True Cost of Owning Mutual Funds & Variable Annuities

As a financial advisor with over 25 years of industry experience, one of my primary goals includes helping investors understand the true cost of owning mutual funds and variable annuities while considering whether such financial vehicles are appropriate for their portfolios. My job is to help people understand their holdings as well as the fees which pertain to those products. Often the cost of owning a mutual fund or variable annuity is far more than what meets the eye.  Mutual funds and variable annuities often contain layers of undisclosed fees, which is why I am a strong proponent of managing a portfolio consisting of individual stocks and offering an all-inclusive transparent fee structure which includes investment advice, transaction charges, risk management services, account maintenance and ancillary financial planning advice with a simple annual advisory fee structure ranging from .75 - 1.25% depending on assets and level of service needed.   

 

Below is a breakdown of various fees which can potentially reduce mutual fund returns.  I have also included examples of how variable annuity fees can affect overall returns.

 

Expense Ratio:  An article in Morningstar Advisor (1) explained that the average fee for a U.S. stock fund could cost up to .90% (1).  This fee can usually be found in the fund’s prospectus.  Many investors, upon reviewing the prospectus, are under the impression that this fee is the only cost involved in owning a mutual fund. This can be very deceiving and a potential trap for investors making decisions based on cost yet mutual funds can include the following lesser disclosed fees listed below.

 

Transaction costs: These costs are not included in the expense ratio and are not found in most prospectuses.  A study by Edelen, Evans and Kadlec found U.S. stock mutual funds have an average transaction cost of 1.44 percent per year. (2).  It can be difficult to determine what is being charged to the investor.  Under the transaction cost umbrella, brokerage commissions, market impact costs and spread cost should be considered when investigating mutual fund fees. Bogleheads (3). 

 

  • Brokerage Commissions:  These are the basic costs of buying and selling stocks within a portfolio’s brokerage accounts.  This information is found within the Statement of Additional information which is made available to investors upon request, but is not generally distributed to shareholders. 

 

  • Bid-Ask Spread:  The difference in price between what the dealer buys/sells a stock and what the investor actually pays for it is the bid-ask spread. (3) Even a spread of .01 cent allows the dealer to capture additional fees on every share traded.  This can be even more excessive for smaller or international stocks. (3)

 

  • Market Impact Cost:  When a portfolio manager decides to trade a substantial position in a holding, the large volume is sometimes enough to influence the market price. Before the entire order can be sold, the heavy volume has the potential to drive down the share price and result in a portion of the shares selling at a lower price, or vice versa.  Obviously, this presents a negative affect for any shareholder.

 

Cash Drag:  Every mutual fund must maintain a certain percent un-invested in cash for transactions and redemptions.  According to a study by William O’Reilly, CFA, and Michael Preisnaro, CFA. (5), over a 10-year time period the cash drag on a large cap stock mutual fund was .83 basis points per year.  In real world language, an investor could potentially pay .83 percent on average for a fund manager to hold their cash.

 

Advisory Fees:  Most brokerage firms have created “managed mutual fund programs” in which a financial advisor is paid to manage the investment managers (Investment managers are responsible for actively managing the portfolio of mutual funds). This financial advisor acts as the “quarterback” for the entire investment process.  There are typically 2 layers of additional fees within this type of program in addition to the expense ratio of the funds.  The first are the fees charged by the broker to quarterback the process as a direct fee to the investor known as advisory fees which can range from approximately .25% to 2.50% depending on asset values.  A secondary internal fee is also levied within the managed mutual fund program by the brokerage firm or mutual fund as their advisory fee.  This is another layer of fees paid by you, the investor.

 

Capital Gains Tax Cost:  Most people don’t mind paying their share of taxes to support our great country, but many investors end up paying higher taxes from imbedded gains within a mutual fund.  Mutual funds held in retirement account are exempt from this issue.  Non-retirement account holders who buy into a fund that has appreciated gains could subject themselves to unnecessary additional taxes owed at year-end when most funds declare a capital gain.  Unfortunately, this applies to the total gain realized by the fund, even if the investor entered into that fund after the stocks appreciated. According to Morningstar, it is estimated that the average tax cost ratio for stock funds is 1% to 1.2% percent per year. (4)

 

Cost Summary:  The following is a summary of potential average expenses an investor could face within a mutual fund.  Because many investors do not use investment advisors, we will eliminate the investment advisory fee for total potential costs. 

 

Potential Total Mutual Fund Fees            Non-Taxable Account           Taxable Account

Expense Ratio                                                                         .90%                                         .90%

Transaction Costs                                                                1.44%                                       1.44%

Cash Drag                                                                               .83%                                         .83%

Capital Gains Tax Cost                                                                                                          1.20%

 

Total Potential Costs                                                    3.17%                                      4.37%

(This is a hypothetical example for illustration purpose only and does not represent an actual investment.)

 

In total, these overlooked expenses create an estimated potential all-in cost of 3.17% for non-taxable accounts and 4.37% for a taxable account. The total cost of mutual fund ownership could lower the annual rate of return from a potential gross 7 percent return to a 2.63% net return. 

 

Variable Annuities:  Now let’s take the above mutual fund investment fee example one step further and consider the additional fees associated with variable annuities.  The average Mortality Expense & Administration (ME&A) fee charged in a typical variable annuity is approximately 1.25% to 1.65%.  This fee is frequently used to pay marketing costs, distribution costs, broker commissions and management fees.  In addition to the ME&A expense, a major percentage of all variable annuities being sold today are accompanied by a living income or return of principal rider attached with additional fees often ranging from .45 to .95 percent.  Taking all these things into consideration, one can potentially add another 1.7 to 2.6 percent to the cost of ownership of a variable annuity.  This does not include the possible negative tax effect of distributions being taxed as ordinary income resulting in a possible 1% to 2% cost for the shareholder.

 

 Potential Total Variable Annuity Fees___  ___

 ME &A Expense                                                        1.65% 

 Living Benefit Rider                                                   .95%                         

 Transaction Costs                                                    1.44%                                     

 Cash Drag                                                                   .83%                                     

 

Total Potential Costs                                        4.87% 

(This is a hypothetical example for illustration purpose only and does not represent an actual investment.)

 

As previously stated, my goal as a financial advisor is to help my clients understand what they own and to shed light on other investment vehicles available to them.  Mutual funds and variable annuities are two of the most common investments in our industry.  I hope this analysis can help investors make thoughtful decisions for their investments.   

 

Richard Hendry- is a Registered Principal with Raymond James Financial Services.   

 

This material is for general information only and is not intended to provide specific advice or recommendations for any individual.  Any opinions are those of Richard Hendry and not necessarily those of RJFS or Raymond James.

 

In a fee- based account clients pay a quarterly fee, based on the level of assets in the account, for the services of a financial advisor as part of an advisory relationship.  In deciding to pay a fee rather than commissions, clients should understand that the fee may be higher than a commission alternative during periods of lower trading.  Advisory fees are in addition to the internal expenses charged by mutual funds and other investment company securities.  To the extent that clients intend to hold these securities, the internal expenses should be included when evaluating the costs of a fee-based account.  Clients should periodically re-evaluate whether the use of asset-based fee continues to be appropriate in servicing their needs.  A list of additional considerations, as well as the fee schedule, is available in the firm’s Form ADV Part 2A as well as the client agreement.

1. Kinnel, Russel. “Mutual Fund Expense Ratios See Biggest Spike Since 2000.” 19 April 2010. Morningstar Advisor. 31 January 2011.

2. Eldelan, Roger M, Richard B Evans and Gregory B Kadlec. “Scale Effects in Mutual Fund Performance: The Role of Trading Costs.” 17 March 2007.

3. “Mutual Funds: Additional Costs.” 3 November 2010. Bogleheads. 11 January 2011.

4. Rushkewicz, Katie. “How Tax-Efficient is your Mutual Fund?” 15 February 2010. Morningstar. 17 January 2011.

5. O’Rielly, William and Michael Preisano. “Dealing with the Active.” 2000. Index Universe. 17 January 2011.

 Securities are offered through Raymond James Financial Services, Inc., member FINRA/SIPC.  Investment Advisory Services are offered through Raymond James Financial Services Advisors, Inc.  Raymond James financial advisors may only conduct business with residents of the states and/or jurisdictions for which they are properly registered. Therefore, a response to a request for information may be delayed. Please note that not all of the investments and services mentioned are available in every state. Investors outside of the United States are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this site. Contact our office for information and availability.© 2019  All Rights Reserved. Privacy Policy. Richard Hendry is a Branch Manager for Raymond James Financial Services, Inc.

 

 

 

 

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