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News November 22, 2004 Issue

Mutual Fund Investors Paying Billions in ‘Hidden’ Trading Costs, Study Claims

An academic study released last week found that in 2002, the average investor in a U.S. equity mutual fund paid 18.2 basis points in explicit brokerage commissions per dollar invested and 24.6 basis points in "implicit" trading costs (namely, bid/ask spread and market impact costs).

On the fund level, the average U.S. equity mutual fund paid 36.1 basis points in commissions and 58.0 basis points in implicit trading costs.

In the aggregate, that all comes to $17.3 billion, which is nearly half of the total fees reported in fund expense ratios, according to the study.

The studyís authors, professors Edward OíNeal, from Wake Forest University, and Jason Karceski and Miles Livingston from the University of Florida, would like to see fund investors provided with better information on trading costs. "We suspect that many mutual fund investors are completely aware of these trading costs and simply assume that the reported expense ration includes them," they said. A press release accompanying the study described the $17.3 billion as "hidden mutual fund trading costs" being paid by U.S. investors "that are not reported openly in the stated expense ratios of mutual funds."

The study found that for nearly half of all small cap funds, 21 percent of mid cap funds, and 7 percent of large cap funds, the fundís total trading costs (commissions plus and implicit costs) exceeded the fundís reported annual expenses. It also found marked differences between the total trading costs of active funds, at 48 basis points, compared to those of index funds, at 6.4 basis points.

The study looked at drivers of explicit brokerage commission costs. Aside from some fairly obvious conclusions (i.e., the higher the fundís turnover, the greater its total commission costs), the study found that the higher the fundís expense ratio, the higher the total commission costs. It also found that growth funds tend to have higher commission costs than value funds. Interestingly, the study found that funds that hold greater numbers of stocks pay lower commissions, although the professors added that "we have no reasonable explanation for this finding."

The study was funded by the Zero Alpha Group, a group of eight independent advisory firms. In a statement, members of the group indicated that they believe the SEC should require trading costs to be included in the fundís expense ratio.

Scott Sarber, v.p. of Petersen Hastings Investment Management, noted that only a portion of trading costs (i.e., the brokerage commissions) is publicly available, "and that is only if you dig into obscure mutual fund documents that very few investors know anything about." The unavailability of brokerage commissions, combined with "the completely unreported implicit costs of trading," said Sarber, results in a "big credibility gap in mutual fund reporting to investors."