From the Yardarm

Mutual fund expense ratios garner a lot of attention from the news media, regulators, and investors. While cost containment is clearly a worthy goal, do a mutual fund's costs deserve to be your paramount consideration? Do they matter at all?

Simply looking at a single data point — especially an often-misunderstood data point — does not make for prudent investing decisions.

Much attention is given to mutual funds' expense ratios: Russell Kinnel from Morningstar proclaims, "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision." John Wasik from Forbes makes a more turgid point: "Fees pile up and ravage mutual funds like zombies."

There's no question that costs matter, and generally speaking when buying a commodity product, cheaper is better. But, cost is not the only critical factor. More importantly, expense ratios do not tell the entire story of a mutual fund's costs. Simply looking at a single data point — especially an often-misunderstood data point — does not make for prudent investing decisions.

So, what's in a Mutual Fund's "Expense Ratio" Anyway?

A mutual fund's expense ratio is the percent of its average net assets used to operate the fund. Shareowners do not pay a fund's expenses directly. Rather, the fund pays its service providers, including investment managers, shareowner servicing agents, distributors, and administrators, as well as other expenses such as incidental taxes, regulatory fees, and investor reporting costs.

Hypothetical Example of a Typical Mutual Fund's Expenses
Annual Fund Operating Expenses
(expenses that you pay each year as a percentage of the value of your investment)
Management Fees 0.75%
Distribution (12b-1) Fees 0.25%
Other Expenses 0.10%
Total Annual Operating Expenses 1.10%

The US Securities and Exchange Commission (SEC) requires disclosure of a fund's expenses as the second item in a fund's prospectus — giving expenses modestly less prominence than the fund's investment objective and considerably more prominence than its returns and manager. The expense ratio used in the prospectus is pulled from the Financial Highlights table (before any subsidies) in a fund's latest annual report. Because sponsors often subsidize expenses to promote a fund, the quoted expense ratio can be overstated.

A fund's performance is always presented net of expenses — more on this in a minute.

Often the largest portion of a fund's expenses goes to the sponsoring firm that established the fund and supervises its operations. The sponsor may be the adviser or may retain an outside subadviser. In any event, the portfolio manager researches, selects, and monitors the fund's investments. These fees typically range anywhere from 0.5% to 1.0% for actively managed funds.¹ Many funds pay flat rates to their managers (a straight percentage of average net assets), but there are a number of different arrangements, such as a break-point structure (as fund assets increase, the rate paid to the manager decreases), and fulcrum fees (where the manager is rewarded for good performance and penalized for bad).

For a mutual fund to be described as a no-load fund, its 12b-1 fee cannot exceed 0.25% of average net assets.

Many funds charge distribution or 12b-1 fees. These fees, specifically designated for the distribution and marketing of mutual funds, receive a fair amount of derision from the financial press, but serve a purpose to investors paying them. For example: although you can purchase shares from a mutual fund company directly, chances are you will buy them from a financial platform, such as Charles Schwab or TD Ameritrade or a retirement plan administrator. Why? Because buying directly requires you to open a separate account at each fund sponsor where you want to invest. The ability to consolidate your investments in one place is an attractive convenience offered by intermediaries and brokerage firms — but it comes at a price. Mutual fund firms typically pay these platforms for access to their distribution services, allowing you the convenience of one-stop shopping. 12b-1 fees help funds cover these costs, and, to the extent that they generally widen a fund's availability, 12b-1 fees encourage greater overall product diversity for investors.

Other fund expenses include operational costs not included in the management fee, such as legal fees, filing and registration fees, custody fees, and the costs to print and mail prospectuses and annual reports.

So, shouldn't you pick funds with the lowest expense ratios possible? Maybe, but let's take a step back and see how expense ratios interact with returns. Remember that a fund's performance is always presented net of expenses, which means that when you examine a fund's total return and average annual returns, the expenses have already been taken out.

Consider the return profiles of the following two hypothetical funds:

Average Annual Returns of Two Hypothetical Investments (as of 09/30/2013)
  10 Year 5 Year 3 Year 1 Year Expense Ratio
ABC Growth Fund 10.00% -2.00% 3.00% 16.00% 1.10%
XYZ Growth Fund 5.00% -4.00% 4.00% 12.00% 0.40%

XYZ Growth Fund's expense ratio certainly makes it an attractive pick. But, over time, ABC Growth Fund has outperformed XYZ Growth Fund and therefore has provided better value for its shareowners, despite the higher cost of ownership. Which would you rather own: a lower cost fund that underperforms, or a higher cost fund that outperforms — and actually makes you more money?

Front-end loads, back-end loads, and level loads are not included in a fund's expense ratio.

Let us be clear: lower costs are generally better, and keeping costs in check is essential. But, cost isn't the only factor. Returns aren't the only factor, either.

Deeper Issues

When choosing a mutual fund, you (and your adviser, if you have one) should consider many factors, including its objectives, risks, and strategies:

  • What effect will it have on your overall allocation? What is its exposure to certain industries and regions?
  • What types of investments does the fund make (stocks, bonds, leveraged securities, hedging strategies, etc.)?
  • Is the fund actively managed by an experienced manager, or does it take a passive approach to investing? (Note that passive funds, sometimes called index funds, often appear cheaper than actively managed funds because they don't have to pay a fund manager to choose investments – they simply mirror an index.)
  • If the fund will be held in a taxable account, how might the fund's strategy affect your year-end tax liability?

The Investment Company Institute (ICI), an industry group dedicated to promoting public understanding of mutual funds and investment companies, computed a simple average mutual fund expense ratio of 1.40% for 2012. They noted that this simple average was quite a bit higher than the 0.77% investors actually paid, reflecting investors' penchant for lower-cost funds.² As a mutual fund's assets grow, its expenses (as a percentage) tend to fall. This benefits both investors and fund companies. But, it does put smaller fund companies at a significant disadvantage when it comes to costs.

The flip side of the growth coin is asset bloat: at what point (regardless of the fund's expenses) does a portfolio manager simply have too much money to invest and therefore run out of places to invest the fund's assets, raising the possibility of underperformance?

What's NOT in the expense ratio?

While expense ratios represent a cost to the investor, other, less obvious costs can also hurt your investment results. These include portfolio trading expenses, tax costs, and sales charges.

Funds incur brokerage portfolio trading expenses when buying and selling securities. These costs include any brokerage commissions, the spread between buying and selling prices, and the impact trading has on the market. Portfolio trading expenses quickly add up (one recent study reported an average of 1.44%³). Unaccounted trading costs are often higher than the featured expense ratio. Instead, trading costs can be obscured in the cost basis of a fund's portfolio. For example, a fund may report the cost of buying 1,000 shares in Company X at $10 per share as $10,030: $10,000 plus a $30 commission (or $0.03 per share).4 Brokerage trading expenses drag most on funds with smaller, less liquid portfolio holdings and high portfolio turnover ratios.

High turnover ratios often reflect hidden trading costs and can also mean higher tax costs.

High turnover ratios can also mean higher tax costs. Each time a fund sells an investment, there is potential for realizing capital gains, which translates into tax liability passed on to you. Tax costs are expenses that can chip away at your returns, but they are not reflected in a fund's expense ratio.

Direct investor charges, such as purchase commissions or early-redemption penalties, are also not considered part of a fund's expenses. These are costs investors pay directly to buy (front-end) or sell (back-end) shares of a fund. A front-end load of 5% means that $50 of every $1,000 you invest is taken off the top (usually to pay the broker who sold you the fund). Brokers may be paid a commission when you purchase under a Rule 12b-1 plan, with the expense paid by you over time.

Advisers sharing their management fees with distributors can act to increase the expense ratio, as advisers resist the pressure to reduce their fees. The amount a fund pays in "revenue sharing" is rarely disclosed, although investors can benefit from services provided by the distributor.

Can a high expense ratio ever be good?

While commonly ignored by financial commentators, for the small number of funds with fulcrum fees, higher expense ratios can indicate better performance and accordingly could be viewed as good for both the investor and the fund. That's because good performance is rewarded with a higher fee rate for fulcrum funds, while poor performance means the advisory fee rate is cut. With these funds, investors benefit from a higher advisory fee just as they suffer in performance when the expense ratio is reduced because of the fulcrum penalty.

There are no simple roads to long-term investment success

No one wants to pay more than they should for their investment, and paying more does not necessarily correlate with greater success. Still, there could be correlation of high expenses to high returns; if not, why would sophisticated investors pay the high fees (customarily, 2% of assets plus 20% of profits) of hedge fund managers?

If cost is your top concern, you owe it to yourself to consider all potential costs, not just those reflected in the expense ratio.

Fund expenses deserve close examination within the context of many other important considerations, such as how a fund's objective matches your own, the fund's performance, and potentially even the fund adviser's ethical record. If cost is your top concern, you owe it to yourself to consider all potential costs, not just those reflected in the expense ratio. Here are some tips to analyzing the expense ratio:

  • Advisory expenses vary depending on the investments of the fund, with high expenses for foreign equities and low expenses for money market funds.
  • Low turnover funds can save significant, often undisclosed, expenses in their operations.
  • Funds investing in large, liquid companies can generally trade with less market price impact.
  • Larger funds generally have lower expense ratios, being able to spread fixed expenses over more investor assets.
  • Fulcrum fee funds showing high expense ratios may be reflecting superior performance, and vice versa.
  • Funds with advisory fee break points reduce the expense ratio as assets grow.
  • Specialized share classes, such as institutional shares, commonly sport lower expense ratios.
  • Sponsors with non-integrated operations, using subadvisers and other outside vendors, generally have funds with higher expenses.
  • Portfolio managers with large investments in their funds will usually work to keep fund expenses low.
 

Footnotes

¹ Barker, Bill. Expense Ratios. The Motley Fool.
Retrieved from http://www.fool.com/school/mutualfunds/costs/ratios.htm

² Reid, Brian. Mutual Fund Expenses and Fees. 2013 Investment Company Fact Book, Investment Company Institute, page 75.
Retrieved from http://www.ici.org/pdf/2013_factbook.pdf

³ Edelen, Roger, & Evans, Richard, & Kadlec, Gregory. Shedding Light on "Invisible" Costs: Trading Costs and Mutual Fund Performance. Financial Analysts Journal, January/February 2013, Volume 69, Number 1, page 33.

4 Note that the commissions a mutual fund or other institutional investor may pay for securities trades can vary greatly and can be affected by a number of factors such as the size and type of the trade, the frequency with which the mutual fund or investor trades, the brokerage firm clearing or executing the trade, and the liquidity of the security being traded.

Other Links

Morningstar quote: http://news.morningstar.com/articlenet/article.aspx?id=347327&page=1

Forbes quote: http://www.forbes.com/sites/johnwasik/2013/06/27/why-mutual-fund-fees-are-too-high/

 

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