CALL it hyperactivity, call it the temptation to fiddle. Chief executives have a tendency to make acquisitions just to show they are doing something. Similarly, fund managers, sitting at their desks all day, have the urge to trade. Otherwise why go into the office at all?
But these trades inevitably incur costs, and not just in the form of fees disclosed to mutual-fund investors as part of a fund’s total expense ratio. When a large fund sells its stake in a small company, for example, the share price may fall significantly as supply overwhelms demand. A recent paper* in the Financial Analysts Journal (FAJ) found these hidden costs were, on average, higher than the funds’ declared expenses and had a significant negative impact on returns.
The academics looked at the record of 1,758 American equity mutual funds between 1995 and 2006. They estimated trading costs by looking at changes in portfolio holdings (which are revealed every quarter), checking the bid-ask spreads for the stocks concerned and making an allowance for the price impact of trades.