The Real Costs Of Owning Mutual Funds.

I received some questions about the actual costs of owning mutual funds after I posted yesterday.  I thought I'd link again at the end of this article what the author, Ty A. Bernicke,  over at Forbes.com says are the real costs.  I'll list the executive summary edition below.

Expense Ratio- The expense ratio is frequently used to pay markeeting costs, distribution costs and management fees.  This ongoing cost can be identified by reading a mutual fund's prospectus.  The average U.S. Stock fund now costs .90% per year according to a recent Morningstar article.  

Transaction Costs- Broken down in the article into three groups brokerage commissions, market impact and spread costs.  The author cites a study that claims that transaction costs average around 1.44% a year.  I think this is probably high but this cost could be at least half of his estimate.

Tax Costs- The author cites Morningstar which claims the average tax cost ratio for stock funds as being between 1-1.2% per year.

Cash Drag- Cost in performance when cash is held in a mutual fund's portfolio.  It should be noted that cash can be an advantage in a declining market and I'd note that mutual funds typically do not hold that much cash.

Soft Dollar Costs- Trade commissions directed to Brokerage firms for either services offered or research.  Note that the SEC and FINRA have really cast a negative eye for these types of services in recent years. 

Advisory Fees- What investors pay guys like me to invest in mutual funds as part of their investment management agreement with say a broker or a Registered Investment Advisor.  I'd also note here that some advisors and most broker/dealers collect something called a 12(b)(1) fee which is an annual amount paid to these folks for continuing to hold their mutual funds.  ETFs do not pay 12(b)(1) fees  and Lumen Capital Management, LLC receives no such fees from any mutual fund we may hold for clients.  

All in the author claims that the real cost of owning a mutual fund in a non-taxable account is 3.17% and 4.17% in taxable accounts.  The author does not take into account any front end load fees which could make these costs much higher.  My own opinion is that he's somewhat high on some of these non-measurable costs such as cash drag and transaction costs.  Still I'd take his basic analysis and say that the costs of most mutual funds is likely between 2.5-3.5%.  Then there's this.

Most mutual funds are closet index funds.  That is most mutual funds have a high correlation to how they invest and an underlying index they are trying to beak.  If you go here  you can compare a five year chart of one of the premier mutual funds, American Funds Growth Fund of America {AGTHX} and the S&P 500 ETF {SPY}.  The chart shows that the actual performance of SPY has been better over five years than AGTHX although the two have traded in virtual identical patterns.  The cost of owing AGTHX is as follows for the A shares.  Maximum front end load is 5.75% on the A shares.  The expense ratio per Morningstar is .71%, management fees are .28% and 12(b)(1) fees run .24%.  The cost of SPY is .09%.  That 0 in front of the 9 is not a misprint!  The only other cost is the commission to buy the security.  Buying a 100 shares of SPY at Charles Schwab would cost you approximately $10 all in.  You can get that cheaper commission-wise if you work on your own at some of the more cut rate firms.  That's a huge difference.  

Game over longer term mutual funds in re costs unless they change.

Link:  Forbes.com: The Real Cost of Owning a Mutual Fund.