Trading: Beware the “Bid-Ask Spread”
While commissions on buying and selling stocks are easy to see, there is a significant extra expense associated with buying and selling stocks, known as the bid-ask spread. For example, if you get a real time quote of $20 for a stock and place a buy order, the price you pay won’t be $20. It will actually be a bit higher, perhaps $20.05. The reason is that dealers of the stock make a profit between the price they pay for the stock and the price they sell it to you. Similarly if you were to sell the stock you may get a price of $19.95. The $0.10 difference is the bid-ask spread. While the spread may appear to be a small price to pay, the more you trade the more spreads you pay and the lower your investment returns. Less liquid stocks, such as small company stocks, tend to have higher spreads, sometimes in the order of several percentage points relative to the price. You should look at the trading volume of an individual stock—if it doesn’t trade very often, it’s likely the spread will be quite high.
Taxes: Uncle Sam wants his pieceI could argue that taxes are visible expenses, but generally when you generate taxes from your portfolio, you will not sell your investment to pay taxes. Instead, it will simply show up on your tax return as an additional tax, paid by funds from other sources. The main sources of taxes are dividends and capital gains. While there has been great fanfare about high dividend stocks in recent years, that will change when tax laws change in 2011. If you have high dividend stocks, those dividends will be taxed at higher rates soon. Even now, only certain types of dividends qualify for lower rates and only if you meet the holding period requirements.
The more potent destroyer of your returns are capital gains taxes. Essentially if you sell a security in a taxable account, you must report the gain or loss to the IRS. Short-term gains (less than one year) are treated just like regular income for tax purposes. If you are trading frequently, it’s likely you are also generating short-term gains.
Mutual fund fees: The LandmineMost investors generally look at only one piece of data when it comes to mutual funds—performance. What you should be looking at first are mutual fund fees. The problem with mutual fund expenses is that you never see them on a statement. Instead, they are embedded within the returns: the returns you get reflect performance after fees. Every mutual fund has an operating expense ratio (OER), which is the percentage of the total assets within the fund that goes to administrative and management expenses. In 2008 the average US stock fund had an expense ratio of 1.66% and international funds were even higher. A landmark study done over a decade ago looked at the performance of mutual funds and concluded that the single best predictor of performance was the OER: funds with low expenses performed better than funds with high expenses.
But wait, I’m not done. Remember that mutual fund managers have to trade within the fund, so they incur bid-ask spreads and commissions within the fund just like you would if you bought and sold stocks directly. The OER does not reflect these expenses. Instead the “fee” comes in the form of lower investment returns. One way to determine whether your fund incurs high internal commissions and spreads is to look at how often the portfolio “turns over”. If a fund turns over 100% of its portfolio in one year, it means that on average by the end of the year, all of the original securities have been sold.
Hold on, there’s more. Within the OER is a hidden little gem called a 12b-1 fee. Many mutual funds charge this fee for marketing purposes, and it usually goes to the advisor who sold you the fund. The 12b-1 fee basically adds nothing of value to you as an investor. So, if you work with an advisor, make sure you check and see whether any of your funds have 12b-1 fees.
Also, make sure you check to see whether you have purchased a load fund or not. A load just means an upfront commission on the shares of the fund itself, and is typically sold by commission-based advisors. Loads usually range from 4-6% but may be lower for larger transactions. So, if you purchase $10,000 of a mutual fund with a 5% load, you will actually only be investing $9,500 in the fund. One way mutual funds and advisors can hide loads is to not charge an upfront load but instead charge a back end load when you sell the fund. Even worse there are funds with both loads and 12b-1 fees.
Finally, a mutual fund manager, which trades frequently within the fund will generate a high turnover which will lead to higher taxes for you. Every time the fund sells a position, there are potential tax consequences if there are gains. Since mutual funds are really conduits between you and the underlying investments, those taxes are passed on to you. So, as trading activity within the fund increases, you generally pay higher taxes. If the fund sells positions held less than one year, you face even higher taxes because the gains are taxed at your regular income tax rate.
Setu Mazumdar, MD practices EM and he is the president of Lotus Wealth Solutions in Atlanta, GA www.lotuswealthsolutions.com