About a year ago, I wrote two blogs, “Mutual funds and their unfair fees – the feeling’s not mutual!” and “Did you know you’re paying someone else’s Mutual Fund taxes?,” that addressed what I believe are numerous misconceptions regarding the composition and magnitude of actively managed mutual fund fees and expenses. In response to comments to these two blogs from a number of our constituents, including customers, we decided to re-post a revised and, we believe, improved version that simplifies a number of the earlier concepts. What follows is the merged and edited blog post:
Actively managed mutual funds’ fees and expenses are not well understood by the investing public. We believe that’s because many of these fees are hard to find in legal disclosures and are not described in a simple or straightforward manner. However, we think the investing public deserves:
- An explanation of why asset weighting fee averages is misleading;
- An explanation of the fees that are misunderstood; and
- A comprehensive list of ALL expenses associated with an actively managed mutual fund.
1. The issue of asset weighting fees
For years the mutual fund industry has asset weighted its fees when measuring industry averages. Wealthfront believes that, based on common statistical practice, arithmetic averages are a more relevant method to evaluate mutual funds’ fees and expenses.
According to statisticians, arithmetic averages are most appropriate for circumstances where one wants to evaluate choices available, whereas weighted averages are most appropriate for circumstances where one wants to evaluate behavior. For example, to evaluate colleges based on tuition, you would compare each college’s tuition to the arithmetic average of all colleges’ tuitions. To evaluate how tuition affects the selection of college (i.e., behavior), you would compare the arithmetic average tuition to the “student weighted” average for tuition.
In other words, an arithmetic average is the best way to compare what mutual funds charge. The asset-weighted average is the best way to evaluate what consumers pay. And our goal is to identify the truth behind what funds charge.
Mutual funds present an analogous situation: To evaluate what mutual funds charge (like the choice of colleges we mentioned above), you should compare the mutual funds’ fees with the arithmetic averages of all of their fees. To identify money inflows and outflows into funds, you should compare the arithmetic averages to the asset-weighted averages (i.e., behavior, or where investors are actually putting their money). Despite this accepted statistical approach, the mutual fund industry continues to use asset-weighted averages to describe their industry averages. We asked Lipper Inc., the highly regarded mutual fund market analyst, to perform a study for us comparing the arithmetic averages (what we normally think of as the “mean”) of actively managed mutual fund fees to their asset-weighted averages. Here is what that study found:
|Non Management Fee||0.471%||0.189%|
|Marketing Fee (12b-1)||0.528%||0.196%|
|Front End Load||0.318%||0.402%|
|Back End Load||0.223%||0.041%|
The arithmetic averages of mutual fund fees are almost 60% higher! So as you can see, asset-weighted averages significantly lower the perception of fees and expenses investors pay for actively managed mutual funds.
Using the asset-weighted mutual fund fee average as the standard against which one compares all mutual fund fees is just as inappropriate as comparing each college’s tuition to the student weighted tuition average. We don’t know how/why this practice of using asset-weighted averages began, but we have a hunch it might have something to do with the effective lobbying efforts of the Investment Company Institute (ICI), the mutual fund trade association. As you might expect, the ICI finds fault with our assertion that arithmetic averages are a more appropriate way to evaluate a mutual fund’s fees. Call us crazy, but we put more stock in the methods used by statisticians than an industry trade group!
Finally, asset-weighting averages encourages investors to direct their money to larger actively managed mutual funds. As we pointed out in “Bigger isn’t better when it comes to mutual funds,” larger funds aren’t necessarily more attractive investments.
2. Misunderstood fees
Just because fees are disclosed doesn’t mean they are well or fully understood. We think almost all mutual fund investors understand they pay a management fee. However, the management fee actually represents a small percentage of the total expense associated with owning a mutual fund (see next section). The following are examples of fees or expenses we believe are not well understood:
- Marketing Fees vs. Loads;
- Commissions incurred by the mutual fund; and
- Opportunity cost associated with embedded tax liabilities.
A. Marketing fees vs. Loads: A load fee is equivalent to a commission the investor pays in order to buy or sell a mutual fund. This is not to be confused with the commission the mutual fund manager pays to buy and sell stocks in your mutual fund’s portfolio (more on that below). Funds that charge a high “front end” or purchase fee tend to have low “back end” or sale fees and vice versa. Funds that have high loads have low marketing (12b-l) fees and vice versa. Funds with low sales loads and low marketing fees have high redemption charges. You can be sure one way or another, even “no load” mutual funds charge investors to invest in their funds.
B. Commissions: Most investors don’t realize a mutual fund’s performance is affected by the commissions it incurs to buy and sell its positions. Regulations instituted in 2009 required mutual funds to disclose their portfolio turnover rate, among other information, but fell short of requiring mutual funds to disclose the amount of commissions they pay. Generally speaking, the higher a mutual fund’s turnover, the higher its commissions.
Commissions can include “hard dollar” costs and “soft dollar” costs. Hard dollar costs refer to the amount the mutual fund pays for the actual execution of a trade. Soft dollar costs represent the incremental commissions brokerage firms charge the mutual fund to pay for outside services such as reimbursing third parties for proprietary research they provide to the mutual fund manager. We have no problem with mutual funds paying for research, but we think they should bear the cost of third party research, not their investors. After all, a fund wouldn’t expect its investors to pay the salary of an internal research analyst. Why should investors pay for third party research?
C. Opportunity cost associated with embedded tax liabilities: Most mutual fund investors think they only owe taxes on the gain in their net asset value (NAV) and income received post-investment. What they don’t realize is they may owe taxes on gains and income accumulated even before they invest in a mutual fund. Imagine you invested in a mutual fund on July 1st at which time the fund had an unrealized gain of $100 million (which is hard to determine because it is only disclosed quarterly and even then we think it is not easy to find in the disclosures). Let’s further assume the value of the fund did not change for the rest of the year, but at the end of the year the mutual fund realized the gains created before you invested. Believe it or not, you are on the hook for your proportionate share of those gains even though you were not an investor when those gains were created. It seems absurd, but it’s how our tax laws work (interestingly individuals who have their money managed in separate accounts are not taxed up front like this).
At the end of what we will assume is your 5 year holding period (the average holding period for a mutual fund held outside a retirement plan according to the ICI), you don’t have to pay these taxes because some other investor is left footing the bill. So in theory you will breakeven on the taxes. However you have given up the opportunity to invest the money Uncle Sam took from you arguably 5 years too early. Assuming you invested the taxes (that we argued you shouldn’t have had to pay yet) for 5 years at the average return for the S&P 500 Index over the past 30 years and then amortized that opportunity cost over the expected 5 year holding period, we estimate you would have lost 0.50% of your account value per year (see detailed explanation in the Opportunity cost associated with embedded tax liabilities section).
This phenomenon would have created a tax benefit if the fund had accumulated an unrealized loss prior to your investment, but over the long term we think it’s much more likely you will incur an opportunity cost because markets are up more often than they are down. Also, non-taxable accounts would not incur this opportunity cost because they don’t pay taxes. Fortunately this kind of opportunity cost is not possible with a separately managed account of the type offered on Wealthfront.
3. Complete list of fees and expenses associated with a mutual fund
Much to our surprise we were not able to find a study that lists in one place all the expenses associated with owning a mutual fund. A number of market research firms had written reports on individual fees, but they never aggregated their reports to display the entire cost. With Lipper‘s help, we were able to identify the average total cost of owning a mutual fund and compare it to the cost of investing on Wealthfront:
|Non Management Fee||0.47%||0.00%|
|Opportunity Cost on Embedded Tax Liability||0.50%||0.00%|
Please see our complete analysis for a detailed description of how each mutual fund fee was calculated along with the appropriate disclosures.
The table above adds the fee categories described in Section 1 (above) with the fee categories described in Section 2 (above). You will notice we chose to use arithmetic averages rather than asset weighted averages for the reasons described in Section 1. We added the Wealthfront column to show the premium one needs to pay on average to have one’s money invested in an actively managed mutual fund vs. in an average separately managed account on Wealthfront (of course fees vary by mutual fund and Wealthfront manager).
As of December 31, 2010, the average management fee associated with a Wealthfront manager was 1.16%. The lowest Wealthfront manager fee was 0.5% and the highest was 2.0% although theoretically a Wealthfront manager could have set his or her fee as high as 3.0%. The average Wealthfront commission is based on our average manager’s portfolio turnover rate of 71% and a commission charge of $0.02 per share (the rate charged by our brokerage partner, Interactive Brokers LLC). Soft dollar commissions are not possible on the Wealthfront platform, which could explain the difference between Wealthfront’s average commissions and the average commission incurred by mutual funds.
Add up all the fees and expenses you pay to own an actively managed mutual fund and we think you’re looking at an annual cost of 3% of assets under management. Paying approximately 3% might explain why consumers are so frustrated with their actively managed mutual fund investments. For a more detailed explanation of all the fees charged by mutual funds, we suggest you read Unconventional Success by David F. Swensen, Chief Investment Officer of the Yale Endowment.
The only fee you pay to Wealthfront is the management fee charged by your manager and it is prominently displayed in real time on every money manager’s portfolio page. There are no marketing fees, sales loads, soft dollar expenses or early payments of taxes since it is a separately managed account. Everything is disclosed because of our philosophy of transparency. Fees should not be the sole basis on which you choose the best person to manage your money, but a 1.7% difference between the average fee charged by Wealthfront and the average total fees and expenses associated with mutual funds is hard to ignore.