Hidden Costs Make Funds More Expensive Than Most Believe

By Yuka Hayashi Of DOW JONES NEWSWIRES
23 January 2004
Dow Jones Business News

NEW YORK -- The cost of investing in mutual funds is significantly more than people are led to believe, because some expenses are hidden from view.

According to a study released Friday, such hidden costs are incurred from trading of securities in fund portfolios and account for, on average, 43% of the disclosed fund expenses among the 30 largest equity funds. In some smaller funds with high portfolio turnover, the hidden costs could be as high as five or six times their disclosed expense ratios.

The study was conducted by a team of academics led by Edward O'Neal, an assistant professor of finance at the Babcock Graduate School of Management at Wake Forest University, Winston-Salem, N.C., and was commissioned by Zero Alpha Group, a network of eight independent investment advisory firms from across the country.

Despite the high hidden costs, mutual funds remain the only practical vehicle for most investors to achieve proper asset allocation and risk management, said Jeff Buckner, a Zero Alpha member and president of Plancorp, a Chesterfield, Mo., advisory firm.

"But better disclosure and education are clearly needed to ensure that investors understand the true costs of owning mutual funds," he said.

Hidden trading costs, which consist of brokerage commissions and estimated implicit bid-ask spreads, are taken out of fund assets before other fees are deducted, and are extremely hard for investors to figure out, Mr. O'Neal noted.

In contrast, investment management fees and 12b-1 marketing fees are readily available, and make up the fund expense ratios that many people rely on to make investment decisions.

The average hidden trading cost for the top 30 stock funds came to roughly 0.3% of the fund's total assets, while the average expense ratio was 0.7%.

The study's authors added the hidden trading costs to the expense ratios, and came up with "true cost" figures for the top 30 funds. Not surprisingly, funds with high portfolio turnovers had high true costs, while index funds offered low costs.

The funds with the highest costs included Putnam Voyager Fund Class A shares with 1.67%, Fidelity Contrafund, 1.64% and Fidelity Fund, 1.61%.
On the other end of the spectrum were three index funds: Vanguard 500 Index Fund and Fidelity Spartan U.S. Equity Index Fund, both with 0.215% and Vanguard Total Stock Index Fund, 0.234%.

Mercer Bullard, president of the investor advocacy group Fund Democracy and a law professor at the University of Mississippi, said the study confirms what many consumer groups have argued for many years: fund expense ratios are misleading.

"Congress should act promptly to ensure that America's investors are provided with full disclosure about fund's portfolio transaction costs,"
he said during a conference call unveiling the Zero Alpha research.

The study also looked at the hidden costs of some smaller funds with exceptionally high turnovers. Interestingly, those included funds managed by some of the companies at the center of the current mutual-fund trading scandal.

For example, PBHG Large Cap Fund, run by Pilgrim Baxter & Associates, had a combined hidden trading cost of 7.43%, compared to its disclosed expense ratio of 1.16%. Strong Discovery Fund of the Strong Funds family had a 3% trading cost, on top of its 1.5% expense ratio.

-By Yuka Hayashi, Dow Jones Newswires; 201-938-2129; yuka.hayashi@dowjones.com