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A Big Fund Cost You Don't See

Expense ratios tell just one part of the story, brokerage commissions and other trading costs are an important part of the investment picture

Karen Dolan, CFA 24 March, 2010 | 11:26AM

When it comes to fund costs, expense ratios take the spotlight--with good reason. Expense ratio data is readily available and its effect on performance is well-documented: Less expensive funds tend to outperform. Tax costs are significant and considered, too, but most funds and investors are sitting on a decade of flat returns and embedded losses, muting the attention paid to taxes.

Trading activity represents a big hurdle to any investment strategy but receives little discussion because the full costs aren't reported and are difficult to estimate. You'd need data on every single trade to capture the true picture, but funds are only required to disclose holdings quarterly, rendering it impossible to know exactly what a manager traded, under what conditions, and when.

Of the main components to trading costs, only one is measured and disclosed by the fund companies--brokerage commissions paid to those executing the trade. The vast majority of funds bury the absolute pound figures deep in the Statement of Additional Information, making it difficult for investors to find and interpret. Morningstar recently started collecting brokerage-commission data in the United States from fund filings.

The Hard (and Soft) Facts of Brokerage Payments
The brokerage commission figures we gathered were eye-opening. The average equity fund pays approximately 0.30% of assets a year. That's roughly 30% of the average no-load large-cap fund's expense ratio. Thus, brokerage commissions can take what looks to be 0.90% paid in expenses each year up to 1.20%.

Where do these costs come from? When we discuss trading with fund managers and traders, they tell us that commissions can run from fractions of a penny up to five pennies for every share of stock they buy or sell, depending on the trade and whether research services are bundled in. Electronic trading networks are on the cheap end and full-service brokers offering research are on the high end of that range.

Many funds conduct more expensive trades with selected brokers in exchange for research services paid for with "soft dollars." The cost is "soft" because the fund is paying an inflated cost to trade and is receiving a different service in return. Arguably, the brokers providing research for soft dollars have an underlying incentive to invite more trades--and thus more commissions--but not necessarily to provide the best research. The soft dollar system makes it hard to know how your dollars are being spent. If the outside research is needed and good, then the fund should buy it, but it'd be cleaner to pay for it with hard dollars. Research costs should be part of the management fee, and only the cost to execute the trade should be labeled a brokerage commission.

Shelling Out the Big Bucks
While the average brokerage cost is significant, much more startling are the huge fees paid by some individual funds that in some cases approach or exceed the entire expense ratios of many core funds. We've reviewed the data available in the US from the past several years, run the calculation, and highlighted 10 prominent funds that paid a lot in brokerage commissions in 2008 and 2009.

Funds have made this list for a variety of reasons. Some have undergone manager changes that drove portfolio turnover, and others are on the list because of active trading strategies.

Manager changes don't always result in big portfolio changes or brokerage costs, but full changes of regime and strategy do. For example, Putnam Voyager underwent a makeover in late 2008 when new manager Nick Thakore took over and put his stamp on the portfolio. The fund's brokerage commissions shot up from approximately $6 million (or 0.10% of assets) for the fiscal year ended July 31, 2008, to north of $21 million (or 0.69% of assets) for the year ended July 31, 2009. Thakore's trading activity was costly, but fast trading isn't a hallmark of his approach and the repositioning has thus far worked. The fund has gained a cumulative 71.5% from the start of December 2008 through the end of February 2010, beating the large-growth average by more than 35 percentage points.

MFS Core Growth took the cake. Its hefty 1.20% brokerage commissions were the result of heavy trading. The fund clocked in a turnover rate of 589% for 2009, a difficult year for its performance. Manager Stephen Pesek's style held up relatively well in 2008's downturn, but, when 2009 rolled around, he didn't hold the junk that was rallying. Pesek didn't want to chase it, but not much he owned was doing well either. He kicked up his trading activity in 2009 from an already high average turnover in prior years, and the fund paid hefty commissions in the process.

CGM Focus is another classic case of a fast-trading strategy. Manager Ken Heebner is well-known for his timely and swift moves in and out of stocks, industries, and sectors. The fund's brokerage costs reflect it. It paid 1.04% of average net assets in brokerage commissions in 2008. CGM Focus' $70.6 million dollars paid in commissions were just shy of the amount paid by American Funds Growth Fund of America, which spread the cost among an asset base that was 28 times larger than CGM Focus'.

Tip of the Iceberg
The trading-cost picture is far from complete, and we've only considered one piece of it here. Market impact and opportunity costs are the tougher and more important pieces to measure because they can easily dwarf brokerage commissions. Putting together a true picture of the trading costs is an important part of the overall investment picture and well worth further study, something Morningstar hopes to keep pushing forward.

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About Author

Karen Dolan, CFA  Karen Dolan is director of fund analysis with Morningstar.