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Expense Ratio Not Representative of Costs Study Condemns Inaccurate Calculation

The true cost of owning a mutual fund is like a submerged iceberg - investors only see the portion of the costs that are visible to them and not what is hidden beneath the surface.

Fund complexes are misleading investors, while inadequate brokerage commission reporting requirements help create a skewed picture of the true cost of owning a mutual fund, according to an academic study of expenses released by Zero Alpha Group.

A major quandary in the fund industry is that mutual fund fees - including the most common denominators investors use when shopping for funds: expense ratios and 12b-1 fees - seriously understate the real percentage due to hidden costs. And that can be a major drag on performance, according to Jeff Buckner, president of Plancorp, a high-net-worth asset management shop.

"I have a hard time imagining any other product, financial or otherwise, where consumers would sit still for such a huge chunk of the costs being hidden," Buckner said, speaking during a conference call discussing the study's findings.

Expense ratios are familiar to most investors, as they are often plastered throughout funds' marketing materials and are supposed to be one way to compare funds in like categories. The expense ratio is simply the fees paid to service providers and advisers, expressed as an annualized percentage of overall assets in the fund. The authors of the report suggest that a true cost number is critical in helping investors make sound investment decisions.

"What most investors do not understand is that there are additional costs borne by investing in mutual funds that result from the trading of securities in the underlying portfolio," said Edward O'Neal, an assistant professor of finance at the Wake Forest University Babcock Graduate School of Management, and an author of the study.

One Piece of the Puzzle

Another piece of the complex puzzle of total fees, the price of trading a fund, is not included in the expense ratio and can often rival or surpass the stated amount investors are told it costs to own a fund. "If you are going to use an expense ratio, it shouldn't be misleading, and this study suggests it is precisely that," said Mercer Bullard, president of Fund Democracy.

Where implicit trading costs are concerned, there are actually two prices for every security - the price of buying and the price of selling, the difference of which is known as the bid-ask spread. Therefore, when buying into and selling out of a stock, a loss is incurred because the manager can be forced to buy at the higher of the two prices and sell at the lower of the two.

Additionally, because funds have such massive buying power, they also have the ability to move the price of a stock via a transaction. If a fund wishes to unload a stock, the price it can sell at can actually get pushed down because of the bulk size of the move.

Despite the fact that performance numbers are shown net of trading costs, O'Neal said the hidden cost number is still important for investors to have, noting that performance is also net of the expense ratio. "These costs that are being incurred are no different than the advisory fees or the distribution company fees that investors are paying, and those are included in the expense ratio," O'Neal noted.

A Numbers Game

The study, released by ZAG, a nationwide network of eight independent investment advisory firms, and conducted by O'Neal, Jason Karceski and Miles Livingston at the University of Florida, used a number of calculations to find out the average amount extra investors were paying to own a fund.

Using 2001 Securities and Exchange Commission data on trade execution quality, ZAG concluded that investors in the 30 largest domestic equity mutual funds were paying trading costs that averaged 43% of the expense ratio.

The SEC study showed that implicit trading costs totaled about 15 cents per share, which translates to about 36 basis points per trade for large trades on both the New York Stock Exchange and the Nasdaq. The Zero Alpha study then measured the 36 basis points up against the funds' turnover ratio. If the turnover ratio was 100%, for example, investors in the fund would incur 36 basis points in implicit trading costs each year.

The average turnover ratio for the 30 largest domestic equity funds was about 57% in 2001. Using the above calculation, the average implicit cost of trading would total 20 basis points for this group of funds. Add to that 10 basis points for average commission costs and the unseen costs to investors equals 30 basis points.

According to ZAG, the 30 largest domestic equity funds had an average expense ratio of just over 70 basis points. So, 30 works out to be roughly 43% of 70. "This means that for every dollar you know you spend on fund costs, another 43 cents is hidden from view," Bullard said. "Even more shocking is the finding that in many cases, portfolio transaction costs can be 400% or more of the expense ratio. In other words, for every one dollar you pay, four dollars or more is not disclosed."

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