"These 'invisible costs' include brokerage commissions, bid-ask spreads, price impact and timing costs," Kadlec says. Unlike fund fees, which are widely reported, these trading costs are very difficult to assess and are generally not reported, he says.
Kadlec and co-authors Roger Edelen
and Richard Evans, the latter two from the Carroll
School of Management at Boston College, studied
1,700 domestic equity funds from 1995 to 2006.
They discovered that trading costs have a greater
impact than expense ratio on fund performance,
"because there's much more variation."
On average, says Kadlec, every dollar spent on
trading costs translates into a 42 cent reduction
in fund value. So while funds recover about half
their trading costs, "the other half is a
deadweight drag on fund performance."
The study looks at various
types of trades among different types of funds, and goes into "excruciatingly
boring details," Kadlec admits. He's right, so I'll spare you and get right
to the punch line.
Says Kadlec, "You might conclude
that all trading is detrimental to shareholder
wealth, but that's not the case if you look deeper
into this issue. The impact of trading on performance
depends critically on who is trading and why.
Large trades are particularly costly to performance
... By contrast, when funds trade in small quantities
for discretionary purposes, the relationship between
fund performance and trading costs is actually
positive. Those funds actually more than recover
their costs and add value."
not going to be easy to figure out which funds have the highest trading costs
because turnover apparently isn't a good measure. But if you look at a fund's prospectus
and quarterly reports, you can learn about the fund's investment strategy and
style. If you're in a growth fund whose managers follow an earnings momentum strategy,
it's a good bet that the fund will incur much higher trading costs than a fund
with a buy-and-hold strategy.
Buy-and-hold is arguably the best strategy for fund investors
to have. A study in the June issue of T. Rowe Price Investor Magazine reveals
the advantages of that strategy over market timing.
a hypothetical example based on actual returns between June 30, 1990, and June
30, 2006, two people invest $100,000. Both portfolios were identically allocated
in the beginning: 60 percent to large-cap stocks, 20 percent to small caps, 15
percent to international developed markets and 5 percent to emerging markets stocks
-- all indexes which investors can't invest directly in, though they can invest
in index funds with low costs.
The wimpy market timer bailed
any time an asset class fell 10 percent within a month and invested that money
in cash. Then when the asset class gained 10 percent within a month, the wimp
summoned the courage to get back in.
Meanwhile, the buy-and-hold
investor stuck with the same portfolio through bull and bear markets.
Guess who won? The market timer
had average annual returns of 8 percent, and his
portfolio grew to $342,600. The buy-and-hold investor's
annualized return was 10.3 percent, and his portfolio
grew to $480,000.
Moral of the story: The
markets may cause motion sickness at times. Just take some ginger and remember
that over the long term, they inevitably will rebound.