Study: Real costs of mutual funds hidden

NEW YORK -- Mutual fund investors are paying billions of dollars in portfolio trading costs that are hidden from view, according to a new study.

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Stock mutual funds incur some $17.3 billion in costs that don't show up in expense ratios, according to a survey of over 5,000 equity funds published last week by the Zero Alpha Group, a group of eight independent investment advisory firms that manage a total of about $3 billion.

On average, trading costs of the surveyed mutual funds were 44 percent of their reported expense ratios, according to the study. The expense ratio is the fund's cost of doing business, as disclosed in its prospectus and expressed as a percentage of its assets, but doesn't include trading costs.

One of the starkest findings: There is a huge gap between trading costs for index funds and actively managed funds. Active funds racked up about 0.48 percent in trading costs per year, compared with 0.064 percent per year for index funds.

"That investors in actively managed funds incur portfolio trading costs that are over seven times that of index fund investors is another in the long line of reasons for investors to favor index funds," said Edward O'Neal, assistant professor of finance at the Wake Forest University of Grade School of Management, in a statement.

O'Neal conducted the study along with Jason Karceski and Miles Livingston of the University of Florida.

The Securities and Exchange Commission has been looking into various costs associated with mutual funds as part of probes of the fund industry over the past year.

Critics of the industry have charged that fund managers turn over their portfolios too quickly, ratcheting up costs for investors, but a report published earlier this week by the Investment Company Institute said managers of stock funds haven't speeded up their trading in recent years.

Another area of concern were high trading costs associated with smallcap funds. These investments had costs above those of any other kind of fund surveyed, at 123 percent of reported expense ratio.

While investors can easily find information on the annual fees charged by funds, transparency only goes so far, according to Scott Sarber, vice president of Petersen Hastings Investment Management of Kennewick, Wash., which is a member of the Zero Alpha Group.

"Only a part of that extra cost is detectable through publicly available documents, and that is only if you dig into obscure mutual fund documents that very few investors know anything about," Sarber said in a statement. "When you add on top of that the completely unreported implicit costs of trading, you are left with a big credibility gap in mutual-fund reporting to investors."

Growth funds have higher-than-average trading costs as a percent of annual expenses, according to the study. It broke the class into large-cap growth funds -- with trading costs averaging 43.1 percent of stated expense ratios -- mid-cap growth, at 86 percent, and small-cap growth.

Value funds have fewer hidden trading costs than growth funds, according to the study.