Dallas County Living Well Magazine Summer 2015 | Page 46

Control What You Can: Keep Your Costs Down By Richard Ferri, CFA Y ou can’t control the markets, but you can control how much it costs to invest in them. Mutual fund costs are often couched in terms of expense ratios and commission charges, aka structural costs. Behavioral costs and tax costs are not as obvious and are often difficult to quantify. It’s wise to know all the costs, so you can prevent them from eating away too much of your return. simple way to quantify how badly someone’s behavior is hurting his or her return. Yet, bad behavior is often the most expensive cost. The Cost Triangle: The Investment Cost Triangle combines structural, behavioral, and tax costs together to illustrate the total costs to which we are all exposed. No one is immune from them, but you can (and should) minimize your exposure. Structural costs have a direct impact on investment performance: When your structural costs go down, your expected return goes up. Many studies have been published over the years that link an investment’s return to its structural costs. Overwhelmingly, a negative correlation exists between cost and return: The higher the structural cost to invest, the lower the average fund return, and vice versa. The Investment Cost Triangle Source: The author’s forthcoming book, “The Education of an Index Investor” Structural costs are easy to quantify because providers are required by law to disclose their fund fees and commissions. Tax costs are more difficult in that they have to be extracted from your individual tax returns. Behavioral costs are the most elusive because there’s no 44 NORTH DALLAS Living Well Magazine | SUMMER 2015 Structural Cost: Securities law requires that fund companies disclose the fees they impose. These costs include management fees, administrative costs, distribution fees, commissions, redemption fees, and more. Since most market-tracking index funds and exchange-traded funds (ETFs) are in the low-expense category, they have generated higher historical returns than higher-cost funds in comparable investment classes. Behavioral Cost: Advertised fund returns are based on a formula that compares the performance of one mutual fund to another after factoring out all deposits and withdrawals from the funds. This is the fund’s advertised performance. A different picture emerges when the performance is based on what investors actually do. This investor return lets us compare the timing of fund purchases and sales (investor behavior) to a fund’s reported performance.