Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance

Industry observers have long warned of the “invisible” costs of fund trading, yet evidence that these costs matter is mixed because many studies do not account for the largest trading-cost component—price impact. Using portfolio holdings and transaction data, the authors found that funds’ annual trading costs are, on average, higher than their expense ratio and negatively affect performance. They also developed an accurate but computationally simple trading-cost proxy—position-adjusted turnover.The expense ratio is one of the few reliable predictors of mutual fund return performance, and the increasing market share of low-cost index and exchange-traded funds suggests that investors use this information when making investment decisions. However, as noted by John Bogle and other prominent industry observers, the expense ratio captures only the “visible” (i.e., reported) costs of mutual funds. Funds incur a host of “invisible” costs that are less transparent to investors—most notably, the transaction costs associated with implementing changes in portfolio positions. In our study, we estimated funds’ annual expenditures on trading costs and examined the impact of those costs on fund return performance.We developed a detailed position-by-position measure of funds’ annual expenditures on trading costs by using fund portfolio holdings data, transaction-level securities data, and U.S. SEC filings. First, we used quarterly portfolio holdings data to determine each fund’s position changes on a stock-by-stock basis. Second, for each position change, we applied an estimate of the cost (brokerage commission, bid–ask spread, and price impact) of trading that amount of that stock in that quarter. Third, we computed each fund’s annual expenditure on trading costs by aggregating the costs of all trades for that fund over the year. We applied this approach to our sample of 1,758 domestic equity funds over 1995–2006.We found that funds’ annual expenditures on trading costs (i.e., aggregate trading cost) were comparable in magnitude to the expense ratio (1.44% a year versus 1.19%, respectively). Moreover, there was considerably more variation in fund trading costs than in expense ratios. For example, the difference in average expense ratio for small-cap growth and large-cap value funds was 0.32 percentage points (1.39% versus 1.07%), whereas the difference in average aggregate trading costs for the same funds was 2.33 percentage points (3.17% versus 0.84%). The more important question concerns how funds’ expenditures on trading costs relate to return performance. We found a strong negative relation between aggregate trading cost and fund return performance. Sorting funds by expenses, fund total net assets, or turnover (the most common trading-cost proxy) yielded no consistent, monotonic pattern of returns. In stark contrast, sorting funds on the basis of their aggregate trading-cost estimate yielded a clear monotonic pattern of decreasing risk-adjusted performance as fund trading costs increase. The difference in average annual return for funds in the highest and lowest quintiles of aggregate trading cost was –1.78 percentage points.Given the power of aggregate trading cost in predicting fund performance, it would be a useful tool for investment decision makers. Unfortunately, these direct estimates of fund trading costs are difficult to come by for reasons of both data availability and computational complexity. The most readily available metric to proxy for trading costs, used by both academics and practitioners, is fund turnover. However, the empirical evidence on the relation between fund turnover and return performance is ambiguous. We conjectured that this ambiguity is due to the fact that turnover does not account for the differential cost of fund trades—which depends on fund size (i.e., trade size) and stock liquidity (i.e., small cap versus large cap). For example, a $500 million small-cap fund with 50% turnover will have much higher trading costs than a $100 million large-cap fund with 100% turnover, despite the former’s lower turnover.To address this underlying deficiency, we propose a simple adjustment to turnover. In particular, we compute “position-adjusted turnover” by multiplying each fund’s turnover by its relative position size. A fund’s relative position size is equal to its average position size (total net assets divided by number of holdings) divided by the average position size of all funds in its market-cap category. Relative position size captures the price impact of the fund’s trades—the greatest component of a fund’s trading costs. We found that this simplified proxy has power similar to that of our more fastidious measure. The difference in average annual return for funds in the highest and lowest quintiles of position-adjusted turnover was –1.92 percentage points. Overall, our results suggest that trading costs are an important determinant of fund performance, and we offer a simple proxy for trading costs that can be used by investors and researchers alike.