Under current SEC rules and Generally Accepted Accounting Principles (GAAP), the brokerage commissions actually paid by a mutual fund are not disclosed as an operating expense, or in the expense ratio calculation provided to investors. Instead, the cash amount paid for brokerage commissions is disclosed annually in a fund's Statement of Additional Information (SAI), which is an SEC filing that is a supplement to the Prospectus. Unfortunately, this number has little value to an investor unless it is compared to the average net assets of the mutual fund and converted into a percentage ratio.
The difficulty of properly measuring transaction costs is further complicated by the fact that mutual funds do not always pay a cash commission to transact in portfolio securities. For example, stocks purchased on the NASDAQ exchange and many bonds are commonly traded via a bid/ask spread, with brokers and other transaction intermediaries being compensated by the difference between the price offered by the buyer (the "ask") and the price offered by the seller (the "bid"). This price spread "cost" is not considered a cash commission payment and so it is not disclosed in the Statement of Additional Information. Instead, the higher price paid by the buyer and the lower price received by the seller are reflected in a fund's capital returns over time.
Another measurement problem in this area is how to evaluate the indirect costs of trading assets in a portfolio. For example, a mutual fund which seeks to purchase a large block of an illiquid security may have a "market impact" cost if its own actions raise the price of the security, as it accumulates its position. Similarly, a mutual fund which expects to have a certain level of redemptions in its shares may need to retain a larger cash balance, creating an "opportunity" cost for this uninvested amount. This "opportunity" cost will be higher for those funds with excessive market timing activities, thereby reducing the returns of longer-term shareholders.
CMFI believes that the SEC should develop a standardized transaction cost measure that is accurate, comparable, and not overly burdensome for mutual funds. However, this process may take several years to complete and, in the interim, something should be done to improve the disclosures that investors now receive of portfolio transaction costs.
CMFI has recommended to the SEC that it act immediately to require better investor disclosure of the actual brokerage commissions paid in cash by each mutual fund, a dollar figure that is currently disclosed--as noted above--in a fund's Statement of Additional Information. For comparison with other funds, this figure should be converted into a percentage of average net assets of the fund and disclosed as a transaction cost ratio. Since transaction costs are not a GAAP expense and are not included in the expense ratio of a fund, CMFI believes that the simplest approach for the SEC to consider is to present these costs as a separate ratio.
An obvious flaw in the calculation of this proposed ratio is the fact that it does not include bid/ask spread transactions. CMFI has developed a proposed method for calculating the "cost" to the fund of bid/ask transactions and this amount would be added to the formula for converting cash commissions into a transaction cost ratio.
This transaction cost ratio would provide an estimate of a mutual fund's transaction costs and be used as an interim measure to improve the information available to fund investors. This approach is preferable to waiting until the SEC has developed a methodology to calculate and disclose fund market impact and opportunity costs in a standardized and comparable manner.
As legendary investor Warren Buffett is fond of saying: "It is better to be approximately right than precisely wrong."