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.