The Error-Proof Portfolio: Don't Let Hidden Costs Gobble Up Your Return

I've been writing a series of articles about how retirees can cut their costs during retirement. Last week's column focused on how to cut your expenses for financial services, including investments, banking, credit cards, and insurance. I came up with 50 tactics for cutting costs, but it turns out I really only scratched the surface when it comes to reducing your investment-related costs. In addition to the easily observable costs that investors pay--such as commissions to buy and sell and fund expense ratios--there are hidden costs to stay attuned to, as well. 

Here are some of the other charges to be aware of as you manage your portfolio.

Bid-Ask Spreads
What They Are: If you're investing in individual securities, particularly less-liquid ones, it pays to be aware of bid-ask spreads when you're buying and selling. The bid is the price that someone is willing to pay for a security at a specific point in time, whereas the ask is the price at which someone is willing to sell. The difference between the two prices is called the bid-ask spread. Bid-ask spreads have the characteristic of heads they win, tales you lose: If you're a seller, you receive the lower price (the bid), and if you're a buyer, you pay the higher price (the ask). (Note that bid-ask spreads aren't an issue for mutual fund buyers and sellers, at least not directly, because the fund is priced just once a day, and everyone pays and receives that same price.)

If you're trading highly liquid securities, the bid-ask spread will tend to be pretty inconsequential, meaning that buyers and sellers generally agree about what the right price for a security should be. For example, on April 15 the bid-ask spread for the exchange-traded fund  SPDR S&P 500 (SPY), which is itself dominated by heavily traded, household-name companies such as  Microsoft (MSFT) and  Johnson & Johnson (JNJ), was just a penny: The bid was $132.31 and the ask was $132.32.

But bid-ask spreads can be more onerous when you're dealing in more thinly traded securities, such as small-company stocks or ETFs with light trading volume. As my colleague Bradley Kay discusses in this article, that bid-ask spread compensates the market maker in the security (which matches buyers with sellers) in case it can't find buyers for the shares and the price moves around a lot before it does. The greater the risk of that happening, the more the market maker demands in terms of a bid-ask spread. Think of the bid-ask spread as the markup on your purchase or sale. Morningstar recently began providing bid-ask spreads, both in absolute and percentage terms, for all of the ETFs in our database.

How to Reduce the Drag: So how can you reduce the drag of bid-ask spreads on your returns? At the risk of stating the obvious, reducing your number of transactions is a good starting point, particularly if you're dealing in any type of illiquid security. Another way to exert more control is to use a limit order rather than a market order. By doing so, you're saying that you're not going to accept any old price when buying and selling (a market order); you only want to transact if you can get a specific price or better. If you're a frequent buyer and seller of individual bonds, check out this unit from Morningstar's Investment Classroom.

Fund Trading Costs
What They Are: Bid-ask spreads aren't just a cost for those trafficking in individual securities, however. They're also an extra cost for mutual funds that buy and sell less-liquid securities. And they're just one of several hidden costs for mutual funds. When I say they're hidden, I mean that these costs aren't reflected in a fund's expense ratio, but they are subtracted from your returns.

In addition to bid-ask spreads, fund shareholders are also on the hook for brokerage commissions that the manager pays to buy and sell shares. Of course, mutual funds should be able to swing better deals on trades than you and I would when buying and selling on a retail brokerage platform. But these commissions aren't chump change, either: As my colleague Karen Dolan discusses in this article, the average equity fund in our database pays roughly 0.30% in brokerage commissions--and that's in addition to the fund's stated expense ratio.

Fund shareholders may also pay so-called market impact costs, meaning that larger funds have a tendency to affect a company's price when they're buying and selling shares. As with bid-ask spreads, market-impact costs are a function of supply and demand. So if a large fund is buying shares of some small company, it may drive up the price of the shares in the process, as other market participants see that there's an appetite for the shares. And the reverse can happen when it's selling; unloading big blocks of a company has the potential to drive down the stock's price. This phenomenon can be particularly painful when large funds are making frequent trades in smaller, less-liquid companies.

How to Reduce the Drag: As with bid-ask spreads for buyers of individual securities, fund trading costs are particularly onerous for funds that trade frequently. It's safe to say that funds with very low turnover rates (less than 25%, for example) will tend to have lower trading costs than those with higher turnover rates, especially more than 100%. By extension, index funds, most of which stick with a fairly static basket of securities, will also tend to have fairly low trading costs.

And high turnover combined with a penchant for less-liquid securities and a sizable asset base can be a triple whammy that drives up fund trading costs. That's one of the reasons why Morningstar's fund analysts are on high alert for signs of "asset bloat," especially among small- and mid-cap funds. If you're considering a fund with any or all of the above characteristics, Morningstar's  Fund Analyst Reports can help you gauge whether you should be concerned.

Company Retirement-Plan Costs
What They Are: Think investing in your company retirement plan is free, apart from whatever you're paying for the individual investments? It might be, if you work for a large employer. Because of their size, some firms are able to get the investment provider to waive any administrative costs associated with running the plan; other employers cover all or part of a plan's administrative costs on behalf of their workers.

But not every company retirement-plan participant is so lucky. Plans may levy administrative expenses on employees in a few different ways, but the key ones are to bundle admin costs into the individual-fund expenses or to charge an extra layer of administrative costs at the plan level. If your plan is taking the former route, you'll see above-average fund expense ratios. If the stock funds in your plan charge more than 1.25% or 1.5% in annual expenses, that might be a red flag that the plan includes a layer of administrative expenses. If the fund expenses are relatively low (for example, less than 0.75% for bond funds and less than 1% for stock funds), that's a good sign, but you're still not out of the woods. Ask your employer for a summary plan description or annual report (often called a form 5500) and scrutinize it for administrative costs. If your plan is charging more than 0.5% in administrative expenses, that's a red flag that your plan is a costly one.

How to Reduce the Drag: If you've determined that your plan is more costly than it should be, your first step should be to complain to human resources and ask your colleagues to do the same. Then plan to contribute at least as much as you need to earn any company-matching funds.

After that, assess whether you're taking advantage of other options that are apt to prove more cost-effective than investing in the company plan, such as funding a Roth IRA. You won't shoulder an extra layer of expenses to invest in a Roth IRA, and you'll also enjoy tax-free withdrawals in retirement and have the benefit of being able to choose from a broad array of investments, not just those on your plan menu. If you still have money to invest for retirement after following those steps, only then does it make sense to put additional dollars to work in a truly costly company plan.

A version of this article appeared Oct. 4, 2010.

See More Articles by Christine Benz

		New! 30-Minute Money Solutions
	Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more.
	Order Your Copy Today--$16.95