Morningstar Advisor - June/July 2013 - (Page 80)
Phillips Curve
Mutual Fund Urban Myths
By Don Phillips
Like all areas of human endeavor, the fund
industry is prone to its share of urban myths—
stories that simply aren’t true but which
contain enough of a basis in reality to make
them seem plausible. These untruths get retold
with such passion and frequency that people
eventually accept them as gospel, and they
become part of the industry’s shared beliefs.
One urban myth circulating among investors is
that mutual funds have hidden fees of 140 to
200 basis points that are omitted from expense
ratios. When these hidden fees are added
to a fund’s stated expense ratio, they presumably bring overall annual fund expenses to
something in the 2.5% to 3% range. When the
additional toll of taxation is taken into account,
the total cost of fund ownership is supposedly
close to 5% for some funds. It’s enough to send
shivers down your spine.
While the terror of taxation on fund shares one
continues to hold is real, the 140 to 200 basis
points in hidden costs are largely fiction.
The idea does have a basis in reality, however.
Mutual funds do omit the cost of trading
securities from their expense ratios. Funds do
disclose in their financial statements the dollar
amount spent on brokerage commissions, and
Morningstar translates this number into a
percentage of assets that can be appended to
the expense ratio to get a truer sense of a
fund’s all-in costs. However, the median
brokerage cost for large-cap U.S. equity funds
is nowhere near 200 basis points. For large-cap
funds, it clocks in at less than seven basis
points. (Small-cap funds have somewhat higher
brokerage costs.) But this number is just the
dollars spent on commissions; it doesn’t
account for the friction of a manager pushing a
80 Morningstar Advisor June/July 2013
stock price up when buying or down when
selling. The estimates of this frictional cost are
what send the projections of the total hidden
costs soaring.
Trading friction is a real cost, but the notion
that it totals 140 to 200 basis points is
preposterous. The early champions of this myth
were salesmen for separate-account wrap
programs who wanted to inflate the costs of
mutual fund ownership to justify the high fees
of their services. These critics are easy enough
to dismiss. But there have been a couple of
academic studies that prop up this notion of
high hidden fees. To these, one should be more
gracious. It is conceivable that a single fund
that did a very bad job at trading could run up
hidden trading costs of 140 basis points, but for
that figure to be an industry average is absurd.
The obvious example that dispels these claims
is index funds. If trading costs were anywhere
near this magnitude, funds like Vanguard 500
Index VFINX would not be able to so closely
mirror their assigned index’s performance.
Index proponents have been quick to point this
out, but they often want the charge of high
hidden fees still to stick against actively
managed funds. That’s not kosher. If the claim
is overstated for index funds, it must also be for
active funds.
Let’s do the math. If actively managed stock
funds really had these costs, the average
fund would trail an appropriate index, which
has no trading costs, by its expense ratio
plus 140 basis points. It doesn’t. Over the
trailing 10 years ending March 31, 2013, the
average U.S. large-cap equity fund, on an
asset-weighted basis, trails the market index
by its expense ratio plus about 39 basis points.
Over the past five years, this figure shrinks to
25 basis points. This means that the total
hidden cost in funds must be less than one fifth
the oft-quoted estimates. Put another way, the
thing lurking in the shadows of your mutual
fund is a squirrel, not a werewolf.
To embrace the 140-basis-point-hidden-fee
claim, one would have to accept that
the average equity fund manager somehow
adds more than 100 basis points of value
through stock picks before the cost of
transacting is considered—an assumption that
would fly in the face of financial theory. If this
were true, then one must also conclude that
indexing is an irresponsible investment choice,
because in choosing an equity index fund,
one would leave behind more than 100 basis
points of readily accessible value. The most
prudent investment choices would be actively
managed, but very-low-turnover strategies,
not index funds. This is the logical conclusion if
index proponents want to claim that active
funds have these high hidden costs.
Clearly, these cost estimates must be
recognized as being grossly overstated. At the
same time, it’s key to note that what’s wrong
with these estimates is their magnitude, not
what they expose. Trading is often counterproductive, no matter how convinced one is that
the next trade will add value. That’s a lesson
for both fund managers picking stocks and for
advisors moving between funds. In many cases,
the best approach, as Jack Bogle likes to say, is
don’t just do something, sit there! K
Don Phillips is president of Morningstar’s
Research group.
Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013
Morningstar Advisor - June/July 2013
Contents
Contributors
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths
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