Four Mutual Fund Metrics That Hurt YOUR Returns

2010 July 14

It bears repeating:  costs matter in investing.  The lower your costs, the higher your returns are likely to be.  Study after study shows that a mutual fund’s expense ratio is the single best predictor of future performance.  However, the rock-bottom expense ratios charged by most index funds isn’t the only reason I’m such a big proponent of index investing.

Here are four mutual fund metrics that seriously hurt your returns.  Naturally, index funds have a large advantage over actively-managed funds in each of the four categories.

The Expense Ratio

This one is obvious.  In investing, you tend to get what you don’t pay for.  What I mean by that is that mountains of research and long experience indicate that practically no actively-managed mutual funds can consistently beat their relevant market index.  Indeed, mutual funds as a group tend to trail the market’s return by almost exactly the amount of their investment expenses.  Gee, what a coincidence.  In light of this fact, it follows that the most logical course of action is to minimize investment costs in an attempt to match as closely as possible the market’s return.

Here’s an example to drive my point home:  an S&P 500 index fund with an expense ratio of 0.20% per year will, over the long term and on average, out-perform a large-cap actively managed fund with a 1.20% expense ratio by, you guessed it, just about 1% per year.  That may not sound like much, but over a 30 or 40 year investment career that 1% could easily be worth an extra few hundred thousand dollars.  Definitely not chump change.

For comparison purposes, let’s assume the average index fund charges just 0.20% per year and the average actively-managed fund charges 1% per year.  We’ll come back to these numbers at the end.

Portfolio Turnover

Portfolio turnover is a measure of how often a fun buys and sells stocks.  For example, a fund with a turnover of 100% holds any given stock for an average of 1 year before selling it.  A turnover of 50% means a fund holds stocks 2 years on average and a turnover of 200% means a fund holds stocks for only about 6 months before selling them.  When it comes to turnover, lower is always better.  Why?  Because rapid trading is costly.  You’ve got brokerage commissions and bid/ask spreads to pay, not to mention the increased income tax liability from selling all those shares so often.

The average stock mutual fund has a portfolio turnover that hovers just under 100% per year;  some higher, some lower.  By contrast, the Vanguard Total Stock Market Index Fund’s (VTSMX) portfolio turnover is a rock-bottom 5%.  That means the fund owns each stock an average of 20 years before selling.  It also means the index fund skips paying all those extra transaction fees owed by the managed fund.

We’ll account for the cost of high portfolio turnover in the sections below on transaction costs and taxes.

Transaction Costs

Transaction costs are a direct result of portfolio turnover.  And make no mistake, as owner of the fund it is you who is paying these costs, not the fund company.  What transaction costs can mutual fund investors expect to pay?  Brokerage commissions are an obvious one.  Even though most mutual funds can trade at lower cost than small individual investors (still $4.95 at Tradeking last I checked), brokerage commissions still take a bite out of returns.

But transaction costs go far beyond the obvious.  Bid/ask spreads are a major expense for mutual funds an can take a significant bite out of your profits.  What is a bid/ask spread?  It’s simply the difference between what the seller is willing to sell a stock for (the ask) and what the buyer is willing to pay for it (the bid).  It’s how the stock exchange makes it’s money (you didn’t they stock exchanges where non-profits, did you?)  For example, the ask on a $25 stock might actually be $25.02 and the bid might actually be $24.99.  As the seller of the stock, you’ll actually only receive the $24.99.  And as the buyer, you’ll actually pay the full $25.02.  Where does the extra $0.03 go?  It goes to the stock exchange as a commission for facilitating the trade.  The bid/ask spread is usually negligible for any one stock purchase or sale, but when done at a rapid pace and at large volume, those pennies begin to add up.  That’s money out of your pocket.

The last major transaction costs are mutual fund loads, which can range anywhere from 1% to 6% or sometimes even more.  Naturally, I don’t recommend you ever buy a fund with a load.  But if you do, don’t forget to count the amount of the load as a transaction cost.  It’s money you won’t be getting back.

It’s important to note that these transaction costs are not included in the mutual fund’s stated expense ratio.  Rather, they are in addition to the management fee you are already paying.  Estimates for how much transaction costs drag on the average mutual fund’s returns vary, but most I’ve seen settle into the 0.4%-0.7% range.  Let’s split the difference and assume transaction costs average about 0.55% per year for most actively-managed funds.  Remember that total stock market index fund with the turnover of just 5% per year?  Its turnover is so low that its transaction costs are negligible.  Chalk up an extra 0.55% per year advantage for the index fund.

Taxes

Everybody hates taxes, but investors have the good fortune of being allowed to choose when and how much tax they want to pay, to an extent.  When you buy a stock, piece of real estate, or any other asset, you owe no tax on your profits until you realize them.  Until you sell that stock you bought last year, you won’t have to pay any taxes on your gains.  Even if you hold it another 40 years, you won’t pay a cent to Uncle Sam until you sell.  It’s not hard to imagine how beneficial this could be.

Remember that actively-managed fund with the 100% portfolio turnover above?  Your tax bill will be through the roof most years because your fund realizes so many taxable gains on a consistent basis.  To make matters worse, this can potentially create a situation where you owe income taxes on a mutual fund in a year that you actually lost money!  This happened to plenty of people in the 2000 stock market crash and many more in the 2008 crash.  I can’t think of anything worse than paying taxes just to lose money, but that’s what may very well happen if you buy an actively-managed fund.

Index funds, on the other hand, are far more tax-efficient simply because they hold stocks longer.  The total stock market fund holds stocks an average of 20 years, so its yearly tax liability should be much lower.  And it is.  According to Morningstar, the Vanguard Total Stock Market Index Fund lost an average of only about 0.34% per year to taxes.  The Fidelity Magellan fund, which is perhaps one of the most well-known actively managed funds, lost an average of 0.86% per year over the past 10 years.  You would have paid almost triple the taxes for owning an actively-managed fund that actually under-performed the index fund by over 2% per year!

These Costs Add Up

Let’s add these costs up, shall we?

The proto-typical index fund sports an expense ratio of 0.20% per year and loses about 0.34% per year to taxes for a total annual expense of 0.54%.  Not bad.

The average actively-managed fund, on the other hand, sports an average expense ratio of 1% and loses about 0.86% per year to taxes.  What’s more, it loses an additional 0.55% to transaction costs due to high portfolio turnover.  Hence, the average actively-managed fund clocks in at a total annual expense of about 2.41%, which is over 2 and  half times more expensive than the index fund!  No wonder managed funds can’t beat index funds:  1.5% is just too great a hole to climb out of.

But this article wouldn’t be complete without this final calculation:

Assuming a $10,000 initial investment, that 1.87% performance lag suffered by the actively-managed funds will cost you approximately $281, 405 in retirement assuming the index fund returns the long-term average of about 10% per year over the next 40 years.

I’m not kidding.

$10,000 will turn into $537,006 in 40 years at 10% per year and only $255,601 in 40 years at (10% – 1.87%) = 8.13% per year.  Costs really do matter!

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