Interesting Morninstar Article on Mutual Fund Trading Costs

From Morningstar:

“…the average equity fund pays approximately 0.30% of assets a year [in trading costs]. That’s roughly 30% of the average no-load large-cap fund’s expense ratio. Thus, brokerage commissions can take what looks to be 0.90% paid in expenses each year up to 1.20%.”

This topic has been receiving more attention over the last couple of years. John Bogle has written about it in his books and I have seen more articles on this topic recently. It’s a good thing.

One of the funds with the highest trading costs is MFS Core Growth A (MFCAX), which payed out 1.2% of fund assets in brokerage commissions. Not surprisingly, the fund’s performance isn’t that great.

What’s bad is these numbers aren’t reported to mutual fund shareholders as part of the management expense ratio.

Should they be?

Yes, mutual fund net returns take into account such fees, but the information on these fees is usually buried in the mutual fund’s prospectus. The author of the article does mention that Morningstar plans to start tracking and publishing this information in the future.

11 thoughts on “Interesting Morninstar Article on Mutual Fund Trading Costs”

  1. It’s good that Morningstar is going to public more on the costs behind these type of funds. There are people who get rich by just being the ‘middle-man’ on these funds: from the brokerage fees, front-loaded sales fees (commissions), kickbacks, advertisers, and all the other stuff.

    Bogle (founder of Vanguard) argues that such fees doom actively managed mutual funds to be underperformers. I tend to agree with Bogle, but at the same time, if the masses all invest in index funds then there is not as much price-control that the short-sellers and active traders bring to the market.

    Personally I wouldn’t want to own an under-performing actively managed fund, while the fund manager (and cohorts) walk away with millions whether you make money or not. But I do see a place for both types. Kudos to Morningstar for bringing more transparency into the fees.

  2. This is an area most investors don’t understand. And, it isn’t a surprised as mutual funds are not required to put brokerage costs and bid/ask spreads in the prospectus. These costs are found on the Statement of Additional Information (SAI). This document is not required to be provided to clients like a prospectus. The prospectus only shows the annual expense ratio, but as the Morningstar article points out, these additional fees really add up. In fact, I am surprised to see 0.3% used; I have seen numbers where the average is closer to 1%.

    I have a friend who use to work at a company that tracked insider sales (corporate insiders). This is information that fund managers could dig up with 10 or 15 minutes work, but this company summarized the info and charged $50,000 per year. That is not a misprint. Anyway, the fund managers would buy it and tell my friend to let his broker know. The broker would pay for it then make up the costs through the brokerage commissions when the fund manager made trades. Doing it this way keeps the cost out of the annual expense fee and can be hidden from those who don’t look at the SAI.

    So before investing in a fund look at more than just the prospectus and annual expense fee. Otherwise, you could end up paying much more than you think for the fund.

  3. I’m a CFP, and I’ll take managed funds 90% of the time. Name me a category (US small cap blend, International large cap growth, global bonds, high yield corporate bonds, etc), and I’ll give you a managed mutual fund that has handsomely outperformed the corresponding index net of all fees.

    Because of proper asset allocation and the outperformance of certain managed funds, most of my clients lost far less than the S&P 500 in 2008 and the majority of them still beat the S&P 500 to the upside in 2009.

    Even a more crappy fund like MFS Core Growth that you cited has still outperformed the Vanguard Growth Index 180% to 123% (net of all fees) since its inception in 1996.

    If even a crappy fund like this with “high trading costs” smokes its corresponding Vanguard index fund, Jack Bogle should be shaking in his boots.

    With almost 60% outperformance in less than 15 years, how worried should we really be about this issue you brought up???

  4. @ Travis: I am a CFP too, and your statement is contrary to every academic work done by PhDs with no hidden agenda. How about this? You give me your favorite funds in each asset class. We will see how they compare five years from now based on their performance relative to an appropriate benchmark.

    In 2008, active funds got slaughtered relative to index funds despite the fact that index funds are 100% invested. The upturn has been the same. I would like to see your references.

    Certainly, there are some funds that have beaten their index, but it is hard to determine if they will continue to do so. If you are a CFP then you know the phrase, “past performance is not a guarantee of future performance.”

    The funds that do seem to find a way to top an index fund year after year actually mimic index funds in many ways: low turnover, low costs, tax efficiency, etc.

  5. Kirk,

    Easy challenge. Where should I start? US large cap value. My favorite there is MFS Value. MFS Value outperformed the Russell 1000 Value index by 7.78% in 2007, by 4% in 2008, and by .79% in 2009.

    US small cap blend? My favorite there is Royce Special Equity. Royce Special Equity outperformed the Russell 2000 by 6.31% in 2007, 14.17% in 2008, and 1.21% in 2009.

    International large cap blend? My favorite there is American Funds Euro Pacific. Euro Pacific outperformed the MSCI Eafe by 7.79% in 2007, 2.85% in 2008, and 7.32% in 2009.

    Intermediate-term corporate bonds? My favorite there is PIMCO Total Return. PIMCO Total Return outperformed the 5-10 yr Barcap Bond Index by 1.02% in 2007, underperformed it by .73% in 2008, and outperformed it again in 2009 by 6.83%.

    And these are the numbers of only the past 3 years. The longer-term numbers are even better. Don’t tell me every managed fund got slaughtered in 2008. 2008 was a great year for most of my managed funds against their indices. Even better if you evaluate them on a risk-adjusted basis.

    The stat that most managed funds underperform their index is very misleading since most of them have betas less than 1.0 against their corresponding index. If a fund is taking on less risk than an index, you wouldn’t expect it to be up more than an index when the stock market rises. The key is to evaluate managed funds on a risk-adjusted basis.

    Past performance is no guarantee of future performance, but I have found it to be very worthwhile. All of the funds I stated before I have been in for many, many years, and I chose them not based on 2007, 2008, and 2009 numbers but on performance prior to that. Obviously, you can see that this research paid off nicely the past 3 years.

  6. Good picks. We shall see if they do as well over the next five years.

    As far as the beta, I agree. When you are required to hold cash for redemptions, you won’t have a beta of a fully invested index. Of course, funds advocate active management because the “pros” can beat the market. So they can’t have it both ways.

    You did well with your picks – good job. I look at long term probabilities and they don’t bode well for most funds. So keep your taxes and expenses as low as possible since those are the only factors an investor can truly control.

  7. Low betas are primarily a result of how the fund managers invest, in my opinion. Cash positions constantly change, yet most funds that I follow maintain constant betas throughout the years. You have to know your manager and how he invests (aggressive, opportunistic, always conscience of downside risk, etc).

    What’s remarkable is that the three equity funds I listed above have all easily outperformed their respective index for the past 3 years (and beyond!) while offering 4-20% less risk (as measured by beta) than their appropriate index. Something else to take into account.

    Outperformance + less risk than the market = definite value added for the client

  8. I agree with Kirk — it is easy to look into the past and then make ‘picks’. Let’s see how the next 5 years turn out for Travis’ picks.

    Travis still has not told us what crystal ball he would’ve used years ago to pick his list. Trying to pick an outperforming actively-managed mutual fund is equivalent to trying to pick the right stock — you can’t unless you can predict the future.

  9. BG,

    It’s sad that the Vanguards and ETF indices out there are brainwashing investors so much. This idea of thought gained momentum in the 90’s when the stock market was going up 30 and 40% a year, and no one could keep up – so everyone figured indexing was the best route. Then came the NASDAQ bubble burst, 9/11, and the financial meltdown, and now more and more people are realizing the benefits of managed funds.

    Why are there hedge funds if no one can beat the market? How did Buffet or any of the other great investors get rich?

    Look at Davis New York Venture (NYVTX), a publicly managed fund anyone can purchase. Since its inception in 2/17/1969, the fund has produced an 11.75% annual return net of fees.

    Meanwhile, the S&P 500 Index during this time returned 9.44% per year.

    These numbers were very similar 10 years ago, so let’s look at how you would have done the past 10 years if you used the past as your guide:

    NYVTX 10 year annual return: 2.43%
    S&P 500: -0.95%

    NYVTX 5 year annual return 1.16%
    S&P 500: 0.42%

    NYVTX 2009 return: 32.06%
    S&P 500: 26.46%

    In summation, NYVTX has outperformed the S&P 500 index by an average of 2.31% per year (including a 5.5% killing in 2009) since 1969 net of fees.

    I really feel sorry for those who put all their money in a couple index funds and think that’s the best they can do. The problem is that there are so many crappy mutual funds out there that don’t add any value… and no one has the time, the data, or the capacity to actually find and compare the indices against the good managed funds. Or research the managers and compare risk-adjusted returns.

    Then again, that’s what good financial advisors ought to be doing for their clients. But just like mutual funds, there are plenty out there that don’t add any value to the client as well.

  10. #9 Travis) I think we are going to have to agree to disagree. It feels like you are looking into the past and _then_ finding good funds. Likely if NYVTX didn’t outperform the S&P500 in 2009, you would not be talking about it right now.

    The only way to know would be for me to ask you: what percentage of YOUR clients did you have in NYVTX _prior_ to 2009? And compare that to the percentage of your clients you have in NYVTX today.

    If the latter is significantly bigger than the former, then you are just finding these great funds after the fact, which is the point I’m trying to make.

    The only way to prove this is for us to wait the 5-years and see how well your ‘picks’ from post #5 do, compared to their respective indexes, between today (April 9th, 2010) and 5 years form now (April 9th, 2014). I’ll see ya then!

  11. NYVTX has been my biggest US large cap holding for the past 5 years. Regardless what happened in 2009, it has a phenomenal 40 year track record.

    I never judge a managed fund based on only 1 year.

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