November 24th, 2020
Today is part II of my latest Making Finance Fun series: mutual fund FUNdamentals. In this episode, I’m going to talk about US stock fund fees. Believe it or not, there is generally more than one fee involved. We will talk about active and passive domestic stock mutual funds, the two main types you can purchase, and the four kinds of fees that you may pay to own a mutual fund. Don’t miss it!
Outline of This Episode
- [3:23] The two main types of stock funds
- [5:09] Fee #1: the expense ratio
- [9:00] Fee#2: Transaction Cost
- [12:55] Fee #3: Cash Drag
- [15:50] Fee #4: Taxes
- [19:38] Interesting nuggets of information
- [26:05] Check out my book!
Fee #1: The Expense Ratio
The expense ratio is basically a management fee. If you go online and type in the name of the mutual fund, you’ll find the expense ratio easily. So what is it? An expense ratio measures the operational costs of the mutual fund relative to the fund’s average net assets. It’s usually a percentage. It pays for the costs the fund incurs, fund managers’ salaries, advertising, and promotional activities, etc.
According to Morningstar, the average expense ratio is 1.1% annually for an actively managed fund. You are paying roughly 1.1% of whatever is in your mutual fund to the mutual fund company for their services. Yours may charge more or less. For an index fund, the average expense ratio cost is 0.49% per year.
Fee #2: Transaction Cost
I’ve found that most people aren’t aware they’re being charged transaction costs. You generally see them in actively managed funds. Why? Mutual funds cannot buy or sell stocks themselves, they have to go through a broker. No one on wall street is running a nonprofit—so the broker charges fees. It’s really difficult to find what the transaction costs are. I’ve only found one average number (study done in 2007 linked below). The average cost is 1.44% per year. Woof. Transaction costs are likely lower on an index fund because they aren’t doing as much trading. Why? Because they’re copying other indexes.
Fee #3: Cash Drag
According to another study, cash drag costs you 0.15% a year. What is it? Whatever mutual fund you own keeps a certain amount of cash in the fund itself. Why? If they feel like the market is too high, they might put half the mutual fund in cash and wait for the stock market to drop. I’ve seen less than 1% all the way up to 80% in cash. They do this if they feel like there’s a pullback coming. If you’ve got $100 invested in the mutual fund and $5 is cash, you’re paying the fee on the whole $100—not just the $5. There is also cash drag in passively managed funds. But again, it depends on your specific mutual fund(s).
Fee #4: Taxes
We aren’t talking about ordinary income tax. I’m talking about capital gains tax. If you buy something for $50 and you sell it for $70, you might have to pay the capital gains tax on the $20.
The average tax that you’ll pay for an active fund is 1% per year. If you have $100 in a mutual fund, you can expect to pay $1 worth of capital gains each year. The fund manager might be buying and selling throughout the time you own the mutual fund. Most years—all of the buying end selling—generates capital gains for you. You may or may not have to pay capital gains taxes, but it varies depending on your situation and even the tax bracket that you’re in.
Index funds are well-known for being very tax efficient. They can pass on capital gains but it is rare. I don’t have an average cost. NOTE: If you have mutual funds in a 401k or a Roth IRA, this doesn’t apply.
I share a few other interesting nuggets of information you’ll WANT to know if you’re going to invest in mutual funds. Listen to learn more!
Resources & People Mentioned
- What are Transaction Costs?
- The Mutual Fund Fees We Don’t Talk About
- 4 Lessons From Another Year of Falling Fund Fees
- Top 10 S&P 500 Stocks by Index Weight
- Why Do Indices Need to Be Rebalanced?
- How Mutual Fund Expense Ratios Work
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