In the words of the American writer, politician and investment analyst Harry Browne, “Everything you want in life has a price connected to it. There’s a price to pay if you want to make things better, a price to pay just for leaving things as they are.”
Like everything else, there is also a price for investing in mutual funds. Most people are familiar with the management-expense ratio (MER) as a measure of the ongoing cost of owning a fund, but there are other not-so-well-known expenses that are nevertheless very real.
Of all the costs mutual fund investors incur, trading costs — which are not included in the MER — are perhaps the least transparent. These include direct trading costs incurred by the fund, which are aggregated into the trading-expense ratio (TER), as well as implicit costs.
Investors can find a fund’s TER in its Fund Facts document or in the Management Report of Fund Performance, available on most fund companies’ websites. The TER represents brokerage commissions and other transaction costs expressed as an annualized percentage of the fund’s daily average net asset value during the period. Like the MER, trading expenses are incorporated into the fund performance figures reported by Morningstar.
The TER for fixed-income funds is usually 0%. That’s because bonds are traded over-the-counter, which means the dealers hold an inventory of bonds that they aim to buy low and sell high to their clients. These dealers don’t charge a commission, but that doesn’t mean there aren’t any trading expenses. As compensation for facilitating the trade, the dealer will mark up the bond’s price above where it’s currently trading, and will purchase it back at a price below its current value. This difference between the purchase and sale prices (called the bid-ask spread) reflects the bond fund’s trading costs. The wider the bid-ask spread, the higher trading costs will be.
Costs not captured in the trading expense ratio are known as implicit costs. Investors must be cognizant of implicit costs, though teasing them out can be tough because they’re not published anywhere.
When small investors buy a stock, they pay whatever the market price is at the time they make the trade. For funds, which move a lot more money, that’s not the case. Let’s say the stock of a fictional company called ACME Widgets trades at $10 a share. That’s the price most of us would pay, but the HighAlpha fund (also fictional) would likely pay more. Because the HighAlpha fund is putting a good chunk of money to work, it may push the price of ACME upward. It’s simple supply and demand. A higher demand leads to a higher price.
The supply side of the equation matters, too. In the case of blue chip stocks like Royal Bank of Canada (TSX:RY), millions of shares change hands every day. The HighAlpha fund could probably buy RBC without pushing up its stock price. On the other hand, if HighAlpha wanted to invest in a small gold miner with a few thousand shares changing hands daily, then it would push its stock price upward. Investors only see the final price HighAlpha paid, not the lower price it could have paid if the trade hadn’t influenced the stock price. The difference is known as market impact costs. Fund investors pay these costs whether they know it or not.
Fund expenses rank among the most effective predictors of long-term returns. They are a hurdle for fund managers to overcome, so it stands to reason that the higher the hurdle, the harder it will be for the typical fund to clear.
Trading costs, just like management costs, add up over time. Not all funds are expensive to own. Funds focused on blue-chip stocks traffic in large, liquid stocks, so their trading costs tend to be lower. TD Dow Jones Industrial Average Index, sponsored by Toronto-based TD Asset Management Inc., for example, holds 30 of the largest U.S. companies and has a TER of just .01%. In addition to its focus on big caps, the TD index fund doesn’t trade much, with turnover a modest 27% annually.
Consider what happens when you trade a lot and invest in thinly traded small-cap, resource-based or emerging-market stocks. Sprott Energy Fund, sponsored by Toronto-based Sprott Asset Management L.P., recently had a turnover ratio of 282% — equal to buying and selling its entire portfolio almost three times in a single year — leading to a TER of 1.95%. That was in addition to its sky-high MER of 3.15%. That’s a huge hurdle for managers Eric Sprott and Eric Nutall to overcome.
Of course, investors should put trading costs in a larger context. Management experience, skill and the soundness of the fund’s strategy matter. Choosing funds with low costs — whether from management or trading fees — helps stack the deck in your favour.
Vishal Mansukhani is a fund analyst on the active funds research team for Morningstar Canada.
Correction: An earlier version of this article referred to trading costs as “hidden costs”.