Rising hidden costs put bite on returns

When the market was charging ahead, delivering annual returns in excess of 20%, few investors cared about the cost of trades.

Now, with the market going sideways, the investment industry doesn’t want to talk about it.

At least one money manager says that’s partly because the industry, particularly brokers, makes a tidy profit off of hidden costs — up by an estimated 15% this year over last.

“Who’s making money on it? Every person that touches the trade,” says Ted Aronson, a partner with Aronson + Partners, a money management company in Philadelphia.

“I don’t mean to make this seem like some smoke-filled room in a vast cabal, but it’s in very few people’s best interests to talk about this issue,” he adds.

One thing is certain, hidden costs associated with trading can take huge bites out of returns.

Compared to 1999, hidden costs are up 15% this year, says Wayne Wagner, chairman of the Plexus Group, an investment consulting firm in Los Angeles specializing in measuring hidden costs.

But fund companies say it’s not a matter of trying to pad the bill. They say hidden costs are merely a result of market inefficiencies they are trying to address.

These costs take many forms. Among them:

* Delayed trades, which occur when large orders are sitting on a fund’s trading desk but aren’t released to the broker because the trader is afraid of affecting the stock’s price. In the meantime, the price moves away from the buyer or seller.

* Missed trades, which are a consequence of delays. If the price moves too much before the trade can be completed, the manager will pull back on the trade.

* Clumsy trades, where the broker executes in such a way that he or she significantly affects the price of the stock.

* Principal trades, where the broker executes a principal trade rather than taking the order to the floor.

Mr. Wagner says they can dwarf visible costs such as mutual fund commissions.

For example, the average cost of trading large-cap stocks is just over 1%. The average cost of swapping a stock in a portfolio for one thought to be more attractive is twice that. Thus the difference in performance must be at least 2% to make the trade worthwhile.

Market inefficiencies

The problem is much more severe for small-cap stocks, according to the Plexus Group. The average cost of trading small-cap stocks is 41/2 times what it costs to trade large-cap stocks.

Mr. Wagner says much of those costs can be attributed to market inefficiencies.

Delaying a trade or conducting it over a period of time rather than all at once may cost an investor money, but it occurs because the trader doesn’t want to tip his hand to others, who can jack up the price.

“The guy with stock to trade doesn’t want anybody to know, but unfortunately he can’t do his executions without leaving some trail,” Mr. Wagner says.

“You tell me how many eyes peering at screens are trying to find that behavior so they can jump in front of it? Anyone who calls themselves a day trader is looking for exactly that kind of signal.”

Mr. Wagner says that kind of activity leads to missed trades. Traders are forced to leave unfulfilled orders because the price at which they started to buy a particular stock has gone up so much, it’s not worth the trouble to fill the rest of the order. Of course, the customer has missed the gain.

The hidden costs such activities lead to, he says, are more prevalent in the small-cap category because those stocks are much more illiquid.

The markets overall, however, have become increasingly illiquid over the years, making hidden costs a bigger problem for funds.

How the companies decide to address them is of major interest to potential investors, even if most investors don’t know what they are, says planner Harold Evensky of Evensky Brown & Katz in Coral Gables, Fla.

“When we look for a money manager, the first thing we look for is, what’s their investment philosophy?” Mr. Evensky says. “The second thing is, how do you implement that? And part of that decision is how you control those elements in trading.”

Out of view

Mr. Aronson, agrees with Mr. Wagner about the underlying causes of hidden costs, but suggests that the investment industry itself may have a vested interest in keeping such costs out of view.

That’s because brokers that may have charged a 40-cent commission a share 25 years ago and now charge 6 cents a share have to make up for that loss somewhere.

Some brokerage houses have dealt with it by becoming more efficient and trading in higher volume, but others make up the difference by sending orders to their principal desk – selling stock out of low-priced inventory – instead of on the floor of the exchange.

Many mutual funds, however, are actively trying to come to grips with hidden costs. One of the best ways to cope is to keep assets from growing too big.

John Bogle Jr., manager of the $19 million Bogle Small Cap Growth Fund and president of Bogle Investment Management Inc. in Boston, says he is a big proponent of closing funds, especially small-caps, before it becomes difficult to buy or sell new securities.

Mr. Bogle also suggests using electronic communications networks to keep hidden costs down.

That’s because trades are done anonymously, making it much harder for day traders to figure out whether to jump in front of a sale.

American Century Investments in Kansas City, Mo., is one of the biggest users of ECNs. Greg Bokach, a senior equity trader with the company, says they have been very helpful in keeping transaction costs down.

In 1999, he says, the company estimates it saved more than $220 million using them.

Other companies such as Aim Advisors Inc. in Houston take a more traditional approach.

Kevin Cronin, head of domestic equity trading, says that although Aim does use ECNs, above all else his traders try to be as proactive as possible when a stock they’re interested in comes up.

No matter how a mutual fund company chooses to address hidden costs, however, it can’t do more than merely lessen their effect on mutual fund returns.

“There’s hidden costs in everything, but we’ve lessened them,” Mr. Bokach says.

“In a truly efficient world, there wouldn’t be an impact, but there will always be a cost of doing business.”