Your Fund's Hidden Costs

Ernest F.

What a great question, Ernest! I bet Ernest also notices other important things, like which filling stations have the cheapest gas--something I'm terrible about (probably because I never fill up until I'm practically on empty). But I digress.

Many of the primary expenditures of running a fund are included in its expense ratio, which encompasses administrative costs, the fees paid to the fund advisor, and, where applicable, a sales cost called a 12b-1 fee. A fund's total returns are reported after expenses, so a fund with a higher expense ratio is automatically at a disadvantage relative to a similar fund with lower costs. For more information on the nuts and bolts of the expense ratio, see "Your Fund Costs Might Be Higher Than You Think".

But Ernest has the right idea in asking about hidden fund costs. It turns out not every dollar your fund spends shows up in its expense ratio.

Trading Costs
A fund's expense ratio doesn't include any loads you might pay on the purchase or sale of a fund; those are separate. And another major group of expenses aren't included in the expense ratio: trading costs. If your fund buys or sells a stock (or a bond), the manager pays a commission on that trade. That's not really any different than the fee you would pay if you were buying or selling a stock or a bond yourself--except the fund manager is probably trading a much bigger amount. Because their transactions are often so large, fund companies usually get a break on transaction fees, although trading certainly isn't free.

Trading costs aren't included in the expense ratio, but they do come out of total returns. In other words, the more your fund trades, the more you--as a fund investor--are likely to pay in trading costs; you just don't see them because they aren't included in the expense ratio.

How do you know if your fund trades a lot? Its turnover rate is a good indication. A fund with an annual turnover rate of 8%, such as Tweedy, Browne Global Value, isn't trading very much. On the other hand, a fund with an annual turnover rate of more than 300%, such as Driehaus International Growth, is changing over its portfolio about three times in a single year on average.

Does that mean you've purchased an inferior offering if your fund trades a lot? Not necessarily. High turnover doesn't automatically equal poor returns. (This is especially true among bond funds, where high turnover rates are sometimes a function of complex trading strategies.) However, if your fund managers--especially equity managers--trade like maniacs, then you should understand that they probably have extra ground to make up in order to cover their trading costs.

Market-Impact Costs and Soft Dollars
A couple of other expenses also fall under the umbrella of trading costs. For one, a fund unloading a large amount of stock--especially the stock of a small, lesser-known
company--may suffer market-impact costs. That is, as the fund floods the market with stock, it may drive the stock's price down in the process, so that the shares get cheaper even as the fund continues to sell. (There's also the opposite problem on the buy side.) Fund companies, especially the big firms, employ large trading staffs that use different strategies to avoid market-impact costs. But if the security is highly illiquid, those costs may be unavoidable.

Finally, the most nefarious hidden cost is something known as soft dollars. What the heck are "soft dollars," you ask? Fund companies have been known to pay higher transaction costs than necessary in order to receive research support or other services (such as Bloomberg terminals) in return. Soft dollars help keep a fund's reported expense ratio low, although shareholders are still paying the price--they just don't know it. My colleague, Russel Kinnel, wrote a great article on soft dollars last year, and this past January he wrote about how the Investment Company Institute, the fund industry's main trade group, has proposed banning soft dollars. Morningstar's Don Phillips also proposed banning soft dollars in his testimony before the Senate in February. Unfortunately, fund companies aren't currently required to report how much they overpay for their trades, so it's hard to know which use soft dollars and which don't or how to quantify the impact. Hopefully, legislation will eventually change the reporting rules surrounding soft dollars.

What's an Investor to Do?
If all this talk of hidden costs has gotten you down, don't fret too much. Fund companies that excel on other fronts--for example, by offering well-managed, low-cost funds--are probably doing right by investors when it comes to trading expenses. And because trading costs come out of total returns, check to see if your fund has delivered strong relative results over the long haul. If the fund's long-term record is good, then the manager probably isn't racking up lots of trading costs--or he has gotten very good at overcoming those charges.

A version of this article originally ran on Sept. 24, 2003.