Mutual funds pay brokerage commissions when they trade, just like you do when you trade individual stocks and bonds in your own brokerage account. This is a significant cost, which is NOT reported as part of the fund’s expenses, but which can be a significant drag on your fund’s performance. Instead, you need to look at a fund’s reported turnover rate as an indication of how much trading and therefore the relative amount of commission expense incurred by the fund. Funds with low turnover have lower trading-related costs - excessive trading in your personal account is rarely profitable, and the same tends to happen in funds that have high turnover.
As reported in TheSkilledInvestor, Professors Karceski and Miles Livingston of the University of Florida and Professor Edward O’Neal of Wake Forest University did two studies in which they quantified the impact of turnover on fund costs, and the results indicate that, for funds with high turnover, they can be as big a drag on performance as a fund’s management fees and expenses.
A typical large fund will have about 57% annual turnover, which means that over half the securities that they started with at the beginning of the year have been traded. This level of turnover results in about 0.3% of trading-related costs. If you have a fund that engages in more active trading, which is more common with growth funds, then the trading-related expenses can exceed the reported management fees and expenses of the fund. Midcap growth funds tend to have higher turnover than large cap growth funds, and small cap growth funds tend to have the highest levels of turnover. Value funds tend to buy stocks and hold them longer awaiting results, resulting in lower turnover, and index funds need only buy and sell securities when the underlying indexes change composition, or in reaction to net inflows and outflows of investment in their funds, so they have the lowest turnover of all.
The professors quantified trading costs based on reported turnover, and you can use these figures as a guide when estimating total fund expenses for funds that primarily hold stocks (bond trading expenses may be higher or lower than stock trading expenses, depending on the type of instrument being traded): The average fund with over 100% annual turnover will have about 0.65% annual trading costs, over twice the trading costs of the large, low-turnover funds reported above. On the other hand, ten of the highest turnover funds had an average turnover rate of almost 500%, resulting in trading-related costs of 3.58%
Now if these trades were all profitable after subtracting the trading-related costs, you wouldn’t care about the resulting expenses, otherwise this hidden cost of up to 3.58% of your fund’s assets is a heavy burden for the fund’s managers to overcome. When you add in management fees and expenses of 1.5% and up that some of these funds often charge, the fund must show a profit of over 5% on dividends and capital gains before it breaks even! All other factors being equal, a fund must take much higher risks to outperform a fund with 4% lower expenses.
If you hold a fund outside a tax-deferred account, then you must pay capital gains taxes on all capital gains reported by the fund, even if you haven’t sold any of your fund’s shares, and even if the value of your fund has shrunk during the year. For high-turnover funds, these capital gains tend to be short-term and are taxed at the higher ordinary-income rate. This is another hidden cost of high-turnover funds.
As we approach the end of the year, take a close look at the funds you hold, how they have performed, and apply some of these principles to see whether or not they are still appropriate for you.
Some additional topics we will cover in upcoming installments include:
- The goldilocks effect - Avoiding very large and very small funds will improve your results
- Spotting fund expenses, front and back-end sales charges, and 12b-1 fees
- Which performance figures really matter and which ones should you care about?
- Are new funds better than older ones?
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