The transaction costs charged by mutual fund managers are often a significant, if clandestine, part of the fund business, but some Washington lawmakers are trying to change that.
In most mutual funds, total transaction costs are equal to or higher than the funds' entire expense ratio, though they are also paid out of fund assets. Of the several categories of transaction costs, only brokerage commission costs are publicly reported, as required by law. Otherwise, investment companies withhold the data.
Enter U.S. Rep. George Miller (D-Calif.), the Securities and Exchange Commission (SEC) and the Department of Labor (DOL), all of whom have joined the fray over such costs.
Miller has authored a comprehensive bill, H.R. 3185, to force disclosure of 401(k) plan fees. Meanwhile, the SEC has proposed a regulation to improve the prospectus format, and the DOL is floating a regulation that overlaps with Miller's bill, though it is less pervasive in scope. Each faction hopes to clear up the obscurity of transaction costs, but of the three, only H.R. 3185 offers even a modicum of clarity.
Components Of Transaction Costs
According to Investment Technology Group Inc. (ITG), a brokerage firm and provider of transaction costs analysis, three main cost categories exist-one explicit and two implicit. The explicit cost, brokerage commissions, is the easiest to calculate but the least significant of the group.
Investment companies take different approaches to brokerage commissions. They may negotiate with the broker a minimal commission, often less than a penny per share, or they may negotiate a higher commission in the nickel-per-share area. The latter commission type usually includes revenue to pay the broker to conduct research for the fund manager ("soft dollars"). In ethically suspect variations on soft dollars, commissions pay for various services of questionable benefit to fund investors. Unethical investment managers may even delegate his or her research duties to the broker, increasing the investment manager's profits.
Implicit transaction costs include timing-delay costs and impact costs. Timing-delay costs occur during the lapse between the manager's initial decision and the broker's placement price. "Think of [delay cost] as the cost of seeking liquidity," writes ITG. Electronic processes have contributed to reduce delay costs over the last five years or so.
Market impact costs result from a price change between order placement and the eventual trade price. A simple example of this is the offering for sale of a significant number of shares, which causes a drop in price.
Assessing The Situation
ITG provides total transaction costs in its online report, ITG Global Trading Cost Review, September 2007. ITG reports on the data collected from its clients, which include the vast majority of large fund managers in the U.S. and Europe. Despite the vast array of data collected, ITG's Ian Domowitz cautions that the reported costs do not correspond with a particular fund or index.
The costs in the ITG report reflect only "one-way" trading; the replacement of a position with another position ("two-way trading") doubles the published quarterly costs. Doubling the reported costs and averaging four quarters of total transaction costs produces an approximate cost for 100% annual turnover.