Mutual fund hidden fees- the biggest culprit is…

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I’m finally nearing the end of what was meant to be a one week gig. Somehow it’s turned into a fortnight, to borrow a British phrase used to describe Wimbledon.

I’m quite eager to move more into the ‘down home’ planning phase of the blog, over the coming month, but not before some hard hitting posts to end ‘mutual fund’ week. I’ve saved the best for last.

When I first wrote a piece on mutual funds, back in the beginning of August, I touched on the ‘mystery behind mutual funds’. Now it’s time to dive in head first and examine the murky world of mutual fund hidden fees. (I’m being a bit over dramatic for effect, after all, Halloween is next week)

A quick refresher

I’m going to take a leap of faith here and assume you’ve read my previous posts on the different kinds of mutual funds. Either you buy a load fund through a financial advisor or you buy a No load fund directly from the mutual fund company itself. The major difference being the load fund hits you with some sort of sales charge.

Other than that, there is little difference between a load fund and a No load fund. If you were to open them up, you’d find all the same mechanisms. They are both diversified portfolios of stocks, bonds, cash, etc., actively managed by a professional management team. They both have to pay the fund manager’s salary, the cost of providing customer service reps, legal and accounting fees, pencil sharpeners and so on.

Now you can find all of this information in the prospectus of most mutual funds. Please refer back to the section of this chart under ‘Annual fund operating expenses’ to see a sample of what you might find in a fund prospectus; it details many of the fees that you would find.

All of these fees are openly disclosed to the investor, via the prospectus, although most fund investors don’t read it anyway.

Institutional size brokerage commissions are the biggest culprit

All the fees I described (above) are easy to find if you look. The fees I’m about to discuss are a lot harder to uncover, but there’s certainly enough public information on the internet, if you know where to look. Without further ado…

The biggest hidden fee for most mutual funds are brokerage commissions or fund trading costs.

For example, when a mutual fund needs to buy or sell a stock, they call up a brokerage firm to execute the order, much like you or I. The only difference is it’s done on a far broader sale. A large mutual fund could easily come in to sell 3 million shares of WXYZ, an order of that size costs alot of money.

Trading costs

Typically, what happens (in the above scenario) is the fund manager will call an institutional trader at the brokerage firm(s) they deal with, and ask to sell 3 million shares WXYZ. The trader will give the fund manager a price, at which the order will be filled, and then charge the mutual fund, lets say 4 cents a share.

The cost of the trade is $120,000. Repeat this process, again and again and again, and the fees can add up very quickly for the mutual fund, over the course of any time interval. That’s why it’s very important to look at the stock ‘turnover’ for the mutual fund that you may be interested in purchasing.

Fund turnover

Some funds are more actively traded then others, depending on the nature of the fund. An aggressive growth fund manager, generally speaking, is going to be far more active than a more conservative growth and income fund.

You can also look for ‘tax efficient’ funds that pride themselves on low turnover, therefore creating less fund capital gains taxes and fewer trading commissions. I’m going to look at a couple excellent mutual fund cost analyzers, in the next couple posts, that plainly list the fund turnover percentage for you to see.

(SAI) Statement of Additional Information

Now the big problem with these institutional size brokerage commissions, for the non suspecting mutual fund investor, is that they are not reported in the prospectus. They are reported on a form called the (SAI) Statement of Additional Information. A form that is not mandatory for investors to receive before purchase; unlike the fund prospectus.

The Statement of Additonal Information is a real pain in the tuckus to go through. It’s drier than leftover turkey and makes the fund prospectus look like a children’s book, I think you get the point. If you’re a conspiracy theorist, it’s all perversely logical. Here’s the thinking…

Most funds don’t want you to be able to easily decipher these additional costs. That’s why they stuff this information in the middle of this SAI document, that’s not easily attainable, and wrap it all in legal mumbo jumbo.

Unsuspecting victim

So, you may think you know what you’re doing, you’ve done your research and find out your No load fund has fees and expenses that you think are fair. Little do you know that the fund, a large cap US growth fund (for arguments sake), had turnover of 131%, which cost the fund shareholders an additional 1.6% in fees (this information found in the SAI)

But how can this be? You went to the prospectus, and double checked using a generic mutual fund fee analyzer, your total fund fees were listed at 1.49%.

Well guess what, add in the 1.6% in ‘hidden’ trading costs, (found in the SAI) which you were completely oblivious too and now you’re getting closer to the true bottom line. Somewhere in the neighborhood of 3.1%.

Psychology 101

Remember the sweeping generalization I always use when describing mutual funds? Out of sight, out of mind. If people don’t see it, don’t know about it or can’t understand it… they won’t worry about it as much. It’s this psychology that helps contribute to the overwhelming popularity of mutual funds.

According to Morningstar, these additional ‘hidden’ trading costs represent an average of 1.25% in annual expenses passed on to fund investors. That means some mutual funds are going to be lower and have reasonable fees and some funds are going to come in shockingly high. The highest in the industry is a whopping 15%!

And while I was researching this article I came across a lot of funds with trading turnover of 200%+. (According to Personalfund.com, average fund turnover of 100% will equate to 1.24% in fees for the fund investor.)

So what does all this mean for you? You have to be careful when choosing mutual funds and know what to look for. Mutual funds are much like people, there are good ones and not so good ones. You need to know how to screen them effectively and associate yourselves with the ones that are good for you in the long run.

Almost finished

Since this post is running very long I’m going to put the remaining bit into a second post. You didn’t think I was done talking about hidden fees did you?

Well, I’m almost done. There’s a few loose ends that I want to tie up in the next post. But the bulk of hidden fees come in the way of institutional brokerage commissions that you can request to see on the Statement of Additional Information.

Simply call your mutual fund family (remember those customer service reps from up above, thats what they’re there for) and ask them to send you a copy. Some fund families may email it to you or allow you to download it online. Here’s a mildly helpful page on how to read a SAI.

Mutual fund expense calculators

Ok. Up above I mentioned a few calculators that I find very useful when it comes to uncovering the true costs of mutual funds. Later this week I’m going to dedicate a post to the Kiplinger Fund Finder and the big daddy of them all. In the meantime, here’s the cliff notes version:

• The FINRA Mutual Fund Expense Analyzer - You can compare the expenses of up to three Exchange Traded Funds, mutual funds or share classes of the same mutual fund.
• Kiplinger’s Fund Finder - a great tool to screen for good funds. An excellent way to input different criteria to find a fund that’s right for you. This tool allows you to see the fund turnover I often referred to in the above post.
• And the big daddy of them all. I’ve been using this fund calculator for nearly a decade now. This calculator was the first to open my eyes to what really goes on behind the curtain. I may actually add it to the site in the future, I’ll let you know. Mutual Fund Cost Calculator - this is the most comprehensive mutual fund cost analyzer anywhere. It will give you the real cost of owning a mutual fund and break it down line by line. I’ll review it in depth real soon. At this site you need to setup a password, which is simple. It’s well worth it if you’re reading this!

Tags: Featured, Hidden fees, Mutual Funds, Statement of Additional Information