Costs matter. Whether you’re buying a car or selecting an investment strategy, the costs you expect to pay are likely to be an important factor in making any major financial decision.
People rely on different information about costs to help inform these decisions. When you buy a car, the sticker price indicates approximately how much you can expect to pay for the car upfront. But the costs of car ownership do not end there. Taxes, insurance, fuel, routine maintenance, and reliability are also important considerations in the overall cost of a car. Some of these costs are easily observed, while others are more difficult to assess. Same too goes for investments.
EXPLICIT FUND COSTS
Mutual funds have many costs, all of which affect the net return to investors. One easily observable cost is the expense ratio. Like the sticker price of a car, the expense ratio tells you a lot about what you can expect to pay for an investment strategy. Expense ratios strongly influence fund selection for many investors, and it’s easy to see why.
Suppose you sort funds into quartiles of least expensive to most expensive, based on the expense ratio. Over the 15-year period ending in 2017, 94% of funds in the most expensive quartile failed to beat their index while 75% of the least expensive category failed. So, while actively managed funds in general failed to beat their index benchmarks, the higher the cost, the more likely they are to fail.
IMPLICIT FUND COSTS
While expense ratios are easily observable other costs are not. Take trading expenses for example. Do you know how much your fund pays on trading expenses? Or how much the fund may move the price of the stock as it completes its purchases and sales. Probably not.
In 2007, an analysis by researchers at Virginia Tech, the University of Virginia, and Boston College found the average fund, based on a sample of 1,706 U.S. equity funds from 1995 to 2005, incurred annual trading expenses of 1.44% per year. Other studies have shown that the implicit costs are about the same as the expense ratio for an actively managed fund. And while trading costs have come down over time, they can still be substantial for active strategies.
The poor track record of funds with high expense ratios has led many investors to select funds based on expense ratio alone. However, as with a car’s sticker price, an expense ratio is not an all encompassing measure of the cost of ownership.
Take, for example, index funds, which often rank near the bottom of their peers on expense ratio. They are designed to track an index, such as those from S&P, Russell or MSCI. When changes are made to an index, demand is high to sell the stocks that are departing and buy those joining. On these days, the cost to make the buy and sell trades is generally more expensive. Being insensitive to these higher trading costs can diminish overall returns. You won’t see this in your expense ratio or in the fund prospectus. Rather, your net returns will simply be less than they otherwise could be.
The total cost of ownership of a fund includes both easily measured explicit costs as well as those that are real but more difficult to measure. Keeping explicit expenses low is important. For implicit costs, remaining flexible and transacting only when the potential benefits of a trade outweigh the costs can help keep overall trading costs down and help reduce the total cost of ownership.
If an investment manager trades excessively or inefficiently, costs like commissions and price impact from trading can eat away at returns. Viewed through the lens of our car analogy, this impact is like the toll on your vehicle from incessantly jamming the brakes or accelerating quickly. Subjecting the car to such treatment may result in added wear and tear and greater fuel consumption and take more money out of your pocket.