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Recent articles by Scott Burns: • Retire to roam, 2/24/2006 • The best age to start Social Security, 2/3/2006 • Frugality: You get it from your kids, 1/20/2006 More... |
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| A fund myth that won't die | |||||||||||||||
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Even professionals spread misinformation about supposedly hidden transaction costs in index vs. managed funds. By Scott Burns "My husband had a hallway conversation with a financial planner who shares an office building with him. The planner said something like, 'Index funds can cost more than load funds because people can buy and sell in and out of the index fund. This triggers transaction costs of buying and selling stock that have to be paid by the index fund. Whereas with the load fund, people tend to stay in it longer. The fees are higher in the load fund, but the transaction costs are lower.' "My husband and I got in a big conversation about this. I thought it was ridiculous. First I asked if the guy sold load funds, and my husband said he didn't; he gave fee-based advice only. "I said that probably the index funds have some kind of pooled cash or shares. And every time someone buys or sells 100 shares of the index fund, they don't actually have to buy or sell individual shares of stock in and out of the fund. Some people sell; some people buy. It all evens out."
So wrote N.B., a reader in Washington state, of an encounter with an enduring story often told by people on the sales side of the mutual-fund business. The facts, please The actual facts, which are as available to those in financial services as they are to financial journalists, are quite different. Related news and commentary on MSN Money
First, the broad index funds have portfolio turnover rates that are small fractions of turnover rates in managed funds. According to Morningstar, for instance, the average turnover rate for all managed, large-blend domestic equity funds is 85%. The average turnover rate for all managed, large-blend domestic equity funds with front-end loads is 74%. The average turnover rate for all managed, large-blend domestic equity funds with deferred loads is 73%. This adds a lot of expense. The average turnover rate for all index funds in the same category is only 18%. The turnover rate in the 10 largest index funds in the category ranges from a low of 2% S&P Depositary Receipts So if there is an expense burden due to portfolio turnover, the liability is on the side of managed funds. Indeed, low portfolio turnover cost is one of the major advantages of broad index funds. Another advantage of index funds is that they seldom have as much cash in their portfolios to meet redemptions as managed funds, though the difference isn't great. The Morningstar data for the same group shows that managed funds had 3.7% of their portfolios in cash, while index funds in the same category had 2.7% of their portfolios in cash. Putting a damper on short-term trading Similarly, most of the major-fund firms now charge fees that discourage short-term trading, whether the fund is managed or an index. Fidelity, for instance, charges a fee of 0.50% if shares of its Fidelity Spartan 500 Index Investor (FSMKX) fund are sold within 90 days of purchase. The fee is paid into the fund, not to the fund company. The idea is to protect long-term investors. Vanguard does not allow purchases within 60 days of a fund sale for some funds and, like Fidelity, imposes a redemption fee that is paid into the fund for some funds. Whatever the relative cost of managed vs. index funds, it has been argued that investors in load funds have advisers who encourage them to hold. Self-help investors frequently change their minds and fail to reap the advantages of long-term performance. That's an issue that may concern self-directed investors. As I have said many times, indolence pays. Send e-mail to scott@scottburns.com and see his Web site (free registration required). | |||||||||||||||
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