Mutual Funds and Performance Based Fees

Investors talk a good story when it comes to fees. While much of the conversation is begun by those who advocate index funds or exchange traded funds (ETFs are index funds that trade like stocks), the question of fees, how they should be paid and even more importantly, how much is usually based on why they (actively managed mutual funds) charge the rate they do. If mutual fund fees are so important to the investor, why haven’t they pushed harder for performance based fees?

Often referred to as the fulcrum fee, this method of charging the investor based on how well the fund manager actually did has been attempted in the past (and is currently being adopted by the Janus fund family) but has not received much more than a luke warm embrace. Is it because we simply don’t invest the way the wealthy do?

Mutual Fund Fees, Performance and the Fulcrum

by Paul Petillo, Managing Editor of Target2025.com

Mutual Fund Fees

There was a time in the not-so-distant past when mutual funds were not highly regarded. They did provide the average investor with the opportunity to purchase their segment of the stock market with the guidance of a fund manager and comfort of knowing that others felt the same way you did. After all, they were giving this fund their money as well.

But not all investors were thrilled with the arrangement and in the day before the internet, the only way you could find out if your fund was charging too much for their services, was to dig. Not all of us were inclined to do so. We were average investors.

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Comparing Mutual Funds to ETFs

If you wonder whether the comparisons most often made between ETFs (exchange traded funds) and mutual funds are done without bias, you would be wrong.  To understand why these traded index funds continue sell their attributes based on cost alone is to miss the point.  While they do have very low fees, as all passively traded funds should, the believers in this investment tool trumpet their attributes but do so not by comparing them to the benchmarks they mimic but to a completely different type of mutual fund, the actively traded variety.

The actively traded mutual fund can be costly.  The reasons for these costs are often quite simple to grasp.  Actively traded mutual funds incur additional costs due to trading more frequently, the research required to make those trades, the assumed risk involved and of course the increased management of those portfolios.  Although it is common practice to use benchmarks as a way of determining performance of actively managed mutual funds, it is not often indicative of what the fund is attempting to accomplish and how many underlying securities are in the portfolio.

Actively traded mutual funds own only a portion of the benchmark (indexes such as the Russell 2000 or 3000, the S&P 500, or total market). More on this unfair comparison.

Supreme Court Rules for the Mutual Fund Industry

If you are not happy with the way your 401(k) plan adviser has invested your money, then, according to the recent Supreme Court ruling, you should invest somewhere else.  In a decision that is clearly a victory for the mutual fund industry and a loss for investor trying to keep fees from overtaking their investment returns, this ruling turns the responsibility of who to invest with back to the individual.


Sound like a loss for the little guy? Read more here.

An Attempt to Tally Mutual Fund Fees

No one ever said it was going to be easy being an investor. Mutual Funds are no different than any other investment. They offer numerous layers, a multitude of nuances and of course, risk. And despite all of the information floating out in the public domain, the ability to tell one fund from the other is still difficult.

So the question is: Can you do the mathematical calculations required to find out how much your mutual fund is going to cost you? Chances are you might say yes, if you consider yourself a very savvy investor, able to filter all of the costs in the prospectus into a final number, understand the tax implications known and as yet unknown, and then be certain that you are right – or as close to right as humanly possible.

But chances are you can’t. Instead you fall squarely into the camp of investors who either have no clue or look at one guiding number and the vast majority of you are 401(k) or IRA investors as well. That number, widely advertised by the one group that lobbies in favor of mutual funds, Investment Company Institute or ICI comes in at an average of about 1.17% for all actively managed funds.

Most financial professionals, understanding that this is the average, suggest it as the top any client or interested investor should pay for the privilege of a little more risk than a simple index provides. Some also understand that this is more a moving target and unless they raise the cap to 1.5% as the max, they may exclude some of the better performing funds in the investment world, even at a slightly higher price.

Read the full article from Target2025.com on mutual fund math.

Mutual Funds Explained: Topic of Fees

Mutual fund investing should be a simple process. It should be straightforward and easy to understand. Unfortunately, once we get involved, we bring our own set of behaviors to the process.

In our first discussion about performance comparisons for mutual funds, we looked at the downside of simply comparing side-by-side an actively managed fund with one of the indexes that are published. These indexes span a wide variety of categories in order to help investors understand how the broader market has done in relation to the fund they own.

Trouble is, no fund, not even index funds are able to buy in total, all of the stocks in a particular index. Yet, index funds are designed to come as close to the index they mimic. Any wide discrepancies, either higher than the index or lower than the index should raise a warning sign to current and new investors. This could point to a style drift, a process whereby the fund manager looks to stocks outside the parameters of the index to beef up returns. because in the world of mutual funds, one-hundredth of a percentage point can often sway the investor's decision of which fund to choose.

Often, this focus on returns drives the investor to funds that are the wrong ones for a long-term approach. Even almost five years since the publication of the paper b the Wharton School :"Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," by Madrian, James J. Choi, professor of finance at Yale, and David Laibson, economics professor at Harvard, folks still do not adequately take these costs into account.

In their experiment, they used index funds as the sole investment. The S&P 500 index, which tracks the 500 largest companies trading on the US exchanges should all have identical returns over the same period. The only difference lies in the fees the fund charges the investor. These fees are often touted as the lowest available and with good reason. The investment itself is passive. Managers buy and hold any underlying stocks in the portfolio until the index itself is readjusted.

Their concern before the experiment was based in the question: why, if index funds outperform actively managed mutual funds most of the time when held over long periods of time, such as twenty years or more, would an investor pay higher fees when index funds charge so much less? They pointed out that when an investor considers fees to relative performance, say when an actively managed fund matches the returns of a passively managed index, the investor will not consider fees as an important factor in the process. If both of the funds in this paragraph earned the same 10% over that twnety years, the difference in real dollars would be over $11,000.

To conduct their experiment, the chose only four funds, all S&P 500 index fund. They all varied slightly in overall fees with the performance of these funds almost identical. They could invest all of the hypothetical $10,000 in one fund, or divide the investment among many funds. The reward for outperforming their cohorts was an actual cash prize: the profits generated by the best performance over the course of a year.

They broke the students in the experiment into three groups: one received a prospectus accompanied by a returns sheet, one a prospectus accompanied by a fee sheet, and the last group, the control group, received only a prospectus. In each case, the prospectus was the same as the one any investor might receive upon request.

The result of the experiment indicated that disclosure did have an effect on the students in all three groups. The group with the returns sheet did the worst. Those that received fee information did better. What was most curious about the results: the students with the fee sheets could clearly see that one fund among the four offered the lowest fees yet not one student put all of their money i that fund despite the relative identical natures of the overall investments.

By no means does this say that fees are or should be the only force in your decision to buy a certain fund. But they should enter into the discussion at a much higher level that that of overall performance.

Next up, the role of the manager.

Paul Petillo is the Managing Editor of Target2025.com

A Performance Discussion on Mutual Funds

The last lines of Matthew P. Fink's book, "The Rise of the Mutual Fund" suggest that although he is a "worrier; nonetheless, I am optimistic". This speaks volumes to the "extraordinary success of mutual funds". Mr. Fink believes that despite the speculation about the maturity of the industry, it is far from falling from its exalted position. This elevated status is due, he writes "to adherence to high standards of fiduciary behavior".

Yet the mutual fund industry continues to be attacked for any number of reasons. The largest component of your 401(k) plan, your IRAs and the driving force behind numerous college savings plans, these investments are often questioned on their transparency, why they charge what they charge and even more commonly, why, if you win one quarter, can you not win the game.

Comparing Mutual Funds
There are numerous ways to compare mutual funds and none of them good. The rule of thumb for a fund is relatively straightforward: look for long-term performance (I have suggested that you also look to how well the fund manager did in poor markets rather than how they did during the good times), the cost of the fund (fees and expenses do not often tell the whole story but offer a telling sign of how much the fund manager trades and why), and the tenure of the manager in charge (an ever shifting picture as fund managers come and go and new managers look to put their investment stamp on the portfolio).

The subject of performance is often more confusing when actively managed funds are compared to indexes. These passive measures are poor indicators of what an active manager holds. This is why, so often, index investors make the claim that not only do passively managed funds offer a cost advantage but because the strategy of buy-and-hold limits volatility, they increase returns by limiting exposure to unnecessary risk. Your cost for less risk however can be higher than the low cost of these funds. Also consider that index funds do not hold all of the stocks in the indexes they mimic. And actively managed funds hold even less.

Looking at Past Performance
Performance also comes to the forefront when we look backwards. For quite sometime now, the mutual fund industry has warned investors that the past is no indication of the future. While this has been disclaimed as a method of disclosure, it is still one of the default guides for new and even seasoned investors when making the choice for which fund to buy.

Over the last decade we have had two bubbles and two market reactions to those events. Had you purchased a mutual fund, any fund as a bubble reached its peak, the previous five years would not have reflected the previous bull market's demise. I clearly remember the sigh of relief as the year 2001 was dropped from the 5 year returns in 2007. No longer would the bad bets made during the internet bubble show up as a stain on the investor information sheets. Ironically, even as some funds dove into the depths, they took the whole market down with them. (As did happen recently in 2008.)

Just by removing the bad year from the five-year returns made many funds appear much better to investors and they flocked to own them again. Averages suggest some odd things. A line-up of one hundred persons, ninety-eight of whom are six feet tall would not change the average if the person on one end was ten feet tall and the one on the other end was three feet in height.

But stock markets rarely have a peak that moves quickly from the bottom to the top whereas the bottom is often reached in less than six months. The top of a bull market takes five years, at least as witnessed over the last decade, to attain. This is not the case for any period prior to this. Bottoms were reached quickly while the top of the market was often a slow slog.

So we have the performance of actively managed mutual funds as compared by using index funds possessing some flaws. And past performance leaving us with no real picture of the future based on the past, how does one judge performance? Without considering fees, the worst day of a fund. Based on the simple idea that, if mutual funds are the primary holding in a retirement account and at one point in time, you will be begin to drawdown that account, picking the worst day to do so gives you a valuable peek at a worst case scenario. That is probably a truer indication of performance that averaging it our over a period in time. You can read more about low-mark performance here.

Next, a discussion about fees.

Paul Petillo is the Managing Editor of Target2025.com

Investing in Mutual Funds: The Mean Reversion

I'll admit as should everyone who writes about investing, there is no silver bullet, no perfect scenario, no predictable table you can follow when it comes to investing. Some suggest that the only way to come close to a comfortable retirement is to invest in stocks. But they have a limited historic return, somewhere in the vicinity of about 6.3%.

Stock funds do worse according to available statistics. The comparisons here get a bit sketchy. In almost every instance, a stock fund, no matter what it invests in, how well it has done, is compared to the Wilshire 5000, an index that represents the whole of the stock market universe.

But in truth, it doesn't even come close. Any sort of index fund that attempts to mimic that index is unable to buy all of the stocks and some buy less than a fourth of what is available. The reason is easy to see and generally accepted: some stocks are simply to small to buy and any investment of any size by any index fund would drive the price of those stocks up. There simply aren't enough shares available (liquidity) to buy.

This comparison suggests that the real rate of return in stock funds is about 3.9% in part, as some suggest, because of fees. And that is if you are fortunate to have the iron-will to stay invested through thick and thin, ups and downs. Sadly, most of us don't.

Our Investment Expectations
We expect everything that is up to stay up and everything that is down to stay down. This leads us to believe that selling a stock fund as it begins to lose share value in favor of a stock fund that is on the top ten lists for the previous quarter or year. Oddly enough, and this is why economist refer to it as the mean reversion, selling on the way down eliminates the opportunity to buy additional shares and a reduced price because we do not expect the fund to recover.

The real trouble is buying a fund at the top with the expectations that there is still additional upside potential. the knee jerk reaction to such a dilemma is to simply buy an index fund and let it ride. The Bogleheads will love this idea. For those of you who are unfamiliar with this emphatic group, they swear by the index fund. It was not a some might think, created by John Bogle of Vanguard but when the age of computers advanced far enough, he became its leading disciple.

Mutual funds present an interesting opportunity even as they seem to offer you more volatility. Even index funds, left alone from the date of your initial purchase, will suffer fits and starts as it lumbers across a thirty or forty year investment career.

Some of us writing about finance will offer you the realistic possibility that a Treasury Inflation Protected Security (TIPS) could do as well as any investor who bought stocks or stock mutual funds. Fine if you are good with 2.6% over a working career.

Because folks usually purchase stocks and stock funds in the hope they will provide some additional growth and risk that will help fund their retirement, pursuing that path might leave you struggling.

The Best Investment Option
The best option remains the hardest one to execute. Ignore the markets in the short-term and invest across a wide variety of investments. begin with actively managed funds. As your wage increases, add more money in the form of index funds that drill into various sectors deeper than a total market index fund might. As you continue to age, add a bond fund or two, domestic and international.

The key is to find low fee funds as compared to their peer group - not to an index. Find a manager who has navigated rough water in the past and emerged with better than average returns. You will have to go back a few years for that. Keep in mind, you are not looking for an average that is comparable when the fund may have lower lows that the funds in its group and an occasional brush with the top ten performers.

In the case of mutual funds, average is good. It avoids the mean reversion problem that many investors have and keeps your risk level at a much higher rate than fixed income. According to Simon Johnson and James Kwak, writing in the Washington Post recently, the goal is to have enough money to buy an annuity upon retirement, in large part because the gamble of outliving your money is simply too great.

Mutual Funds Explained: Why Portfolio Turnover Matters

I discuss in my book, Mutual Funds for the Utterly Confused (McGraw-Hill 2008), the differences between the various expenses that impact an investors interest and return in a mutual fund. Among the sneakiest of these fees, is the turnover ratio. Why do investors still use funds that consistently report high turnover of the stocks in the fund's portfolio can be answered two ways. But first, what is a turnover ratio and how is it determined?

The Turnover Ratio is the result of the fund manager repositioning the portfolio. This is done much more often in a growth fund, where the manager may be looking for fund appreciation and to take advantage of this, they must sell some of what they hold in order to buy stocks that they feel will benefit their shareholders.

To determine the ratio on your own, investors will need to divide the value of both the purchase and sale transactions for the period by two and then, divide that figure by the total holdings of the fund. The higher the trading activity, which usually takes place in a growth fund more than in a value fund, the higher the turnover ratio.

If the turnover ratio is 100%, the fund has changed the underlying portfolio completely over the given the period. Less than 100% turnover, the fund's expenses for trading are lower than a fund that has exceed that number. Questions is: why would a fund manager trade so much if they knew that the cost of this activity creates a tax implication (in a retirement account, this tax consequence is deferred until you actually begin to draw on the funds)?

There are several reasons. New managers, of which there are many new faces in the mutual fund world after 2008, like to find better opportunities than their predecessors. Older managers may be attempting to restructure their portfolio to take advantage of newer opportunities that would redeem their fund's less than stellar performance during the height of the downturn. neither of these reasons though are very good.

You pay for research and subscribe to a charter (what your fund's investment focus is) and expect your fund manager to use these costs wisely. A high turnover ratio basically puts the spotlight on poor decisions followed by poorer, more costly revisions of those decisions. The higher the turnover, the more these managers have ignored research offered by their fund family or found that what you already paid for was somehow flawed. The higher the turnover ratio, the greater the resemblance a fund manager has to a day trader.

Even in a growth fund, these costs can be kept down and thoughtful and prudent trading can help a great deal. Believe it or not, there is a limited number of stocks available at any one time. To buy, you need a seller. As all investors know, the seller must know something that the buyer does not. In the small-cap arena, the number of stocks is much smaller because of liquidity (the number of shares available at any one time). Too few shares means that nay activity will drive the price up on the share price, create unnecessary costs, and in many instances, void any potential the stock might have in the near future.

This doesn't mean you should run for an index fund or even a value fund just because of fees. It does pay to consider them though and whether the fund's performance will be great enough to overcome the higher costs.

In a fund held outside of a retirement account, turnover ratios are essentially a taxable event (selling something profitable always creates taxes) and this is often taxed at the short-term rate. If you are using growth fund in your retirement portfolio (and I highly recommend that this is where they should be held) this tax is deferred. But that is not a reason to hold a fund that turns over its portfolio too much in any given period. For a growth fund, the portfolio turnover should not exceed 50-75%. If it exceeds this, something might be wrong.

Be sure to check out our all important examination of why investors do what they do.