While the Securities and Exchange Commission's new rule requiring greater transparency in the costs of funds-of-funds is geared at protecting those saving for retirement, it could mean more headaches for managers of smaller, non-proprietary funds.

The rule requires funds-of-funds to include not only their own operational costs, but also those costs associated with their underlying funds in their expense ratios, thereby bringing data that, in the case of proprietary funds, is buried in the prospectus to the forefront.

As expense ratios-although not necessarily overall costs-jump category-wide, smaller funds that want to survive are going to have to work even harder to distinguish themselves from industry giants, better articulate their value and perhaps re-examine the composition of their funds.

"It will certainly stifle this part of the industry from growing," said Curtis Teberg, manager of the $36 million Teberg Fund in Duluth, Minn.

But is was the breakneck growth of these funds that incited the SEC to pass the rule, which took effect last week, in the first place. In the five years since Teberg launched his fund, the number of funds-of-funds has increased from 200 to nearly 2,000. Meanwhile, assets in these funds more than doubled from $123 billion in 2003 to $306 billion by the end of 2005, according to the Investment Company Institute.

Lifecycle and lifestyle funds account for the majority of new funds-of-funds. The automatic enrollment and allocation provisions allowed by the Pension Protection Act of 2006 all but ensure that these easy to explain and, therefore, easy to sell products' popularity will continue to surge.

As these products' popularity has increased, so has regulators' scrutiny. They noticed that in an effort to attract investors, some larger companies that bundle together proprietary funds reported expense ratios as low as 15 basis points. While those fees essentially cover the price or advertising and distribution, regulators worried they omitted the fees that large companies were collecting on underlying proprietary funds.

What's worse, the old expense ratios gave investors no easy way to compare costs between competing products, according to Susan Wyderko, executive director of the Mutual Fund Directors Forum in Washington.

Now, by giving investors a complete picture of a fund-of-funds' cost, "it heightens the awareness and focus on expenses," said Jeffrey Keil, principal of Keil Fiduciary Strategies in Denver, Colo.

For those who had invested in products offered by companies like Vanguard and Fidelity, the new expense ratios could be quite a revelation. Some no-load funds that previously reported extremely low or no expense ratios on proprietary funds-of-funds might suddenly show expenses between 60 and 100 basis points. Meanwhile, investors in funds-of-funds with different share classes could suddenly see that the true cost is not 80 basis points, but 1.8%, said Marc Fowler, vice president of The Online 401(k) of San Francisco.

"Projecting out an extra 50 basis points over 20 years could mean hundreds, if not thousands of dollars," Fowler said.

But managers like Teberg, whose fund includes no proprietary funds and targets the retail, rather than the retirement market, say including these costs puts them at a competitive disadvantage.

Of the 507 actively managed funds-of-funds Lipper lists in the marketplace, Teberg believes there are truly only a few dozen like his-run by independent managers with no proprietary funds to draw from.

He argues that his 2.23% expense ratio already includes all the costs of buying, selling and owning his underlying funds. Asking him to add the expenses of those funds into his ratio is akin to asking a traditional large-cap fund manager to add in all the costs of the underlying operating companies that make up General Electric when he buys shares of that blue chip. More importantly, the new rule will require him to report a fund ratio of close to 4%-even though his actual expenses won't change.

"There isn't a brokerage firm that will recommend that," he said. "You just have to sit there and say, How do I overcome this?'"

One way is by replacing high-fee funds with cheaper alternatives, such as exchange-traded funds. The Teberg Fund, for example, has increased the proportion of less expensive ETFs it holds over the past year.

Another strategy is to focus on marketing, said Geoff Bobroff, president of Bobroff Consulting in East Greenwich, R.I.

"Traditional brokers are not as inclined to buy fund-of-funds," Bobroff said. "They are more likely to build their own." Usually, these products take the form of a separately managed account, in which the broker picks the components, packages them as a wrap and adds his own fee. But building such products, and getting necessary approvals, requires time and staff. Savvy fund-of-fund managers can package their products as less expensive, ready-to-sell wraps, he said.

Jeffrey Unterreiner, manager of the $6 million ThomasLloyd Opti-Flex Fund based in St. Louis, Mo., sees building strong relationships with financial advisers as critical. "There does need to be some face-to-face explanation on not just the expenses, but the strategy," he said.

Funds-of-funds overall are an expensive vehicle, he added. Data from October shows that even before the rule change, Opti-Flex's expenses ran between 1.65% and 2.40%, depending on the share class. But good managers add significant value, said Unterreiner. "You can buy an index fund and get average performance pretty easily," said the manager of the nine-year old fund. "But we're aiming for above-average."

Keil agreed that while advisers and brokers will be concerned about the cost to their customers, a higher than average expense ratio will not mean automatic elimination if the product design is unique, and most importantly, the performance is stellar.

Lipper Senior Research Analyst Jeff Tjornehoj doesn't expect the newer, higher expenses to take many financial professionals by surprise, or force them to pull their clients out of the funds, either. "[Some] I'm sure have calculated these figures already in a back-of-the-envelope way," he said. "This is just better disclosure."

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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