Hidden Frictions: The Costs That Do Not Appear on Fee Schedules

The fees you know about are the ones you can manage. The fees you do not know about erode returns silently, appearing nowhere in the headline numbers but showing up in every outcome.

Investment costs extend beyond the management fees and brokerage that appear on schedules and statements. Foreign exchange margins, bid-ask spreads, transaction frequency effects, and timing costs all subtract from returns without ever being itemised. These are not hidden in the sense of being concealed; they are hidden in the sense of being structural, embedded in how markets and products work.

This article identifies the frictions that reduce net returns, explains how they operate, and suggests ways to minimise their impact.

This is general educational information, not personal financial advice.

The Gap Between Gross and Net#

Every investment return you see quoted is a gross return: what the investment produced before your costs are applied. Your actual return, the net return, is always lower.

The gap between gross and net is created by:

• Explicit fees (MER, brokerage, platform fees)
• Implicit costs (spreads, FX margins, market impact)
• Behavioural drag (trading frequency, timing errors)

Explicit fees are disclosed and comparatively easy to track. Implicit costs and behavioural drag are harder to quantify but often larger.

An investor who focuses only on explicit fees is seeing only part of the picture. The frictions discussed below can easily exceed the management fee, especially for investors who trade frequently or invest internationally.

Foreign Exchange Margins#

When you buy international shares or funds, your Australian dollars must be converted to foreign currency. This conversion is not free.

The FX margin is the difference between the rate you receive and the mid-market rate (the midpoint between buy and sell rates in wholesale currency markets). Brokers and platforms typically add a margin of 0.3% to 1.0% or more.

How It Adds Up#

On a $10,000 investment, a 0.5% FX margin costs $50 on the way in. If you later sell and convert back to AUD, you pay again on the way out. The round-trip cost is $100, or 1% of the investment.

For investors who regularly buy international shares, this friction compounds. Ten $10,000 purchases across a year at 0.5% margin each way costs $1,000 in currency conversion alone.

Minimising FX Friction#

• Compare FX margins across brokers. Rates vary significantly; some platforms offer tighter spreads than others.
• Hold foreign currency. Some brokers allow you to maintain a USD or other currency balance, reducing conversion frequency.
• Batch transactions. Fewer, larger conversions may cost less than many small ones, depending on fee structure.
• Consider currency-hedged products. For Australian-domiciled ETFs that invest internationally, hedged versions eliminate your direct FX exposure (though hedging has its own costs and trade-offs).

FX costs are rarely disclosed as a single line item. You see only the effective rate applied, not the margin taken. Calculating the margin requires comparing your rate to the mid-market rate at the time of transaction.

Bid-Ask Spreads#

Every security has two prices at any moment: the bid (what buyers will pay) and the ask (what sellers will accept). The difference is the bid-ask spread.

When you buy, you typically pay the ask. When you sell, you receive the bid. The spread is an immediate cost, paid on entry and exit.

How Spreads Vary#

Spreads are narrow for highly liquid securities (major ETFs, large-cap stocks) and wide for illiquid ones (small companies, thinly traded products).

A 1% spread on a $10,000 trade costs $100 to enter. Another 1% on exit costs $100 more. The round-trip spread cost is $200, or 2% of principal.

Fund Buy/Sell Spreads#

Managed funds and some ETFs apply their own buy/sell spreads, separate from market spreads. These compensate the fund for transaction costs when units are created or redeemed.

A fund with a 0.10% buy spread and 0.10% sell spread costs 0.20% round-trip, in addition to the MER.

Minimising Spread Costs#

• Trade liquid securities. Major ETFs and large-cap stocks have tighter spreads than niche products.
• Use limit orders. Avoid market orders in illiquid securities, which can execute at unfavourable prices.
• Trade during market hours. Spreads can widen outside regular trading hours or during volatile periods.
• Reduce transaction frequency. Each trade incurs spread costs; fewer trades mean lower total friction.

Transaction Frequency Effects#

Every trade you make incurs costs: brokerage, spreads, and potentially tax consequences. The more you trade, the more these costs accumulate.

Research on individual investor behaviour consistently shows that more active traders underperform less active ones.^¹ The underperformance is largely explained by transaction costs and poor timing, not by the quality of investment selection.

The Compounding Effect of Activity#

Consider two investors with identical starting portfolios and identical market returns.

Investor A trades monthly, incurring $20 in brokerage and approximately 0.15% in spreads per trade (24 trades per year).

Investor B trades annually, incurring the same costs but only twice per year.

Over 20 years, Investor A's transaction costs total approximately $9,600 in brokerage alone, plus spread costs and potential tax drag from realised gains. Investor B's costs are $800.

The difference is not explained by investment skill. It is explained by activity.

The Illusion of Improvement#

Frequent trading often feels productive. Each trade is an attempt to improve the portfolio, to capture an opportunity, to avoid a risk. But the evidence suggests that most of this activity destroys value rather than creating it.^²

The investor who trades less is not passive in a negative sense. They have made a decision: that the cost and risk of action exceeds the expected benefit. This is often the correct decision.

Timing Costs#

Even without explicit fees, the timing of trades affects outcomes.

Market Impact#

Large trades can move prices. Buying a significant position pushes the price up as your orders are filled; selling pushes it down. For most individual investors, this effect is negligible. For those trading illiquid securities or large positions, it can be substantial.

Execution Timing#

Prices change between when you decide to trade and when the trade executes. This is not a fee, but it is a cost. The investor who hesitates, or who places orders outside market hours, may receive a different price than expected.

Opportunity Cost#

Money sitting in cash while waiting for the "right moment" is not earning market returns. For long-term investors, the opportunity cost of being out of the market often exceeds the benefit of timing entry.^³

Research shows that investors who attempt to time the market typically underperform those who stay fully invested, largely because of this opportunity cost and the difficulty of timing correctly.

Inactivity and Dormant Account Fees#

Some brokers charge fees for accounts that do not trade within a specified period. These fees are designed to encourage activity, but they can erode the value of buy-and-hold portfolios.

An inactivity fee of $10 per month on a $10,000 portfolio costs 1.2% annually, equivalent to a high MER, for doing nothing.

Avoiding Inactivity Fees#

• Check broker fee schedules before opening accounts. Some brokers have no inactivity fees; others have significant ones.
• Consolidate accounts. Multiple brokerage accounts increase the chance of incurring dormant fees.
• Understand waiver conditions. Some inactivity fees are waived if the account balance exceeds a threshold or if certain conditions are met.

Cash Drag#

Many investment products hold a portion of assets in cash for operational purposes (managing redemptions, awaiting investment opportunities). This cash earns lower returns than the fund's target asset class.

Cash drag is the difference between the return the fund earned and the return it would have earned if fully invested. For most funds, this is a small effect (0.1% to 0.3% annually), but it is a real friction that reduces net returns.

Some ETFs are more efficient than managed funds in this regard, as their structure allows for in-kind redemptions that reduce the need for cash buffers.

Measuring What You Actually Pay#

The frictions described above do not appear on a single statement. Measuring them requires calculation:

• FX costs: Compare your transaction rate to the mid-market rate at the time.
• Spread costs: Note the bid-ask spread at the time of trade and multiply by trade size.
• Transaction frequency: Track total brokerage and estimate spread costs across all trades annually.
• Cash drag: Compare fund cash holdings to stated investment allocation.

Most investors do not track these precisely, and that is understandable. But having a general sense of their magnitude prevents underestimating total costs.

A portfolio with a 0.30% MER but 0.50% annual friction from spreads, FX, and transaction frequency is actually costing 0.80% or more.

The Net Outcome Principle#

Headline returns and stated fees are inputs. What matters is the net outcome: what you actually earn after all costs.

Two funds with identical gross returns and identical stated fees can produce different net outcomes if one has higher hidden friction (wider spreads, more turnover, larger cash drag).

The investor who focuses on net outcomes rather than gross returns or headline fees is asking the right question: what did I actually get, and what did it actually cost?

Summary#

Investment costs extend beyond disclosed fees to include foreign exchange margins, bid-ask spreads, transaction frequency effects, timing costs, inactivity fees, and cash drag. These frictions are not hidden in the sense of being concealed, but they are embedded in market structures and often unitemised. FX margins of 0.3% to 1.0% apply on currency conversions; spreads range from negligible on liquid securities to several percent on illiquid ones; frequent trading compounds brokerage and spread costs over time. The gap between gross and net returns is created by the sum of explicit and implicit costs. Measuring hidden frictions requires comparing transaction rates to benchmarks and tracking total costs across all trades. The focus should be on net outcomes rather than headline figures, because what matters is what you actually earn after all costs are accounted for.

Sources#

1. Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. The Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226

1. Odean, T. (1999). Do investors trade too much? American Economic Review, 89(5), 1279-1298. https://doi.org/10.1257/aer.89.5.1279

1. Vanguard. (2023). The case for staying invested. https://www.vanguard.com.au/personal/education-centre/en/insights-article/case-for-staying-invested