There are hidden costs that are very hard to assess: The cost of turnover in a Fund offered to participants in a 401(k), or other type of participant-directed plan, ⁽¹⁾ can be quite high. Also, "Pay-to-Play" arrangements between consultants and investment managers need to be looked at very carefully.

What is Portfolio Turnover? Simply put, it measures how often, in one year, a fund buys and sells securities equal to the total value of the fund. The prospectus won't tell you. Research services like Morningstar report on turnover but do not try to calculate the effect on the portfolio's performance. That's a tough job to say the least.

A rule of thumb you can use, backed up by academic studies, is that the cost of one "turn," or selling and buying securities equal to 100% of a portfolio's value, is 0.60% or 60 basis points⁽²⁾ . That is, if a fund has $1 billion in assets and 100% turnover in a year, the cost for trading, execution and so forth could be $6 million. At 200% turnover, the number is $12 million; at 300%, $18 million PER YEAR. Another way to assess it is to compare the return of a fund against an Indexed Portfolio or fund. If your fund is consistently performing only in line with an indexed portfolio, you may want to ask why you're paying for the management, which includes portfolio turnover.

Keep in mind, however, if you're trying to estimate the cost of owning a particular fund, you can consider the theoretical cost of turnover as an added cost but you need to be careful. The cost of turnover, while not reported, is, by definition, already in the reported investment results. It shouldn't be deducted or used to adjust the funds returns in any way. In my practice, I don't give a great deal of weight to turnover unless almost all other factors are equal in evaluating two or more fund choices.

"Pay-to-Play" Arrangements are understandings and practices, if not outright agreements, in which a supposedly "independent consultant" consistently recommends or introduces investment managers and other vendors who, by various but indirect means, pay to support, underwrite or subscribe to publications, research, conferences or other activities or services the "independent consultant" offers. In other words, there's a, usually implicit, "quid-pro-quo" in place. Once again, this is a touchy and very gray-area, especially in the 401(k) and other participant-directed plan markets.

As a plan sponsor, you need to ask for a detailed description of the process a vendor or provider employs to determine which funds, including their own, are offered as part of the fund line-up to not only your plan but to ALL plans they service. Although plan vendors will, in varying degrees of detail and honesty, describe their process for selecting funds to offer, I can say, based on nearly 20 years experience, that UNLESS a consultant or platform provider will state in writing that it receives NO FEES OR ANY OTHER FORM OF COMPENSATION, no matter what other criteria are used by a plan vendor, how much a fund company will pay the vendor is almost certainly a factor. It's just the reality of this business. I'll discuss the ethics of this kind of "revenue sharing" later in the series. Next time: "The Dirty Little Secret" of the 401(k) business.