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3 Costs Investors Must Control

The cost to invest in mutual funds is often couched in terms of expense ratios and commissions. These are important structural costs and certainly worthy of your consideration. However, other costs are not so obvious that can eat deep into your investment return. It’s wise to know what those costs are and how they relate to each other.  

Two large costs that are not as obvious as expenses, and often difficult to quantify, are behavioral and tax costs. Behavioral cost occurs when an investor turns over his or her portfolio more frequently than they should and tax cost occurs from fund distributions and share sales in taxable accounts.

Interestingly, the structural cost, behavioral cost and tax cost in a portfolio are often interrelated. If an investor is paying high fees, he or she is usually turning their portfolio over more than a low-fee investor and thereby incurring a greater behavioral cost as well as paying more to taxes relative to their gains. Understanding these costs and how they are related will help an investor earn their fair share of the market’s return.

The Cost Triangle:

The Triangle figure above illustrates how the three costs; structural, behavioral and taxes, combine together to create the total costs we all face. I believe the best investors learn to minimize these costs, but I don’t believe anyone is immune to any of them.

Some costs in Figure 1 are easy to identify and quantify while others are not. Structural costs are generally available because most fund fees and expenses are required to be disclosed by law. However, tax costs are more difficult in that they have to be extracted from tax return data. Behavioral costs are the most elusive and difficult to quantify because there’s very little data available. It also doesn’t help that human beings are overconfident and don’t want to be reminded of behavioral shortcomings.     

Structural Cost:

Securities law requires that fund companies disclose the structural costs they impose on investors. These costs include, but are not limited to, management fees, administrative costs, distribution fees, commissions, redemption fees and more. Some costs are not disclosed, such as the true cost of internal trading by a fund, but by and large a majority of structural costs can be found through research and by asking the right questions.

Structural costs have a direct impact on investment performance. Many studies have been published over the years that link the return of managed funds to investment costs. In every case, a negative correlation exists between cost and return - the higher the structural cost to invest, the lower the average fund return and vice versa.

The data in Table 1 was derived from a recent US equity fund performance study, Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies, by Jason Hsu, Brett Myers and Ryan Whitby. The authors bucketed funds into five categories by expense ratios and compared the results. They measured and compared the performance of thousands of funds from 1991 to 2013, including funds that closed or merged over the period.

Table 1: US Equity Mutual Fund Returns Sorted by Fund Expenses 1991-2013

Fund Expense Ratio

Time Weighted Return

Low

9.22%

2

8.85%

3

8.35%

4

7.84%

High

6.88%

 Source: Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies

In this study, as in all studies I have personally conducted and read about, low-fee funds outperformed high-fee funds. Since most market tracking index funds and exchange-traded funds (ETFs) are in the low expense category, they generated higher historical returns than a higher cost actively managed portfolio. This information is documented in a 2014 Vanguard study, The case for index-fund investing.  Another article I co-wrote with Alex Benke of Betterment, A Case for Index Fund Portfolios, demonstrates how all index fund portfolios performed relative to all active fund portfolios showing index fund results as consistently superior.

Behavioral Cost:

Table 1 represents the Time Weighted Return (TW) of mutual funds. This is the calculation used in the investment industry to compare the performance of one mutual fund to another. TW assumes there was $100 invested in a fund at its inception and that no more money was added or taken out during the investment period. As odd as this may seem, it’s the best way to measure and compare fund managers’ performance. A fund manager should not be helped or harmed by the actions of investors coming and going in the fund. TW factors it all out.

A different picture emerges when the performance of investors in a fund is calculated. This is called a Dollar Weighted Return (DW) calculation. It takes into consideration the timing of money moving into and out of a fund. If a lot of money moves into a fund before superior performance, it increases the DW. If a lot of money moves in before bad performance, it lowers the DW return. The reverse is true for poor performing periods. This shows how investors are faring with their decisions to buy or sell the fund rather than how well the manager has made investment decisions.

A gap tends to form in most funds over time between TW returns and DW returns. This is the shortfall investors incur from poor timing of share purchases and sales. I called this the Performance Gap in my 1999 book, Serious Money, while others call it The Behavior Gap, a term coined by Carl Richards, while Morningstar calls it the Investor Gap. Despite what it’s called, most investors are underperforming the funds they invest in due to bad timing.

Hsu, Myers, and Whitby compared the DW of US equity funds in their study and sorted the results by expense ratios and compared it to TW. The results were eye-opening in that the behavior cost of high fee investors soared!      

Table 2: US Equity Mutual Fund TW vs. DW Returns Sorted by Expenses 1991-2013

Fund Expense Ratio

Time Weighted Return

Dollar Weighted Return

Difference

(DW Ret less TW-Ret)

Low

9.22%

7.88%

-1.34%

2

8.85%

6.93%

-1.92%

3

8.35%

6.07%

-2.28%

4

7.84%

4.80%

-3.04%

High

6.88%

2.87%

-4.01%

Source: Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies

The authors state the exact reason for this pattern is beyond the scope of their paper, however, they wrote “investors who invest in high expense ratio funds might, on average, be less financially knowledgeable or do not have access to professional wealth advisors. Thus, they are more likely to over-extrapolate and aggressively trade their mutual funds to chase past fund performance”. The high turnover caused by chasing performance lowers an investor’s DW return.  

The apparent link between high fund expenses and high portfolio turnover creates double-trouble for less sophisticated investors. Their structural costs are high so the TW returns of the funds are lower, then bad behavior drives down their DW return further. In contrast, investors who use low-fee funds tend to favor buy-and-hold and this creates the added benefit of lowering behavior cost.

Tax Cost:

There are three taxable events that can be caused by mutual funds investing, including index funds and ETFs. The events are ordinary dividend payments, capital gains from fund distributions, and realized gains created by a shareholder fund sale or a fund liquidating.

Dividend distributions primarily come from the interest and dividends earned by the securities in the portfolio after expenses. This also includes net gains from the sale of securities held in the fund’s portfolio for one year or less generating short-term capital gains. All things being equal, a high-cost fund will distribute less than a low-cost fund because of its higher expense ratio, resulting in investors paying less in taxes – what a deal!

Long-term capital gains distributions within a fund represent the fund’s net gains from the sale of securities held in its portfolio for more than one year. When gains from these sales exceed losses they are distributed to shareholders. Since index funds are managed using a low turnover, they often realize and distribute capital gains less frequently than actively managed funds. In addition, equity ETFs have a mechanism for avoiding most capital gain distributions because of the way shares are created and redeemed in the industry. See The ETF Book for a detailed explanation.

In addition to fund capital gain distributions, when an investor sells shares, he or she will have a capital gain or loss in the year the shares are sold. The investor is liable for tax on any capital gains arising from the sale just as they would with any stock.

We learned earlier that investors in high-fee funds tend to turn their portfolio over more rapidly than investors in low fee funds. This would generate lower dollar-weighted returns and may also generate   more frequent capital gains, which would be taxed in the year the gains are realized. The available data bears this out. Morningstar tracks the pre-tax and post-tax adjusted return rankings of mutual funds in each investment category. The Vanguard Total Stock Market Index Fund (ticker: VTSMX) ranked in the 15th percentile for peer group performance on a pre-tax basis for ten years ending in February of this year. After-tax it ranked in the 8th percentile in its peer group.

In the aggregate, higher cost funds have a larger tax footprint than low-cost funds, particularly index funds and ETFs. Investors in high-cost funds end up paying more in taxes relative to their gains.  

The 3 Costs are Inextricably Linked:

Structural cost, behavioral cost and tax cost are interrelated. The less sophisticated tend to be more active when investing and choose high fee active funds and turn over their portfolios more frequently. This lowers their TW return and widens the behavioral gap between DW and TW returns and they end up paying more in taxes relative to their gains. On the other hand, an investor using low-cost index funds and ETF are likely to capture more of the TW return by behaving well, which allows them to benefit from a lower relative tax burden on their gains. Figure 2 summarizes this observation.

Figure 2: How Structural, Behavioral and Tax Costs Interrelate

Source: The author’s forthcoming book, “The Education of an Index Investor”

Summary:

The cost to invest in mutual funds is multidimensional. Expense ratios and commissions are important; however, behavioral and tax costs have a major impact. Understanding how these three costs interrelate and affect returns will help you lower your overall cost and provide you with a higher probability for investment success.