Everybody should understand by now that high mutual fund fees drag performance down over time. Given the large majority of active fund managers underperform their respective benchmarks (e.g. 84% underperformed in 2014, ~75% underperformed over the past 10 years), paying high fees for underperformance over the long run is silly.
The vast majority of your investment portfolio should be invested in low-cost ETF index funds. I’m talking an 80%+ allocation with the rest to seek multi-baggers if that is your desire. For example, if you want to gain exposure to large-cap dividend yielding companies, consider VYM, the Vanguard High Yield Dividend ETF with a 0.09% expense ratio, compared to 0.5% – 1.2% for many other actively managed funds. The good thing about holding individual stocks is that there are no ongoing fees.
In a difficult investing environment, fees matter more than ever. But what may be even more important than the ongoing management fee is the fund’s turnover percentage. I’m going to share with you a case study I recently researched for Motif Investing about how high fees rob you of your retirement. I’ll also give you some insight on how big mutual funds go about selling their huge positions.
THREE POPULAR ACTIVE MUTUAL FUNDS
Take a look at three of some of the largest actively run mutual funds in America. All three firms are private. And all the portfolio managers of these funds are beyond wealthy due to the fees they earn.
A quick analysis tells us several things:
* The 5.75% front load fee charged by the American Funds is incredibly high. Front load is a commission or sales charge applied at the time of the initial purchase of an investment. In other words, if you invested $100,000 in AGTHX, you would have to pay an up front fee of $5,750, and then an ongoing expense ratio of 0.65% a year. That’s kind of nuts, especially if you decide the fund is not for you the following year. The American Funds employ the brightest people on Earth. But even the brightest people on Earth have a hard time consistently outperforming over the long run. Try not to pay front load fees.
* All funds charge around the same Expense Ratio of 0.64% – 0.65%, which makes me wonder whether there’s some collusion going on among the big funds or whether this is just “industry standard.”
* What’s missing from the above charts are the fund’s respective turnover percentages. They are 45% for the Fidelity Contrafund, 29% for The Growth Fund Of America, and just 12% for the Dodge & Cox International Stock fund.
* The Dodge & Cox International Stock fund’s performance of -21.6% over the past year is 16X worse than the Fidelity Contrafund’s performance of -1.37%, once again reminding us that paying a fee for a high chance of underperformance doesn’t make sense.
HIGHER TURNOVER MEANS HIGHER FEES
To illustrate why higher turnover could mean higher fees, pretend you are Will Danoff, fund manager of the Fidelity Contrafund with $78 billion in assets under management. You want to sell 100% of your Facebook holding, which equates to 5% of the fund.
1) Cost per share fee. Wall Street trading desks charge a fee per share to sell. Fidelity owns $3.9 billion dollars worth of Facebook shares (5% X $78B). This equates to 39 million shares selling at ~$100 a share. If Morgan Stanley charges 1 penny a share to sell, the cost comes out to $390,000 in trading commission! Too bad they can’t just pay <$10 per trade like retail investors with online brokerage accounts.
2) Block transaction fee. With an amount this large, a broker will tend to try and arrange a block sale to another interested fund to minimize market disruption. In other words, Morgan Stanley might find one or multiple FB buyers from Wellington, the American Funds, Blackrock, or a large hedge fund to cross the trade and collect a negotiated fee as an agent on both sides. If Morgan Stanely wanted to risk capital, it could conceivably bid on the $3.9B block of FB at a discount to try and resell at a higher price to other clients if it had balls of steel. But $3.9B is too much stock when compared with Morgan Stanley’s balance sheet. Agency transactions are much more common as opposed to principal transactions.
3) Market movement cost. The biggest cost to Fidelity’s Contrafund is likely not the commission costs, but the implication of what selling $3.9B in Facebook stock could do to the stock’s share price if no block transaction is arranged. There is often a leakage when a large fund wants to get out of a large position because multiple people are involved. This is why electronic “darkpools” were invented to keep trading as anonymous as possible. As soon as the Street gets whiff that $3.9B of FB is being sold, traders will tend to front run the sale to get out first. As a result, instead of selling FB stock at $100 a share, by the time the Contrafund gets out, they might have to sell at an average of $95 a share, resulting in $200 million less in proceeds!
Only about $3B worth of Facebook stock trades a day on average to begin with (30 million shares traded X existing price). Therefore, selling $3.9B of stock without disrupting the market, will probably take at least 10 trading days if you instruct Morgan Stanley to be no more than 1/10th of the average daily volume per day. Even if nobody finds out that Fidelity is the seller of $3.9B of stock, savvy traders will still know something is up. The general thinking is that when large amounts of stock is for sale, someone smart knows something bad might be up, and others will tend to sell at the margin without knowing exactly what’s going on.
4) Costs to purchase a new position. Now that you’ve got $3.7 – $3.9B in proceeds from the Facebook stock sale, you now want to buy a new 5% position for your fund. Or, you might want to spread the proceeds to beef up existing holdings. You’ve got to now go through the same process with your institutional broker again. But this time, you will probably have to pay UP for the new shares, especially if the Street gets whiff of your plans. The higher the purchase price per share, the lower your fund’s performance. You could theoretically take months to accumulate your position to cause the least amount of disruption possible, but actively run mutual funds have a fiduciary duty to be fully invested at all times. If the price of the stock you want to buy moves up 3% higher on average, you’ve now got to pay $111 – $117M more for the stock + another several hundred thousand in trading commission cost.
5) Higher taxes. Finally, the more a fund trades, the more a fund has to pay in taxes. Theoretically, if a fund held a position forever, it would never have to pay any capital gains taxes, only taxes on dividends. The short-term capital gains tax rate follows ordinary income tax rates. The long-term capital gains tax rate is at 15% and 20% for most tax payers. Therefore, it behooves investors to hold their positions for at least one year.
INVEST IN LOW TURNOVER FUNDS
Anybody who has experience actively trading their portfolio realizes after a while that many of their gains are often negated by their losses. For over 15 years I was an active trader with 10-20% of my investable assets. When it came time to do my taxes, I was often amazed how futile active trading seemed to be. The great majority of time, I would have been much better off simply holding.
A good rule to estimate is that every 10% in portfolio turnover means a negative -0.1% portfolio drag. Therefore, if a portfolio turns over 100% a year, expect a 1% decline in performance on top of the fees you are already paying. But as we see above with Dodge & Cox International’s -21.6% one year performance, even a low 12% turnover ratio can’t help if they pick bad stocks! The Vanguard Dividend Yield ETF not only has an expense ratio of 0.09%, but a turnover of 11%. Now that’s a winning combination for long term investors.
If you want to see what a fund’s portfolio expense ratio and turnover is, simply head over to Yahoo Finance, type in the fund’s ticker, and click Profile. Or, you can analyze your entire portfolio’s expense ratio through Personal Capitals free Portfolio Fee Analyzer to see how much you’re paying. They suggest a benchmark of paying 0.5% or less in fees. Below is a annual fee analysis of one of my investment portfolios that is at only 0.17%.
Updated for 2017 and beyond.