Advisers showing clients how much funds really can cost

Savvy investors are taking a closer look at the fees that their mutual funds charge, digging into little-understood trading costs for the first time.

It's a critical part of an investment education, advisers tell clients.

Only about 10% to 20% of clients have an understanding of fund transaction costs, but that percentage is far greater than it was a few years ago, according to Joseph C. Feldmann, senior portfolio manager at WNA Wealth Advisors Inc.

“Advisers know that awareness is growing,” he said. “They are educating their clients about it, too.”

“Ten years ago, nobody was thinking about [trading costs],” said Timothy Courtney, chief investment officer at Exencial Wealth Advisors.

“I get more people asking me about it now,” he said. “I don't know if investors as a whole are putting greater emphasis on this or not, but we tell them they should be.”

Mr. Courtney and other advisers consider it part of their job to help investors understand how trading costs affect mutual fund performance. While a mutual fund's reported expense ratio, which covers a fund's operating and distribution costs, is reasonably easy to calculate and compare, trading costs are less transparent and include commissions, bid-ask spreads and the possibility that a big-enough trade could move the market for that security, making it more costly.

BEYOND EXPENSE RATIOS

Not only are trading costs hard to decipher, they exceed the expense ratio for some funds, investment managers said.

Investors' general understanding of expense ratios has driven the popularity of low-expense funds such as index-tracking mutual funds and exchange-traded funds.

The simple fee structure and low prices are a big reason that ETFs are gaining on mutual funds in popularity. Mutual fund withdrawals in the United States outpaced new investment by $100 billion last year, compared with net issuance of $118 billion in new ETF shares, according to the Investment Company Institute. Still, ETFs, which came into existence about 20 years ago, have a long way to go before they rival mutual fund assets. At the end of last year, about $1.05 trillion was invested in ETFs in the United States, compared with $11.6 trillion in mutual funds.

Investors who think that they have solved the problem by moving to low-cost index funds could still end up paying big trading fees, said Robert T. Deere, chief portfolio manager and trading strategist at Dimensional Fund Advisors LP.

S&P 500 index funds “hold the same 500 companies in the same proportions, doing the same thing they all are,” he said.

However, when there is a change in the S&P 500, firms usually rush to buy or sell shares of companies that are joining or leaving the index, which can run share prices up or down and ring up more trading fees.

DON’T FOLLOW THE CROWD

“We refuse to buy at the same time as everyone else and get into the liquidity squeeze,” Mr. Deere said during the Morningstar Investment Conference in Chicago last month. “We know the market in general will raise the price, then it will drop back where it was before.”

Dimensional's S&P 500 fund generally makes its buys a few days later, and the difference means it outperforms its rivals by about 10 basis points a year, Mr. Deere said.

Index funds with heavy investor turnover will have higher transaction costs as they buy and sell to issue or redeem shares, and some indexes inherently are more expensive to track because they include more companies, he said.

Small-company shares tend to be more expensive to trade than those of larger companies.

“It gets even more difficult when you run strategies that are not tied to an index,” Mr. Deere said.

Another factor that drives up transaction costs is that thinly traded stocks have a higher bid-ask spread. Emerging-markets securities can have higher commissions and taxes.

Shundrawn A. Thomas, managing director and global head of the ETF group at Northern Trust Global Investments, sees increasing investor awareness of fund costs and growing unwillingness to pay fees for investments that merely match the market.

“There is a limited understanding of costs, but as we see the market mature, I think we will see more clarity,” he said.

Some third-party providers are helping to educate investors about costs, such as Indexuniverse.com, which offers ETF analysis, Mr. Thomas said.

Mr. Courtney said that he uses Morningstar Inc. to look up fund turnover ratios, and sites such as the personalfund.com website for estimates of total fund transaction costs.

Personalfund.com estimates that a mutual fund with 100% annual turnover gives up an average of 1% of assets in transaction costs.

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