Avoid Mutual Fund Transaction Costs

Last Updated Jun 19, 2009 1:01 PM EDT

You've been trained for years by every personal finance writer worth his or her salt to keep an eye out for your fund's expense ratio. Every fraction of a percentage point in fees and expenses you pay to your fund's sponsor to run the fund is money that comes straight out of your return. The number is easy to find in prospectuses or in a database such as Morningstar.com, so it's a no-brainer to avoid any fund with a high expense ratio. Returns are meager enough these days without these added fees.

All the more reason, then, to pay attention to transaction costs: the costs of trading the securities in the funds. Unlike expense ratios, which funds have to disclose prominently, transaction costs are all but invisible. But in complementary studies, Roger Edelen, an assistant professor at the University of California at Davis, and Arijit Dutta, associate director of fund analysis for Morningstar, found that fund transaction costs are surprisingly ― and painfully ― high.

Dutta discovered that transaction costs cut the performance of the average equity fund by 1.64 percent a year. The effect is most dramatic on small-cap growth funds, which suffer a 2.8 percent hit on average.

In related research, Edelen determined that the higher a fund’s trading costs, the worse its performance. Transaction costs from frequent buying and selling are “vastly more important than expense ratios,” Edelen said in a joint presentation with Dutta at a recent Morningstar conference. “And no one’s talking about it.”

After a year when many funds lost nearly half their value, a couple of percentage points may seem like small potatoes. But these trading costs add up to a bigger share of a fund’s total return than you might think.

Invest $10,000 earning 8 percent annually for 10 years and that 1.64 percent cost strips $3,290 from your earnings. Transaction costs of 2.8 percent would knock returns by $5,337. And that’s before adding in an expense ratio of 1 to 1.5 percent, plus a sales load if you buy through a broker. If stocks return 8 percent a year over the next few years — which might be optimistic — the combination of these costs could cut your annual return by more than half.

But you don’t control a fund’s transaction costs. That’s determined in part by how often the fund manager trades the securities in the fund’s portfolio, and how costly those trades are. So how do you know that?

For starters, you could stick to index funds. When all your fund’s manager is trying to do is match an index such as the S&P 500, after all, he or she doesn’t have to change the fund’s portfolio any more often than the index changes stocks. Fewer transactions mean lower transaction costs.

If you prefer to buy actively managed funds, there’s no way to know for sure which will keep their transaction costs down. But you’ll boost your chances by steering clear of certain types of funds whose investing style tends to run up transaction costs.

Big funds buying small stocks: The larger the fund and the smaller the stocks it holds, the steeper its transaction costs are likely to be. Like a fat man and a small hot tub, a fund that throws a lot of money at a small stock tends to raise the price level when it buys in and lower it when it sells out.

Momentum funds: Mutual funds that specialize in stocks with fast-growing earnings — the momentum strategy — tend to buy shares in high demand. So their purchases help push up the price and the fund’s transaction costs.

Focused funds: These funds tend to hold large positions in only a few stocks. Once again, a lot of money chasing fewer stocks tends to make trading more costly.

The studies don’t mean that actively managed funds are necessarily a bad choice. They just have one more hurdle to clear than index funds, which already have lower expense ratios than actively traded funds. Unless you are convinced that the fund’s manager has the smarts or the system to make up for both the higher expense ratio and the higher transaction costs, stick with index funds.

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