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Do Mutual Funds Have Hidden Costs?

A reader writes in, asking:

I recently read an article from Brightscope explaining that mutual funds incur costs in addition to their reported expense ratios. If that’s true, might it actually be less expensive to use a money manager to buy stocks for me rather than use a mutual fund to do the same?

The BrightScope article is correct that, as a result of turnover within a mutual fund’s portfolio, the fund will incur costs (e.g., brokerage commissions and bid/ask spreads) that are not reported in the fund’s published expense ratio.

Fortunately, with most index funds and ETFs (especially broadly diversified “total market” -type funds), portfolio turnover tends to be quite low. As a result, the fund’s transaction costs tend to be quite low as well.

For example, the following chart (from Morningstar) shows the 10-year performance of Vanguard’s S&P 500 index fund (in blue) as compared to the performance of the S&P 500 index itself (in orange), which incurs neither expense ratio costs nor transaction costs.

As you can see, the two are almost indistinguishable. The costs of portfolio turnover are there, but for an index fund with very low turnover, they’re not usually a cause for concern.

What About Tax Costs?

If the fund is held in a taxable account — as opposed to an IRA or employer plan such as a 401(k) or 403(b) — portfolio turnover results in an additional cost: taxable capital gains. (That is, when a fund sells a holding for a gain, fund investors will have to pay taxes on their share of that gain.)

But, once again, such costs are minimized by using index funds and passively managed ETFs. And the reason is exactly the same as above: Passively managed funds generally have low portfolio turnover, thereby reducing the amount of capital gains realized within the fund in any given year.

To get an estimate of the tax-related costs incurred by an investor who holds a fund in a taxable account, I usually turn to Morningstar’s “tax cost ratio,” which is available by looking up a fund on, and clicking the “tax” tab. It’s important to note, however, that the tax cost ratio assumes the investor is in the highest tax bracket at all times, so in many cases an investor’s actual tax costs would be lower than the reported figure.

Would It Be Less Expensive to Use an Advisor?

It’s very unlikely that using a financial advisor/money manager would result in lower total costs than a do-it-yourself approach with low-cost index funds or ETFs.

In the first place, most advisors use mutual funds themselves, so their costs are usually in addition to the costs of the funds.

And as far as advisors who use individual stocks, the vast majority are the type I’d stay far away from (i.e., the type who make dubious assertions about beating the market using superior stock selection skills). I’d be very surprised to hear of any advisors who implement passive investment strategies using individual stocks, whose total cost would be less than that of a low-cost index fund portfolio.

Generally speaking, the reasons to use an advisor are that you don’t want to be bothered to manage your portfolio, or you don’t feel qualified to do so without assistance. A desire to save on costs generally would not lead to the use of an advisor.

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  1. Francis T. Nicosia says:

    I’m 78s.old and I’m scared that bonds are going to get blasted in the next 5 yrs. So I’m thinking of going 70% money markets and 30% total Vanguard world stock fund. The cash wil cover my rmd and give me enough to cover market drops. What say you? Thank you

  2. Hi Francis.

    I generally do not think that a simple intermediate-term bond fund (e.g., Vanguard’s Total Bond Market Index Fund) is in for anything that could be described as a blasting. With a duration of slightly over 5 years, the fund isn’t super exposed to interest rate risk. (As with any nominal bond fund though, it is exposed to inflation risk.)

    Or, if it is at risk for a blasting, it’s nowhere near the degree of blasting that stocks are at risk for at any given time.

    All of that said, I think a 70% fixed income, 30% stock allocation is perfectly reasonable for a retired investor.

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