Mutual fund fees have long been discussed as one of many barometers of whether any particular fund is worthy of investor’s funds. On the surface, many of the arguments may make sense. However, since this is a topic that is rarely debated, the arguments you hear, read, or see, are always without the counter-points being presented.
Mutual funds are businesses, thus like all businesses they incur many types of expenses. These expenses include transaction costs for the buys/sells of the investments they make; management fees for advisors; operating and accounting costs; marketing and distributions costs; brokerage and custodial fees; transfer agency costs; and legal fees. Like all businesses, those who manage their expenses well most likely will profit. But, should the ratio of their expenses be a significant criterion in selecting a fund for investing?
Ask any mutual fund investor if expenses matter and many will share the axioms often presented by the mutual fund family considered by some as the leader in low cost funds. The fund family is Vanguard. In fact, Google “mutual fund expenses” and a link to Vanguard’s site appear. But, is this the entire story?
Understanding how mutual funds are used can explain the need for certain expenses. Allocation of assets among funds with different objectives does not happen without oversight. When was the last time any mutual fund manager phoned saying the future does not look too bright for their investment style or asset class, and funds should removed and reallocated elsewhere? The answer is never unless additional fees are being paid for the service. Thus, low cost funds do not guarantee above average performance if their focus is in areas presently out of favor.
For investors who take on the job of managing their own funds and are proficient with the task, incurring additional expenses designed to assist in managing the assets is not necessary. The expense in question is called 12b-1 fee. Not all funds have this fee and some no-load funds still have this fee. This fee is paid by the fund assets and is generally paid to fund advisors or brokers to cover promotion, distribution, marketing expenses, and sometimes as commissions to brokers. In my opinion this fee is valuable, especially for those investors who are not comfortable or do not desire to manage their own assets. At QFC we treat this fee as a servicing fee, which compensates us for the continued management of the assets of our clients. If a current advisor is not meeting a client’s expectation, a new advisor should be able to take over assets, receive the 12b-1 fee for their management services, saving the investor thousands in new commissions. However, sadly not all advisors will accept a portion of the 12b-1 since the fee is usually one fourth of one percent paid annually. A recommendation to transfer the assets to an entirely new fund family is made, resulting in a new commission being paid in the range of three to five percent of the assets transferred. There are times when the only answer is a new commission, but this should be the last option to consider.
Fund expense ratio ranges from 0.20% to over 1.5%. The theory assumes more profit is created if the fund’s expenses are lower. This holds true if everything else is the same, but in the mutual fund environment this is rarely true. Many of the funds with low expense ratios are also the largest mutual funds. Clearly there are economies of scale, thus managing funds with three, ten, and even thirty billion dollars should cost less than those with less than a billion in assets. However, the advantage of having low expenses may be lost to the large size of the fund.
Using ships as an analogy consider which ships are more maneuverable and have greater flexibility; comparing a container ship, in excess of 1,200 feet in length, a cruiser approximately 500 feet in length, a yacht around 200 feet in length and a 26 foot speed boat. The size of the ship clearly limits where it can go, how quickly it can change directions, and the quantity and size of its cargo. Similar restrictions apply to mutual funds. Very large funds find it difficult to invest in small companies, thus their possible choices are limited to only very large companies. When positions are taken or sold, it can take large funds days or weeks to complete the change due to the size of the position they have. Expenses are important to consider when buying funds, but should not be the sole decision factor.
For assistance with insurance, estate planning, and managing investments, contact me at Quality Financial Concepts or one of the other Certified Financial Planners in our area. To continue a personal quest for education, you can also view our learning center on our website, www.goqfc.com. There you will find articles on a variety of topics, on-line seminars, calculators, as well as a host of other free tools.