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Why Even Vanguard’s Mutual Funds Cost More Than You Might Think
May 04, 2015

Why Even Vanguard’s Mutual Funds Cost More Than You Might Think

Authors Kurt Vonnegut and Joseph Heller were chatting at a party on Shelter Island. Their host was a billionaire hedge fund manager. At one point, Vonnegut says to Heller, “You know, this billionaire makes more money in one day than you made in your whole lifetime from your novel Catch-22.” 

Heller responds, “Yes, but I have something he will never have…enough.”

Catch-22 wasn’t just read by a few of Heller’s sympathetic friends. It has sold more than 10 million copies.

John Bogle tells this story in his 7th book, Enough.  He says that mutual fund companies--like that hedge fund manager--just can’t seem to stuff enough money in their wallets. In 1945, the largest 25 mutual funds in the United States cost an average of 0.76 percent per year.  Lower trading costs and technological advances have since reduced the cost of doing business—for mutual fund companies. Investors, on the other hand, could be Wall Street’s public patsies. The biggest active funds in 2004 cost 1.56 percent.  Bogle estimated that by 2007, the industry bled more than $100 billion a year from American investors.

Investors can avoid this if they buy index funds.  They’re cheap. But others still hope they can beat the market.  They buy active funds instead.  The smartest among the optimists who hope to beat the market choose what’s cheapest. 

Vanguard’s U.S. Growth Fund (VWUSX) costs 0.44 percent. Vanguard’s Windsor II fund (VWNFX) costs just 0.36 percent. Vanguard’s International Explorer (VINEX), International Growth (VWIGX) and International Value Fund (VTRIX) cost 0.40, 0.47, and 0.44 percent respectively. 

Some investors pay even less for active management. In 2011, iShares launched its first active ETFs. To buy or sell them, investors have to pay brokerage costs.  But they still might be the world’s cheapest active funds.

iShares Actively Managed ETFs Annual Expense Ratio
iShares Enhanced U.S. Large Cap Fund ETF (IELG) 0.18%
iShares Enhanced International Large Cap (IEIL) 0.34%
iShares Enhanced International Small Cap (IEIS) 0.49%
iShares U.S. Small Cap Fund (IESM) 0.36%

Having said that, no active fund is as cheap as it appears. In 2013, professors Roger Edelen, Richard Evans and Gregory Kadlec published Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance in the Financial Analysts Journal.  These invisible costs drain profits just as easily as expense ratio charges.  They include brokerage costs, bid-ask spreads and price impact costs.

Brokerage costs

Active fund managers trade stocks.  When doing so, they pay brokerage fees.  The proceeds come from their respective funds.  Fund investors pay the bill. Between 1995 and 2006, the average active fund cost its investors 0.14 percent per year from brokerage charges.

Bid-Ask Spreads

When fund managers trade stocks, they also pay bid-ask spreads.  These are the small differences between a stock’s buying price and its selling price.  Professors Edelen, Evans and Kadlec say such costs add an additional 0.13 percent to the typical mutual fund.

Price Impact Costs

Finally, investors pay price impact costs.  When fund managers sell or buy a stock, they often aren’t able to do it with a single transaction.  When they begin to sell, it sends the stock’s price lower.  So the fund gets less money per share while the manager is selling.  The opposite occurs when a fund manager buys.  It creates a small demand, which nudges the stock price higher.  On average, this detracts 0.53 percent per year from the typically actively managed mutual fund. 

The Real Total Cost

On average, actively managed funds slap investors with a 0.8 percent annual cost that doesn’t show up on fund prospectuses. Add that to a typical mutual fund’s expense ratio, and it costs active fund investors about 2.1 percent per year.

For your best odds of retiring with enough, consider Index Funds. Invisible costs are lower because they aren’t actively traded.  They may be the only way to end up with more… for less.

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

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