By Kathleen Gallagher
21 February 2004
The Milwaukee Journal Sentinel (KRTBN)
Feb. 21--Since an investigation of improper trading in the mutual fund industry began last year, there has been much discussion about reform. Even though more than 30 companies, including Strong Capital Management Inc., have been targeted in the growing scandal, little has been done.
The Securities and Exchange Commission earlier this month adopted rules that increase disclosure by funds in certain areas. But the SEC made no changes to the complex ways companies charge shareholders.
Four bills introduced in Congress appear to be going nowhere, said Roy Weitz, publisher of FundAlarm.com, an online newsletter.
In the meantime, investors can make sure they're not being taken to the cleaners by understanding the costs their mutual funds charge.
"One thing that has been proven over time is that expenses really impact the return you ultimately realize," said Kunal Kapoor, associate director of fund analysis at Morningstar Inc. in Chicago. "The most common-sense thing to do is buy a low-cost fund -- it's as simple as that."
You can find out how much a fund is charging to manage your money in a prospectus, a document containing specific financial information that is required by the SEC.
"Don't read the prospectus after you bought the fund and you get it in the mail -- read it before you buy," said Maureen Busby Oster, president and chief investment officer of MBO Cleary Advisors Inc., a Milwaukee investment consulting firm.
Fund companies will mail prospectuses to potential investors and typically provide access to them on their Web sites. All funds must file a prospectus and these documents are filed on the EDGAR database at www.sec.gov. The prospectus contains information about the fund's costs, investment objectives, risks and performance.
"Don't just look at performance," Oster said. "It's history, it's interesting, and it may or may not provide insight into the future."
Costs, on the other hand, may show how much you'll be paying for the return you get next year.
Many investors don't think about fees, which are deducted from the assets of the fund, because they never have to write a check for them, Weitz said.
"But it's real money even though you don't see it," he added.
The most important and easily obtainable fee is the expense ratio, which tells you what percent of fund assets are being used for operating expenses and management fees.
If the expense ratio on your fund is 1.59 percent, which Morningstar says is the average for U.S. stock funds, you're paying $15.90 to your fund company for every $1,000 of your money it manages.
Expense ratios that seem small can actually represent a big portion of the income your fund is generating, particularly with bond funds, Oster said. For example, if the gross yield on a bond fund is 4 percent and the fund's expense ratio is 1 percent, then investors are paying 25 percent of the fund's income in fees.
If a fund is sold through a broker or planner, it will also have a sales charge, also known as a load. A front-end load is imposed at the time of purchase, and a back-end load describes when the fund is sold.
"Unless you plan to own something for a very, very long time, you're usually better off paying the front-end load than back-end load -- but even then, you need to look at the expense ratio," Oster said.
Funds with back-end loads, usually categorized as the fund's "B shares," typically have a higher expense ratio than the front-end load share class, usually categorized as "A shares."
There are several Web sites, such as those offered by the SEC and Personal Fund Inc. that help investors compare loads and expense ratios for different share classes and different funds.
Investors can't rely on those measures only, because there are costs to owning a mutual fund that don't show up in the load or the expense ratio. One of those hidden costs is known as soft-dollar arrangements, in which a fund overpays commissions in exchange for certain products and services.
"When you're looking at an expense ratio, you're not getting the whole picture -- and most investors don't know that," Kapoor said. "At the end of the day, the fee most people are seeing does not include things like transaction costs and soft-dollar payments that might be important in determining what their ultimate return is."
Investors in the 30 biggest U.S. stock mutual funds are incurring another 0.30 percent in trading costs on top of the expense ratio, according to the Zero Alpha Group, a network of eight independent investment advisory firms.
That figure came out of a study commissioned by the Zero Alpha Group and done by Edward O'Neal, assistant professor of finance at Wake Forest University Babcock Graduate School of Management, and Jason Karceski and Miles Livingston at the University of Florida.
For funds with high turnover, the trading costs are much higher, the study said.
"Higher turnover almost always means higher transaction costs and higher commissions -- and those don't get reflected in the expense ratio," Weitz said.
When you hold funds with high turnover of 300 percent to 400 percent, "you know they're running up huge transaction costs that are eating up your return," Kapoor said. High turnover doesn't always mean the fund is a bad investment, but it can be a red flag, he said.
Another red flag is when a fund that invests in small company stocks rapidly increases its assets. Shareholders should then question whether the fund is still flexible enough to buy its type of stocks and whether it runs the risk of moving the market in the stocks it is trading, Kapoor said.
Weitz suggests investors who want to drill deeper can look at the fund company's Statement of Additional Information, or SAI, which is sometimes on the firm's Web site and always filed with the SEC. The SAI, for instance, will disclose whether the fund has any soft-dollar arrangements.
"Most fund families have soft-dollar arrangements and they do disclose it in the SAI, but you have to dig for it," Weitz said. "It's often not transparent what they're even talking about."
He says the best plan for investors who don't want to dig that deeply is to seek a fund family, such as American Century, American Funds, Bridgeway Funds or Vanguard, that makes lower expenses part of its corporate mission.
"Check out their Web site -- somewhere in the chairman's letter or elsewhere should be something about what they do to keep costs low, or some discussion of costs," Weitz said. "If you see no mention of low costs then chances are it's not one of the things they sell themselves on, and it's not something they're going to be concerned with."
FIGURE IT OUT
Here are two Web sites with calculators to help mutual fund investors get a handle on costs.
-- www.sec.gov/investor/tools/mfcc/mfcc-int.htm -- The U.S. Securities and Exchange Commission's calculator helps you figure out how much a fund will be worth in the future based on assumptions you enter regarding projected return, holding period and other variables.
-- www.personalfund.com -- This site's calculator provides a written assessment of your fund, an itemized summary of costs to own it and a breakdown of estimated future returns and costs based on assumptions you enter. Your analysis includes valuable information about the fund, such as turnover and the percentage of potential appreciation lost to costs. It also offers a comparison to other, less expensive funds in the same category.