In the world of investing, mutual funds are some of the most commonly used vehicles for people looking to build wealth. They’re a staple in 401(k) retirement plans, individual retirement accounts (IRAs), and brokerage accounts. While they seem like an easy way to grow your money, there is more than meets the eye when it comes to underlying expenses.
These hidden costs can have a serious impact on the growth of your investment over time. Although you may be aware of expense ratios within mutual funds, that’s just one piece of the pie. There are additional fees lurking in the shadows that might not be so obvious. Let’s break down these costs and discuss ways to avoid them.
Expense Ratio: The Known Cost
The expense ratio is the percentage of operating costs for a mutual fund. You can think of it as the running expenses of a business. This information is clearly disclosed, typically around 1.19% on average (see also: 3-Step Plan to Choosing Mutual Funds).
Now let’s compare this expense ratio to credit card interest rates. They are both fees associated with an investment or lending product. The interest rate on a credit card is disclosed, while the expense ratio in mutual funds is easy enough to find as well.
Hidden Trading Costs: The Unknown Fee
Mutual fund companies don’t have to disclose trading costs, which are the expenses that accrue when buying and selling individual securities within a mutual fund (stocks, bonds, etc.). This makes it hard for investors to know exactly how much they are paying in fees.
To better understand this concept, let’s continue with our credit card comparison. Imagine if credit cards also included an additional fee based on the number and size of purchases you make each month, but that information was never disclosed anywhere. This is essentially what happens with mutual fund trading costs.
A recent study found that these hidden trading costs average 1.44%, which is more than the average expense ratio of 1.19%. Overall, this could add up to expenses of 2.63% or higher—ouch!
This study also revealed a troubling reality: these undisclosed trading costs actually weigh down the funds and reduce overall performance. In other words, your money has less potential to grow.
Finding a Solution: Index Funds and ETFs
You don’t have to avoid mutual funds altogether due to these hidden costs. As mentioned earlier, they are still the most common investment vehicles used today. However, there is a solution to this dilemma in the form of index mutual funds and exchange-traded funds (ETFs).
These financial instruments focus on low-cost trading strategies that don’t accrue large amounts of hidden fees. They often have lower internal expenses (expense ratios) than the average mutual fund, which can save you as much as 1% or more in total costs.
Index funds and ETFs are designed to track a benchmark, like the S&P 500, by investing in various stocks (or bonds) and making minor adjustments over time. Essentially, index fund managers do less buying and selling, which means they incur fewer costs.
The mutual fund industry is working through various solutions to address hidden trading costs. But don’t hold your breath, as this issue has been argued for years. In the meantime, be prudent and choose your investments based on your long-term goals. Diversifying a set of index mutual funds or ETFs might just be the answer for you.
It’s crucial to stay informed about the potential costs of investing in order to make well-informed decisions that align with your financial objectives.
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