ETF Prime Archive

Financial Advisor Gone Bad

Going through the summary of mutual fund fees reminded me of this cartoon I found a few months ago:

A Glossary of Mutual Fund Expenses and Fees

It is difficult for average mutual fund investors to understand what they are paying for their investments – especially if they use a broker and the broker is paid through commissions. There are so many share classes, front-end fees, back-end fees, redemption fees, etc. that it is no wonder people are confused.  It’s amazing how many people I know have no idea what they are paying.

So, I went on the web to try and find a good place for people to go to get educated, and to my surprise, the best site I could find was no other than the Securities and Exchange Commission.  The information below is taken directly from their site and is a comprehensive overview of mutual fund fees.  It may not tell you exactly what you are paying, but it should give you a good place to start – and help you know what questions to ask your advisor.

The first list of expenses below are called Shareholder Fees. These represent the fees incurred in some funds that choose to cover the costs associated with an individual investor’s transactions and account by imposing fees and charges directly on the investor at the time of the transactions (or periodically with respect to account fees). These fees and charges are identified in a fee table, located near the front of a fund’s Prospectus, under the heading “Shareholder Fees”.

• Sales loads – Funds that use brokers to sell their shares typically compensate the brokers. Funds may do this by imposing a fee on investors, known as a “sales load” (or “sales charge (load)”), which is paid to the selling brokers. In this respect, a sales load is like a commission investors pay when they purchase any type of security from a broker. Although sales loads most frequently are used to compensate outside brokers that distribute fund shares, some funds that do not use outside brokers still charge sales loads. The SEC does not limit the size of sales load a fund may charge, but FINRA does not permit mutual fund sales loads to exceed 8.5%. The percentage is lower if a fund imposes other types of charges. Most funds do not charge the maximum. There are two general types of sales loads-a front-end sales load investors pay when they purchase fund shares and a back-end or deferred sales load investors pay when they redeem their shares.
• Redemption Fee – A redemption fee is another type of fee that some funds charge their shareholders when the shareholders redeem their shares. Although a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not considered to be a sales load. Unlike a sales load, which is used to pay brokers, a redemption fee is typically used to defray fund costs associated with a shareholder’s redemption and is paid directly to the fund, not to a broker. The SEC limits redemption fees to 2%. The SEC has adopted a rule addressing the imposition of redemption fees by mutual funds in Rule 22c-2 of the Investment Company Act of 1940.
• Exchange Fee – An exchange fee is a fee that some funds impose on shareholders if they exchange (transfer) to another fund within the same fund group.
• Account Fee – An account fee is a fee that some funds separately impose on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount.
• Purchase Fee – A purchase fee is another type of fee that some funds charge their shareholders when the shareholders purchase their shares. A purchase fee differs from, and is not considered to be, a front-end sales load because a purchase fee is paid to the fund (not to a broker) and is typically imposed to defray some of the fund’s costs associated with the purchase.

The list of costs below are referred to as Fund Operating Fees. Funds typically pay their regular and recurring, fund-wide operating expenses out of fund assets, rather than by imposing separate fees and charges on investors. These expenses are typically called Fund Operating Expenses.  In the fee table in the mutual fund prospectus, under the heading of “Annual Fund Operating Expenses,” you will find:

• Management Fees – Management fees are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio , and administrative fees payable to the investment adviser that are not included in the “Other Expenses” category (discussed below).
• Distribution or Service Fees (Often known as 12b-1 Fees – This category identifies so-called “12b-1 fees,” which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses.”12b-1 fees” get their name from the SEC rule that authorizes a fund to pay them. The rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (12b-1 plan) authorizing their payment. “Distribution fees” include 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. The SEC does not limit the size of 12b-1 fees that funds may pay. But under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund’s average net assets per year. Some 12b-1 plans also authorize and include “shareholder service fees,” which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in this category of the fee table. If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the “Other expenses” category, discussed below. FINRA imposes an annual .25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan).
• Other Expenses – Included in this category are expenses not included in the categories “Management Fees” or “Distribution [and/or Service] (12b-1) Fees.” Examples include: shareholder service expenses that are not included in the “Distribution [and/or Service] (12b-1) Fees” category; custodial expenses; legal expenses; accounting expenses; transfer agent expenses; and other administrative expenses.

So there it is, a complete inventory of mutual fund expenses.  Keep in mind that, according to the SEC website, the SEC typically does not impose a limit on what a fund can charge, so buyer beware!!

A Better Mousetrap for Fixed Income

Most investors and advisors who have come to use and appreciate ETFs would agree that the case for ETFs relative to actively-managed mutual funds in the equity arena is firmly established, crystal-clear and completely unambiguous.  But what about in the fixed income domain?

Relative to their equity counterparts, can fixed income ETFs boast of advantages nearly so compelling in the areas of holdings transparency, breadth of systematic coverage of asset classes, consistency of coverage (i.e., lack of style drift and related concentration migration risks), low cost, tax efficiency and trading flexibility (for risk management purposes)?  And are active fixed income mutual fund managers nearly so incapable of consistently outperforming their generic, passive index benchmarks?  The answers, really not surprisingly, are Yes, Yes, Yes, Yes, Yes, Yes, Yes and a very, very big (huge) YES!

“Oh, but there are such important inefficiencies and a lack of price discovery in bond markets that active management and security selection surely must add alpha,” according to the familiar refrain from active fixed-income managers and their legions of marketing and sales specialists.

But is that active managers’ holy grail known as alpha delivered in the real world?  How about if we just cut to the chase and take a look at the world’s largest actively-managed fixed income mutual fund and its corresponding index benchmark?

Let’s  look at the world’s largest actively managed bond mutual fund – PIMCO’s Total Return Bond Fund. with roughly $120 billion in assets across its slate of share classes. The fund earned a 5-Star Morningstar rank overall as well as for 3, 5 and 10 year performance in the intermediate-term bond category.  That 5-Star ranking implies that the fund was in the top 10% within a group of peers falling under the Intermediate-Term Bond Fund classification.  And let’s look also at two ETFs covering the Barclays Aggregate Bond Index – the index identified as Total Return Bond Fund’s “benchmark”.

PTRAX and AGG

PTRAX and BND

Overall, it looks like the world’s largest actively managed bond fund, representing the top ranking 10% of such funds, is basically neck-and-neck with ETFs based on the fund’s passive benchmark index … Morningstar one-year (2008) data show that the PIMCO fund beat the two ETFs on a pre-tax basis by 65-92 basis points but underperformed on an after-tax basis by 51-72 basis points.  On a 5-year basis, PTRAX beat AGG on a pre-tax basis and by 92 basis points on an after-tax-basis.  And, again, that’s part of the top 10% of the Intermediate-Term Bond fund class.  So, going forward, how likely is the Total Return Bond Fund to eek out a long-term positive performance spread to its passive index counterparts?  Whether an investor in the Total Return Bond Fund or another of the 900+ actively managed mutual funds in the space, looking and hoping to fall into that “superior” 10% group, you simply have to ask your self, “Do I feel lucky today?”

American Funds Raising Fees

I referenced an article last month from the Motley Fool [link to post] that discussed the possibility that mutual fund fees would go up in 2009.  Despite the market meltdown of 2008 and the exodus of assets out of equity funds, American Funds has made the somewhat predictable decision that they need to raise their fees so they can, in their words, “maintain our ability to serve fund shareholders in the best way possible”.  Hmmmm.  In case you’re wondering, here are the 2008 returns for some of the largest mutual funds in the American Funds family – these are all ‘A’ shares:

Fundamental Investor:  -39.7%
Growth Fund of America:   -39.1%
Income Fund of America:  -28.9%
Investment Company of America:  -34.7%
New World:  -46.3%
Smallcap World:  -49.4%

See more information here.