When investing, not all costs are disclosed
Many people do not understand how the fees they are paying affect the return they are receiving on their investments. But what you must realize is there are disclosed costs and undisclosed costs.
Some mutual funds charge sales loads up front. A charge of something like 4.75 percent might come off of your investment when it is made. This means you made no profit until 95.25 percent of your money that is actually invested recovers from this purchasing expense.
There could still be other expenses for things such as 12b-1 distribution fees, redemption fee, exchange and account fees and a number of other costs. According to a study by Financial Analyst Journal, the average expense ratio is 1.19 percent.
There are also hidden costs. Mutual funds are making trades for many investors since people are always buying and selling them. This costs the fund company brokerage fees that must be borne by all fund investors. Mutual funds often purchase securities from dealers at ask prices and sell to dealers at bid prices. The difference is the dealer’s profit. Large mutual funds may affect the cost of the underline purchase because they buy and sell in such large quantities.
As we have discussed before, the stock market is a giant auction. If there are more buyers, prices go up, and if there are more sellers, prices go down. If a mutual fund is trading large numbers of dollars, they could move the price. This might not be beneficial to fund investors, since they could make less profit.
Mutual funds are often not tax-efficient for investors. One example might be when you made an investment in a mutual fund and they owned a stock currently valued at $50. If this stock was later sold by the mutual fund for $40, you lost $10 on this share. If it turned out the mutual fund had purchased it for $30 a share, they will have to report a profit of $10 and you will pay taxes on your proportional share when you actually lost.
You could have to pay taxes on phantom income. Since most mutual funds are constantly selling and buying shares of stock, you will have to pay capital gains tax even though you did not personally sell anything. This would not happen with a share of individual stock that you owned. If your investment is with nonqualified money, you could be responsible for a lot of short-term capital gains and ordinary dividends, which are taxed at a higher tax rate. Morningstar estimates this tax inefficiency could cost about 1.10 percent.
A study done by finance professors at several leading universities found another area for concern. They labeled this cost as “sneaky behavior.” One part is “window dressing.” This is when a fund manager sells his poor-performing assets just before quarterly reporting and buys recent winners to make his fund look better. Sometimes there is risk-shifting. This is taking large gambles before reporting time to try a get a little better return. There are other points of concern in this area. While not all mutual funds use these questionable tactics, some do. The professors estimate these actions could cost investors 2.29 percent.
If you are paying an extra fee to an adviser who is just putting you in mutual funds, this is another cost you must consider. There was a study done by Vanguard that showed investors who worked with an adviser achieved an overall better return than ones who did not. This is partly because, as we mention several times per year, your market money must always be in the market, and your nonmarket money should never be in the market. Sound advice can be a benefit.
Just be sure that you are considering all of the cost in your investment, including taxes. It is not just how much you earn that is important, it is how much you get to keep.
Gary Boatman is a Monessen-based certified financial planner and author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”
To submit columns on financial planning or investing, email Rick Shrum at rshrum@observer-reporter.com.