Hidden Fund Fees Add Cost Burden to Investor

WASHINGTON -- One of the last great hidden costs for mutual fund shareholders is the amount that funds pay for brokerage commissions, the fees they pay to buy and sell stocks and other securities.

Investors may be surprised to learn that this cost is not included in their fund's expense ratio -- its expenses stated as a percentage of its assets. But the commissions, like other expenses, are paid from the net assets of the fund and thus are borne directly by shareholders.

The burden is far from incidental and can drag down fund performance, recent studies assert. Mutual funds will pay well over $1 billion in brokerage commissions to Wall Street firms, according to one study published earlier this year in the Journal of Financial Research.

Instead of being described in the prospectus, commission costs are included only in a fund's annual statement of additional information, or SAI, which is not sent to shareholders unless they ask for it. In addition, most investors don't worry about the costs of investing during a bull market, when they are making money.

But mutual fund brokerage commissions are catching the attention of the U.S. Securities and Exchange Commission. The SEC is especially concerned about so-called soft-dollar payments, in which investment advisers get payments from brokers in exchange for steering customer trades to them. The arrangement is called a soft-dollar transaction because the adviser is bartering commission dollars for goods and services. Soft-dollar brokerage payments are supposed to be used for investment research that will benefit fund shareholders and other customers.

SEC Chairman Arthur Levitt Jr. said recently that the commission will launch a targeted series of examinations of mutual funds, investment advisers and the brokerage houses with whom they do business.

Levitt and others at the SEC are concerned that investment advisers may be relying on customer-paid brokerage services to obtain soft-dollar payments to pay for expenses that are rightly the responsibility of the investment adviser, not his customers, who are the mutual fund's shareholders. Abusive shifting of adviser expenses to customers includes using soft-dollar brokerage payments to cover advisers' salaries, rent, vacations, heating and telephone bills and car leases, for example, according to the SEC and investment managers.

Another problem with soft-dollar brokerage services is that the commissions can be higher than those for trades in which there is no rebate, according to research by Greenwich Associates, a financial consulting company based in Connecticut.

Soft-dollar arrangements also complicate expense comparisons among funds. John Reckenthaler, editor of Morningstar Investor, notes in a forthcoming issue that the investment management company that picks stocks for the Twentieth Century funds eschews soft-dollar arrangements.

Brian Mattes, a spokesman for the Vanguard Group, which is well known for running low-cost funds, said transaction costs are a major reason so many fund managers don't beat the market. Mattes and others advise mutual fund customers to avoid high-turnover funds unless they are convinced the manager is adding value to their investment return. "The average stock mutual fund turns over about 85 percent of its holding every year," Mattes said. "Unless the money manager is consistently picking winners, those transaction costs are a drag on fund performance."