Here's how to slap the invisible hand.
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By Christine Benz | 04-18-11 | 06:00 AM | Email Article

I've been writing a series of articles about how retirees can cut their costs during retirement. Last week's column focused on how to cut your expenses for financial services, including investments, banking, credit cards, and insurance. I came up with 50 tactics for cutting costs, but it turns out I really only scratched the surface when it comes to reducing your investment-related costs. In addition to the easily observable costs that investors pay--such as commissions to buy and sell and fund expense ratios--there are hidden costs to stay attuned to, as well. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Here are some of the other charges to be aware of as you manage your portfolio.

Bid-Ask Spreads
What They Are: If you're investing in individual securities, particularly less-liquid ones, it pays to be aware of bid-ask spreads when you're buying and selling. The bid is the price that someone is willing to pay for a security at a specific point in time, whereas the ask is the price at which someone is willing to sell. The difference between the two prices is called the bid-ask spread. Bid-ask spreads have the characteristic of heads they win, tales you lose: If you're a seller, you receive the lower price (the bid), and if you're a buyer, you pay the higher price (the ask). (Note that bid-ask spreads aren't an issue for mutual fund buyers and sellers, at least not directly, because the fund is priced just once a day, and everyone pays and receives that same price.)

If you're trading highly liquid securities, the bid-ask spread will tend to be pretty inconsequential, meaning that buyers and sellers generally agree about what the right price for a security should be. For example, on April 15 the bid-ask spread for the exchange-traded fund  SPDR S&P 500 , which is itself dominated by heavily traded, household-name companies such as  Microsoft  and  Johnson & Johnson , was just a penny: The bid was $132.31 and the ask was $132.32.

But bid-ask spreads can be more onerous when you're dealing in more thinly traded securities, such as small-company stocks or ETFs with light trading volume. As my colleague Bradley Kay discusses in this article, that bid-ask spread compensates the market maker in the security (which matches buyers with sellers) in case it can't find buyers for the shares and the price moves around a lot before it does. The greater the risk of that happening, the more the market maker demands in terms of a bid-ask spread. Think of the bid-ask spread as the markup on your purchase or sale. Morningstar recently began providing bid-ask spreads, both in absolute and percentage terms, for all of the ETFs in our database.

How to Reduce the Drag: So how can you reduce the drag of bid-ask spreads on your returns? At the risk of stating the obvious, reducing your number of transactions is a good starting point, particularly if you're dealing in any type of illiquid security. Another way to exert more control is to use a limit order rather than a market order. By doing so, you're saying that you're not going to accept any old price when buying and selling (a market order); you only want to transact if you can get a specific price or better. If you're a frequent buyer and seller of individual bonds, check out this unit from Morningstar's Investment Classroom.

Fund Trading Costs
What They Are: Bid-ask spreads aren't just a cost for those trafficking in individual securities, however. They're also an extra cost for mutual funds that buy and sell less-liquid securities. And they're just one of several hidden costs for mutual funds. When I say they're hidden, I mean that these costs aren't reflected in a fund's expense ratio, but they are subtracted from your returns.

In addition to bid-ask spreads, fund shareholders are also on the hook for brokerage commissions that the manager pays to buy and sell shares. Of course, mutual funds should be able to swing better deals on trades than you and I would when buying and selling on a retail brokerage platform. But these commissions aren't chump change, either: As my colleague Karen Dolan discusses in this article, the average equity fund in our database pays roughly 0.30% in brokerage commissions--and that's in addition to the fund's stated expense ratio.

Fund shareholders may also pay so-called market impact costs, meaning that larger funds have a tendency to affect a company's price when they're buying and selling shares. As with bid-ask spreads, market-impact costs are a function of supply and demand. So if a large fund is buying shares of some small company, it may drive up the price of the shares in the process, as other market participants see that there's an appetite for the shares. And the reverse can happen when it's selling; unloading big blocks of a company has the potential to drive down the stock's price. This phenomenon can be particularly painful when large funds are making frequent trades in smaller, less-liquid companies.

Securities mentioned in this article

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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