Mutual Fund Concerns: Operating Costs

On 09/22/2010, in Mutual Funds, by Jordan Wilson
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In our last post, we reviewed transactional costs involving mutual funds.

Besides potential sales charges and brokers’ commissions, you must to pay annual fees for the cost of operating each fund on an ongoing basis. These costs can differ significantly between funds and should be reviewed carefully before investing in a specific fund.

In fact, I believe that assessing a mutual fund’s cost structure is a key to investing success.

Depending on where you live in the world, the focus on mutual fund costs may centre on either the management expense ratio or the total expense ratio.

We will look at both today.

Minimizing Fund Expenses is Vital to Investment Success

As I continually remind readers, capital spent on items other than the actual investment is money that does not earn a return and compound on your behalf.

As a fund’s expenses fall into this non-income generating category, they are extremely important to consider when investing in mutual funds.

For example, compare two global equity mutual funds. Last year, both had a gross return of 10%. Fatcat Global Equity Fund had operating expenses of 5% assets under administration (AUM), while Lean Global Equity Fund had operating expenses of 2%.

On a net basis, instead of identical returns, Lean had superior performance. If the same returns and expenses continue in the future, over time there will be a significant difference in shareholder wealth.

Perhaps you invested $10,000 in each fund. In rough calculations (ignoring taxes, distributions, assuming annual reinvestments, same annual returns and expenses, etc.), at the end of 5 years your Fatcat investment would be worth roughly $12,750 and Lean worth $14,700. At the end of 10 years, Fatcat would be worth $16,300 and Lean $21,600. After 20 years, Fatcat would be worth $26,500 and Lean $46,600.

Over time that extra 3% in Fatcat expenses, will have a significant impact on your returns.

In comparing funds, always look at expenses as a key to success.

Management Expense Ratio

The management expense ratio (MER) reflects the annual cost of operating a mutual fund.

The MER is made up of three fee categories: management; administrative; marketing.

It does not include costs associated with buying and selling fund investments.

The MER is a key area of interest when I analyzie a fund. It should be for you as well.

Management Fees

A large portion of the MER is the fees paid to the fund managers or investment advisors.

These are the people that research possible fund investments, determine assets to include in the portfolio, monitor the ongoing performance, and make decisions to sell any assets.

This fee may also include investor relations and fund administration costs, although normally these latter expenses are include in the administrative cost category.

Management fees can be structured in a variety of ways. In the majority of funds though, management fees are based on a percentage of AUM. For example, a fund may have a stated management fee of 0.60% AUM.

In general, the greater the amount of work required from the managers, the larger the fee.

Actively managed funds require more work than passive funds.

Funds that focus on niche markets or areas with relatively poor public information on companies also require greater effort in analyzing and selecting investments.

Funds requiring complex trading strategies tend to need more work than simpler strategies.

So when comparing MERs or the management fee itself, always make sure you compare apples to apples.

For example, it might makes sense that a management fee between two Africa international equity funds is 1.10% AUM versus 1.00% AUM.

One would expect that funds of similar size, investing in the same asset class and region, to have relatively equal MERs (if not, you need to find out why before investing).

But it might less sense in trying to compare these funds against a U.S. large cap equity fund. The U.S. fund likely has better available research and corporate information on possible investments than do the companies based in Africa. As such, it is reasonable to expect greater work being required to assess African companies.

Popular in hedge funds, you may also see performance based management fees on top of the standard charge. The performance fee may be based on on profits earned (e.g. 20% of all positive returns), on profits above a designated “hurdle rate” (a benchmark return such as the U.S. Treasury Bill rate, the S&P 500, etc.), or on profits above the “high water mark” (the highest previous return for the fund).

Administrative Costs

Administrative costs cover the back-office costs of operating a fund.

These may include: legal fees; accounting and auditing expenses; record-keeping and regulatory filings; shareholder and other statement preparation and distribution; custody services; staff salaries; rent and utilities on office space.

One would expect that greater administrative costs would be attached to larger funds. And that is probably a fair assumption in hard dollar terms.

However, as administrative costs are also reported as a percentage of AUM, larger funds may appear to have lower costs. This is an advantage of aggregating one’s capital in a mutual fund. You can spread out the administrative costs amongst many investors, creating an economy of scale that benefits you.

For example, ABC fund has annual administrative costs of $2 million. DEF fund has administrative costs of $3 million; 50% greater than ABC.

But DEF has assets of $3 billion, whereas ABC only has assets of $1 billion. This equates to 0.2% of AUM for ABC, but only 0.1% for DEF.

While ABC may have a lower administrative cost in dollar terms, DEF has a better ratio.

Note that while this ratio might be interesting, it really tells us nothing as to whether either ABC or DEF is well-managed.

The best one can do is to compare the costs to funds of similar size and in the same investment categories.

Marketing Costs

Often mutual funds break out their marketing and distribution expenses.

In the U.S., these fees are known as 12b-1 fees. The designation refers to a relevant section of the Investment Company Act of 1940.

In the U.S., a maximum of 1.0% of the fund’s net assets may be used for marketing the fund.

It may seem strange to pay an annual fee to market a product that you already own. The belief is that by marketing a fund, it will attract new investors. New investors will add to the asset base, creating an economy of scale for the administrative costs. This will result in net savings for shareholders.

I have not seen any evidence to support this contention. And in this age of mutual fund investing, investors look primarily at performance and costs when screening funds. What they may see on a television advertisement or hear about from a sales representative is way down the list of review points. Or it should be.

I consider these costs a waste of money for investors and suggest you do the same.

Total Expense Ratio

Neither the sales charges nor fund transactional costs are included in the MER.

The sales charge is not an expense to the fund. Rather it is a cost to the investor. It makes sense that it is not included in the fund’s cost structure.

Transaction costs incurred when buying or selling fund portfolio investments (e.g. brokers’ commissions, spread differences, etc.) are expenses of the fund.

Note that we are not talking about the broker’s commission you paid when buying or selling shares in a fund. Rather I am referring to the brokers’ commissions and other related costs paid by the fund when its managers buy and sell investments within the fund.

Total expenses are calculated by taking the management expenses (management fee, administrative, marketing) and adding in the transaction costs.

To obtain the total expense ratio (TER), simply divide the fund’s total expenses by the fund’s total assets (i.e. AUM).

Internal Transaction Costs

In assessing funds, perhaps you notice that one fund has a relatively high TER versus its MER. That means the transaction costs are high in that fund. This can be due to poor order executions, high spreads between bid and ask prices, or high portfolio turnover.

High transaction costs may be a red flag when deciding to invest.

If the fund is not doing a good job of executing trades, it may not be getting the best prices on its investments. It may also be paying too much in commissions. Both of these negatively impact returns.

High turnover means more frequent trades (and costs), which impairs profitability.

High turnover may indicate that the fund management lacks confidence or patience in their investment selections with all the selling of current holdings and replacement with new assets. This could be a warning about their probability of future performance.

In some instances, it may indicate churning. That is, excessive trading within an account to drive up commissions. This is less a problem with mutual funds than in other circumstances, but it can still occur.

Finally, every time an investment is sold, there may be a tax implication for fund shareholders. Generating capital gains too early can accelerate the shareholder’s personal tax obligations and hurt compound returns.

Conclusion

First, when comparing fund costs, you always need to compare like funds.

Size, investment style, geographic region, asset classes, etc., they all will impact the cost structure of a fund.

Compare within the category in which you wish to invest if you want meaningful analysis.

Second, all else equal, choose funds with the lowest expenses.

Unless you truly believe that a higher cost fund will generate superior net returns than a lower cost option, stick with the lowest cost possible.

Of course, that is not to say that you should invest in under-performing funds simply because they are cheap. But do place a heavy emphasis on costs when you do your total analysis.

Remember, future returns may or may not be the same as past performance. But there is a high probability that the cost structure of a fund will be consistent in years to come.

As we saw above, what may seem like small differences in costs will create substantial variances in investor wealth over time due to compound returns.

Make your money work for you.

Maximize the amount invested and earning actual returns.

Minimize the money you pay to others and receive no return on.

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