As evidenced by the increasing use of passive investments in DC plans, investment costs have become increasingly influential in terms of how plan sponsors and their advisors select investment vehicles.
Most cost comparisons are based on a fund’s total expense ratio (external costs). However, what is not included in this number is the aggregate trading costs (internal costs). Due to the fact these costs are not calculated and communicated in a straightforward manner, they are often called “invisible” costs.
The two big questions are: How much do these internal costs tally up to and do they have a positive or negative impact on investment return? A recent paper authored by Roger Edelen, Richard Evans, and Gregory Kadlec and published by the Financial Analysts Journal, “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance” offers a few answers to these questions.
The report provides a great deal of detail as to their methodology they used for estimating internal fund costs. The calculations they use seem to be reasonable. They applied this cost analysis to a sample of 1,758 domestic equity funds from 1995 to 2006, and this is what they found:
- Funds’ annual expenditures on trading costs (i.e., aggregate trading cost) were comparable in magnitude to the expense ratio (1.44% a year versus 1.19%, respectively).
- Sorting funds on the basis of their aggregate trading-cost estimate yielded a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase. The difference in average annual return for funds in the highest and lowest quintiles of aggregate trading cost was –1.78 percentage points.
Clearly, the average fund’s internal costs are significant and these cost have a deleterious impact on return. This could be due to the added cost or the fact that they reflect a hyperactive manager who has an ever-shifting investing strategy. Or, perhaps, this lower return could be reflective of forced turnover due to hot money moving in and out of the fund, thus driving up transaction costs. In many respects it really does not matter why there is a correlation. More importantly, at least based on this study, a significant negative correlation exists between the level of a fund’s internal expense and its ultimate return.
The authors also provide a method for approximating a fund’s internal costs. The traditional proxy for internal costs has been a funds turnover rate. The shortcoming of focusing only on fund turnover is that it does not capture the impact of fund size (i.e., trade size) and stock liquidity (i.e., small cap versus large cap). For example, a small cap fund may have half the turnover of a large cap fund and still have higher internal costs. The report offers a methodology, which they call “position-adjusted turnover,” that makes allowances for fund size and stock liquidity. This is a helpful tool to approximate internal fund costs that are otherwise hidden.
Conclusion
Based on this recent analysis, there seems little doubt that internal expenses do matter. In addition, there is a relatively simple formula for estimating these costs.
Besides knowing the costs and factoring these costs into the fund evaluation process, there have been other ways that advisors have sorted out funds with high internal cost:
- Focusing on managers who strongly adhere to a well-defined process and philosophy and are, thus, more likely to make slight course corrections as opposed to changing their course dramatically. Managers with a strong investment philosophy tend to stand by their convictions through unfavorable market cycles.
- Focusing on funds that have low demands on liquidity such as institutional investors or financial advisors committed to long-term investing.
In the event that an index fund is used, many advisors utilize a custom index rather than one seeking to perfectly track a commercial index. A passive fund manager, who has the latitude to trade in a patient manner without having to worry about “tracking error, has more flexibility when it comes to managing transaction costs.
