Mutual Fund Trading Costs Add Up. Are ETFs a Better Option?

According to a study by the Center for Retirement Research at Boston College , 401 (k) plans could seriously bring their costs down if they were to  substitute Exchange Traded Funds for mutual funds in their retirement saving options for plan participants.

Their findings have interesting implications for investors in general, as they shed light on an area of mutual fund expenses not commonly discussed or easily quantified.

Generally when mutual fund fees are discussed, the figure used is the fund’s expense ratio. This is the cost of paying the fund manager, marketing and other fund overhead. For some actively managed funds it can be fairly high, and it’s generally lowest at passively managed index funds. Vanguard is especially well-known for its low fees (as it turns out, partly enabled by that firm’s particular ownership structure in which the funds own the firm.) As we have previously written up, according to Morningstar research,  low fees are the single most reliable predictor of future fund performance,  better than any other metric, including Morningstar’s own five star ranking system.

Expense ratios are fully disclosed and readily available in fund literature and at sites that follow the fund industry,  including Morningstar.

The High Price of Fund Trading Fees

The study by the Center for Retirement Research focuses on a different cost, but one that is both difficult to track and quite significant: a fund’s trading costs. Any time a mutual fund manager wishes to buy or sell a holding, they have to do so through a brokerage. That means the brokerage’s commission will have to be paid by the fund, and part of the “bid/ask spread,”  the difference between what the seller is asking for and the buyer is bidding, will also have to be factored in. On top of that there is another cost, a “market impact” cost.  That comes from the fact that mutual funds, when placing orders, can often actually move the price of the security.  The larger the fund, the larger the trades, the bigger the market impact.

Here’s how the paper’s authors explain the process:

…An equity mutual fund that sells 100,000 shares in company XYZ in order to purchase a similarly large stake in company ABC pays a significant toll to reallocate its funds. It pays commissions for both trades. It also likely sells XYZ at a price below prevailing market as dealers temporarily adjust their estimates of the price needed to elicit sufficient buyers. For similar reasons, the mutual fund buys ABC at a price above the prevailing market price. If, for example, these costs generally amounted to 2 percent of the assets transferred, and if the fund traded 50 percent of its assets during the year, these trading costs would reduce the net return on the fund’s assets for the year by 1 percentage point. Unless these transfers boost the fund’s average rate of return by at least 1 percentage point, this trading activity would be costly for its investors.

Looking at the 100 largest funds in defined contribution plans (401(k), etc.) as of December 2007, the authors found that median trading costs varied from 0.11 percent of fund assets per year among the 20 least-expensive funds to 1.99 percent of assets annually for the 20 most expensive. The more frequently the fund traded, the higher the transaction costs.

ETFs, A Cheaper Option

For forty of the 100 funds studied, that median trading cost was greater than the fund’s explicit expense ratio. So for investors in those funds, the true expense of owning them was more than double what is commonly considered their cost of ownership.

One solution offered in the paper is that 401(k) plans switch from mutual funds to Exchange Traded Funds. A switch from mutual funds to ETFs, which are also publicly traded could cut investors’ annual expenses by as much as 0.5 percent of assets, according to this study. Though that might not sound huge, over time that kind of difference really adds up.

 

3 thoughts on “Mutual Fund Trading Costs Add Up. Are ETFs a Better Option?

  1. Simon Napper

    From our experience looking at 100’s of different plans, I would say three things:

    1. A 401K and other retirement plans are set by the employer and there may be a slow migration to ETF’s which will reduce fees. In the meantime, it’s important you make the best of the plan as is with appropriate asset class diversification. Make sure you have as many different classes (US, International, Real Estate, Commodities, Emerging Markets) as we have shown that makes a big difference to returns.

    2. Some of the higher fees may be worth it. When we built a low cost ETF long term portfolio, we couldn’t find anything that would beat one of the leading Fixed income funds from PIMCO. There are cases when the management fees are worth it.

    3. The bottom line is to not focus on fees but on net returns.

  2. TFB

    Rather than jumping to ETFs, why not just switch to index funds? Same low expenses, no commission, bid-ask spread, or premium/discount associated with ETFs.

  3. Nanette Byrnes Post author

    Great points. On Simon’s point 2 and TFB’s note, the study does look at the question of whether a fund’s performance covered its trading costs and found that actively managed funds were about evenly divided between those who made returns in excess of their costs and beat the market and those that didn’t, leading them to conclude: “on balance, actively-managed funds can entail a substantial amount of additional risk for investors, resulting from their failure to cover their transaction costs.” The 20 funds that traded the least-frequently (turnover of 7%) had a trading cost of 0.11% of net assets (versus 1.99% for the biggest traders, the 20 funds with an average turnover of 79%). Per TFB’s point, the infrequent traders do, the authors note, tend to be “passively-managed funds, like index funds, which have significantly lower total costs than the other funds in the sample.” What I don’t find in the study is a direct comparison of the costs of index/passive funds to ETFs, but that’s an intriguing question.

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