Mutual funds have 'invisible' costs, says UC Davis research

DAVIS
February 26, 2013 12:34pm

There are "invisible" costs that occur when mutual funds trade portfolio securities that can have a large effect on fund performance, according to a new University of California, Davis, study.

"Our results suggest that invisible trading costs have a detrimental effect on fund performance that is at least as material as that of the visible expense ratio," says Roger Edelen, associate professor of finance at the UC Davis Graduate School of Management.

Mr. Edelen and his co-authors analyzed portfolio holdings and transaction data for nearly 1,800 equity funds from 1995-2006. Their findings are reported in "Shedding Light on 'Invisible' Costs: Trading Costs and Mutual Fund Performance," which appears in the current issue of Financial Analysts Journal.

Investors often rely on the commonly published "expense ratio" of mutual funds as a predictor of performance. The expense ratio represents the percentage of the fund's assets that go purely toward the expense of running the fund, including such costs as the investment advisory fee, administrative costs, distribution fees and other operating expenses. As low-cost index and exchange-traded funds grow in market share and popularity, investors increasingly rely on the expense ratio to make investment decisions.

However, in the funds the researchers analyzed, the average annual expenditures on trading costs, or aggregate trading costs, were 1.44 percent, while the average expense ratio was 1.19 percent. And there was considerably more variation in trading costs than expense ratios, researchers found.

"The more important question concerns how funds' expenditure on trading costs relates to return performance," says Mr. Edelen. "If funds are able to recover trading costs with superior returns, these expenditures might enhance overall performance. This, however, does not appear to be the case. We found a strong negative relation between aggregate trading cost and fund return performance."

The study was co-authored by Richard Evans, an assistant professor of business administration at the Darden School of Business, University of Virginia, Charlottesville; and Gregory Kadlec, the R.B. Pamplin professor of finance at Virginia Tech, Blacksburg.