John Bogle suggests the transaction costs incurred by funds (and thus the lag they have on their investments) should be considered as 1% of the fund's portfolio turnover (0.5% for buy, and 0.5% for sell).

What's the theory behind this? And how is the cost relative, when typically transaction costs are defined as fixed amounts?

The portfolio turnover costs of individual funds also tend to persist. Transactions cost money, and we estimate that turnover costs are roughly 0.5 percent on each purchase and sale, meaning that a fund with 100 percent portfolio turnover would carry a cost to shareholders of about 1 percent of assets, year after year. Similarly, 50 percent turnover would cost about 0.50 percent; and 10 percent turnover would cost about 0.10 percent, and so on. Rule of thumb: turnover costs equal 1 percent of the turnover rate.

-- John Bogle, 2007, The Little Book of Common Sense Investing

  • can you cite your source for this quote? – JTP - Apologise to Monica Feb 27 '16 at 14:02
  • added the citation :) – Lawrence Wagerfield Feb 27 '16 at 14:12
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    Presumably the reason the cost is relative is that funds with a higher turnover are likely to engage in more transactions, not just larger transactions. Transactions costs are fixed per transaction, but you still pay more if you do more transactions. – BrenBarn Feb 27 '16 at 15:26
  • Well, that's why index funds -- with very little turnover -- have low operating costs and hence tend to do better than many (most?) of the actively-managed funds. – keshlam Feb 27 '16 at 15:29

Disclosure - I love Jack Bogle. Jack basically invented the index fund, and as a result, let the common investor have an opportunity to choose a long term return of (S&P-.05%) instead of losing nearly 2% that many funds in that day charged. The use of index investing has saved investors many billions of dollars.

The 1% round trip, total cost to buy/sell, was common. Fees for trading have since dropped. I happen to use Schwab who charges $9 for a trade. On $100,000, this is not .5% ($500) but less than .01%. I think it's safe to say that billion dollar mutual funds are paying even less for trades that I do. I believe Jack's example here is a combination of old data and hyperbole.

The cost is not so much for the trades, per se, but for the people managing the fund. An index fund has a manager of course, but it's pretty much run by a computer.

  • The commissions and the staff cost are already included in the reported expenses of the fund. The hidden cost to trading that Bogle is talking about is the bid-ask spread, and propensity for a large fund to move the market against itself when it tries to trade. (The reported values of bid-ask spread are generally narrower than 0.5%, but the theory is the reported value is largely fictitious due to HFT shenanigans.) – jjanes Feb 29 '16 at 4:57

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