Frictional Expenses: The Hidden Investment Tax How the Cost of Changing Securities Can Dampen Your Investing Results

Few investors are aware of the tremendous damage so-called frictional expenses impose on investment performance. By merely reducing these expenses, you may be able to significantly increase your long-term rate of return by lowering your overall cost basis.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.

Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price - $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.