Last Friday, we mentioned John Wasik's Bloomberg column on the implicit costs of mutual fund ownership. This story deserves a closer look, so here are a couple highlights (i.e., lowlights, with our emphasis added to the ugly numbers in the third paragraph):
Once you pull the curtain away from an actively managed mutual fund, you won't like what you see if you are able to tally total expenses.
The corrosive effects of trading and research-related costs are the equivalent of buying a muscular sports car and finding out you have the performance of a sub-compact engine. These charges are poorly disclosed, yet have a negative effect on fund returns.
...
How much trading costs curtailed returns depended upon the size of the stocks traded. Large-company funds averaged 0.77 percent annually on transactions. Small-firm managers averaged 2.85 percent.
...
Part of the reason for cost-inefficient trading may have to do with the nature of the open-ended mutual fund. With money constantly flowing in and out for contributions and redemptions, managers must buy or sell accordingly.
That last passage is especially important because it goes to mutual funds' structural features. Facing ongoing contributions and redemptions, fund managers have no choice but to trade frequently, and the costs of doing so are distributed to all shareholders on a pro rata basis. As with the distribution of realized capital gains even to investors who didn't realize such gains (because they didn't sell any of their own shares), mutual fund investors end up paying the bill for other investors' activity.
As we've noted repeatedly (here and here, for example), the problem with the vast majority of actively managed mutual funds isn't that active management per se is doomed to fail. It's that it's an undesirably low-probability venture in the context of the typical big, diversified, style-constrained mutual fund.
For more on implicit mutual fund expenses, see our previous posts here and here.
Source
John Wasik, "Soft-Dollar, Trading Costs Devour Fund Returns," Bloomberg, July 30, 2007
