Mutual Fund Expense Rations May Not Tell the Full Story

January 23, 2004 ( - As much as 43% of a mutual fund's expenses are being omitted from their expense ratios, and transaction costs of some funds exceed 400% of these ratios.

This omission occurs due to mutual funds failing to report the cost of trading incurred on portfolio turnover – a combination of brokerage commissions and bid-ask spreads.   In addition to a cost increase on the investors’ pocket book, these unreported costs in turn can be a drag overall performance, according to a study conducted for the Zero Alpha Group (ZAG) by Edward O’Neal, assistant professor of finance at the Wake Forest University Babcock Graduate School of Management, along with Jason Karceski and Miles Livingston at the University of Florida.

The study examined the “true costs” of owning 30 of the most widely held domestic equity mutual funds in the United States, representing roughly $750 billion in investor assets at the end of 2001.   Lowest among the “true cost” figures were:

  • Vanguard Total Stock Index Fund (23.4 basis points)
  • Vanguard 500 Index Fund (21.5 basis points)
  • Fidelity Spartan US Equity Index Fund (21.5 basis points).

The low “true cost” rating was the result of low expense ratios and low trading costs, the study found.   Yet, it should be noted that according to data provided by Morningstar cited by the report, these funds reported expense ratios of 0.20%, 0.18% and 0.17%, respectively.

On the other side, plagued by the combination of high expense ratios and trading costs, the among the 30 examined funds with the highest total costs for investors:

  • Fidelity Fund (161 basis points)
  • Fidelity Contrafund (164 basis points)
  • Putnam Voyager A Fund (167 basis points).

While these funds reported expense ratios of 0.56%, 0.84% and 0.88% respectively, brokerage commissions and implicit trading costs estimated by the study drove the true cost of ownership even higher.   In fact, the Fidelity Contrafund had brokerage commissions totaling 0.20% of the fund’s assets per year and estimated implicit trading costs of 0.60%. The Putnam Voyager A Fund had brokerage commissions of 0.29% and estimated implicit trading costs of 0.50%.

The true costs of owning high turnover equity funds with total net assets greater than $100 million were through the roof.   Even though the RS Mid Cap Opportunities fund reported an expense ratio of 1.47% its estimated implicit trading costs were 1.95% and brokerage commissions ran 4.10%, the study found.   This was followed by the PBHG Large Cap fund – expense ratio of 1.16%, trading costs of 4.27%, and commissions of 3.16% – the Strong Discovery Fund – expense ratio of 1.50%, trading costs of 1.74%, and commissions of 1.26% – and CGM Focus – 1.20% expense ratio, trading costs of 1.98% and 1.30% commissions.  

“We estimate that investors in the largest funds are incurring 30 basis points per year in total trading costs. These costs are meaningful when compared to reported fund expense ratios. For high-turnover funds, the total trading costs are much higher,” the study notes. “Together, the commissions and implicit costs are higher than the published expense ratios for each of the 10 high-turnover funds we studied. In some cases, the total costs of trading are more than double the level of the expense ratio.”

Based on its findings, the trio of academics that conducted the study suggests that the US Securities and Exchange Commission (SEC) require funds to report commissions in “a prominent location in the mutual fund prospectus.”  

A copy of the full report can be downloaded at .