The hidden costs of low-cost investments

Asset managers have cut their fees at a dizzying pace in a bid to attract new investors and manage more money. According to Morningstar, the average expense ratio on all US mutual funds and ETFs slipped to 0.45% in 2019. But even as the sticker price on many funds edge lower, the true cost investors pay may be a lot higher. 

Explicit costs are the costs that can be seen or quantified. Investors see these costs on their annual statements or when they buy/sell an asset. The three most common are expense ratios, bid/ask spread, and commissions. 

Expense Ratio: The most common fee tacked on a fund. An expense ratio is what investors pay each year to cover the fund’s operating and administrative expenses. Mutual funds may also charge loads or 12b-1 fees.

Bid/Ask Spread: The difference between what investors are willing to pay and what a seller is willing to accept. Thinly traded ETFs often have wide bid/ask spreads that eat away at investor’s returns.

Commissions: What an investor pays to buy/sell an asset. These costs add up when investors dollar-cost average or trade frequently. That said, many brokerages have moved towards commission-free trading. 

Not all costs show up on a statement, though. Some are hard-wired into the DNA of a fund or may show up after years of ownership. These implicit costs require more time and research to uncover than explicit costs.

Reconstitution: Major indices periodically rebalance their holdings to keep up with the changing market. When this happens, a passive fund will follow suit. The fund buys and sells securities in the same quantity as the index, often resulting in additional costs across an investor’s portfolio. They may see higher trading costs from the additional trading activity, tax liabilities from recently sold positions, and new risks from shifting sector exposure.

Generic: The individual holdings in an ETF or mutual fund stay the same no matter who owns the fund; the trouble is every investor has different goals and values. Some may want to restrict access to fossil fuels in a way that most ESG ETFs can’t offer. Or perhaps they have a large concentrated stock position and don’t want more of the same exposure from an ETF. Not being able to tailor their portfolio to these varying situations can expose them to unintended risks. 

Taxes: Investing and taxes often go hand in hand. When investors sell an asset, as in a reconstitution or a routine sale, their gains are subject to short or long-term capital gains. The specific rate depends on how long they held the fund. Investors may also see a tax bill when a fund distributes a dividend payment. ETFs, unlike mutual funds, allow investors to pursue tax-efficient strategies like tax-loss harvesting, but only in a limited capacity. 

There’s no surefire way to eliminate investment costs, but many of them can be offset with the help of technology. Recent innovations in financial technology, such as direct or custom indexing, have made it easier for advisors to build portfolios that reduce their client’s implicit costs without sacrificing their returns. 

Both indexing approaches claim that directly owning individual securities in a separately managed account (SMA) is more beneficial than a portfolio of ETFs and mutual funds. The difference is that direct indexing replicates the composition of an index using single securities, whereas custom indexing creates the index from scratch. 

Where the two overlap, however, is in their reliance on single securities. Single securities do not have the same upfront costs as traditional funds, meaning advisors and their clients can forget some of the expense ratios, loads, and 12b-1 fees that had previously dragged down performance. 

What’s more, the strategy unlocks a handful of tax savings that are otherwise hard to come by with ETFs or mutual funds; one of those being tax-loss harvesting. Tax-loss harvesting at the security level let advisors pinpoint which gains and losses to harvest and avoid potential wash sale issues. Research shows that this process may yield 1% in tax alpha each year. 

Building a portfolio with custom indexing also eliminates any potential reconstitution costs. Because a portfolio is customized to a client’s goals and values, and not bound to an existing index, their portfolio won’t change when a major index reconstitutes its holdings.

So even though the upfront costs of an SMA may be higher than a low-cost fund, the benefits a client receives throughout the lifetime of their portfolio may more than offset the upfront costs.