Len Boselovic
9 February 2004
Pittsburgh Post-Gazette
If Forrest Gump had been made today instead of in the go-go '90s, maybe the protagonist would be famous for saying: "A mutual fund is like a box of chocolates. You never know what you're gonna get."
New evidence of that comes in a study from Zero Alpha Group, a network of advisory firms that favors passively managed mutual funds. The group looked at the commissions funds pay to buy and sell stocks in their portfolio as well as other trade-related costs. Neither of those costs are included in a fund's expense ratio, which helps investors figure out how much they are paying for professional investment management.
Based on 2001 data, the study computed trading costs for the 30 largest domestic stock funds. The result: Expenses for the funds were an average of 43 percent higher than the average expense ratio of 0.7 percent the funds reported. Instead of paying $70 for every $10,000 invested, average actual expenses were 1.01 percent, $31 higher for every $10,000 invested.
Expenses of some funds were considerably higher than the average. Fidelity's Contrafund [FCNTX] had an expense ratio of 0.84 percent in 2001, but trade-related expenses of 0.8 percent. That means Contrafund investors who thought they were paying $84 annually for every $10,000 invested were really paying $164.
Although trading costs aren't included in the expense ratio, they are reflected in the data investors receive on how their fund is performing.
"But you don't see how much these costs reduce the rate of return," says Miles Livingston, a University of Florida finance professor who co-authored the study.
Funds have to disclose the commissions they pay on securities trades to the Securities and Exchange Commission in something called a Statement of Additional Information, or SAI. Livingston says most investors don't even know the statement exists. Even if they do find an SAI online or have their fund send them a printed version, many investors won't be able to find commission costs in it, much less calculate an expense ratio that includes them.
About the best they can do is look at one tidbit funds do disclose, the turnover ratio. It measures how much buying and selling a fund manager does. A fund with a turnover of 50 percent executes trades -- purchases as well as sales -- equal to half of the fund's assets. "Higher turnover is going to result in much higher costs," Livingston says.
While most investors don't realize how much a fund's trading costs are taking out of their pockets, some don't realize another fee they are paying that is disclosed.
Many funds impose what are known as 12b-1 fees, which help cover distribution expenses. They are paid to brokers to encourage them to recommend funds and to cover advertising and other marketing expenses. The SEC limits 12b-1 fees to a maximum of 1 percent; so- called no-load funds, which don't impose sales charges, can't call themselves no-load if their 12b-1 fee exceeds 0.25 percent.
The fees were conceived as a way to draw new investors to a fund. Theoretically, that would spread a fund's expenses over a larger pool of assets, reducing the fund's expense ratio.
Unfortunately, that's not the way some funds are using them. According to a recent study by Standard & Poor's, 153 funds that are closed to new investors impose 12b-1 fees averaging 0.64 percent. Counting different share classes of the same fund as separate funds, 94 funds levied the maximum 1 percent, S&P says.
In effect, these funds don't want any more money in the fund, but make investors with $10,000 in their fund pay as much as $100 annually as if the fund is still open. "That's outrageous," says Jason Karceski, another University of Florida finance professor who co-authored Zero Alpha's report.
The SEC has required funds to disclose more in recent years and is considering additional measures that would give investors a clearer idea of how funds operate, their expenses and arrangements between fund operators and brokers who sell funds. Many investors don't know a portion of 12b-1 fees go to brokers for encouraging certain funds.
"The SEC should be quite a bit stricter and require a lot of things to be disclosed," Livingston says.
He recommends investing in no-load funds that have low turnover. Index funds, which try to match market performance by investing in the S&P 500 and other broad market indexes, fit the ticket. Karceski says exchange-traded funds, which have lower operating expenses and offer tax advantages, may be an option.
Whatever additional disclosure the SEC ultimately requires, regulators can't force feed the information to investors. As S&P's study of 12b-1 fees demonstrates, many investors ignore information that's already available.
"An investor who is sort of on top of their game can identify the blatantly pilfering funds from the ones that aren't," Karceski says.
That's a start. Whatever the SEC orders or fund operators provide voluntarily doesn't relieve investors of their responsibilities when it comes to making informed investment decisions. After all, as Forrest Gump says, "Stupid is as stupid does."