What does the mutual fund scandal cost?

The mutual fund scandals have received significant publicity in recent times, but how much are they really costing us? The current (November 24th) issue of Fortune offers a useful article on the topic (subscription required):

According to Stanford University business professor Eric Zitzewitz, market timing costs long-term shareholders $5 billion a year, and late trading costs $400 million per year. These losses may add up to 1% or less in lost returns in a given year, he says. That equates to about $10 for each $1,000 invested in a fund.

Of course, in economic terms, the real social cost is given by how much this limits or distorts investment, rather than by the size of the transfer away from investors. The magnitude of this distortion is harder to judge, but investors have been moving out of the funds, and many of them cite the scandals as a factor.

As a very rough exercise, compare this change in returns to the Bush tax cut on dividends. The previous top rate on dividends had ranged up to almost 40 percent, now it is 15 percent. So, tricky questions of incidence aside, you get to keep 25 percent or so extra of your gross dividend return. If the dividend rate on the stock is, say, 4 percent, you gain about one percent on your investment asset value, each year, from the tax cut. Which may be just about how much you are losing back to the mutual funds.

Some work on Eric Zitzewitz’s home page suggests that market timing can costs investors as much as two percent a year (this seems high to me, plus it is odd that Fortune then cites him as saying one percent). Yet another source, taken from his home page, cites a loss of 0.6 basis points on domestic funds, and a startling 5 basis points on international funds.

Plus you must pay expense ratios, which average at least 1.5% a year. Upfront sales commissions, a one-time fee, average more than 4.5% and sometimes run as high as eight percent of asset value or more.

Now mutual funds do not comprise the entirety of investment, by any means, but under this estimate the costs of mutual fund fees and chicanery, on a given investment, could be much more than the benefit reaped from the Bush tax cut.

There are two ways to look at this. First, all these fees may reflect marginal costs within a rational equilbrium. In that case the tax cut will provide a modicum of relief and encouragement.

Second, these fees reflect investor insensitivity to their true returns. This would suggest that the dividend tax cut, in the broader scheme of things, hasn’t done much to stimulate additional investment. I’ll guess-timate that this latter option is more relevant than the former.