When it comes to determining a portfolio’s actual costs, many investors think they simply have to look at the expense ratios of their portfolio’s funds as well as any loads that were paid upon purchase (Class A Share Mutual Funds, for example). If using a money manager who charges a fee for his expertise, then this expense is added as well. Because these costs are explicit, they are easily determined. However, it is the implicit, or hidden, costs that investors should be concerned with because this is the culprit that often robs the investor of portfolio returns. So let’s look at explicit and implicit fees in more detail.

Explicit Fees: The Fees You Can See
The Security and Exchange Commission requires that fund companies disclose both shareholder fees and operating expenses in a fee table in the mutual funds prospectus. Shareholder fees and operating expense fees are considered explicit fees.

Shareholder Fees (1)
Upfront Load or Front-end Load Charge—This fee is paid when you purchase shares in the mutual fund. These fees typically go to the broker who sells the shares to you. A front-end load fee will be deducted from the actual dollar amount of your investment. For example, if you invest $10,000 in a mutual fund with a 5% front-end load, your investment in the actual fund would be $9,500. According to the NASD, front-end loads cannot exceed 8.5% of your investment.

Purchase Fee—Some mutual funds charge their shareholder a fee just to buy shares of the mutual fund. This purchase fee is captured by the fund company and not the broker selling the mutual fund.

Deferred Sales Charge or Back-end Load—This is a fee you pay when you sell the shares of the fund or funds you own. This fee typically goes to the brokers who sell the fund’s shares. The most common type of deferred sales charge is a Contingent Deferred Sales Charge. CDSC charges are dependent on how long the investor holds the shares and can decrease to zero if the investor holds the shares for a specified period of time. CDSC charges usually are accompanied by a 12B-1 fee.

Exchange Fee—Some mutual funds charge this fee if the shareholder transfers to another fund in the same mutual fund family.

Account Fee—Some mutual funds charge an account maintenance fee when the investor’s account values are less than a particular dollar amount.

Operating Expenses (1)
Management Fees—These fees are paid out of the fund assets to the mutual fund’s investment manager(s).

12B-1 Fees—These fees are paid by the mutual fund’s assets to pay for marketing and selling the mutual fund.

12B-1 fees also are used to pay for distribution of the mutual fund via brokers and other sales channels.

Other Expenses—Expenses not covered under 12B-1 fees, such as shareholder service expenses, custodial expenses, legal fees, accounting expenses, and transfer agent fees.

Expense Ratio—The expense ratio represents the total of the fund’s operating expenses. The expense ratio is a percentage of the mutual fund’s average net assets and typically is the most common method by which investors compare costs of their portfolio.

Although “No Load Mutual Funds” means that there is no sales load, these funds still are subject to shareholder and operating expense fees.

Implicit Fees: Hidden Costs Hurt Investors
Although it has been said that what you don’t know won’t hurt you,” when applied to investing, nothing could be further from the truth. The implicit fees are not printed in the prospectus or any mutual fund reports because they truly are hidden. Fortunately, implicit fees can be estimated because all mutual funds have turnover.

Mutual fund turnover is the percentage of the portfolio’s holdings that have changed over the past year.2 When the mutual fund manager sells the holdings (turnover) inside the mutual fund, this creates hidden transaction costs. This transaction cost is called the Bid-Ask spread expense. Because the cost to buy a stock is different from the cost to sell a stock, this spread difference is a cost that is hidden from investors and comes out of the fund’s performance. The cost of turnover can be determined by multiplying the turnover by the Bid-Ask spread expense.

For example, the average turnover for US small mutual funds was 100% for the year ending 2005. The Bid-Ask spread cost for US small mutual funds averages 2% to buy (bid) and 2% to sell (ask). When multiplied by the turnover of 100%, the result is a 4% hidden cost to the investor. This does not include the explicit cost. Considering that the average expense ratio of all US small mutual funds was 1.58% in 20052, the total cost to the investor hovers around 6%. It is no wonder that active fund managers have a difficult time beating the average passively managed index fund (no stock picking required). To make matters worse, it is difficult to be a prudent buy- and-hold investor when active managers turn over their funds and create hidden cost to investors.

Prudent Approach with No Stock Picking or Market Timing
Investors who pick stocks, time the market, or rely on the past performance of a fund to build a successful portfolio, have a good chance to join the ranks of many investors and be disappointed with the result. The majority of mutual fund managers fail to beat a simple, passive index approach. So what is an investor to do? Free Market Portfolio Theory combines three essential components that are grounded in academic and scientific research. These components allow the investor to embrace the power of diversification, understand the implications of risk, and capture the market return. The result is a low-cost (explicit and implicit) investment approach engineered with hard-to-get institutional funds not available to retail investors.

F. LeRoy Bell is president of Compass Financial Strategies in Abilene, an Independent Investment Advisor, and an authorized TMAIT Advisor. If you have questions about this article or other financial issues affecting your practice, contact TMAIT at 1-800-880-8181 or contact@tmait.org.

(1) www.sec.gov/investor/pubs/inwsmf.htm
(2) Morningstar Principia Software