Is This Hidden Cost Sapping Your Retirement Savings?

by Eric Roberge CFP on 1 May 2014 0 comments

Mutual funds are the most commonly discussed investment vehicle. They are an option in almost all 401(k) retirement plans, individual retirement accounts (IRAs), and brokerage accounts. However, there is more than meets the eye when it comes to underlying expenses. Over time, this minor detail can have a severe impact on the growth of your money.

You may be aware of expense ratios within mutual funds, but the list of fees goes on — and these additional fees are not readily apparent. The expense ratio consists of the operating costs of the mutual fund. (Think of a mutual fund as a business and the expense ratio as the costs of running that business.) It is shown as a percentage, and the average mutual fund expense ratio is about 1.19%. (See also: 3-Step Plan to Choosing Mutual Funds)

Mutual Fund Trading Costs Are Hidden

Trading costs are the expenses that accrue when buying and selling the individual securities (stocks, bonds, etc.) within a mutual fund. The problem is that mutual fund companies are not required to disclose this information. Therefore, these fees are virtually hidden from the average person. Sure, there are ways to estimate these fees, but it's complicated and still only an estimate.

To better understand what I'm talking about, let's compare a mutual fund to a commonly used item: the credit card. We all know that most credit cards charge interest on the unpaid balance each month. It's pretty clear that they do this — the interest rate is listed right on your statement. This is like the expense ratio in a mutual fund.

Just like you calculate the interest for your credit card by multiplying your interest rate by the current balance, the same goes for calculating the expense ratio cost in a mutual fund. You multiply the expense ratio by your total investment amount in the mutual fund. For example, a $10,000 investment in a mutual fund with a 1.20% expense ratio would cost you $120/year. (These calculations are over-simplified, but you get the idea.)

What if I told you that credit cards also tack on another (hidden) fee based on the number and size of purchases you make on your card each month? (They don't, but for comparison's sake, imagine they did.) How would you feel about not having that information disclosed anywhere?

Investors End Up Paying Undisclosed Buying and Selling Costs

This is exactly what happens with mutual fund trading costs. The more a mutual fund buys and sells stocks, bonds, etc., the more expenses you pay as an investor. According to a recent study, these hidden trading costs average 1.44%, which is more than the average expense ratio of 1.19%. This means that the overall expenses could add up to 2.63% or more. Yikes!

The study points out that if mutual funds were able to deliver better returns by trading more, then paying these expenses would be worth it. Unfortunately, the results of the study prove that the invisible trading costs actually weigh down the funds, thereby reducing the overall performance. Put simply, your money has less potential to grow.

How to Avoid Trading Costs

So what do you do? Avoid investing in mutual funds completely? You could do that, but that is impractical. As mentioned previously, mutual funds are the most common investment vehicle used today. However, there is a solution to this dilemma.

Index mutual funds and exchange traded funds (ETFs) focus on low-cost trading strategies, and therefore don't accrue large amounts of hidden fees. These investment vehicles often have much lower internal expenses (expense ratios) than the average mutual fund as well, which can save you as much as 1% or more in total costs. (See also: A Guide to Online Brokers)

The goal of these investment vehicles is to track a benchmark (i.e. the S&P 500), which means they invest in various stocks (or bonds) and make minor adjustments over time. Basically, index fund managers do much less buying and selling and therefore they accrue fewer costs. (See also: 3 Steps to Getting Started With Index Funds)

The mutual fund industry is still working through various solutions to this hidden cost issue. But don't hold your breath, as this issue has been argued for years. Until then, be prudent and choose your investments based on your long term goals. The key is to be aware of the potential costs of investing. A diversified set of index mutual funds or ETFs may be the answer for you.

Did you know about hidden trading costs in mutual funds? Will you be reconsidering them now that you do?

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