Hidden Costs of Mutual Funds

A recent Wall Street Journal article highlighted a well kept secret of mutual funds:  investors may be paying more for their mutual funds than they realize.  Most investors are familiar with the “expense ratio” charged by funds.  These fees typically cover the cost of the portfolio manager and other expenses involved with operating the fund.  According to Morningstar, the average expense ratio of U.S. stock mutual funds is 1.31% of total assets.  For comparison, the average expense ratio on similar ETFs is 0.29%.  However, what many investors don’t realize is that this expense ratio doesn’t include charges related to buying and selling securities for the fund – charges that are typically hard for investors to quantify due to either poor or non-existent disclosure by funds.

So what exactly are these additional charges and how much can they cost investors?  The article highlights four main components of these charges:  brokerage commissions, bid-ask spreads, market impact costs, and opportunity costs.  Brokerage commissions are simply the charges a fund incurs to buy and sell securities.  The bid-ask spread is essentially the difference between the highest price that a buyer is willing to pay for a security and the lowest price for which a seller is willing to sell that security.  This spread can impact returns since a fund continually buys securities at the higher price and sells at the lower price.  Market impact costs result from funds causing a change in the price of a security before their trade has been completed due to the size of the trade and the liquidity, or lack thereof, of the security.  Opportunity costs arise when fund managers can’t purchase or sell a security at a desired price because of this market impact.  A study conducted last year puts these total costs at an average of 1.44% of total assets.  This is in addition to the 1.31% average expense ratio.

While ETFs also have exposure to these transaction costs as securities are bought and sold to track a targeted index, these passively managed products typically have a fraction of the turnover of actively managed funds.  With a number of mutual funds averaging more than 100% turnover, these hidden costs can soar and erode investor returns.  And when investors factor in research indicating that the majority of active mutual fund managers underperform their benchmark index, they’ll have to ask themselves if they’re getting what they pay for.