What are undisclosed fees?

When it comes to investing there are both disclosed fees and undisclosed fees.  Disclosed fees are those that are required by law to be reported.  Undisclosed fees are those that are not required to be reported by law.  To understand what these undisclosed fees are you must understand what active management it.

Active management is the attempt of either an individual or a money manager to try and out-perform the stock market rates of return by actively trading individual stocks and/or engaging in market timing – predicting when to be invested (in the market) or not be invested (out of the market.)

In order for active management to beat the market they must perform better than their comparative benchmark.  For example a large cap mutual fund would be compared to the S&P 500 index.  Because they are attempting to beat the index they are going to incur some additional fees in their attempt.  And so they must beat their benchmark while including fees, taxes, trading costs, etc.

Active management creates an undisclosed fee to investors called transaction costs and bid/ask spreads.  There have been many studies done to show investors what this active trading costs investors.  On average this active trading costs investors an additional 1.44% per year.    This in addition to the  management expense ratio (MER).  The MER typically includes management fees, 12b-1 fees, and other expenses deducted from assets or charged to all investors accounts (U.S. Securities and Exchange Commission 2000.)  The average MER for  mutual funds is 1.45%  per year, which together with an average trading cost of 1.44%, renders a total average annual fund cost of 2.89% per year for the average active mutual fund.

Ken French of Dartmouth’s Tuck School of Business estimates that investors collectively spent $102 billion per year in trying to achieve above-market rates of return.   Unfortunately this active trading does not produce better returns.

We do not use actively managed funds.  To find out if you are using actively managed funds and what those funds may be costing you please click here.

 

1 Virginia Tech University and Boston College “Scale Effects in Mutual Fund Performance.”  The role of Trading Cost” examined 1,706 U.S. stock funds from 1995 to 2005.  Another study by Edelen, Evans, and Kadlec (2009), in a survey of 1,758 U.S. equity funds, found that trading costs were 144 bps.

2 Morningstar Principia dated 12/31/09 and DFA Return Software dated 12/31/2009

3 Barras, Laurent, Scailet, wermers, and Russ, “False Discoveries in Mutual Fund Performance:  Measuring Luck in Estimated Alphas” (May 2008).  Robert H. Smith School Research Paper No. RHS 06-043 Available at SSRN: http://ssm.com/abstract=869748