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From the Trading Pits

Fortunes Accomplice and the Hidden Costs of Investing

By From the Trading PitsFOXBusiness

In the late 1980’s, “Where’s Waldo” became a publishers’ fantasy.  Thousands of books flew off bookstore shelves as children busied themselves struggling desperately to locate the mysterious Waldo amid images chock full of run-of-the-mill things.  Many of the pictures contained “red herrings” – red and white objects included in the image that tricked the reader into thinking they may have found Waldo.  The irony is that Waldo was often in plain view – just hard to detect in a sea of the plain and ordinary.

The hidden cost of investing – particularly mutual fund investing – is a lot like Waldo: The fees are visible but it takes careful contemplation to find them.  The “red herrings” of explicit costs muddle the problem.  Most investors presume the disclosed expense ratio related charges are the only costs in mutual fund investing.

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Imagine your mutual fund is like a sailboat moving along with the breeze.  Fund expenses are like drag anchors that trim your progress.  The higher the cost, the bigger the drag on the portfolio.  In the immediate term, a little extra cost does not seem to make much distinction to your profit/loss.  However, over a decade or two, it can make a monumental difference in your retirement plans.

Educated investors know the cost of owning a mutual fund is required by law to be listed in the prospectus under “expense ratio.”  For example, a fund that charges 1.25% of assets each year is about the U.S. average but what’s missed by the vast majority of investors is that nearly all funds have other expenses not covered in the expense ratio.  The hidden “drag anchors” slow your rate of return a fraction of a percentage here and a fraction there.  Compounding together over time, they can have an enormous impact.

Finding the Waldos

What exactly are these hidden expenses?  First of all, the disclosed expense ratio is the amount paid to the portfolio manager and other operating expenses.  And you cannot have a mutual fund unless you have both of those things.  The hidden expenses are the trading costs associated with buying and selling the stocks within the fund.

Are mutual fund companies attempting to break the law by not reporting these costs?  Absolutely not!  In fact, despite an effort to pass a law requiring full disclosure of these costs, tracking them in detail has been found to be prohibitively complex.  No two companies seem to record them in precisely the same manner.  So, while experts agree that these costs significantly affect returns, they also admit that there is not enough information for the average investor to determine on his own if the fund he’s buying is “expensive” or not.

However, you can look for clues.  One indicator of excessive cost may be the rate of “turnover” – the ratio of stocks that have been bought, sold, or replaced in one year.  For instance, a turnover of 50% means half the stocks in the fund were sold and replaced with other stocks.  Turnover of more than 100% can indicate trading costs are higher than average.  But that’s not always the case: There may be valid reasons for a high turnover rate at any given time.

Bid-Ask Spread Cost

All equity mutual funds own individual stocks.  Depending on whether or not the manger is actively trying to beat the market or passively attempting to track the index, there will be turnover of stocks that are bought and sold inside the mutual fund.  If a manager is actively trying to beat the market by selling and buying individual stocks, there is a turnover of stocks that in turn creates internal transactions inside the mutual fund.  This turnover can add 1%-3% of costs that you do not even see because it comes out of the return of the fund itself.  If a mutual fund is not actively managed and is tracking an asset class or index, this cost will be much lower since there is very minimal turnover.

So, the bid-ask spread costs are the actual cost to buy and sell those individual stocks inside the mutual fund itself.  Here is a plain example:  If you go to the newspaper and look at the NYSE or NASDAQ page you will see stock prices and a column that says bid and ask.

The bid price of buying the stock differs from the asking or selling price.  This spread difference gets paid to the person who is making the market (market-makers is the industry term) in that particular stock.  Depending on the size of the stock (for example whether it’s large or small stock) these spread prices will vary.  As a rule of thumb, the larger the stock (think P&G) the smaller the spread since more shares are traded on a daily basis.

This I believe….

In the 1950’s, the legendary radio personality Edward Murrow hosted a unique radio program entitled, “This I Believe.”  The show’s format was fascinatingly creative: Guests – famous and not so famous – would read aloud their personal life philosophy and beliefs.  An instant hit, the program’s popularity continued for years.  In an entertaining way, it actually challenged listeners to test and formulate their core beliefs.  The concept driving the program was to share with the listening public the rules that one lived by to guide them through life.

The program really helped the listener stop for a brief moment and gain a deeper appreciation and articulation about a personal philosophy that served as one’s guide.

Similarly, when it comes to investing, a declarative investment philosophy can be a set of guiding principles that shape and inform your financial decision making process.  Affirming a specific philosophy about investing (e.g. I will learn the what’s and whys of my funds expenses) will do wonders in keeping you on the path towards reaching your investment goals.  And relying on strongly held core convictions can also provide the reassuring nudge that’s needed when markets do what they inevitably do.

What do you think?

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