By Gail MarksJarvis
Knight Ridder/Tribune Business News
27 January 2004
Saint Paul Pioneer Press
Watch out.
A study released last week shows that what you don't know about your mutual funds probably is hurting you.
Investors often are paying layer upon layer of hidden costs for the mutual funds they hold, the study found, and in many cases those charges are so excessive that even clever fund managers can't select stocks and bonds skillfully enough to overcome the drag the costs impose on returns.
Until recently, fees received little attention from the average investor or from government regulators. But with the recent trading scandals in the mutual fund industry, the fund business is under a microscope. And advocates for the public have been urging the federal government to alert investors about crippling fees.
According to advocates, fees are more harmful for investors than the illegal trading activity that has grabbed the Securities and Exchange Commission's attention during the last few months.
The most recent study, done by Edward O'Neal, of Wake Forest University, and Jason Karceski and Miles Livingston of the University of Florida, supports that argument.
Their research shows that current regulations only require mutual funds to reveal part of what funds charge investors. In fact, individuals unknowingly are paying about 43 percent more for expenses than they realize when they look at what's called the "expense ratio" -- or the official cost number that the federal government requires each fund to report.
In other words, for every $1 you know you pay for expenses, you actually are paying another 43 cents in hidden costs. And while the "expense ratio" on your mutual funds may suggest you are giving up 1.6 percent of your assets a year for the privilege of being invested in a mutual fund, the true cost to you is more like 2.2 percent or 2.3 percent, says O'Neal.
If that seems like a small number, just think of what you would have done to make even 2 percent on your funds as they plummeted during 2001 and 2002.
And an individual fund manager would be jubilant about earning a return 0.5 percentage points above his competitors in any year, because it's tough to outsmart the others as a stock-picker.
Savvy investors know to examine costs because costs are the one part of investing an investor can control.
An array of academic studies have shown that cutting costs is a reliable way to improve investment returns -- but selecting a fund that's been a strong stock picker in the past is not reliable, argues O'Neal.
So he, like others who have studied investments, urges individuals to compare the costs of funds before buying them. And he leans toward index funds because the lowest-cost funds, such as the Vanguard 500 Index, had total costs at less than 0.25 percent a year.
Among the highest cost funds identified by the researchers, was PBHG Large Cap. While PBHG's expense ratio is only 1.16 percent, the study revealed the fund's costs actually total a whopping 8.5 percent.
"I am skeptical that any money manager could outperform expenses of 4 to 8 percent," says financial planner Jeff Buckner, of Chesterfield, Mo. Besides the "expense ratio," which includes the cost to manage and market a fund, the researchers calculated total expenses by including a mutual fund's brokerage commissions and other trading costs associated with buying and selling stocks day-in-and-day out.
Brokerage commissions add about 27.5 percent in expenses for funds, the researchers said.
Even though the commissions and other trading costs adversely affect an investor's return, the researchers note that it's almost impossible identify to those costs given the government's current reporting requirements.
The "Statement of Additional Information" for each mutual fund company helps, but doesn't show the full picture.
Consequently, Mercer Bullard, president of Fund Democracy and a law professor at the University of Mississippi, is requesting that the SEC amend its reporting requirements so each fund must tell investors what they are truly paying their mutual funds.
Investors, however, can protect themselves somewhat in the meantime. Watch what's called the "turnover" number that currently is reported in each mutual fund's prospectus. This number relates to how many times a mutual fund buys and sells stocks during a year. For example, turnover of 100 percent indicates the fund turns over -- or sells -- the entire portfolio of stocks throughout the year.
That's a lot of selling, and with each sale or purchase of a stock, the fund incurs commissions -- costs that the individual investor in the fund must pay.
It's not a perfect measure, but O'Neal suggests buying funds with a lower turnover rate can protect investors.