Why Your Low-Cost Investment Fund is Costing You 51X More Than You Think

by | Jan 28, 2020 | Total Cost of Ownership | 0 comments

What if I told you that your “low cost” investment fund could be costing you 51X more than the management fee that is disclosed in the fund’s prospectus? You would probably wonder how this could possibly be.

First, let’s frame an example of how this happens. Let us assume that you believe that the earnings of large-cap S&P 500 companies will outperform the consensus. Therefore, you will purchase an extremely low-cost S&P 500 fund. Being cost-conscious, you select an S&P 500 fund like VFINX or FXAIX, which charge approximately ~1.5 basis points annually, and you plan on holding this fund for four months. You will invest $1,000,000. Let us also assume this fund has a 2% yield and pays dividends quarterly (.50% per quarter).

You unknowingly purchase this fund just before the ex-dividend date. At this point, the investment fund will have a 50 basis point “dividend premium.” A dividend premium means that the fund has collected dividends over the payment period that equal 50 basis points of the net asset value. These dividends have now become a component of the price, and when you buy the fund, you also buy the dividends. Purchasing a dividend is equivalent to buying the seller’s taxable liability. Quick question: Why would you ever want to buy someone else’s tax bill, making you now responsible for paying it?

As soon as you place this trade, you are assuming the seller’s tax liability. Purchasing traditional investment funds is an excellent strategy for people who like to pay other people’s taxes.

Now let’s examine the hard costs that you will incur in just four months. To keep things simple, we will assume that there is no commission. That leaves us with two costs:

  • First, we will calculate the management fee that we will pay the fund manager. Since we only held the fund for four months, we prorate the management fee by multiplying the total annual management fee by .33333 or 1/3 of the year (.015% multiplied by .33333 = .005%). Next, we calculate the management fee in dollars by multiplying .005% by our investment of $1,000,000. The result is equal to $50 in management fees. You might be thinking that $50 in management fees is perfectly reasonable for investing $1,000,000 for four months? But hold on, we are not done.
  • Since you bought this fund when it had a 50 basis point dividend premium, the money that was used to purchase this dividend will be returned to you, and then taxed as ordinary income. Here is how that math breaks down.
    • First, we will multiply your total investment amount by the dividend premium as a percentage of the net asset value. $1,000,000 * .50% = $5,000. Here is where things begin to go sideways for you. Since you spent $5,000 of your investment buying this dividend, this $5,000 will be returned to you when the dividend is paid. This repayment represents a return of your capital. Nevertheless, you will owe taxes on the return of your own money because that is how the current system works.
    • Finally, we calculate the taxes you will owe as a result of buying a dividend. We will assume that you have a high state and federal combined marginal tax rate of 50%. We multiply your tax rate by the dividend you bought – $5,000 * 50% = $2500.00.

You will owe $2,500 in taxes for NO reason. You did not earn $5,000. Yet the system is structured such that you will owe taxes on it anyway.

We conclude by analyzing the cost of the investment fund that was disclosed to you vs. what the investment fund actually cost you. The result is that you end up paying 51X more than what you thought you would pay!

Disclosed Cost = $50.00, which is the management fee owed to the manager

Actual Cost = $2550.00, which is equal to the management fee plus the taxes owed

There you have it. You paid 51X more for this investment fund than you thought!

What a waste of your hard-earned money. What can you do about this so that you don’t spend your entire investment life paying taxes that you do not owe?

You can #BuyFairShares. If this fund used FairShares, the total and final cost realized by the investor would be $50.00, not $2,550.00, because you did not have to pay someone else’s taxes. With FairShares, you never have to pay taxes that you do not owe. You only pay taxes on what you earn.

We encourage you to reach out to your financial advisor and the investment funds that manage your money and tell them that you want to #BuyFairShares .

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Jeremy Roseberry