Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Wilmington Small Cap Growth Fund (ARPAX) is in the Danger Zone this week. Deceptively high costs coupled with poor holdings make it difficult to expect this mutual fund to make money for investors.

Normally I don’t write about ultra expensive funds because they have so little in assets. As detailed in “Cheap Funds Dupe Investors”, investors are typically very good at avoiding expensive funds. Most very expensive funds have less than $30 million in assets, and often as low as $4-5 million.

With $136 million in assets, ARAPX has gathers a significant amount of investor money. So why are investors flocking to a fund whose total annual costs of 8.51% are the highest out of 357 small-cap growth funds?

The answer is that the costs are charged to investors in less-than-obvious way. There is not a high expense ratio. ARPAX hits investors with a heavy front-end load and massive transaction costs.

ARPAX’s expense ratio of 1.47% is fairly reasonable. Morningstar rates the fee level of ARPAX as “Average”. Their analysis simplistically overlooks the other costs of investing in this fund.

Front-end load is a nasty cost because it hurts investors in two ways. The initial one-time cost is obvious, but investors also incur the opportunity cost of less money in the fund to earn future returns. In other words, by reducing the principal investment, front-end charges permanently impair the future returns to investors.

ARPAX has a front-end load of 5.5%. Assuming a three-year holding period (the average length of investment in mutual funds), this front-end load is costing investors 2.1% per year.

As bad as ARPAX’s front-end load is, it charges investors more than twice as much in transaction costs. With an annual portfolio turnover ratio of 561%, it has estimated transaction fees of 4.74% annualized over three years.

Contrast this with the 0.05% annualized transaction costs (with no front-end load) for our highest rated small-cap growth mutual fund, Virtus Equity Trust: Virtus Small-Cap Core Fund (PKSFX). PKSFK achieves these low transaction costs by having an annual portfolio turnover ratio of only 10%. There are plenty of other funds out there that don’t pass on to investors the massive trading costs that ARPAX does.

Combining ARPAX’s expense ratio, front-end load, and transaction costs, you get a total (all-in) annual cost of 8.51% annualized over three years. This means ARPAX must outperform its ETF benchmark [Shares Russell 2000 Growth (IWO)] by 8.21% annually over three years before all costs to create value for investors.

That kind of performance is a lot to expect from any fund, especially one with as poor holdings as ARPAX. Over 28% of its assets are allocated to stocks that receive a Dangerous-or-worse rating. Clearly, the fund manager’s strategy of high turnover is not resulting in an optimal portfolio.

Investors Real Estate Trust (IRET) is one of my least favorite companies held by ARPAX and earns my Very Dangerous rating. IRET has a return on invested capital (ROIC) of 5%, in the bottom quintile of companies I cover. In the ten years that our model covers for IRET, it has never generated positive economic earnings. Despite this poor performance, IRET’s valuation is very high. At ~$9.51/share, the current stock price implies that after-tax profit (NOPAT) will grow by 19% compounded annually for the next 12 years. Betting on that kind of growth is risky for any company, much less one with no recent track record of profitability.

The only consolation for investors in ARPAX is that, given the amount of transactions it carries out, it will probably sell off IRET by the end of this sentence. Unfortunately, given the fund’s track record, it will probably just replace it with another Dangerous company and charge investors another unnecessary transaction fee.

I often stress the importance of analyzing a fund’s holdings on this blog. However, failing to do due diligence on a fund’s costs can also be potentially damaging to investors. Our rating of the total annual costs of a fund boils down all the different costs associated with investing into one value that is comparable across all funds.

Without doing due diligence into costs and holdings, investors can be fooled into thinking that a fund like ARPAX justifies the fees. New Constructs’ research allows investors to understand the true cost of being in a fund.

Here is a free copy of my report on ARPAX with a detailed breakdown on our Total Annual Costs rating and analysis on each component that produces the 8.51% number above.

Sam McBride contributed to this report

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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