund Transaction Cost Study:
http://www.zeroalphagroup.com/headlines/hiddenstudy111704.html
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
(c) Scott Burns, 2022