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The gain drain
Mutual funds’ hidden costs
After combing through a decade’s worth of data on some 1,700 actively managed mutual funds and their underlying stocks, finance professors at Boston College and Virginia Tech report on an onerous, hidden expense of mutual fund investing. Roger M. Edelen and Richard Evans of Boston College and Gregory B. Kadlec of Virginia Tech spent two years painstakingly analyzing U.S. Securities and Exchange Commission filings and stock exchange records to find that, on average, mutual fund investors lose 1.44 percent of their investment each year to costs incurred by fund managers for the purchase and sale of securities, including broker’s commissions and the “price impact” of trading large blocks of stock. These unreported trading costs come on top of the publicly disclosed costs of items such as research, sales, and administration, which, combined, average another 1.21 percent. Their research paper, “Scale effects in mutual fund performance: The role of trading costs,” is presented at the online Social Science Research Network.
In a phone interview, Edelen observed that, on the whole, “active managers are picking the right stocks and moving in and out of the market at the right time.” It’s just that their “skills are swamped by their implementation costs, so that, on net, shareholders find themselves behind the starting line.” This doesn’t necessarily mean most funds will have negative returns, but according to Edelen, the average fund would do better if it traded less. The study found that—again, on average—with every $1 in trading costs a fund’s value decreases by $.41. Significantly, funds that trade in relatively small blocks did increase in value when they traded, by about $.40 for every dollar in trading costs. But funds that trade in large blocks lost $.80 per dollar of trading cost, mainly owing to price impact—the bidding up of share prices that accompanies a dramatic and sudden increase in demand, or the bidding down that results from an increasing supply.
The researchers also found that trading by funds that invest in small firms, where even smallish blocks can represent a substantial chunk of a firm’s outstanding shares, has more than three times the price impact of trading by funds that invest in large firms.
Brokers’ commissions cost the investor less than price impact does, but they’re also significant, and excessive, according to the study. Many funds pay 4 cents per traded share, compared to the 1-cent per share commissions available from discount brokers. “Soft dollars,” as such differentials in commissions are known, compensate brokers for research and for help with selling fund shares. They amount to little more than an accounting trick, said Edelen, a way to hide sales and research costs that are supposed to be reported as fund expenses.
While the study prescribes no remedies, Edelen supports mandatory disclosure of soft dollar costs—either that or an outright ban on soft dollars. “Trading volume,” the number of shares a fund buys and sells in a year, should also be publicly disclosed, he said.
If and until such changes take place, how might mutual fund investors avoid excessive trading costs? Only with blunt instruments, it appears. Edelen, for instance, would advise investors to approach the larger mutual funds (as measured by assets under management) cautiously, because they tend to trade in larger blocks. “Success leads to fund growth, and growth kills success,” he said. “It’s ironic, but that’s the way it works.”
Funds that invest in small companies should also be viewed with a wary eye, as should funds undergoing rapid growth or shrinkage, because trading dictated by large cash flows tends to be less informed, and less successful, than discretionary trading—another finding of the study.
One alternative would be index funds, which invest in an unchanging basket of stocks corresponding to the contents of an index such as the S&P 500. Index funds, unlike their actively managed counterparts, trade rarely and pay rock-bottom commissions when they do, but their managers can’t load up on an undervalued stock or a promising new issue, nor can they position fund portfolios according to current market conditions.
So should you go index or actively managed? Edelen’s ideal fund would have the best features of both categories. “Why can’t you have the cost efficiency of an index fund,” he asked wistfully, “on top of an actively managed fund’s exciting . . . stock picking and market timing?”
David Reich is a writer based in the Boston area.
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