Checklist for finding hidden costs in fund documents

A fund's headline expense ratio shows the ongoing cost of running the fund, but it is rarely the whole story. Sales charges, short-term redemption fees and the costs of trading inside the portfolio can each reduce what an investor keeps, and not all of them appear in the number printed on the first page. Most of these costs are disclosed somewhere in the fund's documents. The challenge is knowing which document to read and which line to check.

The sections below separate costs into three groups: charges paid when you buy or sell shares, costs generated by trading inside the fund and the places where each cost is described. The final section ends with a checklist to work through for every fund you compare. Convert each percentage into dollars using a hypothetical investment of 10,000 dollars, because a percentage is easier to judge once it becomes an amount you could see on a statement.

Sales charges and redemption fees

A sales charge, often called a load, is a fee that pays the people who sell or service the fund. A front-end load is a percentage taken out of your purchase before the rest is invested, so a 5 percent load on a 10,000 dollar purchase leaves about 9,500 dollars working in the fund. A back-end load, sometimes described as a contingent deferred sales charge, is charged when you sell and usually declines the longer you hold the shares. Some funds also charge a redemption fee on shares sold within a short period after purchase, often as a way to discourage rapid trading.

Sales charges are frequently reduced for larger investments through breakpoints, and the prospectus should describe the thresholds. Ask whether your investment qualifies for a discount and whether accounts held by the same household can be combined to reach a threshold. Funds can also offer several share classes with different fee structures while holding the same portfolio. The same investment can therefore cost different amounts depending on which class you buy, so confirm the class before you invest rather than after. Investors who buy exchange-traded funds also pay the bid-ask spread and any commission on their own trades.

Trading costs inside the fund

Some costs never appear as a line in the fee table. When a fund buys and sells holdings, it pays brokerage commissions where they apply, and it generally pays the bid-ask spread, which is the gap between the price a buyer pays and the price a seller receives. Large trades can also move prices against the fund, a cost known as market impact. These expenses reduce the fund's returns even though they are not part of the expense ratio. Funds that trade more often generally incur more of them. Because these costs are harder to see than the expense ratio, comparing two funds only on the headline fee can overstate the advantage of the cheaper one when it trades far more heavily.

The portfolio turnover rate is the best starting point for judging how much trading a fund does. The prospectus reports the percentage of holdings replaced during the fund's most recent fiscal year. A high turnover rate does not prove a fund is expensive, and a low one does not guarantee low trading costs, but it signals where a closer look is warranted. Turnover also matters for taxes, because gains realized through trading can be distributed to shareholders who hold the fund in a taxable account.

Where to find each cost in the documents

Fund documents are long, but cost information is concentrated in a few places. The summary prospectus is a short document that usually contains the fee table and an expense example. The full prospectus describes sales charges and fund policies in more detail. The statement of additional information covers further details, including brokerage practices, and the annual and semiannual reports contain financial statements where some trading costs may be reported. Use the following checklist for each fund you compare.

1. In the shareholder fees section of the fee table, note any front-end or back-end sales charges, redemption fees and account fees.
2. In the annual fund operating expenses section, note the management fee, any distribution or service fee and the total annual operating expenses.
3. Check for acquired fund fees and expenses, which apply when a fund invests in other funds and can add costs not included in the main line.
4. Read the footnotes for fee waivers or expense reimbursements, and note whether each waiver is temporary.
5. Use the expense example to see the dollar cost of a hypothetical 10,000 dollar investment over one, three, five and ten years.
6. Note the portfolio turnover rate, then look for reported brokerage commissions in the statement of additional information or the annual report.
7. Confirm the share class and any breakpoints that apply to the amount you plan to invest.

Once you have the figures, compare total costs across funds with similar goals and similar strategies, rather than setting a low-cost fund beside one that does something very different. Costs are one input to a decision, not the whole decision, and a fund's documents cannot tell you whether its strategy will suit your goals. For a significant investment, a qualified financial adviser can help you read the documents in the context of your full situation.