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Beware Hidden Costs of Mutual Funds – Massachusetts

By Harry S. Margolis

Robert M. Skloff of Silver Pine Capital recently told me about an article in Forbes Magazine that estimates the average annual cost of owning mutual funds as about 3% for retirement plans and 4% for taxable investments. This does not include any cost charged by a financial advisor or 401(k) manager, which generally average 1% annually. Over time, these costs can easily cut the value of a retirement plan by more than 50%.

The article, “The Real Cost of Owning a Mutual Fund,” by Ty A. Bernicke lists the following costs:

  1. Expense Ratio. This is the published cost of the mutual fund, which averages .9% per year.

  2. Transaction Costs. These are hidden costs, including brokerage commissions for trading stock, which will be higher for actively-traded funds. Bernicke also argues that mutual funds that buy and sell large amounts of stock actually move the market, increasing the cost of purchasing shares and lowering the price when selling. This cost, presumably would be smaller both for smaller funds and for funds that do not trade often. Bernicke cites an article estimating these costs as averaging 1.44% per year across all mutual funds invested in stock.

  3. Tax Costs. For mutual funds owned outside of retirement plans, Bernicke estimates an annual 1% tax cost, largely for capital gains when shares of stock in the fund are sold. While the fund might realize gains, the owner may not profit because she may have bought into the fund after the share value had increased. So, she may be paying taxes on gains she never realized.

  4. Cash Drag. All mutual funds hold some money in cash in order to take advantage of opportunites to buy into the market and to pay out redemptions for people selling their holdings. Investors, however, pay their .9% expense ratio on these funds which they could otherwise leave in a bank account or certificate of deposit. Further, if the market is rising over time, the cash portion of the mutual fund does not go up with it. (Of course, this also minimizes losses when the market drops.) Bernicke estimates the average cash drag of mutual funds as .83% per year.

Over time, an extra 2% a year in costs can seriously harm the value of an investment portolio, reducing it by 20% over a decade, 40% over 20 years, and by more than half over the 30 plus years most people save for retirement, not even counting for the effect of compounding the costs over time.

Many of these virtually disappear for investors who purchase index or exchange traded funds. Such funds often have expense ratios of less than a tenth of a percent, experience very little trading, and are virtually fully-invested. However, since building a well-diversified portfolio can be a rather complicated undertaking, both Bernicke and Skloff also make the case that owning a diversified portfolio of individual stocks. Not only does this permit the investor to avoid these hidden costs, but she can control her fate in terms of realizing capital gains. Moreover, Skloff argues that a low-cost combination of ETFs and actively-managed individual securities offers the best of both worlds: a well-diversified portfolio without the high costs typically associated with mutual fund investing.

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