Fig Lockerbie ripped up the last of his lottery tickets and tossed them into the fire. He vowed never to get caught up in a game where the odds were stacked against him.

"Those darn ping pong balls hate me," he said as the singed stubs went brown and then vanished into the flames.

It was late and the stench of infomercials filled the room as he fingered the remote control for salvation. Taking comfort in knowing that the entire cast of "That's Incredible" continued to thrive in their acting endeavors he stumbled across a spot for Mangy Mutt Mutual Fund. With a clever 1-800 number (1-800-BOW-WOOF) and a spiffy portfolio manager promising to purchase the best companies Fig's money could buy, he was sold, and he called immediately after dialing for a psychic reading and ordering up a Thighsmasher.

A week later the prospectus for Mangy Mutt arrived. He was impressed with the full-color brochure and tender shots of three generations enjoying a picnic of cucumber sandwiches and Yoo Hoo. The humanitarian side of Fig took heart in knowing that the fund had never beaten the S&P 500 Index. He was not exactly sure what an S&P was but he knew that it would be inhumane to actually beat hundreds of them silly. In his quest for high returns he was sure that the high expense ratio of 2%, and the high portfolio turnover rate of 200%, were good things. The only drawback he saw was that there was no load.

"Why couldn't I have found a loaded fund," Fig asked his collection of velvet paintings. . . rhetorically. He tore out a check and sent it in anyway. Even if there was a load void, who can argue with an empty fund when it is kind to the endangered S&P species? He made sure to indicate that he wanted to reinvest all dividends and capital gain distributions. While a green Fig he knew that money in his own hands was a dangerous thing.

Time passed, the unopened Thighsmasher collecting dust in the attic, and after a year of Mangy Mutt compunding Fig was shocked to find that his $1,000 investment was still worth just $1,000.

"Well at least I didn't lose money," he said at which time Ms. Motli Fool broke through a velvet Elvis and shook her head sympathetically.

"But you did Fig," she said. "Inflation over the last year has chewed away at what your initial investment can now buy. Worse still is the opportunity cost of what your money could have made in other investments. You took on risk and were rewarded as if you had parked that money under your pillow."

Fig got depressed and thought fondly of his lotto days. Along with his account statement, where he found that he had 10% more shares but now valued at 10% less than his initial investing price, he found the fund's annual report. He was surprised to find that the portfolio holdings at the end of the year were some of the best performing stocks over the last twelve months. With time to spare and a patient Motli they found that the average weighted gain of the stocks the fund owned at that time had risen an average of 20% over the last year.

"I don't get it," Fig said, "literally! I should be up 20% right?"

"Not quite, there are plenty of reasons why your return is lower than that but chief among them would have to be:

1) The fund's high expense ratio

2) The hidden transaction costs in buying and selling stocks in the portfolio

3) Window dressing by the portfolio manager at the end of the year

4) The fact that the fund paid out a huge capital gain distribution of 10% of total assets.

Fool shoots, Fool scores!

The correct answer is #3 but this one was a bit tricky so let's have Motli go over why the others are not right first. . .

"The expense ratio of 2% is almost twice as high as the average diversified stock fund but that is just part of the problem," she explained. "Mutual fund companies have to make money and this is where everything from their management fees to the cost of office paper clips comes from. There is no free lunch and that is why even index funds that keep their expenses to a fraction of 1% will still fall just shy of the indices they are tracking."

"Good thing I didn't pay a load then," Fig said, beginning to appreciate why the S&P should get a good spanking now and then.

"True," Motli said. "There are also the churning costs not reflected in the expense ratio. You see, the fund has to pay commissions on the stocks it buys and sells. Given the high 200% portfolio turnover, that means the average holding only lasted six months. Then we have the spread, which is the difference between the bid, or the highest price someone is willing to pay for the stock, and the ask, which is the lowest price at which someone is willing to sell the stock. Even with the high turnover this amount is usually less than the expense ratio, but is yet another reason for underperformance."

"What about this 10% dividend," he said. "Show me the money!"

She explained how the dividend was reinvested in more shares. The share price dropped 10% the day the 10% dividend was paid out. If not, his $1,000 investment would have been worth just $900 -- but with a $100 check sent his way. It was a zero sum game and had no impact on the fund's performance or lack thereof.

"My head's getting dizzy, Motli."

"Then grab a seat as I explain window dressing," she said, and Fig complied.

Motli explained how fund managers report their portfolio holdings annually, and in some cases quarterly, to their shareholders. To give the appearance that they are savants, some will dump their poor performers and load up on the winners of the past year in time for the close of the fund's fiscal year.

"It makes for good reading but you can't window-dress the ultimate sign of accountability, and that is performance," Motli said.

"Hey," Fig said. "Why don't I do a little bit of window dressing myself and dump this dog of a fund?"

Motli didn't say a word. She simply tapped her finger on her forehead and disappeared through the velvet Elvis painting.

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