Beware of Hidden Fund Costs

Frequent trading, big tax bills and large cash positions can eat into returns.
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Over the last few years, investors have become more aware of the importance of mutual fund fees such as expense ratios, marketing fees and sales commissions. That's definitely a good thing.

But there are other kinds of costs, such as trading and taxes, that are much harder to spot and can significantly eat into returns -- enough so that you may have to put off retirement for several years.

"Even small costs can make a very significant difference over time," says Thomas McGuigan, a principal in the Old Lyme, Conn., office of Burns Advisory Group, which manages over $300 million in assets.

McGuigan is particularly concerned with funds' transaction costs, which include trading commissions and the difference between bid and offer prices on a security being bought or sold. These are not included in a fund's expense ratio, which is a measure of operating costs and management fees, and they can be hard to spot. Funds report their turnover, which is the lesser of either their purchases or sales, but not the total number of their transactions.

Depending on the type of asset, the cost of frequent trading can be quite high. McGuigan is wary of managers who churn small-cap stock portfolios, for example, since trading volume in these securities is relatively thin. That means spreads between bid and offer prices tend to be wider.

Frequent trades can also generate big tax bills, which further undercut performance. When a fund sells a security that has appreciated, it generates a capital gain that must be passed along to shareholders.

A recent study by Lipper Research indicates that over the past decade, the average stock fund gave up 1.6 percentage points in annual return to federal taxes on capital gains and dividend distributions, while the average bond fund gave up 2.4 percentage points in annual return. These figures don't even take into account state and local taxes.

Morningstar supplies information on its Web site about funds' potential exposure to capital gains, and this can give you a sense of their future distributions. Fund families also announce future distributions on their Web sites.

Investors may want to avoid purchasing any fund just before the end of the year, when they tend to make distributions. And if you consider holding funds that trade frequently, generating big tax bills, you should do so in retirement accounts so the tax bite will be deferred.

Holding large amounts of money in cash can also act as a drag on a fund's performance, although managers have to keep some cash on hand to meet redemptions from shareholders, and they generally scale up or down on cash positions when their view of the market changes.

Alan Seigerman, chief operating officer of ReFlow, a San Francisco company that helps mutual funds manage their cash flows, says the trades that fund managers make to put new money to work, or to liquidate holdings to meet redemptions, "are poor producing trades," since managers may not be not be able to time their purchases or sales optimally.

Seigerman said the invisible costs generated by assets flowing in and out of funds can easily eat into returns by 0.5%, which could mean the difference between meeting your retirement goals or not.

For example, consider a 50-year-old couple with $2 million in invested assets who want to retire in 10 years and receive a monthly income of $10,000. They can do this if they invest $15,000 a month and receive an annual return of 7% on their portfolio.

But if their returns fell by 0.5% to 6.5%, the couple would have to work until they are 64.2 years old to get the same post-retirement income. If performance is eroded even more to 6%, they would have to put off retirement until age 66.8.

While it can be tough to avoid many of these costs, there are some ways to avoid funds that may have hidden fees. Start off with the information that funds are required to disclose. If a fund consistently holds large amounts of cash, that may be an indication that they are not putting their money to work effectively.

And even though the turnover that funds report isn't the same as the total number of their transactions, it can still provide a sense of how much a manager is trading compared with his or her peers. (The number of transactions can vary greatly depending on the strategy employed, so be sure to compare funds with similar strategies.)