Minimizing costs is a sure way to improve investment performance, and this book warns the reader about all the costs, not only expense ratios, that are incurred when investing in mutual funds or ETFs.
Investors are increasingly cognizant of the expenses that are incurred when investing in mutual funds or exchange-traded funds (ETFs), because these costs are a key determinant of fund performance. Mutual funds are required to publish their expense ratios in fund prospectuses, and most present the information on their websites. Such information is also freely available from independent sources, such as Morningstar’s website.
But expense ratios are only part of the costs directly or indirectly incurred by investors. In Someone Will Make Money on Your Funds—Why Not You? A Better Way to Pick Mutual and Exchange-Traded Funds, Gary Gastineau, a senior portfolio manager with H.G. Wellington and Co., explains the various kinds of costs that investors incur and how they should go about picking the best funds. According to Gastineau, investors can add 2 percent to their annualized returns by reducing operating and sales expenses, the capital gains tax overhang, and transaction costs embedded in a fund’s management process.
For most investors, the fund’s expense ratio is significantly less than half of the annual costs that are incurred. Even investors in low-fee, no-load index funds are paying significant transaction costs, such as the costs associated with providing free liquidity to market timers and last-minute traders. Gastineau recommends that investors avoid funds with “flow” greater than 100 percent. Flow is a measure of shares sold and redeemed as a percentage of average shares outstanding over the year. These costs are mostly avoidable if the fund has high redemption fees.
Other transaction costs weigh upon the performance of index funds. For instance, funds indexed to the S&P 500 Index are not cost-effective investment vehicles because of the hidden transaction costs from front running by investors when index changes are announced. These index funds also have to pay a licensing fee, estimated at 6 bps, to Standard & Poor’s. All these and other costs, the author estimates, add up to embedded transaction costs in the range of 50–100 bps a year. For the Russell 2000 Index, he estimates transaction costs in the range of 100–300 bps a year, although he does not reveal how he derived his estimates. The only scholarly study that is cited arrived at lower transaction cost estimates for the S&P 500. 1 A recently published version of this study found that Russell 2000 index fund investors lose 130–184 bps a year and S&P 500 index fund investors may lose as much as 12 bps a year because of the predictability and timing of index changes coupled with fund managers’ objective of minimizing tracking error. 2
To minimize transaction costs, Gastineau proposes the creation of proprietary—or as he labels them, “silent”—index funds, which are indices that because they do not preannounce changes, preclude front running. These funds could also enhance returns by providing liquidity when needed by other funds. Such funds should outperform comparable index funds by up to a few hundred basis points, depending on the turnover ratio, capitalization range, and popularity of the index.
The author is an advocate of ETFs because of their distinct advantage relative to open-end funds when net redemptions occur. The in-kind redemption feature of ETFs enables these funds to avoid realizing capital gains and, consequently, to avoid taxable gains distributions. To meet redemption requests, ETFs can deliver the lowest-cost shares, relative to current market value, in the portfolios, leaving the fund with relatively high-cost positions. A conventional fund will sell its highest-cost stock first, leaving it with low-cost positions in the portfolio, thereby exposing the fund to capital gains realizations. Conventional funds can also deliver stock in kind to a large redeeming shareholder, but such opportunities, according to Gastineau, are limited for these funds, although he fails to explain why such redemption opportunities are limited for conventional funds.
Many ETFs have done a poor job of tracking their benchmark indices. Gastineau provides an exhibit of the median tracking error and ranges of tracking error for most U.S.-based ETFs for 2002 to 2004. The exhibit shows that some ETFs that invest in country and sector indices have underperformed their benchmarks by more than 200 bps in individual years; in a few instances, the deficit exceeded 350 bps. A recent article in Business Week reached similar conclusions from 2006 data. 3 The major ETF performance detriment appears to have been excessive fund cash balances, which is surprising because a fund manager’s responsibility is to keep the fund fully invested and because liquidity for redemptions is not a pressing issue for ETFs. In another exhibit, Gastineau presents a list of funds recommended for tax-deferred accounts (open-end index funds) and for taxable accounts (ETFs). These funds have low turnover, low expense ratios, and significant early redemption fees.
Gastineau states that foreign stocks are an unnecessary luxury for most U.S. investors because, with the growth of globalization, world financial markets have become increasingly correlated. The reduced diversification benefits coupled with higher costs make international investing worthwhile only for investors with net worth exceeding $5 million. This comment needs amplification because it implies that the expense ratio declines as the invested amount grows. Mutual funds and ETFs are not known to reduce expense ratios, however, for individual investors who increase their investments in these funds. International diversification is a sensible proposition for most investors because it allows investment in faster-growing, albeit riskier, economies and may help guard against a devalued dollar.
Minimizing costs is a surefire way to improve investment performance, and Someone Will Make Money on Your Funds doe s inform the reader about the costs that are incurred when investing in mutual funds or ETFs. Paying high fees for active management is fraught with risk because past performance, the metric investors generally use to gauge competence, is a poor indicator of long-term superior performance. Gastineau should be applauded for enlightening readers on investment funds’ cost structures. We hope a future edition of the book will provide corroborating data for the potential performance enhancements that he asserts.