SEC Preparing to Shine a Brighter Light on Fund Fees

Imagine a store where you pay by handing your wallet to a salesperson who then liberates 1.31% of your cash. That's how 88 million Americans pay their mutual funds, and the funds won't even tell you exactly how much you paid.

The Securities and Exchange Commission thinks you should know. It will soon release a study on mutual fund fees that will recommend that funds give shareholders information "to quickly and effectively estimate the actual amount they have paid fund managers during a given period," says SEC Chairman Arthur Levitt.

The SEC's proposal is in response to a recommendation by the government's General Accounting Office, which released a mutual fund fee study earlier this year. The GAO wants funds to put detailed fee information in shareholders' quarterly statements. The fund industry, always technologically challenged when asked to provide more disclosure, has argued that this would be too costly and burdensome.

The SEC may have found a way to make both sides happy by allowing you to determine approximately how much you paid in fees while minimizing the costs to funds of providing the information. The SEC's proposal would require funds to disclose the amount of expenses paid on a hypothetical $10,000 account. Thus, if you had $13,792 in your account during the entire period covered, you would simply multiply the expenses of the hypothetical $10,000 fund by 1.3792 to determine exactly how much you paid in fees.

If you bought or sold shares during the period, you could do a rough calculation of your average account size and get a close estimate of your costs.

Of course, the devil is in the details, and in this case the details are the location of the disclosure. The logical place to show how much you paid in expenses would be where you're shown how much your account rose or fell during the period -- your quarterly statement. Unlike the prospectus, which is about as clear and likely to end up in the trash as a Palm Beach ballot, shareholders actually read and save their quarterly statements. But the industry is likely to prefer that the harsh reality of fund fees be provided where it is least likely to be noticed, such as in the fund's semiannual report.

Levitt pointed out that fund fees could take a huge bite out of your returns. He used the example of a $1,000 investment in an S&P 500 index tracking fund made in 1950, which should be worth about $500,000 today. But after fees, this total drops to $230,000, and if the fund is not tax efficient it shrivels to $65,000. "Without paying attention to costs, an investor stands a better chance of earning a million dollars as a contestant on Survivor," observes Levitt.

The SEC also plans to confront you with the effect of taxes on fund returns, another often hidden cost of mutual fund investing. In March, it proposed that funds be required to disclose after-tax returns in prospectuses. It's expected to adopt the rule by the end of the year.

Unfortunately, you may need a Ph.D. to decipher after-tax returns. Funds currently must show one-, five- and 10-year returns in their prospectuses. The new prospectus performance table will provide one-, five and 10-year returns, each on a before- and after-tax basis. In each case, returns assume you held your shares at end of the period and that you sold the shares at the end of the period. This 12-headed hydra will provide information you need, but it's a pity that it's being stuffed in the prospectus. The old and new disclosures look something like this:

Reporting Fund Performance
Before
	1 Year	5 Year	10 Year
Total Return	___%	___%	___%

After
	1 Year	5 Year	10 Year
If you continue to hold shares at the end of the period:
Before-Tax Return	___%	___%	___%
After-Tax Return	___%	___%	___%
If you sell your shares at the end of the period:
Before-Tax Return	___%	___%	___%
After-Tax Return	___%	___%	___%

Absent from current SEC proposals is any plan to account for the largest hidden fund expense: brokerage commissions paid on fund portfolio transactions. Vanguard founder John Bogle conservatively estimates that funds' portfolio transaction costs average about 0.5% annually -- almost three times the total expense ratio of the (VFINX Quote)Vanguard 500 Index fund!

Despite what fund brokerage costs can do to your bottom line, they are a secret. The fee table in every mutual fund prospectus provides the fund's expense ratio, and even lists separately the management fees and 12b-1 marketing fees. Not only are brokerage costs not listed separately; they aren't included in the fund's expense ratio at all

In his speech, Levitt said investors might be stunned to know that full-service commissions paid by mutual funds have averaged "5 to 6 cents a share for nearly a decade." This is surprising coming from Levitt, because two years ago he voted to remove this information from the prospectus, thus making it virtually impossible for you find it out.

Levitt's criticism of fund directors for paying "little or no meaningful attention to the brokerage costs of mutual funds" may foreshadow future SEC disclosure initiatives. Once Levitt pushes through his after-tax returns and fund expenses proposals, he may decide it's time that investors attended to mutual fund brokerage costs and require their disclosure as well.