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Mutual Fund Urban Myths

Like all areas of human endeavor, the fund industry is prone to its share of urban myths.

Don Phillips, 06/17/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Like all areas of human endeavor, the fund industry is prone to its share of urban myths— stories that simply aren’t true but which contain enough of a basis in reality to make them seem plausible. These untruths get retold with such passion and frequency that people eventually accept them as gospel, and they become part of the industry’s shared beliefs.

One urban myth circulating among investors is that mutual funds have hidden fees of 140 to 200 basis points that are omitted from expense ratios. When these hidden fees are added to a fund’s stated expense ratio, they presumably bring overall annual fund expenses to something in the 2.5% to 3% range. When the additional toll of taxation is taken into account, the total cost of fund ownership is supposedly close to 5% for some funds. It’s enough to send shivers down your spine.

While the terror of taxation on fund shares one continues to hold is real, the 140 to 200 basis points in hidden costs are largely fiction. The idea does have a basis in reality, however. Mutual funds do omit the cost of trading securities from their expense ratios. Funds do disclose in their financial statements the dollar amount spent on brokerage commissions, and Morningstar translates this number into a percentage of assets that can be appended to the expense ratio to get a truer sense of a fund’s all-in costs. However, the median brokerage cost for large-cap U.S. equity funds is nowhere near 200 basis points. For large-cap funds, it clocks in at less than seven basis points. (Small-cap funds have somewhat higher brokerage costs.) But this number is just the dollars spent on commissions; it doesn’t account for the friction of a manager pushing a stock price up when buying or down when selling. The estimates of this frictional cost are what send the projections of the total hidden costs soaring.

Trading friction is a real cost, but the notion that it totals 140 to 200 basis points is preposterous. The early champions of this myth were salesmen for separate-account wrap programs who wanted to inflate the costs of mutual fund ownership to justify the high fees of their services. These critics are easy enough to dismiss. But there have been a couple of academic studies that prop up this notion of high hidden fees. To these, one should be more gracious. It is conceivable that a single fund that did a very bad job at trading could run up hidden trading costs of 140 basis points, but for that figure to be an industry average is absurd.

The obvious example that dispels these claims is index funds. If trading costs were anywhere near this magnitude, funds like Vanguard 500 Index VFINX would not be able to so closely mirror their assigned index’s performance. Index proponents have been quick to point this out, but they often want the charge of high hidden fees still to stick against actively managed funds. That’s not kosher. If the claim is overstated for index funds, it must also be for active funds.

Let’s do the math. If actively managed stock funds really had these costs, the average fund would trail an appropriate index, which has no trading costs, by its expense ratio plus 140 basis points. It doesn’t. Over the trailing 10 years ending March 31, 2013, the average U.S. large-cap equity fund, on an asset-weighted basis, trails the market index by its expense ratio plus about 39 basis points. Over the past five years, this figure shrinks to 25 basis points. This means that the total hidden cost in funds must be less than one fifth the oft-quoted estimates. Put another way, the thing lurking in the shadows of your mutual fund is a squirrel, not a werewolf.

To embrace the 140-basis-point-hidden-fee claim, one would have to accept that the average equity fund manager somehow adds more than 100 basis points of value through stock picks before the cost of transacting is considered—an assumption that would fly in the face of financial theory. If this were true, then one must also conclude that indexing is an irresponsible investment choice, because in choosing an equity index fund, one would leave behind more than 100 basis points of readily accessible value. The most prudent investment choices would be actively managed, but very-low-turnover strategies, not index funds. This is the logical conclusion if index proponents want to claim that active funds have these high hidden costs.

Clearly, these cost estimates must be recognized as being grossly overstated. At the same time, it’s key to note that what’s wrong with these estimates is their magnitude, not what they expose. Trading is often counterproductive, no matter how convinced one is that the next trade will add value. That’s a lesson for both fund managers picking stocks and for advisors moving between funds. In many cases, the best approach, as Jack Bogle likes to say, is don’t just do something, sit there!

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Don Phillips is a managing director of Morningstar, Inc.

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