Besides potential sales charges and brokers’ commissions, you incur ongoing fees for the costs associated with operating a mutual fund. These costs can differ significantly between funds and should be reviewed carefully before investing.
Assessing a mutual fund’s cost structure is key to investing success.
Minimizing Fund Expenses is Vital to Investment Success
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, two global equity mutual funds each had a gross return of 10% last year. Fatcat Global Equity Fund had operating expenses of 5% Assets Under Management (AUM). 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 annual 3% in Fatcat expenses will have a significant impact on your compound returns.
Management Expense Ratio
The Management Expense Ratio (MER) reflects the annual cost of operating a mutual fund. Note that some areas of the world call this the Total Expense Ratio to reflect the inclusion of all costs. Then they consider the management fees separately. Just ensure you understand what is included in any fund ratio calculation.
The MER is made up of three fee or expense categories: management; administrative; marketing.
It does not include costs associated with buying and selling fund investments (e.g., commissions, loads, brokers’ fees).
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. So there can be a wide disparity in management fees between funds.
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.
When comparing MERs or the management fee itself, always make sure you compare apples to apples.
For example, it might make sense that a management fee between two Africa international equity funds is 2.10% AUM versus 2.00% 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 may make less sense 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. It is reasonable to expect greater work being required to assess African companies. Greater work equates to higher fees.
Or perhaps the U.S. large cap fund has AUM of $10 billion. In comparing that with another fund holding only $100 million in assets, you may expect the larger fund to have a lower MER. For the simple reason that the bigger fund has more assets against which to spread its costs. Would you expect a fund with $10 billion in assets to require 100 times the management costs versus a $100 million fund?
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. Same as with fund management fees.
Perhaps 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 has lower administrative costs in absolute dollars, 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 (i.e., commission or load) is not a fund expense. Rather it is a direct cost to the investor. It makes sense that it is not included in the fund’s cost structure. Same if you have to pay a brokerage fee to buy or sell the fund.
Transaction costs incurred by the fund when buying or selling fund portfolio investments (e.g. brokers’ commissions, spread differences, etc.) are expenses of 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 (AUM). As stated above, many jurisdictions now blend MER and TER, so you may only see the MER stated. If so, it should also include these internal trading costs.
To further complicate matters, sometimes TER relates only to Trading Expense Ratio. So it is separate from, rather than cumulative with the MER. Anything to confuse investors. And yes, that is a goal of fund companies.
Internal Transaction Costs
In assessing funds, perhaps one fund has a relatively high TER versus its MER. That means the transaction costs are high. 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. Unless high frequency trading is the strategy.
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 (unless that is the strategy).
High turnover may indicate that 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 future performance.
In some instances, it may indicate churning. That is, excessive trading within an account to drive up brokers’ commissions. Less a problem with mutual funds than in other circumstances (e.g., managed accounts), 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 assessing fund costs, always compare like funds. Size, style, geographic region, asset classes, etc., they all impact the cost structure. 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.
