- here's what it means in calculating expenses:   Trading Costs (use a low-end figure) x Turnover = Total trading costs. So, 0.6% x 2.2 = 1.32%.

Why use the 2.2 factor for a 120% turnover? Simple: You have to `establish' a position in a security before you can turn it over; and, that's true for each security in the portfolio. The entire portfolio is established, then 120% is `turned over' in a year.  

You should add this figure (1.32% in our example above) to the fund's annual expense ratio to get combined annual expenses plus trading costs.   According to Morningstar, the typical equity fund has annual expenses of 1.4% annually.   1.32% in trading costs plus the 1.40% annual expense ratio gives a total of 2.72% in true costs.

Are we done?  Not at all.

There are also `market impact costs' to consider, and these are NOT disclosed.  What's market impact?

When you or I sell 100 shares of a security, it doesn't really impact the price. But, when an institutional investor buys or sells huge blocks of a security, the price can be affected. How much? According to Business Week magazine (4/3/2000), market impact costs can range between 0.15-0.25%!  

You guessed it: The market impact of each trade is multiplied by turnover, too. So, using the low-end market impact cost in our hypothetical, we'll apply the turnover factor: 0.15% x 2.2 = 0.33%.   Add the 0.33% to our 2.72% and we can estimate the true costs (disclosed and hidden) of our fund.

So our hypothetical fund with a 1.4% annual expense ratio that experiences a 120% annual turnover could actually be costing the shareholder 3.03% annually, quite a bit more than the 1.40% expense ratio disclosed in the prospectus.   Hmmm.

Annual Expense Ratio                                                         1.40%
Turnover 2.2 x 0.6%                                                             1.32%
Market Impact Costs2.2 x 0.15%                                          0.33%
Total                                                                                  3.05%

Is that bad? It depends! Some managers may be worth an extra 3.05%. Some aren't worth a penny. Few, if any, can consistently outperform their own index.  And, most investors don't know how to do the math.

Think about it. For a manager to tie an index that went up 10%, for example, the manager would have had to achieve a 13.05% return! You may think that's only 3.05% over the index, but you'd be wrong. 3.05% over 10.00% is actually outperforming the market by 30.5%! No wonder so few managers outperform and virtually none can do it consistently.

It's like anything else: Value is relative. But, it's too bad that most investors see only the annual expense ratio and assume it's everything they pay. As you can see from this hypothetical yet realistic example, disclosed annual expenses can actually be less than half of the total investors really pay!

That's not all. Go pull out your last mutual fund statement that you received. I'll wait.   Read it carefully. Do you see any of your expenses and fees enumerated in dollar terms? ANYWHERE?

No fee deductions anywhere at all? Do you suppose it's free?

Of course not. They just adjusted the fund price - the NAV - after the deduction of all costs and expenses so your costs are `hidden' in the price of the shares.

Interesting, huh?

Here's a paper (Understanding Mutual Funds) you can download that discusses mutual funds in more detail.  Enjoy!