Know Your ABC's: The Impact of Fees on Investment Performance

By G. Gregory Smith, Jr.

As a follow up to our study on how taxes can impair investment returns, we thought it only logical to address how fees are another “hidden pitfall” for investors. The following discussion is intended to be a primer on how investment managers are compensated. The multitude of investment vehicles on the market today prohibit a comprehensive explanation, but we hope this paper can help educate you on the various terms, structures, and layered fee arrangements that you may encounter in today’s market. Please keep in mind that you must always read the prospectus for each fund you intend to purchase to fully understand what fees will be charged.

Over the last several years, the variety of fee structures in the mutual fund and managed account industry has expanded. To keep it simple, we will focus on the three most basic types that brokerage houses and banks are currently using. Please note, this is a general discussion and the underlying prospectus provided by an investment advisor or broker will highlight various break points, refunds, marketing fees and trailers that are unique to each product. The purpose of this paper will be to arm you with the appropriate ammunition in order to ask the right questions when making decisions regarding mutual funds, “WRAP” programs, and “Manager of Managers” programs.

Types of Fees

The Expense Ratio

The total fee to have your money invested in a mutual fund is represented by the expense ratio. It is sometimes referred to as the “management expense ratio.” The expense ratio is composed of the following:

Management Fee: The cost to employ the actual manager(s) of the fund. This pays the salaries of the men and women who make the buy and sell decisions of what goes into a mutual fund. The fee is typically between 0.5% and 1.5% of the amount invested.

Marketing Fee: This is the fee that is paid to the broker who sold the mutual fund. It is a yearly fee that can be anywhere from 0 to 1%. This fee is called a “12b-1” by those in the investment industry.

Trading costs: All mutual funds and asset managers incur trading costs when managing money. It is the brokerage commission a manager pays to buy or sell an investment and can come in the form of a “ticket charge,” a “per share charge,” or a markup. This fee is essentially hidden in a mutual fund because it does not appear in any of the aforementioned fees. Mutual fund or separate account managers who have high turnover, or make trades very often throughout the year, will incur higher trading costs.

Administrative Costs: These include necessities such as postage, record keeping, customer service, printing statements and general office expenses of the management company. This fee is typically between 0.10% and 0.40%

The average equity mutual fund charges around 1.5% in total expenses. You will generally pay more for specialty or international funds, which require more expertise from managers. These types of mutual funds often charge investors in excess of 2.0%.

Sales Loads

Although “no-load” funds exist, investors most often encounter these when they purchase directly from a mutual fund company, or from a fee-based advisor that is not a broker-dealer. There are two types of sales loads that the mutual fund industry uses to compensate brokers above and beyond the annual 12b-1 fees discussed above. They are:

Front-end loads: The simplest type of load; you pay the fee when you purchase shares of the mutual fund. If you invest $100 in a mutual fund with a 5% front-end load, $5 will pay for the sales charge, and $95 will be used to buy fund shares.

Back-end loads (also known as deferred sales charges): Here you pay the load when you go to sell the fund and it is charged as a percent of the sale proceeds. Most funds with back-end loads have a charge that decreases the longer you own the fund. For example, a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if you sell in the first year, 5% in the second year, etc. If you don't sell the mutual fund until the seventh year, there is no deferred load.

Mutual Fund Share Classes

A-shares: In general, the term “A-shares” implies a front-end load. These fees can be as low as 1% and as high as 5.75%. Though slightly different for each mutual fund (check the prospectus) this fee generally goes to the broker who sells you the fund. Often there are breakpoints for the amount of money invested, meaning the load decreases as the amount of money invested increases. However, these breakpoints are usually accompanied by a deferred sales charge. So the front end fee is reduced, but if an investor sells within a certain time period, a back-end load is introduced.

B-shares: B-shares imply that you will pay a back-end load when you sell the fund. These fees can be as low as 1% and we have seen as high as 6%. Again, each fund is slightly different (check your prospectus), but this fee generally goes to the broker who sells you the fund. The biggest issue with B-shares is that if you bought the fund recently and want to sell, you find yourself in a situation where you could lose an additional 1-6% of your invested principal.

C- shares: Class C shares often have a higher 12b-1 fee but usually do not have loads. In some cases the 12b-1 will be closer to 1% rather than the typical .25% to .5%. This would imply that your expense ratio could be between 2% and 2.5%.

With all three types of funds mentioned above, the management and administrative fees are still present. The share class (A, B, or C) simply gives you an idea as to what combination of load and 12b-1 fee you may be charged, but it is essential to analyze each fund individually. As I mentioned at the beginning of this discussion, we will keep it simple. There are funds that combine tenets of all three share classes (i.e. have a 3% front-end load with a 1% back-end load and a 0.5% 12b-1). Don’t let anyone tell you the financial community isn’t creative. Also, many funds have an “Institutional” share class which usually means that there are no loads and a lower expense ratio, but an investor must have north of one million dollars invested to have access to these shares.

Manager of Managers

Known by many names, and more common with affluent investors, the Manager of Managers program has gained popularity over the last decade. Originating from the old brokerage “WRAP” programs, this investment approach is very common today.

Here’s how it works. You hire a fee based investment advisor or bank to help you invest your money. They in turn take your money and hire other managers to invest it according to an asset allocation model. So, they may determine that based on your risk tolerance, 10% of your portfolio should be invested in small cap stocks. They will go out and find a manager who specializes in small cap stocks and give him or her 10% of your portfolio.

In principal, it is very much like buying a selection of mutual funds, but instead you are paying for a separately managed account (meaning individual stocks and/or bonds). In reality, there are no strong differentiating factors between using five mutual funds for diversification or five managers in an asset allocation model. The flawed impression given is that an account is truly customized to you as an individual. In reality, just like a mutual fund, you are getting the model of the underlying manager. In this case, you are not exposed to 12b-1 fees or loads that occur with mutual funds. However, you still end up paying multiple layers of fees. One fee goes to the advisor to select these managers and another fee goes to the manager. In aggregate, investors still often pay close to 2% for this type of strategy.

On a side note, this model became very popular with the industry because it put the advisor “on your side of the table.” In other words, it is an attempt to transfer the responsibility of investment performance away from the advisor and onto the underlying managers he or she has chosen to hire for you. It took the traditional investment advisor and turned him/her into a client relationship manager while creating a new layer of fees.

Impact of Fees

All this may seem a little petty. So what if you pay your advisor 1.5% instead of 1.0%? As you can see from the illustration below, fees can have a tremendous impact over time. The example below assumes constant returns for two different strategies; a fee only advisor buying individual securities who charges 1% and an advisor using mutual funds with an average fee of 1.5%. All else being equal, $1,000,000 invested over 25 years shows a return difference of almost $1,000,000 (or the entire original investment!). Even the seemingly small 0.5% can make a huge difference over time.

For More Information

There are a number of great websites available free of charge that outline the different fees charged by mutual funds. Below are two of the more helpful ones: Morningstar and Yahoo! Finance

Below is the SEC webpage that discusses the types of fees charged by Mutual Funds:

http://www.sec.gov/answers/mffees.htm

2017-04-04T09:18:27+00:00