Mutual Fund Fees: Transparency and Worth
By Ryan Warm
Mutual funds are popular among investors because they are diversified investment vehicles managed by full time professionals. It’s a way people outsource the management of their savings. Crucially, investors are often unaware of the many fees and expenses that fall outside a fund’s expense ratio, unless they take the time to study and research the matter. There are all sorts of possible mutual fund fees, including hidden expenses and returns-damaging practices, that may impact an investor’s gains. Active managers justify their sometimes, hefty fees by pointing to performance, so it’s useful to evaluate mutual fund performance against passively managed and index funds. The ethics of mutual fund fees largely involve the issue of transparency. As such the best policies on fund fees are those that lead to true, total, transparency.
Part 1: Brief History of Mutual Fund Regulation
To understand the basics of mutual fund fees, its necessary to know the laws and regulations that govern them. The Securities Act of 1933, also known as the “Truth in Securities Act,” requires funds to disclose important information regarding securities offered for public sale. The Securities Exchange Act of 1934 established the Securities and Exchange Commission or SEC, which was granted regulatory authority over the entire mutual fund industry. The Investment Act of 1940 furthered the push towards transparency in mutual fund investing, mandating the disclosure of funds’ financial health and investment policies. The 1940 Act introduced the N-8A form, which gives investors insights to a fund’s operating expenses and fees. The Act also mandates mutual funds provide investors with a prospectus (a document detailing investment information about a mutual fund), annual and semiannual reports, annual privacy notice, and “some forms of tax information” (Meggitt, 2019). The SEC ensures all prospectuses include a fee table outlining Shareholders Fees, which include sales loads, redemption fees, exchange fees, account fees, purchase fees, and Annual Fund Operating Expenses. The latter expense group includes management fees, Distribution and Service (12b-1) fees, and other expenses (SEC, 2019). In 1970, amendments were added to the Investment Act of 1940. These amendments prohibited investment companies from engaging in “deceptive incentive compensation practices” (Business Dictionary, 2019). One notable addition within these amendments, section 36(b), permits mutual fund investors to sue funds for charging excessive asset management fees.
The Financial Industry Regulatory Authority (FINRA), created in July 2007, oversees security firms in the U.S. FINRA works alongside the SEC to enforce mutual fund regulations and govern the way firms market and sell mutual funds (Meggitt, 2019).
Part 2: Fees, Fees, and More Fees
Annual Fund Operating Expenses
Annual Fund Operating Expenses are annual fees an investor pays each year as a percentage of the value of her investment. These expenses include management fees, distribution and service (12b-1) fees, and “other expenses” (Capital Group, 2019). As a whole, Annual Fund Operating Expenses are known as the expense ratio.
Management fees are expenses paid to a fund’s investment advisors for managing the investment portfolio. These fees are usually the largest contributor to the expense ratio (Morningstar, 2019).
Distribution and service fees, often called 12b-1 fees, are fees paid by the fund to cover distribution expenses and shareholder service expenses. The distribution fees are “fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature” (SEC, 2013). Shareholder service expenses are fees paid to persons to respond to “investor inquiries and provide investors with information about their investments” (SEC, 2013). FINRA has capped 12b-1 fees at 1% of an investors’ assets in a fund. The portion of 12b-1fees used to pay marketing and distribution expenses are capped at 0.75% and the portion used to pay shareholder service fees is capped at 0.25%. Studies suggest that around 70% of mutual funds charge 12b-1 fees in at least one share class. The average annual mutual fund 12b-1 fee is around 0.13% (Furhmann, 2019).
The “other expenses” portion of the expense ratio can be delegated to a number of services and tasks. These fees can be related to recordkeeping, custodial services, taxes, legal expenses, accounting, and auditing. These expenses are reflected in a fund’s daily net asset value but does not appear as a distinct charge to shareholders (Hayes, 2019).
Shareholder Fees:
Shareholder Fees are fees charged when an action is made on a fund. These fees are paid directly from the investment into a mutual fund. These expenses can include sales loads, redemptions fees, exchange fees, account service fees, and purchase fees (Vanguard, 2019).
Sales loads are fees a mutual fund charges to compensate brokers who complete the buying and selling transactions of a fund. This fee is similar to the commission an investor pays when purchasing any type of security from a broker. Sales loads can be in the form of front-end sales loads or back-end sales loads. A front-end sales load is a fee an investor pays when she purchases shares, while a back-end sales load is a fee an investor pays when redeeming shares. The SEC does not limit the number of sales loads a fund can charge, but FINRA ensures all load expenses do not exceed 8.5% of the purchase of sale (SEC, 2013).
Redemption fees are fees charged by a mutual fund when an investor sells her shares before a certain time period. Mutual funds are intended to be long-term investments and do not want short-term buyers. These fees discourage frequent traders and market-timers from buying and selling mutual fund shares repeatedly over short periods of time (Motley Fool, 2016). Most fund companies use a redemption fee timeframe of 30 days. The SEC limits redemption fees to 2% (SEC, 2013).
Other shareholder fees include exchange fees, accounts fees, and purchase fees. An exchange fee is only applicable if an investor wishes to transfer shares to another mutual fund within the same fund group. An account fee is the fee mutual fund companies charge investors for the maintenance of their accounts (SEC, 2013). This fee may only apply to specific investors, as it frequently targets accounts that have balances below a certain dollar amount. For example, Vanguard charges an annual $20 account fee for fund account balances below $10,000 (Vanguard, 2019). A purchase fee is a fee some funds charge when an investor purchases shares of their fund. This differs from a front-end sales load because this fee goes directly to the fund instead of a broker.
Hidden Fees:
The Annual Fund Operating Expenses and Shareholder Fees described above are the only fees outlined and required to be disclosed by the SEC in a fund prospectus. However, there are a number of “hidden” fees and costs that apply to mutual funds. Generally, fees are considered hidden if they are not disclosed on the fee table in the prospectus.
Transaction fees, or brokerage fees, are the transaction costs mutual funds incur from buying and selling securities in the portfolio. These brokerage commissions are shared by all mutual fund investors, adding to the list of fees investors pay. Transaction fees are not required on a mutual fund’s prospectus. A Vanguard prospectus writes that “as is the case with all mutual funds, transaction costs incurred by the fund for buying and selling securities are not reflected in the table” (Berger, 2018). Investors in small-cap growth funds pay an average of 3.17% per year in transaction costs. Investors in large-cap value funds pay an average of 0.84% per year in transaction costs (2018).
Tax inefficiencies are another hidden cost of investing in mutual funds. Many investors are unaware of fund tax inefficiencies, as these are not explicitly stated or clearly explained by funds. The way taxes are calculated for stocks and mutual funds are vastly different. “Stock investors pay taxes on an investment only if they have pocketed dividends or income or have sold the fund for a profit…but investors in conventional mutual funds can get stuck with a tax bill on their mutual fund holdings, even if they’ve lost money since they’ve held the fund” (Morningstar, 2011). This is because capital gains taxes paid by the mutual fund are for security gains received on the lifetime of the investment. Mutual fund taxes do not consider individual investors’ returns or positions. To fully understand mutual fund tax inefficiencies, here is sample scenario:
An investor buys a mutual fund that holds a stock valued at $50 a share at the time of her purchasing the fund. Over a period of time, this stock drops to a value of $40 a share, and the mutual fund proceeds to sell the stock. The investor lost money on this investment and should be entitled to a tax write-off. However, it is possible that, before the investor entered the fund, the mutual fund purchased the stock at a value of $30 a share. Because the mutual fund received capital gains on this investment, all investors must share the tax on the profit of the fund.
In short, mutual fund investors may pay taxes on capital gains they did not receive, reducing their return on investment (Kim, 2016). The average cost of mutual fund tax inefficiency is approximately 1.10% per year (Morningstar, 2011).
The last “hidden” fee may not be considered a fee or expense, but rather a missed opportunity for excess returns. Mutual funds keep approximately 5% of their assets in cash. These cash assets are used for transactions and day-to-day redemptions of shares. While cash assets are convenient and practical for funds themselves, the cash eats away at investors returns. Return on equities are expected to exceed return on cash by 6% over an extended time period of time. Ultimately, when mutual funds keep 5% of their assets in cash, investors accumulate another 0.15% in hidden costs (Berger, 2018).
Part 3: The Worth of Mutual Funds
The Morningstar U.S. Fund Fee Study
Morningstar’s U.S. Fund Fee Study shows that investors paid less to own funds in 2018 than ever before. Results found that U.S. open-end mutual funds and exchange-traded funds had an “asset-weighted average expense ratio of 0.48% in 2018, down from 0.51% in 2017” (2019). This 6% fee decline translates to an estimated $5.5 billion in saved expenses.
The savings are consistent with the “fee war” mutual fund companies have been facing over the past couple of decades, as the industry experiences a “mass migration” to lower-cost funds (Godbout, 2019). The asset-weighted average expense ratio has fallen every year since 2000. Investors are now paying around 50% less to own funds than they were in 2000, 40% less than they were 10 years ago, and around 26% less than they did 5 years ago. Morningstar attributes this overall decline to greater awareness and increasing investment literacy, intensifying competition among asset managers and funds, and the shift towards fee-based financial advice instead of the traditional commission model (Morningstar, April 2019).
Although mutual fund fees are consistently declining, and investors are saving billions compared to previous years, this does not yet justify their fees or make their expenses “worth it.” The asset-weighted average expense ratio for active mutual funds was 0.67% in 2018. The asset-weighted average expense ratio for passive funds was 0.15% in 2018 (2019). This means that active-fund investors paid 4.5 times more than passive-fund investors to own their funds. This is the widest gap “between active and passive fund fees since” Morningstar began tracking trends in asset weighted average fees in 2000 (2019). To see whether or not these active funds are overcharging their investors, we look to the Morningstar Active/Passive Barometer and the SPIVA Scorecard.
The Morningstar Active/Passive Barometer
The Morningstar Active/Passive Barometer measures around 4,600 unique funds that “account for approximately $12.8 trillion in assets, or about 69% of the U.S. fund market” (2019). The latest semiannual report found the following results, in comparing high expense active funds with their low expense passive counterparts among 1 and 10-year periods.
Short-term Measures: In 2018, only 38% of active U.S. stock funds outperformed similar passive funds. This number is down from 46% in 2017. Additionally, only 35% of active funds beat the passive composite for their category in 2018 (Morningstar, Feb. 2019).
Long-term Measures: Over the 10-year period ended December 2018, only 24% of all active funds outperformed their average passive rival. In that same period, the funds with the lowest expense ratios had a 32.5% success rate, while funds with the highest expense ratios had a 17.2% success rate. In terms of survival, almost 67% of the cheapest funds remain a fund, while only around 50% of the most expensive funds are still managed (2019).
Overall, this study shows that in general, active funds are not worth the premiums they charge. They are unable to, more times than not, compensate for the high expense ratios and turnover rates that damage investors’ returns.
The SPIVA Scorecard
Another credited data source in the active versus passive debate is the SPIVA Scorecard. The SPIVA Scorecard breaks down active fund performance based on market capitalization to see if funds may have an advantage in certain markets. Overall, the SPIVA U.S. Year-End 2018 report found that 2018 was the “fourth-worst year for U.S. equity managers since 2001.” Results showed that 68.83% of domestic equity funds underperformed the S&P Composite 1500 (2019).
Large-cap funds: For the ninth consecutive year, the “majority of large-cap funds underperformed the S&P 500.” Only 35.51% of these funds were able to beat the index (S&P Dow Jones Indexes, 2019).
Small-cap funds: The majority of small-cap funds also struggled to outperform the respective index in 2018. Only 31.55% of the actively managed funds were able to beat the SmallCap 600 index (S&P Dow Jones Indexes, 2019).
Mid-cap funds: As a sign of hope for actively managed funds, 84.80% of mid-cap funds outperformed their index in 2018. This is the second consecutive year that mutual fund managers were able to beat the MidCap 400 index (S&P Dow Jones Indexes, 2019).
Overall, the SPIVA Scorecard is consistent with the Active/Passive Barometer. Although some active funds are able to beat their respective index and provide excess returns to their investors, a majority of the funds are not worth the added fees and consequently charge far too much for their services.
Part 4: Ethical Concerns About Mutual Fund Fees
There are numerous ethical concerns with the fees mutual funds may charge their investors. Mutual fund fees are often unclear or hidden, resulting in a lack of certainty and transparency for investors. This why is professional databases such as the Morningstar Active/Passive Barometer and the SPIVA Scorecard are only able to compare and quantify expense ratios and must leave out Shareholder Fees and Hidden Fees in their calculations.
On the surface, 12b-1 fees may seem transparent. As noted, FINRA capped the fee at a total of 1%, with a maximum of 0.75% for marketing and distribution and 0.25% for shareholder service fees. Therefore, investors can be certain they will not be paying more than 1% of their assets towards this fee. However, there is a complete lack of transparency on what this fee actually funds. A description and blanket statement of “marketing, distributing, and service” is given, but no further specification is provided. As an investor, it’s impossible to tell if this fee is being put to good use. In addition, this fee incentivizes a conflict of interest. A portion of 12b-1 fees are used towards the compensation of brokers who sell the mutual fund to investors. This gives brokers an incentive to recommend funds with high 12b-1 fees. Regardless of whether this incentive is utilized, the fee in inherently unethical because it can increase the profit of a broker or advisor at the expense of the best interest of the investor.
The “other expenses” component of the expense ratio features a remarkable lack of transparency. The fee is known to cover a number of things, such as recordkeeping, custodial services, taxes, legal expenses, accounting, and auditing fees, but does not appear as a distinct charge to shareholders. Once again, the investor receives little information, and is unable to see if this fee is being used for her best interest.
Hidden fees that mutual funds do not directly disclose or clearly define in their prospectus, while legal, are unethical. Transaction fees are not required on a mutual fund’s prospectus and are never included in a prospectus fee-table. In order to find previous year transaction costs, an investor must sort through the 100+ pages of the lesser known Statement of Additional Information. To the common investor, comparing transaction fees among multiple funds in not practically workable. Even for an experienced investor, this process is time consuming and can be unmanageable. These fees are unethical because they do not allow investors to fully examine all investment options and make decisions based on fully available information (Ell, 2018).
In addition, mutual funds are not required to include their tax inefficiencies and cash policies as an expense or fee on its prospectus. Fund companies do not disclose any important information that might clarify how taxes are calculated within a fund. The fastest way to understand a fund’s tax implications is to compare its pretax return with its tax-adjusted return. Investors must also then consider state and local taxes, which are not included in any tax-adjusted returns because they vary across the country. Consequently, calculating multiple funds’ tax implications is difficult or unwieldy for the lay investor. While tax inefficiencies and the percentage of cash assets in a fund may not be outright considered as fees or expenses, they still potentially reduce investor returns, making their hidden and unclear nature unethical.
Part 5: Policy Prescription
Despite the improvements made to the Investment Company Act in 1970, there are still many regulatory concerns associated with mutual funds. Section 36(b), which permits mutual fund investors to sue funds for charging excessive management fees, has proven ineffective over the years. Section 36(b) has never resulted in a verdict for plaintiffs. The “extremely fact-bound nature of the excessive fee standard” makes obtaining “early dismissal of suits difficult and litigation lengthy and expensive” (Quinn, 2018). There is also little evidence these lawsuits are effective in reducing fees when funds are sued.
A new set of amendments must be added to the Investment Company Act to give more power and transparency to investors. Pre-existing sections, such as 36(b), need to be expanded from their narrow focus on excessive management fees, to all fees and expenses. New sections must be added to eliminate unclear and hidden fees, requiring clear descriptions and explanations of all fees and return-diminishing practices. In addition, mutual funds should be required to breakdown the components of each fee so that the 12b-1 and other expense fees are more defined, allowing investors to see what each fee pertains to. With this, funds should explain the necessity of each fee, and describe how they plan to translate additional fees into added return for the investor. Mutual funds should strive to guarantee that anything that could have a sizeable impact on a fund’s returns, good or bad, are clearly stated on the summary prospectus.
Recently, FINRA completed a “mutual fund waiver initiative.” This initiative set out to confirm that mutual funds were waiving fund sales charges for eligible accounts. Essentially, FINRA did an investigation to verify that mutual funds were not overcharging charitable and retirement plan accounts (Ong & Rote, 2019). On July 17, 2019, FINRA announced that it reached settlements with 56 member-firms and obtained a total of $89 million in restitution for “nearly 110,000 charitable and retirement accounts as a result” of the initiative (2019). This initiative, which reduced unnecessary and unlawful mutual fund fees, was a necessity. FINRA must continue running initiatives that hold funds responsible for their fees, and the SEC needs to create legislation to increase transparency and trust between funds and their investors.
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