How Expensive Are Mutual Funds, Really?

Folks, I’ve been in the investment/financial industry for a long time, going back to 1998 when I landed my first job at Vanguard.

If there is any one thing I’ve noticed about this industry is how ‘hidden’ fees are on various products.  ALL products have fees.  Let me repeat that ALL PRODUCTS HAVE FEES!  How do you know there are fees? Because if people didn’t make money selling the various product, the product would not exist. It’s really that simple.

For this blog post though I want to focus on one of my pet peeves and that is mutual fund fees. In future posts I’ll focus on other products and their fees, don’t you worry.  But for now, let’s just focus on the elephant in the room because more investors have mutual funds than any other type of investment.

Mutual Fund Expense Ratio

When asked what the fees are of a particular mutual fund most people, and advisors, will go to a website and look up the Expense Ratio.  Here’s an example using the Fidelity Magellan mutual fund:

You can see the Net Expense Ratio is .67%.   In 2019, this fund ran just a bit more than half of the industry average for its peer group. Not too shabby.

So, most consumers, and advisors I am sorry to say, would stop there and say Fidelity Magellan fees are .67% thus it costs $6.70 per $1000 invested per year.   That is pretty low relative to industry averages, they’d say. And, of course, that is a correct statement.  .67% expense ratio is quite impressive. Kudo’s must go out to Fidelity.

More Fees Than Just Expense Ratio

The expense of your fund doesn’t stop at the expense ratio!  Trading costs are also an expense that is not part of that expense ratio.  Here’s what a couple finance professors found:

“We found that funds’ annual expenditures on trading costs were comparable in magnitude to the expense ratio.”

This means that the actual trading costs of the funds are essentially the equivalent of the fund’s expense ratios, thus DOUBLING the cost of the funds! But where do you see those costs??? You can’t.  Trading costs are nowhere to be found. It’s completely hidden from the view of the investor.  Unfortunately, while one may not be able to see what it costs for the fund to trade, one will certainly bear it because trading costs are not free.  Ignorance, once again, is not bliss when it comes to your investments.

I wish I could say it’s just a couple rogue professors making this argument about fund costs.  But it’s not. This has been an industry bugaboo for years. John Bogle, the founder of Vanguard and many others have cited these hidden costs as a way investors are not capturing all the gains they should be.

So, how then can you estimate the trading costs of a fund, given it is such a prominent expense and one that is not transparent?  Consumers and advisors alike would say “Look at the turnover.”  Turnover is the percent of the portfolio that is traded every year.  A fund with a 100% turnover means that fund trades its entire holdings each year. A fund with a 50% turnover means that fund trades half its holdings each year.

Example of Turnover

Going back to Fidelity Magellan here is their chart from 2019.

You can see towards the very, very bottom of the screen we have a turnover percentage of 51%.  Quick quiz to see if you’ve been paying attention.  If Fidelity started the year with 100 stocks, how many stocks were traded during the year?

I’ll let you figure that out. But just remember turnover is the percentage of the portfolio that has been traded during that year.

However, does turnover give a TRUE indication of the trading costs of the fund? Not according to our good professors.

“For example, a $500 million small-cap fund with 50% turnover will have much higher trading costs than a $100 million large-cap fund with 100% turnover, despite the former’s lower turnover.”(emphasis mine)

So, while it may seem you’re doing your due diligence while analyzing turnover AND expense ratios to get an idea of the true cost of the mutual fund you’re investigating, unfortunately there is truly no way to know the actual costs.  And that’s not good.

Huge Difference in Fund Performance

Because to go back to our professors one final time, “the difference in average annual return for funds in the highest and lowest quintiles of aggregate trading cost is -1.78 percentage points.”

You read that right 1.78% you could lose in returns if your fund has large trading costs. Unfortunately there is absolutely NO WAY for you to know what those trading costs are.  A funds prospectus won’t tell you the trading costs. The SEC doesn’t tell you a funds trading costs.  So, you literally do not know! And here is the author’s final conclusion:

“Overall, we conclude that so-called invisible trading costs have a material and negative effect on fund returns.”

You can’t any more clear than that.  Trading costs hurt returns. Trading costs though can not be identified which is a shame because investors are losing money to fees they don’t see.

What’s the solution?

Well, most likely, if a fund’s turnover is low, it’s not trading much.  A true index funds for instance, have turnover less than 10%.  Now, as we stated above, turnover is not the same as trading costs. However, one can make an assumption that a very low turnover will give one reason to believe that trading isn’t being done frequently thus keeping trading costs low.

Secondly, you CAN view each funds internal expenses.  Funds with higher expenses and higher trading costs will have a MUCH harder time capturing market returns.  There really is not other way to look at it.

Those funds have significant headwinds in their fees they need to overcome.  Some funds WILL overcome those fees, most won’t.  And unfortunately, the ability to identify which funds WILL overcome the fees in advance, is something no investor has ever proven the ability to do consistently.

I wish  could say there were better ways to positvely identify funds that will capture market performance. That ability just doesn’t exist. So, what a good investor will do and her advisor is identify funds to own via process of elimination.

Remove funds with high fees which can be identified. And remove funds that look like there could be high trading costs too.  The only way I know how to do that is start with turnover.  Low turnover MAY, and I have to emphasize may because there is no way to know for sure, but low turnover may indicate lower trading costs.

Another article for your review. Why You Should Invest in Morningstar 5-Star Funds. Click here.
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