The Hidden Costs Inside Mutual Funds

Investors pay, on average, 0.35% more for an index-tracking mutual fund than for an index-tracking ETF, based on the expense ratio.

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They say you get what you pay for, but sometimes you don’t. Even when you do, you may not understand how much you had to shell out and exactly what for. In the case of mutual funds, you may have to pay a lot more than you realize—and keep paying for as long as you own them.

Typically, mutual funds that passively track a stock or bond index are cheaper to operate than actively managed funds. Exchange-traded funds (ETFs) are even cheaper because nearly all ETFs track indexes, too, and the ETF structure lets them do that more efficiently than mutual funds.

Mutual funds are usually more expensive than ETFs.

The average asset-weighted total expense ratio (TER) for a mutual fund investing in a blend of all equities is 0.74% of assets, according to the most recent information from the Investment Company Institute. That number encompasses the management fee and certain other outlays. Because many of those costs are fixed costs (the same regardless of the size of the fund), smaller funds tend to have larger expense ratios, all things being equal. The “asset-weighted” average corrects for that phenomenon. The corresponding figure is 0.39% for ETFs, according to Morningstar.

So a mutual fund costs you 35 basis points more than an ETF right there—or $3.50 for every $1,000 invested per year.

These higher expenses come out of shareholders’ pockets. That helps to explain why a majority of actively managed funds lag the net performance of passively managed funds, which lag the net performance of ETFs with the same investment objective over nearly every time period.

These higher expenses come out of shareholders’ pockets.

Funds are required to disclose their TERs, so at least investors can make an informed choice about whether owning a mutual fund or availing themselves of a manager’s skill is worth the extra money. Fair enough. The problem is that the TER is not the only cost of fund ownership; there are others that can be significant but are not clearly disclosed and, therefore, harder for investors to quantify.

Add trading and turnover costs.

It should come as no great shock that there can be a lot of activity involved in actively managing a mutual fund, but the sheer amount of trading may surprise investors. Many funds have an annual turnover exceeding 100%, meaning that every stock or bond bought for the portfolio is sold, on average, within a year. It’s also not uncommon for funds to take positions in hundreds of securities, producing a frenzy of trading.

A fund’s TER includes the expense incurred when investors buy or sell fund shares, but it doesn’t account for trading costs incurred by the fund itself, such as brokerage commissions (for the fund’s active trading), the bid-ask spread (the gap between what the seller of a security receives and the higher price that the buyer pays), and market impact. That’s the term applied to the fact that a big order can move a stock’s or bond’s price disadvantageously; buyers may have to pay more than prevailing market prices to find enough shares to fill their orders, and sellers may have to accept lower prices to dispose of all of their shares.

When you add up all these costs, well, they add up. A study by the think tank Demos highlighted research indicating that a fund’s trading costs can exceed its TER, more than doubling the total cost. ETFs and other index funds can have large numbers of holdings and incur trading costs, too, but they tend to be far lower, as the portfolio holdings change only occasionally. That means that the true gap in expenses between ETFs and actively managed mutual funds may be far wider—and impact returns to a far greater extent—than the difference in TERs.

Add load fees.

The added expense of active management doesn’t stop there. The way that financial advice is dispensed and paid for has changed dramatically in recent years, but some funds still tack on a sales charge, or load, ostensibly to compensate the investor’s advisor. A typical load is 5% and assessed when a fund is bought—though it can be lower. Still, investors pay.

Todd Rosenbluth, director of fund research at S&P Capital IQ, a financial data provider that is part of McGraw-Hill Financial, pointed out that some funds feature a trailing commission instead, say 1% deducted from a fund’s returns, that’s kicked back to the advisor for every year that the shareholder remains invested. “Trailing fees are spelled out front and center, but people may not realize it,” Rosenbluth said. “That’s 1% a year on top of everything else.”

Lastly, add taxes.

Beyond sales charges, trading costs, and administrative and marketing expenses, “everything else” includes tax liability. ETFs and mutual funds alike are required to distribute capital gains to shareholders each year. Distributed (taxable) gains are likely to be higher in the case of actively managed mutual funds because they engage in more trading in the normal course of running their portfolios and also because they must do more buying and selling to accommodate investors entering and exiting their funds.

To make matters worse, investors often are forced to pick up someone else’s tab. The gains that a fund distributes may have been realized on positions held for many years, Rosenbluth explained, but all current shareholders, even recent investors in the fund, are on the hook for them. The amount can be substantial after a lengthy bull market.

“What we saw in 2014 is that some actively managed mutual funds had capital gains of as much as 10% of net asset values,” he said. “Active management creates capital gains [and the taxes on those gains] eat into investor returns more than you realize.”

Sometimes managers organize their buying and selling to be as tax-efficient as possible, he added. They try to book long-term gains instead of short-term gains or wait until after the start of the year to lock in a gain. But other managers pay far less regard to tax issues, he noted.

In contrast, the ETF structure can provide a persistent boost in returns.

What’s so insidious about hidden fund costs is that they are seldom seen but always there, eroding returns year in and year out. But it works in reverse, too. Any savings that accrue from owning vehicles with lower expense ratios like ETFs, for example, will provide a persistent boost to returns for as long as investors own them. To be sure, some brokerages do add trading and other fees for ETFs as well, but generally ETFs will be less expensive.

As Rosenbluth put it, by owning more expensive funds, “you’re already starting off behind on your goals, so anything you can do to shave those costs down will help you get ahead of the game.”