The stuff that could make all the difference in your Mutual Funds

Fees and Expenses.

Investors in mutual funds incur two primary kinds of expenses and fees: Fund expenses and loads.  Whereas fund expenses are paid indirectly from fund assets throughout the year, sales loads are one-time fees that investors pay either at the time of purchase or when units are redeemed.

Take a deep breath and let’s go for a deep-dive into those expenses

hold your breath for a deep-dive into fees and expensesFund expenses cover operating expenses and fees, whereas sales loads are one-time charges and may either be front or back end sales charges.

The US Securities and Exchange Commission (SEC) summarizes the regular fund operating expenses by enlisting these fees into the category: Investment Advisory Fees, Marketing and Distribution Expenses, Brokerage Fees, Custodial Fees, Transfer Agency Fees, Legal Fees, and Accountants fees. Lots of fees, right?

A fund’s prospectus will enlist certain charges under the Annual Fund Operating Expenses.  These charges include Management Fees, Distribution or Service Fees, Other Expenses, and Total Annual Fund Operating Expenses.  These expenses are charged indirectly as they are paid out of fund assets.

Separately, Shareholder Fees are fees and charges imposed directly on investors for transactions.  These may include Sales Load, Redemption Fee, Exchange Fee, Account Fee, and Purchase Fee.

Most investors, however, are acquainted with expense ratio.  This is one of the most important parameters used while selecting a fund.  This parameter is calculated by dividing operating expenses by the assets under management.  These expenses include Operating and Administrative Costs and Fees.  The fees are operational expenses and range from 0.25%  to a maximum of 1% of the fund’s net asset.  The largest portion of these expenses is attributable to the fees paid to the fund managers or investment advisors.

Still holding your breath?

Before moving on to sales load, it must be noted that many investors believe the expense ratio to be the only charges levied; however, Transactions Costs, Tax Costs, Soft Dollar Cost, and Cash Drag may be the other charges!

Transaction costs may be in the form of brokerage costs which may or may not be found in the prospectus.  Transaction costs also include “spread cost” which is incurred once a fund manager buys or offloads securities.  It is the difference between the ask price and bid price.

Tax costs may be incurred whether or not an investor makes capital gains.  If the fund manager changes portfolio, tax must be paid on appreciated stocks.  Soft dollar cost comes into play once the fund manager hires brokerage services.  Fund managers may seek research or other services from brokerages.  This cost is usually not made public.

Sales Loads are usually one-time charges or commissions that investors need to pay either at the time of purchasing a fund or selling.  Thus, it can either be front-end load or back-end load charges.  Front-end load charges are commissions paid at the time of initial purchase.  It is usually deducted from the invested amount, thus lowering the actual investment value.  Back-end loads are paid at the time of offloading mutual funds.  It is also known as contingent deferred sales charge or load.

Back up to the surface

I do see clearly now.So, can you tell me why most people know exactly how much they pay for their cellphone, which isn’t much, but have no idea how much they pay the person/company managing their mutual funds or unit trusts?

Actually we do have our brains to blame for that oversight.  All of the above fees are a small number – typically less than 3% – while the fund’s performance can be a big number, sometimes surpassing 15% a year.  And the expense figures barely fluctuate at all while the performance numbers are forever flashing up and down.  As a result investors consistently say that they consider past performance to be much more important than current expenses when they pick a fund. We fall prey to the Bigness Bias.

Decades of rigorous research have proven that the single most critical factor in the future performance of a mutual fund is that small, relatively static number: its fees and expenses. Hot performance comes and goes, but expenses never go away.

The fact that many funds have many different hidden fees suggests to me that the fund houses themselves don’t think that people would pay as much for their services if they charged in a clear and up-front way.

For me those complex fee structures fall right smack into the field of “illusion of complexity”.  And the longer it takes someone to explain their investing approach, the worse off it tends to be, but the more intelligent it sounds to unsuspecting investment consumers. are they qualified

The entire financial industry is in the business of selling complexity to justify their existence.  They are a for-profit enterprise.  As such, asset managers and asset owners (that’s us) have a relationship beset with natural conflicts.  We are hardly rowing in the same direction, we are not even sitting in the same boat!

Lucky us, there are less complex and more transparent alternatives available: ETFs.  They even do serve as a good tool to slaughter some of our biases.

If you still want to stick with your actively “managed” mutual funds, do at least check your expenses ratios.  Morningstar found that in every time period they tested and with all else being equal, low-cost funds beat high-cost funds in every single asset class.

In conclusion there are many important facets to consider when constructing your investment portfolio, but none of the technical building blocks will matter if you can’t control your behavior and manage your biases.  Never stop learning more about your biases.

This brings me to the most essential question of them all: Do penguins have knees?

 

In case you want to read more about those fees in the Singapore context, then check out Budget Babe’s post on that topic.

6 Comments

  1. Hi Andy,

    What is your view on Aggregate Asset?
    Zero annual management fee. Pay only on performance.

    • Hi Blursotongking,

      Advantages: The guys from Aggregate Asset Management are professionals who want to marry the advantages of low fees with the advantages of an active stock picking approach. I believe they are on the right track, as their income is mainly dependent on their stock picking skills (besides collecting a 2,000 SGD upfront from each client). They even do have a 5% penalty for early redemption. By this they want to make it clear that they are only an option for a long-term investment horizon and for money that they investor certainly does not need within the next three years. This does address the behavior gap so many of us show when it comes to investing (we are bad in timing the market, time in the market is mostly the better but emotionally more difficult choice)
      It’s also quite fair to say that it is not a scam. They are transparent. They share who they are, where they are located (they want to talk to each investor personally first before taking their money), and where the funds are kept (in a custodian account with DBS).

      Disadvantages are: high minimum investment sum of 150,000; must be an accredited investor; redemptions are not as easy as with ETFs (this could be a good thing for the long-term investor who might get tempted to sell in a short downtrend); regression to the mean (they might not be able to sustain their benchmark beating past performance in the future); they only invest in Asian stocks (investor has to take care of his own geographical and asset class diversification by buying other funds/products in addition).

      Overall I do see their value proposition positive.

      Has anyone experienced Aggregate Asset Management first hand with their own money?

      • Put my money with them about 3 years back – after meeting the team twice and also checking their background with some friends in the funds business. They are widely diversified (across HK and SG), low cost and follow a strategy which is rather difficult for retail investors to replicate more cheaply.

  2. Thanks and that’s really true on various cost impact to mutual fund (or unit trust mostly we call it here) ,,, I don’t have any unit trust in my portfolio ,,and would like to share my ” bad ” experience learned from my investing in unit trust ,,, 🙁
    Cheers!

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