October 18, 2016 | by James Behr Jr
Last week, we discussed the importance of avoiding Equity-Indexed Annuities which give the illusion of principal protection and growth. This week, we will discuss how investors should ignore and avoid specific Mutual Funds and Closed End Funds (CEF) sold at the Initial Public Offering (IPO) in order to remain steadfast on the path to reaching their investment goals.
Mutual Funds, by nature, offer investors with a wide variety of investment opportunities. However, not all of these opportunities are worth pursuing as reliable investment vehicles. We will discuss why investors should ignore and avoid Mutual Funds with 12b-1 Fees, Proprietary Mutual Funds, and Front-Loaded Mutual Funds.
A 12b-1 fee is an annual marketing or distribution fee that mutual fund investors pay to the fund managers, usually ranging from 0.25% – 1%. The initial intent of a 12b-1 fee was to utilize marketing to increase the fund’s assets under management, thus lowering the expenses due to economies of scale. However, in practice, these economies of scale are rarely recognized. By paying the 12b-1 fee, an investor is paying their broker a fee to attract new investors to the fund, which reduces the value of the fund without increasing the per share net asset value. The 12b-1 fees are also included in the expense ratio of a mutual fund and thus, reduce the investor’s returns. In theory, 12b-1 fees may seem like an effective way to promote mutual fund growth, but these sunk costs reduce returns and should be avoided altogether.
Proprietary Mutual Funds, in simplest terms, are mutual funds that are sold and managed by the same brokerage firm. The immediate red-flag that is raised with Proprietary Mutual Funds is in regards to the Fiduciary Standard. Proprietary Mutual Funds can lead to perverse incentives by brokerage firms in which the firm can suggest certain “in-house” funds to receive high fees although there may be other preferential alternatives with stronger performance. Furthermore, if an investor decides to switch brokerage firms, they may incur additional fees and expenses to fund managers in order to switch firms. As previously discussed, higher fees and expenses translate to decreased investor returns. As an investor, your interests or incentives should never come after the interests or incentives of your brokerage firm. Reduce this possibility and avoid investing in Proprietary Mutual Funds.
Front-Loaded Mutual Funds consist of an initial fee paid when a mutual fund is purchased. The fee reduces the initial investment from the onset of the position. For example, assume a mutual fund has a front-end load of 5%. If an investor were to provide $1,000 to a fund manager, the manger would only invest $950 in the fund. The front-end load serves as a form of compensation to the fund manager before the manager’s credibility can be verified in the form of investor returns. In other words, front-end loads compensate fund managers for potentially being profitable. It does not take a savvy investor to recognize that compensating a manager before they prove their prowess is a questionable concept. Investors should avoid Front-Loaded Mutual Funds that may obstruct them from reaching their investment goals.
Last month, we posed the question, “Would you ever buy something worth $1 for $1.01 or more?” The question correlates to purchasing a Closed End Fund (CEF) at the Initial Public Offering (IPO). Purchasing a CEF at its IPO price, an investor should expect to pay a premium. The premium is derived from all of the fees associated with opening a new fund, such as underwriting fees and legal fees. For example, an investor may pay $25 for $23 worth of assets. The residual $2 is used to cover the costs of the aforementioned underwriting and legal fees, to name a few. A few months after the fund’s inception, these premiums usually turn to discounts, causing investors to significantly underperform the net asset value of the fund. CEFs serve as reliable investment vehicles, but as an investor, avoid buying a CEF at the IPO as it includes bearing the cross of corresponding fees in the form of a premium.
Mutual Funds and Closed End Funds are popular amongst investors due to the instant diversification, professional management, and potential returns that they offer. However, investors should still avoid Mutual Funds with 12b-1 Fees, Proprietary Mutual Funds, Front-Loaded Mutual Funds, and CEFs sold at the IPO. Why settle for investments that could inhibit the realization of your investment goals?