Why your fund’s expense ratio is only half the story

I just got out of an interview with Ric Edelman, a financial advisor and asset manager. The conversation was wide ranging, but he pointed out a weakness in reported mutual fund expense ratios that I hadn’t thought about until now.

When we tell people to find funds with low fees, most often, we’re talking about a fund’s expense ratio. It’s that seemingly small percentage of assets that a mutual fund company takes out of your fund to pay for things like fund manager salaries, rent for their offices, and so on. Of course, over time, just one percentage point of difference in your return can make a huge difference. (See chart, and sorry about the color issue. Needless to say, the fund with the lower expense ratio is the higher line.)

Growth of $10,000. Assuming an 8% annual return.

Growth of $10,000. Assuming an 8% annual return.

Unfortunately, that expense ratio, found so easily in the prospectus and categorized at Morningstar, only represents a fund’s ongoing costs. It doesn’t include the transaction costs that can bring down a fund’s actual return. In something like an index fund which has low turnover, that cost will be negligible. But in an actively managed fund, in which a manager is buying and selling stocks all the time, Edelman says that the fund’s total expenses can sometimes be significantly higher.

Let’s take the Dryden International Value Fund, by way of example. I’m not trying to pick on them. I just noticed that their portfolio turnover rate last year was 27%. In other words, it switched out about one in every four stocks that it owned last year. In the past, the fund’s turnover has been much higher, hitting a pinnacle of 121% in 2005.

According to the fund’s prospectus (page 53), the no-load shares’ expense ratio is 1.31%.

But let’s see how much that 27% turnover cost them last year. In the fund’s “Statement of Additional Information” on page 86. You’ll see that the fund spent $156,431 in brokerage fees last year. According to Morningstar, the fund’s Net Asset Value right now is about $136 million. That means that investors paid an additional 0.11% for those transaction costs without knowing it.

I’m not saying that 0.11% is a lot, but it seems like that kind of off-the-top fee is exactly what investors think they’re getting in an expense ratio. And according to a study by a few researchers from Boston College and Virginia Tech, the trading costs of a fund can sometimes exceed that of the expense ratio.

It took me about 30 minutes to find that Statement of Additional Information and calculate the added cost. If it’s unreasonable to do that yourself, a reasonable proxy is to just look at the turnover rate, which is pretty easy to find in the prospectus. The higher the turnover, the more you’re likely paying in hidden broker fees. But besides that, you probably want a mutual fund manager who picks stocks for the long run anyway and doesn’t have to switch around a quarter of his portfolio every year.

– Joe Light

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