The True Cost of Owning a Mutual Fund

Paul DursoAsset Management, Investing, Planning, Retirement, Risk ManagementLeave a Comment

I teach financial class in several states and of all those classes, I have yet to run into an individual who truly understands to actual cost of a mutual fund. So, I wanted to simplify the cost breakdown for you. In order to do that, I have evaluated six different areas: expense ratio, transactions (commission & market costs), taxes, cash drag, soft dollar compensation and advisory fees. That’s a lot to take in, isn’t it!? Just wait until you see the numbers!

Expense Ratio

This is the most understood cost of mutual funds out there. This is the expense that is deducted to pay for marketing costs (12b-1 fees), distribution costs and mutual fund management fees. Most of the time, these costs can be found in the mutual funds prospectus. The National average cost for expense ratio is now .90% per year according to a Morningstar article written by Russel Kinnel.

Transaction Costs

A study conducted in 2007 by Edelen, Evans and Kadlec discovered that the average US mutual fund accumulates 1.44% in transaction costs per year. This cost can be very hard to figure out and will not typically be found in the prospectus.

Tax Costs

Most investors pay a fair share of taxes generated by mutual funds. Most investors don’t notice these taxes, unless they are holding the mutual funds outside of an IRA, 401k or other tax differed account. Unfortunately, mutual funds allow for new investor to pay taxes on gains that older investors received, even if the newer investor didn’t profit from that gain. According to Morningstar, the average tax cost ratio for a stock fund is about 1.10%.

Cash Drag

Cash drag is the ability for the mutual fund manager to maintain liquidity in the fund for potential buying opportunities and possible redemption responsibilities, if someone sold the mutual fund. A study conducted by William O’Reily and Michael Preisano who both hold their CFA desinations say that the average cost of cash drag in a large cap mutual fund is .83% annually. It should also be noted that cash drag can negatively affect a mutual fund performance in  a good market but can also help the performance in a negative market.

Soft Dollar Cost

This is one of the most difficult expenses to estimate. Soft dollar costs are another way mutual fund companies find compensation. Essentially, this is a quid pro quo arrangement. Mutual fund managers get research and or other benefits in exchange for the mutual fund transaction business through their brokerage house at a premium rate. This tends to keep the cost and expenses out of the way and become very difficult to determine. I am unable to find research to give what I would consider to be accurate information to be detailed in this blog, so we are not going to include it in our calculations at the bottom.

Advisor Costs/Fees

The final cost will only be associated to those who work with advisors who charge a fee for their supervision of mutual fund management. Many fee based or fee only advisors will manage an investor’s portfolio for an annual fee ranging from .50% to 2.50% of the annual balance. This fee is required to be disclosed and is charged in addition to all other fees mentioned above.

Summary of Costs

Below you will see a summary of all categories mentioned above, excluding soft dollar cost and advisor fees. If you are working with an advisor who charges an annual fee that manages mutual funds, it would be advisable to add his fee to your calculation to get a better range of what you are paying to hold your mutual fund portfolio.

Expense Breakdown

Non-Taxable Account Taxable Account
Expense Ratio 0.90% 0.90%
Transaction Costs 1.44% 1.44%
Cash Drag 0.83% 0.83%
Tax Cost 0.00% 1.00%
Advisor Fees
Total Cost 3.17% (not counting advisor fees) 4.17 (not counting advisor fees)
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As you can see above, mutual funds may cost much more than most individual investors realize. On the flip side, mutual funds can provide many benefits if used properly.

Closing Comments

As I state in all of the classes I teach: “If you own something, I hope you can answer the following question.” What is the reason you bought that investment and why should you keep it?

Owing mutual funds are not bad, but there might be other ways to invest without all of those expenses.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]

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