The adage ‘you get what you pay for’ doesn’t always hold true. Sometimes, you don’t. And even if you do, understanding how much the true cost was (and exactly what it was for) can get confusing. As far as mutual funds are concerned, clients may have to pay a lot more than they realize—and these costs continue for as long as clients retain ownership.
Generally speaking, mutual funds that passively track stock or bond indexes are cheaper to operate than actively managed funds. ETFs are even more cost-effective—mostly because nearly all ETFs track indexes as well, and the structure they provide allows exchange-traded funds to accomplish this more efficiently than mutual funds.
Mutual Funds are more costly than ETFs
The most recent information available on the market reveals that the average asset-weighted total expense ratio (or, TER) for mutual funds that are investing in a blend of all equities is .74% of assets. This number also encompasses management fees, and certain other outlays. The majority of these are fixed costs (the same no matter the size of the fund) although smaller funds tend to carry larger expense ratios. The corresponding numbers for exchange-traded funds are .39%.
So, right off the bat, a mutual fund costs clients 35 basis points more than ETFs. This equals out to $3.50 for every $1,000 invested on an annual basis.
This higher expense come directly out of client’s pockets—helping to explain why a vast majority of actively managed funds lag net performance comparable to that of passively managed funds, and passively managed funds lag the net performance of ETFs that have the same investment objective over pretty much every single period.
Mutual funds, thankfully, are required to disclose their total expense ratio (TER)—so financial planners and investment advisors can assist clients at making informed choices about whether they should own a mutual fund or if availing themselves of a manager’s skill are worth the increased cost. The problem arises when the TER is not the only cost of fund ownership—there are plenty of other costs that can be significant but lack the transparency and disclosure that the TER has—therefore, making it increasingly difficult for investors and their advisors to quantify.
Don’t Forget Trading and Turnover Costs
It’s no great surprise that there are a lot of activities involved in actively managed mutual funds—the sheer amount of trading could come as a surprise to investors. A large number of mutual funds have annual turnovers that exceed 100%– this means that every stock or bond purchased for the portfolio has been sold within a year on average.
A mutual fund’s total expense ratio also includes the expenses incurred when investors buy or sell fund shares—but doesn’t account for trading costs that are incurred by the actual fund (brokerage commissions for the fund’s active trading, bid-ask spread, market impact, etc.). This all boils down to the fact that big orders can move stock/bond prices disadvantageously.
A recent study highlights research that shows a fund’s trading costs can quickly exceed its total expense ratio—more than doubling the total cost of ownership. ETFs, among other index funds, can have a large number of holdings—incurring trading costs as well, but these tend to be far lower—portfolio holdings change only occasionally. This means that the true gap in expenses between ETFs and actively managed mutual funds could be far larger than previously thought—impacting returns to a far greater extent than differences in TERs.
Finally, Account for Taxes.
Even with sales charges, trading costs, as well as administrative and marketing expenses, ‘everything else’ also includes tax liability. ETFs and mutual funds are both required to distribute capital gains to shareholders on an annual basis. Distributed (or taxable) gains are more likely to be higher when it comes to actively managed mutual funds as they engage in more trading through the normal course of running their portfolios. Also, they must do more buying and selling to accommodate investors entering and exiting the funds.
To make it even harder to swallow, clients who invest in mutual funds are often forced to pick up someone else’s tab. The gains that these funds distribute may have been realized on positions that were held for many years, but current shareholders—even recent investors in the fund—may foot the bill. This can be a substantial amount after a lengthy bull market.
ETFs Can Provide Persistent Boost in Returns
The worst part about hidden fund costs is that they’re rarely seen, but are always there—eroding clients’ returns year in and year out. This can work on the reverse end too, any savings accrued from owning investment vehicles with lower expense ratios (like ETFs, for example) may provide a persistent boost to returns for the entire time that clients own them. Some brokerages do add trading or other fees to ETFs, but generally speaking, these products will be less expensive than their mutual fund counterparts.