June 6, 2017 | by James Behr Jr & Christopher Paleologus
Since the 1960’s, mutual funds have seen an exponential increases in demand. Mutual funds have basically become a “go-to” investment for retail and institutional investors alike. According to Investopedia, over $28 trillion is currently invested in mutual funds worldwide! Today, investors often praise mutual funds for their diversification and professional management.
However, what is rather unknown are the numerous “hidden” fees associated with mutual funds. Unlike common stock, where investors only compensate brokers based off agreed-upon trading commissions, mutual funds incorporate various expenses. The two most prevalent mutual fund expenses are management fees and 12B-1 fees. Management fees are costs incurred for the services of investment managers. Management fees are usually set between 0.5% and 2.0% of net AUM (Assets Under Management), depending on the firm. Companies state that management fees should be positively correlated to the expected performance of fund managers. Thus, for managers with strong past performance, management fees would tend to be higher. 12B-1 fees are relatively less acknowledged than management fees. 12B-1 fees cover a company’s annual marketing and distribution costs. These fees are set between 0.25% and 1% (maximum allowed). Firms stress the importance of the 12B-1 fees to investors, stating that increasing assets and economies of scale will help them in the long-run.
What makes mutual fund costs “hidden” is not the fact that they are concealed from prospective investors. Both management and 12B-1 fees are clearly stated in the prospectus shown to investors before a purchase. Rather, it is the end-use of these fees that should concern investors. It is required that management fees be paid regardless of manager performance. This notion is quite alarming, based off the consistent lackluster returns mutual fund managers have garnered. According to a recent SPIVA scorecard, 66.11% of large-cap fund managers underperformed compared to the S&P 500 in 2015. Ultimately, mutual fund companies are charging investors for poor performance. In addition, the firms that do in fact outperform rarely ever maintain their success. According to recent research conducted by S&P Global, only 4.28% of managed funds stayed in the top quartile between September 2013 and September 2015. In an industry where managers rarely ever exceed their benchmark, investors are paying unnecessary fees for the illusion that managers can offer a competitive advantage.
Firms will also insist that more marketing to consumers will increase the size of the fund and in turn, increase existing investors’ profit. With over $28 trillion invested in the global mutual fund market, it is hard for companies to justify levying 12B-1 fees to increase economies of scale. Bigger is not necessarily better when dealing with the size of a mutual fund as there is evidence that larger funds actually underperform smaller ones. According to a 2014 study from Novus Research, smaller managers have outperformed larger managers by 2.2% per annum over the past 10 years. The main reason for this disparity is due to a phenomenon called asset bloat. Asset bloat refers to the constraints managers face as AUM increase. It tends not to be an issue for bond, index, or money market funds which operate in large market segments and have higher liquidity. However, for equity mutual funds, asset bloat makes it challenging for fund managers to invest actively and effectively. As AUM increases, the number of fitting investments shrink and transaction costs rise. Fund managers are put in a predicament; they must decide whether to expand their stock selections or increase positions in stocks they already own. Often times, when mutual funds become so large, they perform like indexes rather than individually managed funds. The expansion of these funds takes out the role of the manager completely.
Additionally, excessive marketing does not need to be exercised by behemoth companies such as Vanguard and Fidelity because of their popularity amongst investors. Thus, these “marketing” fees are actually charged for superfluous reasons. Today, 12B-1 fees are mainly used to reward intermediaries for selling a fund’s shares. As the pie chart from ICI portrays below, only 5% of 12B-1 fees are actually allocated to advertising and other sales-promotion services! The bulk of 12B-1 fees, 63% to be exact, are allotted to the compensation of the broker. This compensation adds no value-added service to the investment and does not increase the performance of the fund; it simply helps brokers put extra cash in their pocket.
So are mutual funds poor investments? Not entirely. Low cost mutual funds can still be viable vehicles for diversification. Over time, these investments have the potential to deliver decent returns. If you decide to invest in a mutual fund, seek smaller funds with low expenses! In fact, funds with lower expenses have been shown to generate greater returns than funds with higher expenses.
Due to the fact that the overwhelming majority of fund managers underperform and 12B-1 fees provide no added value to investors, mutual funds may not be the best investment for you. An excellent alternative to a mutual fund is an ETF, or exchange-traded fund. An ETF is a security traded on an exchange during the day and tracks an index, commodity, or a basket of assets like an index fund. Because it acts like an index, ETF’s provide instant diversification. However, what separates an ETF from a mutual fund is its lower costs. According to Morningstar, the average ETF expense ratio is less than the average actively managed mutual fund expense ratio. ETF’s also do not charge 12B-1 fees or any sort of load! ETFs provide many similar advantages mutual funds offer but can be available at much lower costs.
Soe, Cfa Aye M. “SPIVA U.S. Scorecard.” SPIVA ® U.S. Scorecard, pp. 1–1., us.spindices.com/documents/spiva/spiva-us-yearend-2015.pdf. Accessed 24 May 2017. Soe, Aye M. “Does Past Performance Matter? The Persistence Scorecard.” Thought Leadership – Research, Jan. 2016, us.spindices.com/resource-center/thought-leadership/research/. Accessed 23 May 2017.  Gentilini, Andrea. “How AUM Growth Inhibits Performance.” HubSpot, Novus Research, May 2014, cdn2.hubspot.net/hub/305037/file-809445518 pdf/Novus_Research/How_AUM_Growth_Inhibits_Performance.pdf?t=1400251676926&submissionGuid=f5c05d4c-e8bb-4c3b-80cf-9572d3274ea8. Accessed 26 May 2017.  Investment Company Institute  Hayes, CFA Adam. “Exchange-Traded Fund (ETF).” Investopedia, 11 Apr. 2017, www.investopedia.com/terms/e/etf.asp. Accessed 24 May 2017.