Mutual Fund Hidden Cost: Brokerage Commissions

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.

Comments

  1. Ben Mathew says:

    Great article. Informative, interesting articles like this are why I keep coming back every day and have for a few years.

  2. I always notice that expense ratio for vanguard funds is always lower than Fidelity, but if you compare Fidelity fund to its equivalent Vanguard fund, the percentage change in NAV for Fidelity is mostly higher.

  3. Is your math right on that last calculation? I get .000069.

    Hey, great article by the way.

  4. @DannW – You have to convert to percent by multiplying by 100.

    For example, 1 out of 100 = 1/100 = 0.01 = 1%

  5. I happened to catch that article too. This is another advantage of index investing. There simply are not that many trades to make.

  6. Glad I stopped by today. I had always known that higher turnover funds would experience a high trade volume – but I always, incorrectly, assumed that cost was part of the published expense ratio. Yikes! Guess that prospectus is good for yet another thing.

  7. Finally some good information to read and research further on.

  8. A friend of the family is a pro in the passive assest management world. He says Vanguard index funds are generally 9′s on a 10 scale. They lose a point because index funds still have to trade quite a bit to maintain balance and track to the index.

    His method is to re-balance much less frequently; the big savings in passive investing come from avoiding trades, not in closely matching the selected index.

    I can’t get him to tell me how often, or what triggers a re-balance. And he’s only hinted at how much net worth I’d need to become a client (way more than I have now).

  9. Thanks for posting this article. It’s helpful to know where to look to find out what your fund spends on brokerage commissions.

    Are commissions not factored into investments’ cost basis for mutual funds, ETF’s, etc? For instance, if a fund buys AT&T stock worth $100,000 total and pays $100 commission total, the reported cost basis is $100,100 or $100,000? And the total returns provided in annual reports, on Morningstar, etc don’t need to be adjusted for commission cost, right? Really curious about this.

  10. And Now you have a Better Idea of how The Big Fund Companies Like PIMCO and AMERICAN Funds got so big, so fast..
    Just like the Old Insurance Days, when the Ins. Co.’s that paid the Highest Commissiion to Brokers , while providing the same Service to clients, got so Big..

    And Maybe why The Likes of Index funds are Either Not Offered or Very Few are Offered in One’s Company Mutual Funds listing to invest into..

    And Imagine if all companies Had to Offer Indexes and Balanced Funds? Imagine If They just had to Offer a Bal. Fund like a VWELX and a VWINX? Those 2 alone would have at least 5x more $ in them by now!

    It’s All One Big Pay Off!

    and Not even Pro’s can Figure out all the Expenses in these Pension Plans anymore..

    I’m just Jealous I wasn’t a Broker to those Companies selling Funds to their Plans..

Trackbacks

  1. [...] for Not Investing in ETFs? @ Frugal Dad – Max Out Your Tax Advantaged Accounts First @ Money Ning – Mutual Fund Hidden Cost: Brokerage Commissions @ My Money Blog – How to Open a Roth IRA Account @ Moolanomy – Considering ETF Investing and Mutual [...]

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