Full transcript with subheadings:

Understanding the True Costs of Mutual Funds

Over the last 28 years that I’ve been in business, one of the things that I consistently find is that people are paying way more for owning their mutual funds than what they think they’re paying.
This originally hit me probably about eight years into the profession, when I had a mutual fund wholesaler that was asking me what I look at when I’m recommending mutual funds for clients.

Expense Ratio: The Common Misunderstanding

I said the name of a fund company that I really liked, and I talked about their expense ratio being reasonable for what they delivered, in my opinion. He stated to me that the expense ratio doesn’t tell the whole story of the costs that mutual fund owners are paying. Essentially, that sent me down some pretty deep rabbit holes trying to figure out what he meant and what the different costs associated with mutual fund ownership actually are.

So today, I’m going to do my best to uncover what mutual funds really cost you and your retirement so you can make more educated decisions going forward.

What we’ll cover are quantifiable costs and actionable takeaways. The quantifiable costs associated with mutual fund ownership include the expense ratio, transaction costs, cash drag, and tax costs.

Expense Ratio: What You See Is Not All

We’ll go over each of those individually, starting with the expense ratio. Now, if you look at the expense ratio associated with actively managed mutual funds, what I believe happens—and as most people believe, I would say close to 99% of the people that I meet think—the only cost they have to pay for owning a mutual fund is the expense ratio.

The expense ratio is usually converted into a percentage, and you can find it in those little booklets called prospectuses. These costs typically pay things like marketing, distribution, and management fees. The average annual cost of an actively managed mutual fund, according to Morningstar, is 0.59%.

So, on a $100,000 investment at 0.59%, that would be $590 per year.

If you want to do some research quickly to find out what different mutual fund expense ratios are, I really like using Yahoo Finance, which has tons of information on many mutual funds.

For simplicity, I took a screenshot of one mutual fund called the Overweight Small Cap Opportunities Fund. According to Yahoo Finance, this mutual fund had an annual expense ratio of 1.25%. So that’s a quick way to find out what the expense ratio is for a mutual fund.

You might be interested in, or if you already own a mutual fund and want to find out what it costs, that’s a good place to start.

Transaction Costs: The Hidden Fees

What is much harder to find are transaction costs. When our mutual fund manager buys and sells stocks in a brokerage account, it creates brokerage commissions, which are not included in the expense ratio.

You can find brokerage commission information in something called a statement of additional information, which is separate from your prospectus. You either have to request it from the fund company, or you can often find it online. But it only tells part of the story.

It tells you what the brokerage commissions are associated with that mutual fund, but there are reasons why it only tells part of the story, which I’ll explain shortly.

When I tried to quantify the cost to a mutual fund investor annually, I looked at a lot of research done by others trying to quantify the total transaction costs.

There aren’t a lot of studies, and no recent ones I’ve found. The most credible found that the average annual transaction cost is above 0.75% per year. On $100,000 invested, that’s an additional $750 beyond the expense ratio.

Even though it’s difficult to quantify transaction costs fully, you can research for a general idea. A few important things to know: number one, there’s turnover with mutual funds, usually expressed as a percentage.

If a mutual fund has 61% turnover, it means about 61% of holdings are bought and sold annually. More turnover usually means higher costs. Also, small-cap and international mutual funds tend to have higher costs due to the nature of their trading platforms and related costs.

Those stocks, versus large-company stocks or bonds and bond mutual funds, tend to have higher costs at similar turnover levels. More turnover leads to higher costs, especially in small-cap and international funds compared to large-cap and bond funds.

To find out turnover for a mutual fund, I again used the Overweight Small Cap Opportunities Fund; Yahoo Finance says it has 61% turnover, which isn’t bad. Some funds have over 100% turnover.

Higher turnover typically means higher costs on top of the expense ratio. To find out brokerage commissions for a fund, you need the statement of additional information, often available online.

Remember, brokerage commissions are not included in the expense ratio. They are in addition and do not cover other costs like market impact, spread, and soft dollar costs, which are tough to quantify. Higher turnover and international funds usually mean higher costs.

Cash Drag: Opportunity Costs

In addition to expense ratio and transaction costs, there’s cash drag. Mutual fund managers hold cash to facilitate liquidity for transactions.

Mutual fund companies handle daily orders to buy and sell funds or give investors their money back, requiring cash holdings to avoid constant security sales.

Many mutual fund companies hold chunks of cash. The downside is, especially in good market years like this one, cash returns are low compared to stocks growing robustly.

In bad market years, cash can be beneficial since it doesn’t lose value when stocks drop.

On average, the market goes up seven out of ten years. The average cost of cash drag to the investor annually is about 0.26%.

On a $100,000 investment, that’s roughly $260 per year.

To gauge cash holdings for a mutual fund, again check Yahoo Finance.

Anything below 1% cash is low drag; above 1% is higher than I’d be comfortable with.

Tax Costs: The Hidden Impact in Taxable Accounts

Now, if you own a mutual fund outside a tax-advantaged account like an IRA, Roth IRA, 401(k), or 403(b), you’ll face tax costs.

When you buy a mutual fund, the manager owns many stocks. If those stock values increased and the manager sells them, they realize capital gains tax, distributed to all fund shareholders.

Everyone owning the fund at sale time shares in capital gains tax.

The average tax cost, per Morningstar, is approximately 1.9% per year for high-income investors.

So when adding all these costs up—expense ratio, transaction costs, cash drag—the total is about 1.6%. For taxable accounts, taxes also take about 3.49% annually from returns.

That’s why analyzing mutual fund costs closely is crucial. Many funds have significantly lower costs than what I shared.

To understand costs better, try free resources like Yahoo Finance for expense ratios and cash levels, the statement of additional information for transaction costs, and Morningstar’s resources.

These resources help unveil true mutual fund costs. It’s important because past top-performing funds often don’t maintain their success over time.

Looking at previous top 25% funds over five years and their following performance shows only 19%-27% stay top performers.

That means roughly 75% fail to maintain top status.

In my opinion, two main factors predict future performance: controlling unnecessary taxes and controlling unnecessary expenses.

Conclusion: Take Action

Thanks for spending your time with me today. I hope you learned a lot.

If you want to talk to knowledgeable advisors, we have certified financial planners specialized in minimizing unnecessary costs and maximizing retirement investments.

You can schedule a virtual meeting or a quick 15-minute call at Bernicke.com. We’d love to help you. Thanks again for your time today.