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.

Turnover represents the average length of time that a security remains in a portfolio. Dividing 1,200 by the turnover rate reveals the average number of months a manager holds his positions. For instance, a turnover rate of 100% means the manager holds a security in his portfolio for an average of 12 months.

The ITG data yields at least two important observations. The first is that transaction costs have trended downward over the past five years. In 2003, U.S. large-cap two-way transaction costs totaled 146 basis points per 100% turnover. In 2006, the corresponding annual cost was 92 basis points, a decline of 54.

The second observation is that brokerage commissions historically have constituted a minor share of total transaction costs. Of the 54-basis-point decline between 2003 and 2006, a savings of 13.5 basis points was due to lower brokerage commissions.

Similar trends are evident for small-cap equity transaction costs. In 2003, annual two-way transaction costs for 100% turnover averaged 226.5 basis points; in 2006, 148.5 basis points. Of that 78 basis point decline, 22 points were due to lower transaction costs.

Implications For Fiduciaries

Despite the fact that transaction costs and expense ratios are analogous and similarly expensive, fiduciaries pay close attention to the latter and typically neglect the former. For instance, HR Investment Consultants' industry-standard 401k Averages Book helps fiduciaries benchmark plan costs, but it does not address transaction costs. Expense ratios constitute about 90% of the book's cost benchmarks; if transaction costs were included, it would approximately double the benchmarks.

Therefore, plan fiduciaries should attend to transaction costs. Prudent fiduciaries rely on a meticulous decision-making process, and that process should account for transaction costs. Investment dollars ideally flow only to those investment companies that provide fiduciaries with the necessary data.
If total transaction costs cannot be obtained, fiduciaries should strongly consider index funds as an alternative to actively managed funds. Index funds incur about 80% less in transaction costs than actively managed funds without sacrificing performance. An industry mantra holds that long-term returns for actively managed funds trail their respective indexes.

H.R. 3185

Congressman Miller's H.R. 3185, "The 401(K) Fair Disclosure For Retirement Security Act Of 2007," requires disclosure of "estimated trading expenses" to plan sponsors as well as disclosure of "[estimated] trading costs" in the participants' annual statement. Estimates lack specificity, however, and could prove useless. Investment companies have a financial incentive to provide generic data, so that comparisons between funds lack credibility.

The bill anticipates disclosure of explicit costs, such as brokerage commissions, but uncertainty exists regarding implicit transaction costs. The language of the bill does not refer to implicit costs by name (for example, timing delay costs, impact costs, bid/ask spreads, etc.), and the congressman presumably would have named them if that were his intention. That omission can be rectified in future revisions, though these would give rise to the problem of standards and conformity. At the moment, firms tally transaction costs using a variety of algorithms and methods, and there is no consensus about any one way of measuring them.

In 2003, the SEC noted, "Because the implicit costs, which are difficult to identify and quantify, can greatly exceed the explicit costs, there is no generally agreed-upon method to calculate securities transaction costs." If Rep. Miller does not impose a single standard for computing transaction costs, then the reported data will be constantly under attack from rival firms using alternative methods. If the congressman does impose a single standard of computation, then he elevates some vendors and injures others.

  
Proposed SEC And DOL
Regulations Fail The Test

The SEC has proposed regulations designed to update the mutual fund prospectus format, merely seeking to explain the relationship between turnover and transaction costs. For instance it asks that the portfolio turnover rate "be accompanied by a brief explanation of the effect of portfolio turnover on transaction costs and fund performance" (emphasis mine). It is likely that the contemplated explanation already exists on numerous Web sites or in print.   

The DOL proposes to mandate the disclosure of brokerage commissions and soft dollars to the fiduciaries of 401(k) plans. However, incomplete transaction cost data actually makes the work of fiduciaries more complicated and raises as many questions as it answers. For instance, fiduciaries must determine whether the incomplete data provides meaningful information about unknown implicit costs, a nearly impossible and legally imprudent assumption. This same flaw may afflict H.R. 3185 if the bill contemplates the disclosure of only explicit costs.

The DOL opines that fiduciaries can insist on receiving additional information from providers, but the proposed regulations narrowly define "compensation or fees." While brokerage commissions constitute compensation, investment companies would likely take an opposite position regarding implicit costs. In the face of such difficulties, there's another approach that should receive serious consideration.

A Promising Proposal

In 2003, the SEC solicited comments on how best to disclose transaction costs. Because there is no consensus, ITG's Domowitz proposed reporting gross returns (including expenses) alongside standard investment returns (net of expenses). The gap between gross and standard returns would reveal all the expenses that diminish returns, including total transaction costs and expense ratios.

Seeing both gross and standard returns may result in better fund selection. Russell Kinnell, Morningstar's director of mutual fund research, writes, "Look for low costs-still the best predictors of performance." He also notes that less-expensive funds have less standard deviation, since managers must assume less risk to achieve their goals.

The elegant simplicity of this method recommends it to policymakers. First, investors do not require a detailed breakdown of costs in order to ascertain which funds spend and keep more of their investment dollars. Second, this method works with the investor's predilection for exciting data, such as returns.

In his book Your Money and Your Brain, Jason Zweig reports that the human brain acutely responds to variable data: Flashier factors like performance and manager reputation are more vivid and changeable than a fund's expenses, so they "hijack our attention." Similarly, Morningstar's Kinnell reports that five-star mutual funds "with high-risk strategies often charge more because volatile returns lead investors to mistakenly tolerate higher expenses" (emphasis mine). Gross and standard returns immediately attract attention but also highlight the cost factor that separates the two numbers. Investors may be inclined to strike a balance between seeking returns and minimizing costs; consequently, they may migrate toward index funds.

Research indicates that professionals will also benefit from seeing total costs. Zweig reports that a recent survey indicated advisors rank expenses far down on the list of important factors when selecting a mutual fund. Moreover, elite MBA students failed to minimize costs when asked to choose between four S&P 500 index funds with varying loads, expense ratios and inception dates.

This approach is best suited for the average investor, although professionals should benefit. Therefore, efforts should be made to solve the quandary of reporting implicit transaction costs. Advisors and fiduciaries would hopefully make more accurate determinations with access to specific costs data.  

Conclusion

Neither Congress, nor the SEC nor the DOL have successfully placed total transaction costs in the hands of investors, advisors and fiduciaries. Given the recent attention in Washington to 401(k) fees, why do the various players not take up the issue of implicit transaction costs? Parties dicker over relatively minor administrative costs while enormously expensive implicit transaction costs escape scrutiny. Perhaps before the advent of index funds, implicit costs were of less significance, but now that index funds represent a solid alternative to actively managed funds, the issue should be addressed.