How much more can the client afford to pay for underlying "implementation solutions" and still have a chance of achieving long-term success? If you think a mutual fund is a bargain at a 1.25% operating expense ratio, this article may change your mind. It's not my purpose to bash funds, but instead to help you evaluate which funds represent a sound value proposition for clients, when all costs are considered.

Visible Vs. Invisible Costs

The visible part of fund costs is contained in the "operating expense ratio," which summarizes the fund's "fee table" in its prospectus. The operating expense ratio divides the sum of a fund's annual (recurring) expenses and sales commissions by its net assets. According to Lipper, the median operating expense ratio for U.S. stock funds is 1.46%, and this is 9% higher than three years earlier.

However, a significant component of expense is ignored by this ratio, and that is trading costs. In the past, many advisors and investors have assumed this cost was inconsequential, because funds qualify for very low trading commissions amortized over large amounts of assets. Recent studies have shown such thinking to be misinformed.

A typical institutional commission is 5-6 cents per share for each side of a trade, or about 10-12 cents per roundtrip (one buy, one sell). During the 1990s, as vast assets poured into funds, managers could often effect strategies with one-way trades (buys). Now that net cash flows have fallen, managers are often forced to sell securities before making purchases, so the number of roundtrip trades has increased.

Also, studies have found that the 10-12 cent per share roundtrip commission is only a part of trading costs absorbed by fund investors. According to an estimate made by one institutional money manager, Theodore R. Aronson, and summarized by The New York Times, the total cost to investors of each roundtrip trade averages about 59 cents, about 2.2% of the amount traded. (For a breakdown, see the box below.) If a mutual fund portfolio has a 100% annual turnover ratio and zero net cash flow, you might then expect that it's total annual trading cost could be about 2% above the published expense ratio-perhaps 3-4% in total cost.

Source: Theodore R. Aronson, a principal in the firm of Aronson & Johnson & Ortiz, as published by The New York Times, 2/9/03.

Aronson's estimates are supported by a scientific analysis by Roger M. Edelen, a professor at The Wharton School, as published in the Journal of Financial Economics in 1999. Edelen evaluated the cost in mutual fund performance that an average equity manager sacrifices in return for providing a "liquidity facility" to investors. He observed that the need for liquidity causes managers to make "uninformed" trades they otherwise would not, which reduces investment performance below an expected level. He concluded that this cost is about 1.5% multiplied by the fund's "realized flow volume," a measure of asset turnover and trading activity. In approximate terms, a fund that turns over 100% of its assets annually can be expected to sacrifice about 1.5% annually to liquidity-induced trading costs.

Edelen's work actually supported the value of fund managers, because it showed that they trade not only to improve performance but also to provide investors with liquidity. He suggested that when this "liquidity cost" is considered, managers on the whole perform better than published statistics indicate.

Making Opaque Costs More Transparent

At present, trading costs are opaque to advisors and investors in virtually all mutual funds and variable annuities. (These costs are deducted from Net Asset Value, so performance is reported net of them.) But the opacity could soon change because of efforts in Congress spearheaded by two important House committee chairmen, Michael G. Oxley (R-OH) and Richard H. Baker (R-LA), to force more disclosure of these costs. Also, the Department of Labor (DOL) has underway a continuing evaluation of cost disclosure in participant-directed retirement plans, including the 401(k) market. The DOL reportedly is concerned that plan participants are not being given enough information to evaluate the costs of investment options, including brokerage commissions and trading costs in mutual funds.

Ironically, the focus on trading cost is emerging at a time when the mutual fund and variable annuity industries are introducing new choices that are bound to generate even higher costs. These include:

• Fund-of-funds that pool several mutual funds, each independently managed.
• Blended funds that combine multiple managers into one fund. For example, they may allocate part of assets to a growth manager and another part to a value manager.
• "Lifestyle funds" that combine several funds or managers and systematically adjust the risk level as the client advances toward retirement.

The additional costs in these vehicles can include: 1) two separate layers of management fees; 2) extra trading costs involved in allocating cash flows among managers or adjusting risk levels; and 3) rebalancing assets among managers or styles. Some fund groups have concluded that each internal rebalancing event within a fund can add 50-100 basis points to trading costs. Rebalancing trades meet Edelen's definition of "uninformed," i.e., liquidity-motivated.

In some of these new choices, it's likely that total annual costs-including operating expense ratio, trading and rebalancing-could total 4-6% of assets annually. If you and your broker-dealer are charging .75%-1.25% for the many services that you provide, while a fund is charging two or three times that, perhaps you should consider whether the relationship between cost components and their value-added is truly in balance.

Common-Sense Suggestions for Fund Cost Management

What can you do to help your clients select mutual funds and variable annuities that meet all their requirements, including cost-efficiency? Here are a few suggestions:

• Consider the trend in funds' operating expense ratios. For example, is today's higher than it was a year or two ago? This analysis can suggest whether visible cost components are rising.
• Some fund groups have begun publishing "performance attribution" statistics that explain why specific funds did better or worse than benchmarks. This data focuses mainly on the impact of sector and specific stock selection, but it also may include a section on "other" influences on performance. Costs usually are the largest component of other influences, and the impact of costs versus a benchmark is always negative. In such attribution analysis, trading costs aren't opaque or invisible. They are detailed in black and white. So, pay attention to the "other" statistics.
• Start talking to your wholesalers about their funds' strategies in regard to trading costs. Ask if their portfolio managers attempt to minimize these costs and how.
• Pay attention to cash flows in selecting funds for your clients. Funds that are persistently in net redemptions are more likely to have higher liquidity-induced (uninformed) trading costs.
• An emerging trend is for funds to trade shares through an "omnibus broker"- basically a super-discount institutional trader. The omnibus broker may charge the same 5-6 cents per share as other brokers, but it then can rebate up to 75% of this commission back to the fund, greatly reducing direct trading costs and their impact on fund performance. Ask wholesalers whether their funds are utilizing omnibus brokers.
• Pay attention to the mutual fund portfolio turnover statistics published by Morningstar. In the past, advisors have used this data mainly to measure tax-efficiency, but it also can indicate trading cost impact. The average equity fund now has a turnover of about 100% per year. Conservative, cost-conscious investors might best be served by funds with operating expense ratios below 1.0% and turnover below 100%.
• Consider whether clients have specific objectives that require the fairly high-cost structures of blended or lifestyle funds. Don't put clients into funds that automatically rebalance assets internally among multiple managers, unless clients clearly accept the benefit of rebalancing and its related tax and trading costs.
• Consider the investor's need for a "liquidity facility" and its cost. Does a given investor need to pay what Aronson and Edelen have estimated to be a 1-2% annual cost for the privilege of being able to exchange out of a mutual fund at any time, using a systematic withdrawal feature, or rebalancing among funds periodically? If not, solutions such as separate accounts, exchange-traded funds, folios or fee-based brokerage accounts may help to reduce costs.
• In conducting due diligence on fund-of-funds, lifestyle funds, etc., ask whether the entity has an "oversight manager." This manager reviews each proposed trade made by underlying managers to avoid those with offsetting impact or duplicative costs. (For example, underlying Manager A wants to buy IBM stock on the same day that underlying Manager B wants to sell IBM stock.) The lack of an oversight manager can literally throw trading dollars down the drain.

Above all, help your clients manage all their investment costs by educating them on how much they pay, the impact of costs on long-term performance, and alternatives for meeting cost targets. Each review session with a client should devote a minute or two to summarizing costs. When clients want to know why they have underperformed benchmarks, remind them that costs are an important reason.

Being completely candid with clients about costs is one way you can meet the challenge of a changing environment. It's also an important way to remind clients that your objectivity, professionalism and services are certainly worth their cost.

End note: A few financial advisors responded to last month's column by asking a version of this question: "What if I can help investors achieve superior investment performance over time? Shouldn't clients expect to pay higher costs for that?"

Here is my answer: Investors should expect to pay more for this service, provided three conditions are met: 1) You set and maintain a level of risk that is comfortable for the client; 2) Performance is measured on a risk-adjusted basis; and 3) You have the ability-legally, ethically and operationally-to adjust the client's costs for actual risk-adjusted performance, so that the client does not pay for under-performance.

It's my impression that few advisors can meet all three conditions. Investors should not necessarily pay more when superior performance is earned through higher risk exposure, especially when that exposure is more than they want or need. An advisor could theoretically track the risk-adjusted performance of a client's portfolio using a tool like Sharpe ratio. Morningstar's Principia Pro, for example, can calculate Sharpe ratio for a portfolio of stocks, bonds, mutual funds, variable annuities or combination of them. But Principia Pro currently can only make this calculation based on a fixed portfolio over a fixed holding period. It can't track risk-adjusted return in a fluid portfolio that involves periodic investment, withdrawals, exchanges, rebalancing events, etc.

Many professional advisors have the ability to help clients set and meet goals for portfolio allocation, risk, and costs. Few have the ability to track and consistently meet goals for risk-adjusted performance. The most professional way to earn higher compensation for helping clients pursue superior risk-adjusted return is through an asset-based fee (as in a separate account).