News Analysis
BusinessWeek
February 8, 2006
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How to Kick a Fund's Tires

It's a bit late to learn about hidden fees or untried managers after buying in. Here are some tips to avoid those and other unpleasant surprises

Investors know they should examine a mutual fund's fees and performance record before writing that check. Though many people get help from a financial adviser to find the best funds (see BW Online, 4/8/05, "Finding the Right Money Coach"), knowing where to look under the hood can help avoid getting a lemon.

Low fees are a good thing, but there may be a catch. FundAlarm.com publisher Roy Weitz noticed that E*Trade (ET ) recently promoted its E*TRADE S&P 500 Index Fund (ETSPX ) as one of "the industry's lowest-cost stock index funds." The fund has an expense ratio of 0.09%, well below the 0.39% average for its Lipper category.

The fine print reveals that E*Trade will limit its fees only temporarily. "There is no assurance that [E*Trade] will continue these expense limits beyond April 30, 2006," a footnote reads. Without this fee waiver, E*Trade's index fund would carry a 0.78% expense ratio. By comparison, Fidelity's Spartan 500 Index Fund (FSMKX ) charges 0.1% and the Vanguard 500 Index Fund (VFINX ) shares cost 0.18%. Both funds require shareholder approval to raise fees. E*Trade's fund doesn't, but a company spokeswoman says the brokerage plans to keep its fee caps in place for at least another year.

Weitz fears that investors may get confused when companies trumpet those fees to sell index funds, which compete mostly on price. To check if expense ratios are temporary, read all the footnotes in fund advertisements. NASD rules require companies to disclose the non-waived fee, even if they're touting something lower. Failing that, visit the company's Web site and skip to the section of the prospectus devoted to expenses.

Fee waivers aren't the only way funds can be less attractive than they might appear. This week's Five for the Money looks at how investors can make sure they're getting exactly what they bargained for when they stash their hard-earned cash.

Look at costs beyond just the expense ratio.
"Fees are the most important single factor in evaluating a particular fund," says Mercer Bullard, founder of investor advocate Fund Democracy. So investors should know whether their funds carry hidden costs.

Trading costs can slash investors' returns, but they aren't included in expense ratios. To avoid getting burned, investors should be wary of funds with turnover rates higher than 100%, says Christine Benz, director of fund analysis at Morningstar (MORN ).

So-called opportunity costs are another factor. Some funds may be too large to buy some of the small-cap stocks they might have in the past. Watch out especially for funds that combine high turnover rates with a large asset base or a focus on smaller companies.

Taxes can also hit investors' pocketbooks without showing up in a fund's expense ratio. Funds that frequently distribute dividends or have high turnover rates might give investors an unwelcome surprise on April 15. These funds might be more suitable for tax-deferred account such as a 401(k) or IRA.

Scrutinize performance figures.
Just because a fund has had a couple of good years doesn't mean it's right for everyone. Investors planning to hold a fund for only a few years should read up on the fund's performance volatility, not just its overall performance.

On a number of Web sites, investors can look at the bar chart that shows a fund's returns for each year. "If you have bars that fluctuate up and down dramatically, you know that this is not a short-term investment vehicle," says Bullard.

Don't put money in a volatile fund unless you can afford to leave it there for at least five or 10 years. If investors wind up scrapped for cash when the fund is having an off year, they might end up having to eat substantial losses.

Weigh the risks looking forward, not just backward.
Some investors study measures like standard deviation to learn how risky a fund is. But that only gauges a fund's previous risk levels. Investors should check forward-looking risk measures, too.

Investors should analyze a fund's fundamentals, such as sector weightings and the percentage of the fund's money in its top holdings. Risks can crop up if a fund bets heavily on certain industries or companies. For example, a fund that bets heavily on small stocks may be vulnerable if large ones begin to outperform, as many market watchers have been predicting, says Morningstar's Benz.

Do your homework on a fund's portfolio managers.
A fund is only as good as the people who run it. But sometimes portfolio managers jump ship, particularly during the fund industry's recent consolidation. Investors should make sure a fund with a good record still has the same management team.

Portfolio management information is usually available on a fund's Web site. Also check the prospectus. "A fund could have the greatest track record in the world, but if the portfolio management team that posted that track record is no longer running the fund that history is basically irrelevant," says Brian White, vice president and director of mutual fund marketing with Ryan Beck.

The fund's daunting statement of additional information (SAI) tells how much money, in broad terms, a manager has invested in the fund. In theory, a manager with "skin in the game" has more incentive to rake in high returns.

The SAI also indicates how many other accounts a manager handles. This might include separately managed accounts run for institutional investors or wealthy individuals. If the fund skipper manages a big amount using the same strategy, the fund might bump into problems when trying to unload securities. "They're basically fishing in the same water," Weitz warns.

Watch out for incubated funds.
Sometimes fund companies launch new funds to a select group before making them available to the public. Typically, only employees and their families can invest for the first few years. Industry insiders call these funds "incubated" because they build up a track record under artificial conditions.

Delaware Investments introduced Delaware Small Cap Core (DCCAX) last year. But the press release announcing the launch listed the fund's start date as December, 1998. What's more, the fund previously had a different name and investing style, but it still touted the track record it had piled up while closed to normal investors. A Delaware spokeswoman declined to comment.

Incubated funds aren't necessarily bad investments. Still, investors should be leery of them because a manager running an incubated fund doesn't have to deal with inflows and outflows from regular investors. So when the funds open their doors, investors are looking at performance numbers that occurred under vastly different circumstances.

It can be tricky to spot incubated funds. In most cases, though, the phrase "limited distribution" will appear somewhere in performance footnotes or in the history of the fund. "They never use the word incubated," Weitz says.

It's easy for fund investors to suffer from information overload. But ask the right questions, and you can rest assured your nest egg isn't in a Trojan horse.