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 subcompact engine. These poorly disclosed charges have a negative effect on fund returns.
For every dollar a fund spends on trading, assets were pared by an average of 41 cents, according to a recent study. Soft dollars, which are excess commissions paid to cover research and other services, also hurt investors.
Not only do these expenses reduce performance, they can also predict lower future returns. All too often, the more managers trade, the more fund holders suffer.
The study, titled Scale Effects in Mutual Fund Performance: The Role of Trading Costs, should be noted by every mutual fund investor and regulator. It was written by Gregory Kadlec of Virginia Tech University, Roger Edelen of Boston College and Richard Evans of the University of Virginia. The research examined trading costs of 1,706 funds in existence from 1995 to 2005.
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. The study also found a relationship between the size of the trade and returns.
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.
Kadlec and his colleagues scoured fund documents such as statements of additional information, required yet arcane filings that are difficult to understand, even for experts.
In addition to trading costs, they also wanted to know how much soft-dollar deals affect total returns. A typical arrangement would cover the cost of research in exchange for trading through the broker who offers the transaction. The commissions typically are higher than average and are passed along to investors.
Investors are confounded if they want to know how much trading and soft dollars cost because those items aren't included in expense ratios, which cover all other management expenditures.
In dollars, cost-related drag can be measured and it stings. Say you had $100,000 in a stock fund returning 10 percent, with 1 percent in annual expenses over 20 years. With additional yearly trading costs of 0.4 percent, your total investment over that time would be reduced by about $43,000 if you figure in foregone earnings and reduced return.
A way to shelter yourself from theses losses is to consider passive investments such as index and exchange-traded funds.
These portfolios have almost no trading and soft-dollar costs. What you see is what you get, and the real performance is no mystery.