Why the Mutual Fund Industry Does Not Want To Reveal $10 Billion in Hidden Costs to Equity Fund Shareholders

Common Sense on Mutual Funds: New Imperatives ...
Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (Photo credit: Wikipedia)

The average actively managed equity mutual fund has a turnover rate of approximately 100%. This means that each year all the stocks are sold and new stocks are bought in the fund. Keep in mind that you bought these funds as a long term investment. The only real benefit to all this trading is the fees it gnerates for the brokers.

 

Now, a new research paper points out that investors in equity funds are incurring trading and market impact costs of up to $10 billion annually and considerably more if you include all mutual funds. This is due to the current unfair pricing of mutual fund shares.

In practice, new, liquidating shareholders in mutual funds are not paying their portion of trading commissions that are deducted when they build their current portfolios. But the way the fund industry is structured, long-term buy-and-hold investors assume these costs over time, thus transferring their wealth to new and liquidating shareholders, many of them who are short-term traders. As a result, wealth is transferred to new and liquidating shareholders, many of whom are short-term traders.

In practice, long-term holders, many of whom are saving for retirement, pay an unfair amount of the portfolio brokerage and market impact costs. Shareholders who trade frequently should pay for the churning and the additional costs they create.

The most equitable solution is for the fund’s accrued commissions to get added to the fund’s net asset value (NAV) per share for new purchasers and subtracted from net asset value per share for liquidating shareholders.

But while this would be a fair practice for all shareholders, it is complicated by the fact that fund management companies are compensated based on the assets under management (AUM) of their funds. Since there are many high-frequency short-term traders, many fund companies recognize that correcting this problem could reduce fund AUM’s, which, in turn, would reduce fund company revenues.

This study is a more compelling reason to avoid actively traded mutual funds. These costs hurt the performance of long term investors and remain hidden.

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