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July 2008 Mutual Fund Red Flags

These funds have big brokerage tabs.

Christopher Davis, 08/05/2008

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Costs matter. The more you pay, the lower the likelihood you'll get peer-beating performance. But the best-known and most-well-disclosed cost--the expense ratio--isn't the only one you should care about. In addition to the expense ratio, fund managers face another hurdle from the trading costs associated with implementing their strategies, which include bid-ask spreads, market impact costs, and brokerage commissions. While it's difficult to put a finger on the first two, we know exactly how much funds spend on commissions each year. Because they usually represent only the tip of the iceberg in total trading costs, you should pay close attention to funds that have paid a lot in commissions.

With that in mind, we trolled the Morningstar 500 universe for funds that pay an outsized share of their assets every year to brokerage commissions. To come up with our numbers, we looked at what the funds spent on commissions over the most recent 12- month reporting period and compared it with their average net assets over the period. Below are a few funds that caught our eye.

Manager Ken Heebner's concentrated portfolio and willingness to bet big on hot sectors may have gotten this fund more mentions in this column than any other. Well, you can add another reason to the list: Heebner's frenetic trading style. Turnover reached an all-time high in 2007, climbing to 384%, the equivalent of buying and selling the entire portfolio nearly four times in a single year. Not surprisingly, his fund paid the highest percentage of its average net assets to commissions of any fund in the Morningstar 500 last year, at 0.53%. Before you buy this fund, consider that the wild performance swings that stem from Heebner's approach should probably weigh heavier in your thinking than costs. This one should account for only a sliver of a diversified portfolio, if any. Brandywine BRWIX and Brandywine Blue BLUEX Bill D'Alonzo and his crew look for stocks that can beat quarterly earnings expectations, a short-term focused strategy that leads to high turnover, though it's far from Heebner territory. (It was 162% for Brandywine and 182% for Brandywine Blue last year.) As a result, brokerage commissions as a percentage of average net assets weighed in at 0.47% for the former and 0.33% for the latter for the year ended May 15, 2007. Some of those costs can be attributed to soft-dollars agreements, in which fund shareholders overpay on commissions in exchange for research. Still, we have confidence in management's intensive research process. Deep analysis and a quest for moderate valuations have led to topflight returns.PAGEBREAK

Managers Special Equity MSEIX
With six successful small-cap investors managing slices of this fund's portfolio, this offering has surface appeal. Yet the fund's 1.47% annual expense ratio is a fifth higher than the typical no-load small-cap fund, which already puts the fund at a disadvantage. That hurdle grows higher with relatively high brokerage costs, which clocked in at 0.32% of its average net assets for the year ended May 1, 2007. The result has been supbar long-term returns--the fund ranks in the bottom quartile of the small-blend category over all trailing periods.

Fidelity Select Technology FSPTX
Other tech funds such as Allianz RCM Technology RAGTX and T. Rowe Price Science & Technology PRSCX also racked up relatively high commissions-- but this one stood out. For the year ended Feb. 29, 2008, the fund's annual brokerage costs came in at 0.33% of its average net assets. Tech funds traffic in highly volatile stocks and generally trade a lot, and this fund is no exception. (Turnover was 204% in 2007.) The fund has also had a lot of manager changes, leading to even higher trading costs when new management makes changes to the portfolio. As far as tech funds go, this one has appeal thanks to its very deep research staff, but it's not a top-rate choice.

Christopher Davis is a fund analyst with Morningstar.

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