By Richard Ferri, CFA
You can’t control the markets, but you can control how much it costs to invest in them. Mutual fund costs are often couched in terms of expense ratios and commission charges, aka structural costs. Behavioral costs and tax costs are not as obvious and are often difficult to quantify. It’s wise to know all the costs, so you can prevent them from eating away too much of your return.
The Cost Triangle: The Investment Cost Triangle combines structural, behavioral, and tax costs together to illustrate the total costs to which we are all exposed. No one is immune from them, but you can (and should) minimize your exposure.
The Investment Cost Triangle
Source: The author’s forthcoming book, “The Education of an Index Investor”
Structural costs are easy to quantify because providers are required by law to disclose their fund fees and commissions. Tax costs are more difficult in that they have to be extracted from your individual tax returns. Behavioral costs are the most elusive because there’s no simple way to quantify how badly someone’s behavior is hurting his or her return. Yet, bad behavior is often the most expensive cost.
Structural Cost: Securities law requires that fund companies disclose the fees they impose. These costs include management fees, administrative costs, distribution fees, commissions, redemption fees, and more.
Structural costs have a direct impact on investment performance: When your structural costs go down, your expected return goes up. Many studies have been published over the years that link an investment’s return to its structural costs. Overwhelmingly, a negative correlation exists between cost and return: The higher the structural cost to invest, the lower the average fund return, and vice versa.
Since most market-tracking index funds and exchange-traded funds (ETFs) are in the low-expense category, they have generated higher historical returns than higher-cost funds in comparable investment classes.
Behavioral Cost: Advertised fund returns are based on a formula that compares the performance of one mutual fund to another after factoring out all deposits and withdrawals from the funds. This is the fund’s advertised performance. A different picture emerges when the performance is based on what investors actually do. This investor return lets us compare the timing of fund purchases and sales (investor behavior) to a fund’s reported performance.
Many researchers have compared a fund’s advertised performance to its investors’ returns. In most funds, investor returns tend to lag behind fund performance, which means that investors are making poor timing decisions. One research paper linked a large performance gap to higher structural cost. The results were astonishing!
Investors who pay high fees for investment products are, on average, receiving less of a fund’s return than those who are paying low fees. To be blunt, this is probably because people who pay high fees tend to be less financially astute and are more likely to trade based on recent past performance. That doesn’t work. Paying low fees and staying the course toward one’s own financial goals is almost always a better choice.
Tax Cost: Within taxable accounts, there are three taxable events that can be caused by investing in funds: dividend payments, capital gains from fund distributions, and realized gains created by a shareholder fund sale. Dividend distributions primarily come from the interest and dividends earned by the securities in the fund’s underlying portfolio, after expenses. Long-term capital gains distributions within a fund represent the fund’s net gains from the sale of securities held in its portfolio for more than one year. Since index funds are managed using a low turnover, they often realize and distribute capital gains less frequently than actively managed funds, especially short-term gains that are taxed at a higher rate.
Total Cost: Structural, behavioral, and tax costs are often interrelated. If an investor pays high fees, he or she is usually also turning over the portfolio more than necessary, and incurring higher behavior gap costs while increasing taxes relative to their gains. Understanding how these costs relate and controlling them will help you earn––and keep––your fair share of the market’s return.
Less sophisticated investors pay at every turn. They’re buying high-cost funds and trading them more frequently. Research, not to mention common sense, shows that this lowers return, widens the behavior gap, and exposes the gains to a higher tax burden.
In contrast, index funds are a great way to control your triangle of total costs. The fees are lower, there’s less tendency for the investor to chase past performance (and no performance-chasing within the fund itself), and the tax burden on gains is minimized. It’s a win, win, winning strategy.
RICHARD A. FERRI, CFA
Managing Partner and Chief Compliance Officer
Richard (Rick) Ferri is the founder, Managing Partner, and Chief Compliance Officer at Portfolio Solutions®. He directs the firm’s research and education, and is the Head of the Investment Committee. Rick has over 25 years of experience in the investment industry including more than 10 years as a financial consultant at two major Wall Street firms. He graduated from the University of Rhode Island with a B.S. degree in business and from Walsh College with an M.S. degree in finance. Rick is a CFA® charterholder who has published extensively on low-cost investing using index funds and ETFs, including six books and hundreds of articles. Rick is also a retired Marine Corps officer fighter pilot.
You can learn more about Rick Ferri and read his biweekly blog postings on low-cost investing strategies in our blog section or at www.RickFerri.com.
