The Fund Fees You Don't See

It's simple math: The more you pay to invest, the less you'll get back in return. So-called "frictional costs" -- brokerage commissions, fees, loads, 12b-1 fees, and taxes -- leave less money to compound through the years. Which is why The Motley Fool has long recommend discount brokers and no-load, low-cost mutual funds. The problem with the latter, however, is you don't always know how much you're really paying a fund to manage your money.

This isn't news to listeners of The Motley Fool Radio Show. In an interview last November, John Bogle -- founder of the Vangard family of mutual funds -- had this to say about fund fees:

Management fees in this industry run about 1.6% for the average equity fund. By the time you add in portfolio turnover costs, which nobody discloses, and you add the impact of sales charges and opportunity costs because funds aren't fully invested, and out-of-pocket fees, you are probably talking about another 1.4% of cost, bringing that 1.6% management fee or expense ratio up to 3% a year. That is an awful lot of money.

In other words, the average mutual fund has to earn 3% a year just to break even. Ouch.

Backing Bogle's assertion is a report (pdf file) released last month by the Zero Alpha Group, a network of independent advisory firms that promotes index investing. The study, conducted by Edward O'Neal, assistant professor of finance at the Wake Forest University Babcock Graduate School of Management, calculated the true costs of owning 30 top domestic stock funds during 2001. The results: 43% of the costs of owning a fund are not revealed by the expense ratio, the only easily accessible way to assess a fund's fees.

How does this happen? The ZAG report has the answers.

Brokers making us broker
Funds must pay commissions to buy or sell securities, just like you and me (though they receive volume discounts). These commissions, however, are not part of the expense ratio. Nor are they usually revealed in a fund's prospectus. To find out how much a fund pays its broker -- money that comes straight out of the fund shareholders' pockets -- an investor must dig through the fund's Statement of Additional Information, which is filed with the SEC, or the semi-annual filing of form NSAR. Raise your hand if you've heard of these documents.

That's what we thought. (The two of you with raised hands can put them down now.)

Furthermore, fund families are not required to file separate documents for each fund. Rather, they can file one, big document that contains the information on many funds. According to the ZAG study, these documents can be more than 100 pages long. Have fun trying to find info on the one fund you're interested in.

On top of that, the brokerage costs disclosed in form NSAR are for all the funds that have been grouped together for filing purposes -- not broken down by individual fund -- so the figure is practically meaningless. (We must also mention that the study found that some information in the NSAR filings was suspicious. One filing reported commissions that were 10 times the size of assets under management and 16 more that disclosed commission costs that exceeded net assets in the fund.)

Then there's the question of what is really being bought with the commissions. In many cases, it's not just payment for trade executions, but also payment for other services. These so-called "soft dollar" arrangements can be used to pay for research, equipment, and even personal services, according to the ZAG study.

Spread 'em
Commissions aren't the only costs of buying and selling stocks. Investors also have to pay "spreads."

When you see an online stock quote, chances are that's not the price you'd get if you bought this stock. That's because what you'd be looking at is usually the "bid" -- the price at which a market maker is willing to buy. What you'll pay is the "ask" -- a higher price at which a market maker is willing to sell. This spread in the prices means that investors (including mutual funds) must buy at a slightly higher price than at which they would sell. All investors face this "implicit cost," but it is magnified with a fund because it makes so many trades. However, you won't see this implicit cost listed in a fund's prospectus, either.

So how can an investor evaluate a fund's true costs? Start with evaluating expense ratios. Those are clearly stated in a fund's prospectus, on the fund's website, and in standard sources of mutual fund information such as Morningstar.com.

As for commissions and spreads, the easiest -- though inexact -- way to measure these costs is by looking at a fund's turnover, which measures trading activity. According to the ZAG study, "For high-turnover funds, the total trading costs are much higher. Together, the commissions and implicit costs are higher than the published expense ratios for each of the 10 high-turnover funds we studied. In some cases, the total costs of trading are more than double the level of the expense ratio."

How much does it matter?
A few years ago, I was discussing a specific fund with a friend, which had returned 20% the previous year. I pointed out that she was paying 2.0% a year in fees to be in this fund. Her reply was "I can afford to pay 2% to earn 20%."

That certainly sounds reasonable. After all, how much could paying an extra 1% or 2% a year hurt overall returns? Let's take a look.

Say you have the choice between two funds in your IRA. Before expenses are taken into account, both funds manage to post average annual returns of 10%. One fund takes out 0.5% in expenses, reducing its real return to 9.5%. After 20 years of depositing $250 a month in your IRA (thus reaching the current annual contribution limit of $3,000), you'd have $190,271.

The other fund, however, takes out 1.5% in expenses, reducing its real return to 8.5%. How much would you have after 20 years' worth of $250 monthly deposits? Just $167,060 -- more than $23,211 less. (We must point out that time is a factor here, too, so if you haven't funded your IRA for this year or last, you're not too late. Visit our IRA Center for details.)

OK, so that's a hypothetical example, assuming that the higher expenses don't earn you higher return. So, using Morningstar.com's Fund Screener, let's look at real life by examining the large-cap blend funds (i.e., funds that invest in both growth and value companies) that outperformed the market over the past decade.

Of the 40 large-cap blend funds that beat the S&P 500 over the past 10 years, 26 had an expense ratio less than 1.0, and only five had expense ratios that exceeded the large-cap blend average of 1.29. Only 11 of the 40 funds had turnovers above the category average of 82%. Furthermore, just seven of these funds charged any kind of load, which shows that you don't have to pay a commission to get an excellent fund.

So, the majority of large-cap funds that beat the S&P 500 have lower-than-average expense ratios and turnovers. Can the same be said of small-cap funds? Again consulting the Morningstar.com Fund Screener, only 38 small-cap blend funds beat the S&P 500 over the past 10 years. While only 12 of those funds had expense ratios below 1.0, 34 of the 38 funds had an expense ratio below the 1.57 charged by the average small-cap blend fund. As with the large-cap funds, only seven of the long-term market beaters charged a load. Also, only seven of the funds had turnover that was higher than the category average of 94%.

Pointing toward index funds
Of the 30 funds O'Neal studied, the lowest-cost investments were index funds. Their expense ratios are much lower (about 0.20) since they do not spend very much on management and analysts. Also, since the turnover in indexes is relatively low, the frictional costs of index funds are likewise low.

It should be noted that the ZAG study found that the Fidelity Contrafund had one of the highest total costs of the 30 funds studied, yet it is among the few funds that beat the S&P 500 over the past decade. Plus, both its expense ratio (0.99) and its turnover (80%) are below average. So, using those two metrics alone won't tell the whole story, in terms of costs or performance.

But if you want to stack the chips in your favor, seek no-load, low-cost, and low-turnover funds. In the words of ZAG member and Foster Group President Mark Stadtlander:

In the vast majority of cases, frequent trading does not contribute to performance and, instead, exposes investors to implicit costs that are unneeded and counterproductive to a long-term goal of capital growth. My advice is simple: If the true fee picture for any financial product isn't clearly disclosed, go for the lowest cost alternative in terms of an index or asset class fund or funds.

Robert Brokamp is the co-author ofThe Motley Fool Personal Finance Workbookand the author ofThe Motley Fool's Guide to Paying for School.


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