Funds of Funds Facing Expense Ratio Rule Change

NEW YORK -- Mutual funds that invest in other funds can bring diversity to a portfolio, but can also add layers of expenses. A new rule requiring so-called funds of funds to tabulate costs from underlying funds could result in surprises for some investors.

Previously, funds were required to list only the expenses added at the top _ the funds of funds level. Under the new rule, which takes effect with the new year, investors could see expense ratios of their funds of funds jump.

While advocates say it adds an important layer of transparency, managers of some smaller funds of funds are crying foul, saying the rule will paint their funds as more expensive than they essentially are.

"In many cases, funds of funds have layering of fees taking place. This will help provide investors with a better understanding of the actual costs of investing in a fund of funds," said Susan Ferris Wyderko, executive director of the Mutual Fund Directors Forum, an organization for independent mutual fund directors.

"It's the actual cost of investing as opposed to hiding some of the expenses," said Wyderko, who spent 20 years at the Securities and Exchange Commission.

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Wyderko said investors will have an easier time determining how much will be lost to expenses with various funds.

Opponents argue that the disclosures will penalize funds of funds by making their expense ratios appear disproportionately large. They argue the expenses in the underlying funds are already reflected in the net asset value of those funds.

"It already has a fixed expense rate included in there," said Curtis Teberg, manager of an eponymous fund of funds. "I'm not paying $10 a share plus 50 cents per share in administration fees," he said, referring to his costs when buying shares of a fund.

He said the Teberg Fund, whose assets total $136 million, will see its reported expense ratio jump to about 4 percent from 2.33 percent.

"I think it's a great disservice. It will kill this type of product. This indicates to the people that we're a greedy part of the industry and we're not."

Teberg expects only several dozen funds of funds to be hurt by the rule change, as the bigger players can more easily hold down costs or use proprietary funds.

Andrew Gogerty, an analyst at Morningstar Inc., which rates funds, dismisses the argument that the just because expenses of an underlying fund are reflected in its net asset value the expenses shouldn't matter. "The (net asset value) is calculated after the expense hurdle," he said.

"If investors have a potential idea about what type of hurdle they have when they buy an investment they can better evaluate the manger's potential to help them meet their investment objective."

Many larger funds of funds, like those run by Vanguard Group, won't show a change in their expense ratios as many of the funds of funds they offer are built using in-house products. Vanguard's Total International Stock Index fund, for example, doesn't impose expenses of its own. The fund is made up of other Vanguard funds and the company can therefore simply absorb administrative costs for running the fund of funds.

Advocates contend the gains in transparency are worthwhile.

"Just about everyone in the industry says, 'You really don't expect me to compete with Vanguard on price do you?"' said Jeff Tjornehoj, an analyst at fund-tracker Lipper Inc. "The motivation for investors is, 'I'll pay a little bit more but you better deliver for it.' If you're in a fund of funds that's in some rather expensive funds, then you better be a good allocator to justify the level of expense."

Jeffrey J. Unterreiner, who manages the Opti-Flex Fund, a small fund, is somewhat concerned about losing investors though he contends the fund's returns justify the expenses.

"I think we are a more expensive approach to managing money," Unterreiner said. "With a traditional mutual fund you're paying for security selection. With our investment approach you're paying for security selection and asset allocation."

The expense ratio of the Opti-Flex Fund is about 2.4 percent. Unterreiner expects it might rise about a percent under the new rules, though he said some investors likely would already have passed up the fund given its current expense ratio.

"I could field a baseball team pretty cheaply, but I'm probably not going to win a lot of games or put a lot of people in the seats," he said of running a fund and focusing too much on expenses rather than returns.

He said his results justify the costs. The fund, whose assets total about $6.5 million, is up 16.6 percent for the year, an average of 14.9 percent in the past three years and an average of 10.7 percent over five years, though Unterreiner didn't manage the fund for the entire five-year period.

"Obviously, over the time period if I've been doing the management we've added value. And that's really the only reason we offer our services to anyone."