(MONEY Magazine) – What goes into making a good equity mutual fund? Smart stock picking, obviously. But low costs help tremendously too. After all, a fund's expense ratio--the average reported by U.S.-focused stock funds is 1.5% of assets per annum--represents money you lose year in, year out, no matter how well your fund does. But those published expenses tell only part of the story: Your fund also incurs hidden trading costs every time its manager buys or sells a stock. Over the years, these extra nickels and dimes can add up to a huge drain on your return.

No fund can eliminate these expenses, but the American Century fund family in Kansas City, Mo. is pushing back hard. "A dollar saved in trading costs is worth just as much as a dollar earned through good investments," says John Wheeler, head trader for the $90 billion firm. Wheeler isn't talking just about paying lower than average brokerage commissions, although American Century does. The group has also found a way to reduce the so-called market impact of its trades.

We'll delve deeper into that murky subject in a moment, but first let's talk results: Last year American Century's transaction costs were 75% below the median for comparable firms, according to independent consultant Abel/Noser Corp. All in all, American Century saved nearly $540 million on trades. That's a nice chunk of change to keep in shareholders' pockets.

Mother of invention

One reason American Century cares so much about trading costs is that it is especially vulnerable to them. Its portfolio managers specialize in aggressive "earnings acceleration" investing (their term), which requires them to move quickly into and then out of stocks. The American Century Vista fund, for example, holds on to its typical stock for just 18 weeks, compared with 94 for the typical stock fund. It's a risky approach that has sometimes backfired but has lately been paying off. (See "But Are the Funds Any Good?" on the next page.) Harold Bradley, one of American Century's senior portfolio managers, says that whittling down trading costs is crucial to making this trigger-happy style work. "Necessity is the mother of invention," he quips.

American Century sends 55% of its trades--double the industry norm--through cut-rate electronic brokers like Instinet and Archipelago (in which the firm has an investment) rather than through traditional Wall Street brokerage houses. As a result, the funds pay an average 2¢-a-share commission every time they buy or sell a stock, instead of the 4¢ or 5¢ many big investors typically shell out.

But electronic markets offer an even more important advantage: They're anonymous. Why the obsession with secrecy? Simply put, American Century doesn't trust the big Wall Street brokerage houses to be discreet about its orders. Whenever an institutional investor like a mutual fund tries to buy or sell a lot of stock, that tends to affect the price--driving up the cost of what it wants to buy, and driving down the cost of what it wants to sell. That's what's known as market impact. It only gets worse if other traders get wind that, say, "a money manager in Kansas City" is buying IBM, so that they can buy ahead of American Century. Says Wheeler: "It's just plain irresponsible for a fund manager to assume Wall Street isn't going to take advantage of the information that you just bought a new stock for a $10 billion fund, a stock you're probably going to be buying every day until you accumulate a 1% position." To foil this, Wheeler routes all first buys in new investments, as well as first sells in those he's exiting, through the electronic brokers.

NO STRINGS

Why isn't this kind of penny-pinching more common in the fund industry? Wheeler blames the use of "soft dollars"--the practice of funds paying extra trading commissions to brokerage firms in exchange for research and, in some cases, even goodies like computers and newspapers. American Century considers soft dollars little more than legalized kickbacks and doesn't use them. "Here's soft dollars in a nutshell," says Wheeler. "Funds take whatever bill they want paid--say $200 in money magazine subscriptions--multiply it by 1.6 and then send that $320 to a broker in the form of higher commissions than they'd otherwise pay. Then the broker writes MONEY a check for $200." The fund company essentially passes the bill for the magazines along to its funds' shareholders in the form of inflated brokerage commissions.

Concerned about how trading costs might be eating into your savings? It's tough to know exactly how much you're really paying for a given fund. But here are steps you can take to reduce the toll.

-- Ask your fund company to explain its policy on soft dollars. Although a restriction on soft dollars doesn't automatically mean a fund is keeping trading costs low, it is a signal that the managers are concerned about the impact of hidden expenses. American Century isn't the only firm with soft-dollar restrictions. For example, Fidelity has declared that it will use soft dollars only for research. And the MFS funds, which were pulled into last year's market-timing scandal, have also recently clamped down on the practice.

-- If you aren't attracted to American Century's brand of go-go growth investing, you can easily avoid high trading costs by investing in funds that buy and hold large, liquid stocks. Washington Mutual Investors and Selected American have turnover rates below 15%. And don't forget indexers. Vanguard 500 Index typically trades just 2% of its portfolio a year, which means trading costs aren't a problem.