Hidden Costs

In addition to charging explicit and implicit costs, mutual funds also charge hidden costs. The following are some of the hidden costs charged by mutual funds.

Transaction costs: Transactions costs cover the expenses of buying and selling securities; transaction costs cover the expenses that are not covered by any other fees. These expenses include commission costs, bid-ask spreads, and soft-dollar arrangements. Mutual funds that have high turnover—funds that buy and sell a lot of securities—will have much higher transaction costs than mutual funds that use a buy-and-hold investment strategy. Recent research has shown that in some high-turnover funds, the hidden costs of trading are more than double the explicit overall expense ratio. Such costs significantly reduce the amount of return on the fund.

Commission costs: Commission costs are the costs incurred by the mutual fund by buying and selling the securities in the fund. Mutual fund companies are not required by law to disclose the amount of commission costs in the prospectus, although this information should be included in the firm’s statement of additional information. A good way to evaluate commission costs is to look at the mutual fund’s turnover ratio. The turnover ratio is a measure of trading activity during the current period. The turnover ratio is calculated by dividing the average number of net assets in the fund by the amount of securities that have been bought and sold. A turnover ratio of 50 percent means that half of the value of the mutual fund has been bought or sold during the period. Not only does turnover raise transaction costs, but it also results in short-term capital gains, which are taxed at a higher percentage rate than long-term capital gains.

Bid-ask spread: Contrary to popular belief, investors may be charged different prices for buying a security than for selling a security. The difference between these two prices is the bid-ask spread. This spread can vary depending on the liquidity of the security and the supply-and-demand for the security.

Soft-dollar arrangements: Many mutual funds have soft-dollar arrangements with brokerage houses whereby brokerage commissions include charges for services in addition to charges for order execution. These commissions may be charged for research, access to information sources, computer equipment, and even personal services.

Other hidden costs: In addition to transaction costs, mutual funds may charge several other hidden costs, such as account transfer fees, account maintenance fees, inactivity fees, and minimum balance fees. Account transfer fees are fees charged for moving assets either in or out of an existing account. Account maintenance fees are charged for maintaining your account. Inactivity fees are fees charged if you do not trade for a specified period of time or if your account remains inactive during a specified period of time. Minimum balance fees are assessed if you fail to maintain the minimum account balance required by the mutual fund company.