You might know the expense ratio of the mutual funds you own, but do you know how much of your money they spend on brokerage commissions? Yes, even huge billion-dollar fund managers have to pay someone to execute their stock trades for them, and it can sometimes involve a murky world of “soft” dollars where expenses are hidden from investors through inflated stock commissions.
Morningstar article A Big Fund Cost You Don’t See explored this hidden cost and found that the average equity fund pays approximately 0.30% of assets a year in brokerage commissions. If your equity reports an expense ratio of 0.90%, that would bring the total expenses including commissions to 1.20%. (When comparing performance numbers, those are usually reported after all expenses.)
However, these are just averages. Some funds have high turnover and thus lots of trades relative to their asset balances. The Morningstar article highlighted 10 funds that paid over 0.60% of assets in brokerage commissions recently. One of these is CGM Focus (CGMFX), which I seem to read about a lot in popular personal finance magazines. They spend 1.04% of assets on stock commissions, on top of the 1.23% official expense ratio. Overcoming a 2.27% total expense drag every single year is quite difficult – some would say nearly impossible over the long run.
I am not saying they do this, but you can see how it would be beneficial for a mutual fund to shift some of their costs onto the stock commission side and reduce the highly publicized expense ratio figure.
I also ran across this Mutual Funds’ Hidden Costs page at Retire Early Home Page, which was last updated in 2005 but provides some historical perspective. In 2004, Forbes magazine revealed that the Dreyfus Founders Passport Fund paid an “astonishing” 4.64% of assets towards brokerage commissions.
It also states (again back in 2004):
The average US domestic mutual fund pays about 5 cents in brokerage commissions for every share of stock bought or sold in the fund. Vanguard averages about 2 cents per share in its low-cost index funds.
What about Vanguard index funds?
This made me want to investigate Vanguard’s brokerage commission hit further. To calculate it yourself for any mutual fund, you’ll need two numbers. First, you’ll need the total net assets as of December 31st, found inside the fund prospectus. Second, you’ll need to track down the total brokerage commissions spent, found inside the fund Statement of Additional Information (SAI). Luckily, these are both easily found on Vanguard.com for any specific fund – just click on “View prospectus and reports”.
In 2004, the Vanguard Total Stock Market Index – Investor Shares (VTSMX) had an expense ratio of 0.19%, and brokerage commissions of only 0.0077% of net assets In 2008, the expense ratio was 0.18%, with the commission costs dropping to only 0.0069% ($5,643,000 divided by $82 billion). As the fund grows, the expenses per dollar are reduced – something I’ve come to see and expect from Vanguard.
This goes back to one of the structural features of index funds – they do not need to trade very much to maintain their goal of tracking an index based on market capitalization. If one company rises (or drops) even significantly in value, they simply represent more (or less) of the index accordingly. There is little need to buy or sell in response to market fluctuations. Instead, trades are made primarily due to new fund purchases and redemptions by investors, or due to the occasional change in the tracking index.