Portfolio Turnover and Transaction Costs

We aren't quite sure when this was published, but we know it was relatively recent. And whatever its publication date, it's worth reading. And whether you read it or not, its central argument is worth understanding: The hidden costs of mutual fund ownership often exceed the stated costs of mutual fund ownership. The implications of all this (for retirement plan sponsors, service providers, and rank-and-file investor-participants) are very important indeed.

The paper in question, by Gregory W. Kasten of Unified Trust Company, appeared in the Journal of Pension Benefits. Its title is cumbersome but telling: "High Transaction Costs from Portfolio Turnover Negatively Affect 401(k) Participants and Increase Plan Sponsor Fiduciary Liability." Indeed. (Download Kasten on Portfolio Trading Costs in 401k Plans.)

Here are Kasten's key findings (emphasis added in bold):

Some important 401(k) costs are turnover-related transaction costs from the portfolio manager's trading. This poorly understood "invisible" cost can be several times higher than more "visible" asset management fees or 12b-1 fees. Because such costs are virtually never included in the prospectus, nor in the fund's published expense ratio, most plan sponsors, plan advisers, and the vast majority of participants are unaware of the significant cost impact high portfolio turnover has on their future retirement benefit.

Unified Trust Company studied 2,431 fixed income funds and 10,922 equity funds for the one-year time period ended December 31, 2006. The average annual turnover of all fixed income funds was 159.8 percent, and the turnover among various fixed income asset classes ranged from 90.9 to 278.4 percent. The average turnover rate of all equity funds was 92.7 percent, and the turnover among various equity asset classes ranged from 58.0 to 182.2 percent.

Next, Unified Trust Company applied the turnover costs per 100 percent turnover based upon published studies it reviewed to the turnover rates of the mutual fund asset classes in the study. It measured an additional average cost of 0.23 percent for fixed income and 1.47 percent for equity funds. A number of equity asset classes experienced turnover-related costs greater than the average expense ratio for the group.

The effective average annual cost (published expense ratio plus turnover costs) was 1.28 percent for fixed income funds and a whopping 3.09 percent for equity funds.

This isn't optional. The reality is too obvious and too important to deny, its effects too devastating to ignore. All serious fiduciaries must consider the nature and consequences of implicit costs in their plans.

But they need to do more than acknowledge them. If those costs are too high, and they're way too high in the vast majority of plans, serious fiduciaries need to reduce them. To do otherwise is to stop well short of ERISA's fiduciary standard of care for participants and their beneficiaries.