Author Archive

Life Settlements – a Good Investment or no?

Posted by  |  Comments Off

Life Settlements - a Good Investment or no?A life settlement is the sale of a life insurance policy by the owner to a third-party, typically for cash in an amount greater than the surrender value (why else would a person sell their life insurance policy?). The buyer assumes ownership and pays the premiums necessary to keep the policy solvent. Upon the death of the insured, the buyer of the policy receives the death benefit.

Generally speaking, life settlements are an option for policy owners of high net worth who are over 65. Independent estimates report that one in five policies in this group has a market value exceeding the cash value offered by the insurance carrier.

The market for life settlements started out on a rational basis. The original business plan for life settlements was to purchase unwanted or unneeded policies as an institutional investment from policyholders over 65 whose health had deteriorated more rapidly than the aging process would indicate. This primary factor established the mortality arbitrage necessary to make the purchase price higher than the policy’s surrender value.

Are life settlements a viable investment?

There are a number of pitfalls policyholders must consider before selling their policies, but if you are in the market to purchase life settlements, it’s important to consider a few details. First, the life settlement market has become quite active, indicating that the industry has convinced itself these life insurance policies are mispriced. As the industry has developed, it’s begun eying the policies of healthy insured individuals and labeling them as attractive targets as well.

Life settlement brokers have begun purchasing policies and repackaging them. These packages are then sold to small institutional and individual investors with the original message: these are unwanted policies from policyholders who are at least 65 years old and in unexpectedly deteriorating health. Unfortunately, all of the packaged policies may not adhere to the investment model.

This is what some in the industry refer to as ‘dumb money’ because the investors don’t know how to analyze the investment potential and they don’t understand that an accurate assessment of life expectancy is critical to this particular investment’s success.

Our Conclusion?

While the life settlement businesses started out as a worthy secondary market for limited situations, the market has gotten out of control. Huge, often hidden, fees and commissions have been assessed to these life settlement package investments. Add that to the misplaced understanding that these policies are all great investments and you have a poor reason to invest. In many cases, the insureds should not be selling their policy until it is about to terminate, and investors shouldn’t become owners of another person’s life insurance policy.

The return of Income Tax Breaks for Donations after 70 ½

Posted by  |  Comments Off

Making donations after 70 1/2The recent tax bill (enacted December 17th) had some good news for those age 70 ½ or older. A popular tax break for those who make charitable donations from their individual retirement accounts was resurrected. Under the new law, IRA owners who are 70 ½, can donate up to $100,000 per year from their account to one or more charities.

How donors benefit

Under the new law, which was first enacted in 2006, resurrected in 2008, and lapsed again in 2009, a donor receives no tax deduction for such charitable contributions, but they also don’t have to include the IRA withdrawal in their taxable income.

Essentially, that means the withdrawal will not inflate your taxable income. You can make donations from a SEP or SIMPLE IRA as well, provided no contributions were made into those accounts the same year as the gift was distributed.

Donate according to the rules

The rules further indicate that the donation should be issued directly to a public charity (we’ll talk about how to pick one in a minute). Private foundations, donor-advised funds, supporting organizations and charitable gift annuities do not count. The charity must also acknowledge the gift in writing.

Making the Most of your Charitable Donations

Posted by  |  Comments Off

Making your donation countIn a recent post, we described how to take advantage of a recently resurrected tax break for charitable contributions if you are 70 ½ and how best to research a charity so you know your money will be well-spent. In this post, we’re going to talk about ways to maximize your charitable giving (even if you’re younger than 70).

Focus your dollars

If you have a limited amount to give, experts say that it’s best to concentrate your giving on the charity that is most important to you. Not only does this make the decision-making process easier for you, it also gives you an easy out when other groups approach you for your dollars. Focusing your dollars means your cash will have a bigger impact.

Consider donating more than cash

Donating objects such as jewelry, automobiles, or the use of a second home can have just as big an impact as sending a check because those objects can be auctioned off for more money. Also, non profits nearly always need volunteers and there are many roles within a charitable organization to fill. You can ask your favorite charity what they might need in the way of time or other, and you can find opportunities at

Give while you shop

If you shop online, you can use a free portal called to send a percentage of your shopping dollars to a favorite charity – without changing the price tag of the items you buy. As an example, a $50 purchase with Famous Footwear generates $2.60 for the non profit of your choice. Register with and you get coupons and free shipping deals as well.

Avoid these losses and scams

Donations are diminished by 2-3% when you pay with a credit card because of card issuer processing fees. Even fund-raising sites take as much as a 4.75% cut when they process your donation. Pledging through a for-profit telemarketing firm can take as much as half your donation, so it is the most ineffective method of giving.

Look-alike websites are often set up with URLs and names that are very similar to charity organizations. These phishing sites are set up to steal your financial data and are very common right after a disaster, when people are more likely to open their wallets for the victims.

The most effective way and safest way to donate is to issue a check directly to the charity. Their website will have the address where you should send the check, but it can’t hurt to give them a quick call to double-check you have an accurate address just to be sure.

Filed Under: Charitable Donations

Get Acquainted with your Charity’s Financial Practices

Posted by  |  Comments Off

Researching your charityEven if you have a favorite charity, doing a little homework can reassure you that your donation is going to a good cause rather than lining the pockets of the charity’s executives.

  1. Look for an IRS-approved charity. Tax-exempt status means your contributions are tax-deductible, plus the IRS has become pretty good at weeding out bogus organizations. Of course, the IRS hasn’t become perfect at it yet, and so, you’ll want to continue with the next steps.
  2. Locate the charity’s Form 990. These forms are public information for any charity that earns more than $25,000. You can access charity tax returns through these evaluation websites: GuideStar and Charity Navigator. To get the Form 990 for any organization, you’ll have to register (for free) and conduct and Advanced Search. If you have the charities’ exact legal name, that helps.
  3. Check the charity’s excess or deficit. This is essentially their operating profit and loss statement and it’s likely you’ll want to see expenses that are pretty close to the revenue numbers.
  4. Check their net assets at the end of the year. This figure is the charity’s net worth as of that date. You might be surprised to find that number can be quite high, but ultimately you choose whether to add your donation to their pile or not.
  5. Check their functional expenses. This schedule tells you how much was spent on various categories for the charity’s services. In most cases, you’ll want to see expenses that are consistent with the charity’s stated purpose and mission. It’s also nice to see modest overhead numbers, but again, it’s ultimately your decision.
  6. Finally, check the salaries and other distributions to officers, directors, and employees. This doesn’t mean you have to avoid giving to a charity simply because the CEO makes over $100,000, however. According to Charity Navigator, the median CEO salary for charities with expenses between $3.5 and $13.5 million is $160,000.

Try not to fixate on charity ratings

The websites shown above: Charity Navigator and GuideStar have sprung into being to help donors evaluate a charity, specifically their administrative, employee, and fund-raising expenses. While it’s important to look at their ratings, it’s also important to understand that non profits have become experts in managing their rating. In the past, some have disguised fund-raising mail as ‘educational material’ or passed fund-raising costs along as charitable program expenses.

Of course, there’s also the other side of the coin: some charitable organizations earn lower ratings when they don’t deserve it. For example, groups with higher overhead, such as food banks, may have higher administrative costs because the provide a direct service to people in need.

Best method if you’re still unsure? Pick up the phone and ask the non profit to explain the numbers behind their rating. Speaking with an executive or financial officer – and be sure to ask specific questions – can tell you a lot about whether that particular non profit deserves your money.

Filed Under: Charitable Donations

To schedule or Not to Schedule? Protecting Your Valuables

Posted by  |  Comments Off

To schedule or not? Protecting your valuablesIt’s likely you know that if your wedding ring is stolen, most homeowner’s insurance policies will cover the replacement, but what you may not know is that homeowner’s policies include sub-limits of coverage for certain items and may entirely exclude other items. For example, your homeowner’s policy may limit jewelry coverage to $5,000 if stolen, and most policies do not cover mysterious disappearance, or just plain losing the item.

The best way to make sure your investment in jewelry, art, or any other valuable possession is protected is to designate a specific amount of insurance on that item. When that is done, the item is considered “scheduled” and it is protected.

Chris Ballard of the Ballard Agency in Bellevue has years of experience scheduling many types of unique, high-value items including—Chiluly Art, masterpiece paintings, Native American baskets and rugs, and varied collections including wine, coins, stamps, and even baseball cards.

Chris writes:

There are many advantages to adding special coverage for your jewelry.  One advantage is a greatly reduced or waived deductible.  Many people carry high deductibles on their homes, because they will never turn in a small claim.  However, when people lose, damage or have jewelry stolen the high deductible is far less appealing.  Scheduling an item provides greatly enhanced coverage, such as mysterious disappearance or loss of a stone from the setting.  It also presets the value, (called AGREED VALUE) so there is no debate over the amount you will receive should you need to replace something.

Another solution to avoid scheduling each item used by many insurance companies is the “Blanket Limit of Insurance” which allows you to buy a lump dollar amount for Jewelry or other items.  One way this can be used, is to “schedule” your high value pieces and buy a blanket limit of $20,000 for the remaining part of the collection.

While the additional cost of scheduling an item is not high, some companies offer a reduced rate when jewelry is kept in a vault, or if the stone has been “Gem printed” (marked with an identifiable number) to prevent stolen items from being easily sold.  Additionally, central station alarms also help with the rates on both your home and jewelry collections.

In order to schedule your jewelry, collectibles, or other expensive items, you should contact your insurance advisor.  Working with them and your advisory team, you can determine what items should be scheduled.  It should not be a cumbersome process.  If, however, you have a unique collection or item, you will be wise to work with your advisory team to have at least one other insurance specialist provide a quote because while most firms cover jewelry, not all insurance companies have experience with all types of collectibles.

Managing insurance and related risk management issues is an extremely important part of your integrated wealth management plan, which is why we advise reviewing insurance coverage at least every five years to ensure your types and levels of insurance are in line with your long-term objectives.

Talking with Mom and Dad Before it’s Necessary

Posted by  |  Comments Off

Talking with Mom and Dad Before it's NecessaryAccording to a 2006 survey of 1,000 people by Home Instead, Inc., an Omaha-based provider of in-home elderly care, as high as 42% of adults between the ages of 45 and 65 say that having ‘the talk’ with their parents is the most difficult discussion of their lives. Deciding when aging parents can no longer live on their own, and what their next step should be is often an agonizing one – for parents and for their adult children.

According to 2008 federal data, however, it is a crucial step because:

  • Approximately 70% of people over 65 are expected to need some long-term care services.
  • More than 40% of people over 65 are expected to spend at least some time in a nursing home (the average is three years).
  • And 20% of people over 65 are expected to need long-term care services for more than five years.

Putting together a planned strategy with your parents can be a great way to start the discussion. It can give Mom and Dad a way to define and explain their goals and needs. The strategic plan can define the factors that determine when it is appropriate to get in-home help or make the move to assisted living.

Timing May Be Crucial

While many seniors do fine at home, others need long-term care facilities or something as simple as a visiting home aid. Either way, it’s important to start such conversations early. The rule of thumb is “the 40-70 rule”, which means if you’re 40 or your parents are 70 then it’s time to start talking.

Concerns about dementia, of course, will put additional pressure on the situation. People with dementia are eventually unable to make decisions in their own best interests. In addition, they may begin to misinterpret what other people are trying to do for them. Seniors with dementia may become paranoid, depressed or so confused as to be incapable of taking care of themselves.

Having the talk with your parents before the danger of dementia is crucial to their safety. Plus, having a strategic plan in place takes some of the pain out of the decision-making process if that time comes.

Considering the Options

While some busy working adult children may feel pressure to push their parents into choosing the most efficient option, taking the time to discuss the options and encouraging their parents to stay independent as long as possible is nearly always the better choice. Not only is this the less costly option, it also keeps the elderly parent in familiar surroundings.

Parents may resist their offspring’s efforts to relocate them for a variety of reasons. It’s important for adult children to recognize that their parents have their own reasons for wanting to stay in their homes. Some parents worry their children and grandchildren will miss the family home. In some cases, they fear their close friends or siblings will be left alone. Spending the time to figure out what those reasons are will help everyone find the right solution, not just the most expedient one.

Not all elderly parents have to move into assisted living immediately either. In some cases, when elderly parents show signs of not taking care of themselves well, they may simply need some in-home help with cleaning the house or keeping up with the bills. When one parent dies, the other may show signs of not caring for themselves well. The surviving spouse may simply need more regular contact with friends and a social support system to stay motivated and engaged.

Update Jewelry Insurance to Reflect Rising Gold Prices

Posted by  |  Comments Off

Update Jewelry Insurance to Reflect Rising Gold PricesIn the past ten years, the price of gold has nearly quintupled and some experts are warning of another price bubble – one similar to the inflationary mania that impacted high-tech in the ’90s and the rise in residential real estate less than ten years after. Other experts are certain that gold has a strong position near $1,200 per troy ounce and could continue to rise into 2014.

While the dramatically rising prices for gold and other precious metals has helped many investor portfolios, it’s important to consider the impact on your jewelry. Adjusting your insurance to account for the higher prices is necessary – otherwise, you could be in for an ugly surprise if it has to be replaced due to loss or theft.

For those owning valuable jewelry collections, the price spike in gold has sparked an increase in prices of other precious metals, including silver and platinum. While most investors know the price of gold on any given day, they are far less likely to be aware of how the price of gold and other precious metals is affecting the value of their own jewelry collections. Gerald Escobar, principal of Asset Archives, recently indicated they had seen clients under-insured across all categories of valuable collectibles, including wine, fine art, antiques – and yes, jewelry. According to Escobar, clients who don’t proactively manage their valuables can be under-insured up to 40 or 60%.

  1. The first step in updating your jewelry insurance is to get an updated appraisal.
  2. Then, you’ll want to update your insurance coverage.

Update Appraisals

Clients need an updated inventory of their valuables if a loss occurs, and they should keep multiple photographs of their collections in a bank safe deposit box and at home. Accurate inventory record-keeping is vital to determining exactly what was lost and to obtaining an accurate claim settlement. An independent appraiser can be invaluable in determining current replacement value for your articles, including providing adequately detailed descriptions.

Update Coverage

With updated appraisals in hand, review your insurance policy to ensure you have adequate coverage. For exceptional items that were scheduled on a valuables policy, the value stated in the policy should be updated to reflect current replacement cost.

Top insurance companies offer valuables policies with a little extra protection for their clients, including:

  • Valuables policies with built-in buffers against market value appreciation. The additional coverage is a cushion in case market appreciation causes the coverage to be too low at the time of loss. For this buffer to be adequate, however, it must be periodically updated.
  • Valuables policies with built-in annual inflation adjustment. Of course, when gold prices are quintupling every ten years, their standard 2 or 3% increase simply isn’t enough protection. So, even with this protection, you’ll want to make periodic updates.
  • Some home insurance policies include higher sub-limits, such as up to $10,000 for jewelry, but these may still be inadequate if you own a gold bracelet originally purchased at $4,000 ten years ago, which is now appreciated to $16,000.
  • Many insurance companies allow grouping of similar valuable items, such as wine or art collections, to be covered under a blanket policy. With this approach, you would set a coverage amount for the entire collection without having to estimate the value of each and every item, making the overall policy easier to manage.
  • Valuables coverage also has the advantage of no deductible.

While you may need to increase coverage for your jewelry and other valuable items, you can manage the cost of your insurance by changing storage locations. It’s much cheaper to insure jewelry that is stored in a bank safe deposit box rather than at home. Clients with valuable jewelry that is infrequently worn should consider keeping those items at the bank. Use is on a limited basis, but that may well fit your needs anyway.

Finally, once you have updated your valuables coverage, consider scheduling a reassessment every three to five years as a rule of thumb.

New Estate Tax Rules for 2011 and 2012

Posted by  |  Comments Off

Estate tax rule changes for 2011 and 2012Last October, we wrote about the uncertainty around the estate tax and the potential changes that were coming depending on Congressional action. As you know, following the Tax Relief Act of (very late) 2010, that uncertainty has been laid to rest. In this post, we’d like to summarize the changes enacted by Congress at the end of 2010 and discuss a little about how those changes will affect you.

Regarding Estate Tax Rules, the following is a summary of the enacted changes:

  • The estate and generation-skipping transfer taxes were phased out and fully repealed in 2010.
  • The gift tax rate was reduced to 35%.
  • The gift tax exemption was increased to $1 million for 2010.
  • The estate and generation-skipping transfer taxes for 2011 and 2012 were reduced from the top rates of 55% to 35% and the exemption amount was increased from $1 to $5 million (as indexed after 2011).

Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate, gift, and generation-skipping tax rules were set to automatically reinstate in 2011 unless Congress enacted changes before 2011. That would have meant the estate tax rates returning to the rates of 2001, with with the top estate and gift tax rates reverting to 55%!

Some additional technicalities that were included in the Tax Relief Act include, but are not limited to, the following:

  • For gifts made after December 31, 2010, the Act reunifies the gift tax with the estate tax and allows an application exclusion amount of $5 million with a top estate and gift tax rate of 35%.
  • The Act also provides that the generation-skipping transfer tax for descendants dying or gifts made after December 31, 2009 is equal to the applicable exclusion amount for estate tax purposes. Specifically, up to $5 million for 2010.

This means that up to $5 million in generation-skipping transfer tax exemption may be allocated to a trust created or funded during 2010. Although the generation-skipping transfer tax is applicable in 2010, the tax rate for transfers made during 2010 is 0%. The generation-skipping transfer tax rate for transfers made in 2011 and 2012 will be 35%.

Life Insurance – an Investment for Life

Posted by  |  Comments Off

Life Insurance - a golden egg or waste of money?While most people understand the primary idea behind life insurance – wage earners spend a little each month on a life insurance plan so that if they die, their dependents can enjoy some degree of financial security without their income – most do not understand the whole picture. For example, do those who are financially secure need life insurance?

Most individuals will say no, but the experts say, yes!

Traditionally life insurance is an investment because of the death benefit. Unlike equities, life insurance is a (some would say heavily) well-regulated industry that guarantees eventual payout assuming the client pays the premiums – an advantage that may not have sounded important a few years ago, but is likely more appreciated by everyone studying their equity portfolios today.

Life Insurance Advantages

In general, financial advisers see life insurance as a long-term investment useful to most of their clients. Life insurance has three primary advantages over other types of investments:

  • certainty
  • liquidity
  • favorable tax treatment

Let’s go over each of these advantages in a little more depth.

The question about certainty, that is whether life insurance will pay out or not is invalid, of course. The real question is how much the policy will pay out. As you well understand, the sooner the insured dies, the better the return on investment – this is the perverse truth about life insurance, and it’s true even for the types of policies used as investments, those that are whole life insurance policies. These require the insured to pay relatively higher premiums while they are young – to offset, of course, a potential payout if it becomes necessary. With these policies, part of each premium (the monthly cost of the policy) is isolated as cash value. This cash value is eventually used to keep premium costs lower as the person grows older. These cash values grow tax-free over the life of the policy and continue to remain so unless the owner makes a withdrawal while they are alive.

Life insurance is considered liquid because the insurance company is obliged to pay the proceeds as soon as a claim is filed. It’s also considered liquid because life insurance, in general, sidesteps probate. Liquid cash always has an advantage because it can be used immediately to buy things and it’s of particular advantage for an estate. Without that liquid cash, heirs may be stuck trying to pay estate taxes and may be forced to sell substantial property or other assets in order to pay them. So, having the balance of the life insurance proceeds can often mean significant savings for the insured’s heirs.

Lawmakers see life insurance as a hedge against catastrophic loss rather than a true investment and so it has retained, over the years and over the passing administrations, significant tax advantages. Specifically, all of the cash value collected in a permanent life insurance policy grows tax free. This includes the cash value in policies that move away from the classic life insurance model and instead serve as a wrapper for equity investments. This wrapping method can be especially useful for wealthy or affluent investors who invest their money in hedge funds, because short-term trades don’t benefit from low capital-gains rates. In almost all cases, life insurance can be passed on to heirs tax free as well. With federal estate taxes slated to return in the near future, those who want to avoid that particular tax may find setting up a special life insurance trust with a trusted individual as trustee will give them additional tax benefits. With the buyer/insured no longer in direct possession of the policy, it is not included in their estate and the proceeds of the policy can be distributed free of tax.

Other Advantages of Life Insurance

Life insurance policies also help those in the position to make large donations or gifts during their lifetime. In most cases, such transfers are subject to a gift tax, but an additional advantage of a life insurance trust, is that it accumulates cash over a rather long time. That is, over the life of the insured. When properly drafted, a life insurance trust can benefit from an annual contribution up to $13,000 for each beneficiary without being subject to gift tax. Those annual contributions are allowed to grow tax free and can eventually become a fairly significant sum. With the proceeds passing on without being subjected to additional income, estate, or gift taxes, it’s an excellent method for distributing comfortable sums of cash to your heirs. Of course, the key to this method is getting started early.

When you are making large contributions to a life insurance trust later in life, the gift tax will not be too great because the amount of the gift isn’t the amount the policy will eventually pay out, but rather the amount needed to pay the premium for a particular term. Also, the gift tax can be reduced even further by implementing some complicated planning techniques. Instead of paying the gift tax yourself, for example, you might loan the money to your life insurance trust to do that for you. This is only useful when interest rates are at favorable rates because you wouldn’t normally want the trust to have to make big interest payments (and interest-free loans are strictly limited under the tax code). With interest rates currently at rock bottom, you could loan the money to your trust for very little.

If you loan the insurance trust the money to purchase the policy outright, you could avoid the gift tax altogether, but that would require a larger and potentially costly loan.

Short-term Life Insurance – useful or no?

While the benefits of long-term, or permanent, life insurance are clear, the benefits of short-term policies is more debatable as it eliminates many of the advantages held by long-term life insurance. One of the advantages of permanent life insurance is that you can still indirectly access the policy’s current value – even after you have formally given it to a trust. This is because the trustee can always borrow against the cash value of the policy and loan you that money. If you don’t pay the money back, the depleted cash value may mean insufficient funds to completely pay the premiums on the policy in later years, which ultimately reduces the payout. On the other hand, individuals setting up life insurance trusts can take comfort in knowing their money is available if they absolutely need it – a technique that is not the case for many estate-planning techniques.

Some investors ‘overfund’ their life insurance policies with more cash value that is needed. Some experts consider this a useful investment technique because it avoids income taxes, and others aren’t so sure because there are other forms of financial planning that are far less cumbersome and don’t involve the charges imposed by many insurance companies. Rarely, however is an estate plan created without a life insurance component. With estate taxes set to return to over 50% soon, affluent investors would be well served to look into life insurance for a life investment.

What does it cost to own a mutual fund? More than you’d like.

Posted by  |  Comments Off

How can investors know the real cost of a mutual fund?Executive Summary of article:

  • “… the average investor can’t begin to get an understanding of the costs due to the lack of information.”
  • Studies show that the average mutual fund costs between 2% and 3% per year.

According to Morningstar, Inc., most U.S. stock funds pay an average of 1.31% of assets to the portfolio manager each year in addition to other operating expenses. Other costs related to the buying and selling of securities are not reported in the expense ratio and those expenses can make a fund 2-3 times as expensive as advertised.

What exactly are the costs of owning a mutual fund?

There are four primary costs that affect a mutual fund’s price. These are:

  • Bid-ask spreads. These represent the gap between the lowest price at which a seller is willing to sell and the highest price the buyer is willing to pay. When the fund does a lot of trading on less-liquid holdings, such as small stocks, these costs can add up quickly.
  • Broker commissions. These are the commissions paid to the brokers who operate the fund. The SEC requires three years of these costs to be disclosed in a fund’s statement, but the SEC does not require them to be factored into the expense ratios.
  • Market-impact costs. These last two are often the largest component affecting trading costs. They occur when a large trade changes the price of a security before the trade is completed.
  • Opportunity costs. Opportunity costs occur when the impact of a trade inhibits a fund manager filling an order on their desired terms.

This results in either a less-favorable price or fewer shares transacted.
While it’s very important to look at the expense ratio before purchasing a mutual fund, it’s also important to understand that that number is not going to capture all the costs.

What do the experts say?

Richard Kopcke, an economist at he Center for Retirement Research at Boston College recently co-wrote a study about the fees and inherent trading costs of retirement funds, such as 401(k)s. Kopcke’s study reviewed the 100 largest U.S. stock funds held in retirement plans as of December 2007 and found that annual trading costs averaged from 0.11% in the quintile with the lowest costs up to 1.99% of assets in the quintile with the highest costs. The median was 0.66%. Kopcke’s conclusion was that the average investor can’t begin to get an understanding of these additional costs due to the lack of information.

Another study updated last year by Richard Evans, associate professor of finance at the University of Virginia’s Darden School, put the average trading costs of thousands of U.S. stock funds at 1.44% with an average of 0.14% in the lowest quintile and 2.96% at the highest. Evans’ conclusion was that high trading costs tend to have a negative impact on fund performance. On average $1 in trading costs decreased net assets by 46 cents in this study.

Stephen Horan, head of professional education content and private wealth at CFA Institute, a non profit association of investment professionals estimates that trading costs for stock funds total 2-3% of assets annually although conservative reported estimates put these costs closer to 1%. According to Horan, these transactional trading costs are very real and unfortunately, the expense ratio just does not capture all of the costs.

How can this be happening in these times?

One reason trading expenses are unreported is due to the complexity. That complexity leaves fund companies in disagreement about how to calculate the costs. Even fund experts have trouble coming up with estimates that are similar.

Of course, another reason is that fund firms aren’t all that anxious to disclose their costs either. The SEC tries to revisit this issue every few years, but it still hasn’t come to a conclusion or established a set of rules.

All of this leaves investors in the dark about the true cost of their mutual funds.

Where are we on the disclosure debate?

In 2003, the SEC indicated to Congress that trying to include all trading costs in the expense ratio would produce a number that was not comparable, and it would vary from fund to fund. There simply isn’t an agreed-upon methodology on how to quantify implicit transaction costs such as market-impact costs. Therefore, requiring fund managers to disclose total trading costs would result in investor confusion.

While nearly everyone agrees that investors are entitled to and should have that information, until the methodology is developed there will be a lot of larger companies who pay trading-cost consultants to estimate their trading costs, but midsize and small investment managers who can’t afford to pay accountants will continue to wait for the methodology to be developed.

Get Clues from the Turnover

Meanwhile, investors can get clues from a standard albeit imperfect measure of how much trading the fund is doing. This is called the turnover, and it shows at what rate stocks are being replaced in the fund. This is an imperfect measure because some stock funds that have a lot of new money coming in don’t have to sell to generate cash. In this case, their turnover rate would be zero even though the fund is likely buying a lot of stocks.

Last year, the SEC voted to require fund companies to disclose one year of turnover and move that information to the front of a prospectus. Turnover of more than 100% can indicate that the hidden trading costs may be on the high side. Of course, there can be a number of factors that impact turnover during a given period and turnover can vary over time. Still, it’s a clue as to the hidden trading costs that are undisclosed.

« Older Entries