It is no big secret that actively managed mutual funds generally have high fees which can be crippling to long term results. Net Expense Ratios have become widely circulated information and are the basis for many investment decisions. This is as it should be, expense ratio is very important, but the true cost of actively managed mutual funds is usually much higher than people realize because of hidden costs.
The total costs of actively managed mutual funds come from these four sources:
- Management Fees (if applicable)
These are pretty obvious. Most funds or managers charge between 0.75% and 1.5% of assets per year. Some unlucky folks end up paying someone a fee to pick other funds that charge full fees. If you are paying an advisor who buys full fee mutual funds for you, run.
- Trading Costs
By definition, active strategies trade more than passive index strategies. Commissions are so cheap these days that the direct cost isn’t usually meaningful, though it can still add up. The “Spread” can be much more important. The spread is really the difference between the bid price that someone is willing to pay for a stock and the ask price that someone is willing to sell a stock for. Let’s say you own Microsoft and the bid is $20.00, and you accept this because you want to sell. Then, a second later, you decide you want to own the stock again. Assume the asking price will be $20.01, so you will lose a penny to buy it back. For more liquid stocks like Microsoft, this usually isn’t a big deal. But for smaller stocks, bid/ask spreads can often add 0.5% or more to the cost of a trade. For funds that trade a lot, this can add up fast.
- Market Impact
Often ignored, this is the impact on a stock price from large amounts of buying or selling by a fund manager. For fund managers who need to move millions or billions of dollars around, market impact is very real. There is no way around it. When a major fund player decides to sell a stock, that stock will go down, and when it decides to buy, it will go up. The bottom line is paying higher prices when buying and accepting lower prices when selling. The impact is especially large in trades of smaller company stocks. This can easily reduce return by 0.5% to 1% per year for actively managed funds with more than a few hundred million dollars in assets. By definition, most investor’s money is in funds with large amounts of assets, often tens of billions of dollars.
Active mutual funds usually have relatively high turnover. Any time a gain is realized in a fund, it must be passed on to shareholders, meaning you pay the taxes on it whether you participated in the full amount of the gain within the fund. You may even pay capital gains taxes if you have a loss in a fund. The impact can be significant in long time horizons, perhaps up to 5% of total wealth.
Adding the four costs together, we see that active mutual funds have a built in disadvantage that usually runs between 1.0% and 3.5% each year. That may not sound like much, but if your total return assumption is a reasonable 7%, you are talking about up to half of your expected return. This should be unacceptable.
We urge you to consider the total costs, explicit and hidden, if you use mutual funds.