The Hidden Costs of Mutual Funds

 

With the push to increase the transparency with what investors pay for advice, one area that is not truly transparent are the costs associated with mutual funds. While mutual funds do disclose their expense ratios, many costs are not published, and can erode your real returns. Here are a couple of examples of these costs, and what you can look out for.

Disclosed Costs: The disclosed costs of mutual funds are supposed to be revealed to you. But there are many of these costs. For example, there can be shareholder fees, which can consist of front-end loads, back-end loads, purchase fees, redemption fees, exchange fees, and account fees. There is also the expense ratio, which includes operating costs, management fees, 12b-1 distribution fees, and administrative costs.

How much do they cost? According to a study published in the Financial Analyst Journal that was authored by finance professors at the University of California Davis, University of Virginia, and Virginia Tech, the average expense ratio is 1.19%.

Hidden Costs: Mutual funds conduct trades, many on behalf of other investors. For example, after you buy a mutual fund, the mutual fund will continue to accommodate other investors as they invest into and divest out of the mutual fund. Their trading on behalf of other investors imposes a cost onto you. There are three sources of these costs. First, mutual funds must pay brokerage commissions when they trade. This cost is shared by all mutual fund investors. Second, mutual funds will often purchase securities from dealers at ask prices and sell securities to dealers at bid prices. Ask prices are higher than bid prices. This bid-ask spread represents the dealer’s profits. Because mutual fund investors are commingled, the profits that go to dealers when mutual funds trade - in order to accommodate other investors entering or exiting the fund - impose a cost onto the fund, which is shared by all investors. Third, when mutual funds trade, because their trades are often so large, their trades can cause securities’ prices to move. Their buying can push prices up, and their selling can push prices down. This is known as price impact, but because the price of the impacted securities tends to subsequently return to its previous price, price impact causes mutual funds – and you – to lose money.

Costs Due to Tax Inefficiency: Mutual funds are infamous for their tax inefficiency. Here is a sample illustration. Suppose you buy a mutual fund and it contains a stock valued at $50/share. Let’s suppose the stock price later drops to $40/share. Assuming no other stock prices change, you have lost money in your investment. Now let’s suppose the mutual fund decides to sell the stock. It is possible that the fund purchased the stock at $30/share before you purchased the mutual fund. This means mutual fund investors must pay a capital gains tax on the $10/share profit that the fund realized (i.e., it bought the stock at $30/share and sells it at $40/share). As an investor in the fund, you can share the burden of this tax. This means you can pay taxes for capital gains that you did not personally enjoy, even if you lost money on the mutual fund investment.

How much do they cost? According to Morningstar, the average cost of mutual funds’ tax inefficiency is about 1.10%.

The Total Cost: So, in total, how much can mutual fund costs eat away at returns? A lot. Here’s a simple illustration: Suppose you have $100,000 to invest in the stock markets, and the markets go up in value by 8% after you invest. You might think that you will make $8,000. But if you invested that $100,000 in a mutual fund, then your returns can be much less. Here’s my estimate. While the market has increased by 8%, your returns could be eroded by disclosed costs (1.19%), hidden costs (1.44%), and costs associated with the tax inefficiency of the mutual fund (1.10%). These costs could leave you with just 4.27%, or only $4,270 instead of the expected $8,000.

If you’re concerned about your mutual funds or have other questions about your investment, we’re happy to offer a complimentary review of your portfolio with no obligation. We know that everyone’s situation is unique, and to truly offer you the best advice we can, we need to learn more about your situation. To set up a brief phone call, or an in person meeting with our of our advisors, you can call us at 216.520.1711, email us at Quarterback@Lineweaver.net, or simply click here.

Securities offered through Triad Advisors. Member FINRA/SIPC. Advisory services offered through Lineweaver Wealth Advisors, LLC. Lineweaver Wealth Advisors, LLC, is not affiliated with Triad Advisors. Information contained herein is not tax advice and should not be considered as such.  Each individual’s tax situation is unique and different. For advice related to your specific tax situation, please contact your personal tax professional

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Posted by Lineweaver Financial Group in Mutual Funds, Expense, Costs

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