Typically, when you trade a stock, your costs include broker commission, exchange clearing fee, stamp duty, taxes on these fees and sometimes custody fee for overseas stock exchanges. This trading cost typically ranges from 0.2% to 0.25% of transaction value, with significant part of the cost coming from the broker commission. If you trading amount is small, there can be a minimum broker commission, hence, increasing the trading cost as a ratio of transaction value. For mutual/hedge fund, the broker commission will be lower and can be in around 10bps or 0.1%.
For mutual/hedge fund, if the fund’s strategy is to trade regularly, on daily/weekly basis, the trading cost will increase dramatically. If each trade cost 10bps or 0.1% of asset, and you turnover your portfolio 5x a year (e.g. if your portfolio is $1m and your total trading value – buying and selling – in a year is $5m), your trading cost is 5 x 10bps = 50bps or 0.5% a year.
Some funds have soft commission arrangement, which make higher broker commission of 10-25bps. If we assume 25bps, 5x portfolio turnover means total trading cost of 1.25% a year.
What is this soft commission? E.g. with broker commission of 25bps, the fund can arrange a soft commission of 17bps, so that the broker can only keep 8bps for themselves. The fund can utilise that 17bps by asking the broker to pay for research related expenses, such as bloomberg terminal, research database subscription, or payment to other research house. Let’s use some numbers. If the fund buys shares worth $1m, the broker commission is $2500. The broker keeps $800 for themselves, and pays $1800 to other third parties that the fund instructs it to. These third parties provide research-related services to the fund. Note, traveling across cities and countries to visit companies and meet management are considered research-related activities, hence, travel expenses (transport + hotel) are charged to the fund. Since it’s charged to the fund, why not fly a little better and stay in a little better hotel? What do you think?
Why does the fund have such arrangement that cost investors more money? Well, I don’t know how this all started. In my view, it does increase the cost to investors, putting them at a disadvantage. In a fund’s view, they want/need this soft commission to help pay for their research related services. Without this soft comm, the fund has to pay out from its own pocket. Since it’s research related, why not charge it to investor? The person who first came out with this idea creatively transfers investor’s money to the fund’s own pocket to pay for their research expenses and justifies it by saying that it’s research related expense for the investors’ benefit.
For any other forms of investment fund, e.g. unit trust, mutual fund, hedge fund, etc, they have management fee and performance fee. They also charge the fund administrative fee, legal fee, audit fee, prime broker fee to the fund.
For large funds, these fees can add up to 2-3% of net asset per year. For small funds, these fees can add up to 4-5% of net asset per year because the fund admin/legal/audit fees become a larger percentage of the net asset.
Many unit trusts and mutual funds also charge sales charge of 2-5%.
When we add up all the costs above, it can be very substantial. For active large fund with low trading frequency and no sales charge, the total cost can be around 2-2.5%. For active small funds with high trading frequency and no sales charge, the total cost can be 6-7%. Note, I have not factored in the sales charge and performance fee. Index fund is a special case that does not involve active fund management, hence it skips many of these costs, brining total expense ratio below 1%.
Stock market average return over long term is 8-10%. Look at the fees above. It ranges from 30% of stock market return to 80%! That is the key reason why so many professional fund managers are unable to beat the average market return.
When you are deciding which fund to invest in, do take note of the expenses. Usually you can see the management fee, performance fee and sales charge on the fund brochure. Admin fee, legal fee and audit fee may be quite small to large fund, but don’t neglect them if it’s a very small fund size as they can be quite substantial. When it’s obmitted from the brochure, do ask what’s the expense as percentage of asset. You may also want to find out soft commission arrangement, if any. You’ll be surprised how they can eat away the investors’ return.
Let’s say the total expense is 4% a year for a small hedge fund, coming from 2% management fee, 1% from audit/legal/admin/prime broker fees, 1% from their high trading frequency and soft commission arrangement. If your target is 10% a year from this hedge fund, then the fund needs to get 16.5% gross return. From this 16.5%, we deduct 2% management fee, 1% audit/legal/admin/prime broker fee, 1% trading cost due to high frequency trading strategy. From remaining 12.5%, 2.5% goes to performance fee. So, investors get the remaining 10%.
See the difference? This small active hedge fund needs to get 16.5% gross return to match market average return of 10%!
If the total expense is 2%, the fund still needs to achieve gross return of 14.5% to get net return of 10%.
Most mutual funds and hedge funds underperform the market because of high expenses. Only very few good ones can really outperform the market on net performance consistently.
To get average market return, it’s quite easy. Just buy low cost index fund. To get additional 1% above market return, you’ll have to put in much more effort. The 2/20 management-performance fee by hedge fund make it a high challenge for hedge fund to beat the market. So, if you want to invest in a hedge fund with 2/20 structure, make sure it has a track record of consistently beating the market for many years on net performance (at least 6/10 years).
Many hedge funds can beat the market for 1-2 years simplying by taking higher risk or by leveraging. Simply by investing in riskier stocks, in good years, they can get much higher return. In market downturn, those contrarian will all make money from shorting, while those long-only hedge funds and mutual funds will look like losers. That makes performance measurement very tricky thing to do. Novice investors usually pay attention to last 1-2 years performance only.
There is another fee often overlooked by retail investors. Market spread fee.
For every share, there is bid and ask price. The difference is called spread.
For very liquid stocks, the bid-ask spread is usually the tiniest possible value (could be 0.5 cent, 1 cent, 5 cent, 10 cent or more based on the price). The spread is so small that it usually doesn’t make a difference to you.
However, for illiquid stock, the bid-ask spread can cost you a few percentage points. For example, for some illiquid stock, your buying/selling shares worth just $100k can move the price up/down by 5% or more. This is part of the trading cost that is very often ignored by novice investors. After they bought shares worth $100k and the price rose 5%, they thought they made wise decision. Try selling the shares and you’ll see the price falls by 5% or more.