The low-down on mutual fund fees
One of my newer clients was reading her fund prospectuses (prospecti???) recently and asked me to explain how the various fees work. After getting over my initial surprise that someone actually reads the fund prospectus (just kidding, I know you all do!), I figured that this was a topic that might be of interest to some other people out there. After all, there is a lot of talk in the financial media about mutual fund fees – but I also find many people misunderstand how they work. Fund expenses are complicated stuff, and although I will try to explain in simple terms, please forgive me if I cause your eyes to glaze over.
Management Fees. These fees pay the manager of the fund (Vanguard, Pimco, etc.) to do their job. The fund manager selects the investments that go into the fund. Theoretically, the more the manager is doing (the more ACTIVE he is), the higher the fees are going to be. An index fund typically has the lowest fees, because the fund’s investments are already selected for it. All the manager has to do is buy and sell shares of stocks to mimic the holdings that comprise the index which the fund tracks. This can largely be done by computer, so costs and fees are minimal. A fund manager who researches and selects stocks will have higher costs to pay for his analysts and research tools. And researching small companies, or overseas companies, or specialty market segments tends to be more difficult and expensive than researching large well known companies.
It is important to realize that management fees are paid for by the fund itself – not by the investor. So if a fund advertises a return of 8%, that implies that the fund earned 8% after all its internal operating expenses were met. While it may be surmised that if the same fund didn’t have its 1% in management fees it WOULD HAVE earned 9% – this is a somewhat flawed logic, since without the expenses that fund would not have existed in the first place. See below for further discussion of the impact of fees on investor returns.
Sales Charges (aka “loads”). These are fees which go directly to compensate the broker who sells the fund. They are essentially a sales commission paid by YOU the investor. Front end loads (typically identified as Class A) are paid for up front by the investor. If you buy a fund with a 5% front end sales charge (load) for $1000, then $50 is taken out of your investment to pay the selling broker, leaving you with a $950 investment. Level load funds (typically identified as class C) have fees usually of about 1% per year deducted from the investors account to pay the broker. Over many years level load is more expensive – but since you paid less up front it is easier to sell the fund without any loss.
Most fee based or fee only investment advisors (as opposed to commissioned advisors) do not accept commissions on mutual fund shares, which means these sales charges will normally be “waived”. If you are paying your advisor a fee for his services, make sure you are not also paying a commission. That would be double dipping, and would not be appropriate in most cases.
12b-1 fees. OK this may be the least understood (and least discussed outside the industry) of all mutual fund fees. Many funds have a small annual fee called a 12b-1 fee listed on their prospectus. This is a fee that is remitted to the brokerage firm that hold the shares and is supposed to pay for paperwork, marketing services, etc. It is often used by commission brokers to pay an additional annual commission to the salesman. However, these fees may also be used by custodians (such as TD Ameritrade) to offset the costs of including a fund in a No Transaction Fee trading platform. In this case, the additional fund cost (typically about .25%) may be more than offset by the fact that an investor does not have to pay a trading cost or commission every time he buys, sells, or rebalances his portfolio.
Trading Costs. The direct cost to the fund of executing transactions (buying and selling stocks or bonds) is not included in either of the above. And it is almost impossible to determine what the trading costs of a fund are. They are not listed in the prospectus. As with management expenses, these are costs paid for by the fund before quoting any returns to investors – so these are not expenses you pay directly. However, it is sensible to surmise that the more a fund manager trades in and out of stocks, the higher his trading costs. Those who don’t mind reading a fund prospectus can look to the Turnover rate to estimate how often a manager trades. A fund with a 10% turnover rate sells about 10% of his holdings in a given year. This would be pretty low, and suggests the manager holds onto an investment for an average of 10 years. A fund with a 100% turnover rate would on average sell every holding (and replace it with a new one) every year. This would be a very high turnover ratio.
Tax Costs. Don’t ignore the tax implications of a fund you own. The more a fund buys and sells shares, the more likely you will be to see taxable capital gain distributions at the end of the year. You will receive a 1099 and pay tax on these distributions. Index funds tend to have fewer capital gain distributions – but not necessarily so! High turnover funds are more likely to spin off taxable gains than low turnover funds. And of course, you don’t have to worry about tax implications if your fund is owned in an IRA or 401k.
So is the lowest cost fund always the best choice? Many in the media seem to take this simplistic approach, but it is not necessarily so. It is true that most managers of your typical domestic stock funds fail to do any better than a similar index fund. This is often attributed to the fact that the investments the fund holds needs to beat the index by the amount of the fee just to result in a tie! Few managers seem to be able to generate these results solely by “picking” large cap US stocks. So for exposure to these stocks, an index tracking mutual fund or ETF might be the best approach. However, in more nuanced and complicated segments of the market (international, emerging markets, fixed income, alternative strategies) a good manager may be worth his keep even after considering fees. This does not necessarily mean he will generate outsize returns. In fact, a manager can just as well add value by avoiding trouble spots and reducing risk and volatility. To support this premise, studies have shown that active managers historically have enjoyed their best years (vis a vis their benchmark index funds) when markets are losing money.
Fund expenses are important – but they should not be the only consideration when choosing an investment to add to your portfolio.