Impact of One-Time Charges and Recurring Fees on Fund Performance

The impact of one-time charges can be significant. The most important charges of this type are sales charges. Aside from sales charges, some funds also charge a penalty for early redemption of shares. This is intended to discourage market timers who tend to switch between funds frequently.

Sales charges can be applied at purchase or deferred until you sell the fund. Sometimes the deferred charge is contingent upon how long you hold the fund; then it is called a contingent sales charge. If you stay invested in the fund long enough, this charge can go to zero.

Consider two funds, one a load fund with an initial (front-end) sales charge of 3 percent, the other a no-load fund without any sales charge. Say you invested $1,000 in each of these funds, using your IRA. The load fund takes $30 right away, leaving you with $970 invested. Now let the money stay there for 20 years, with automatic reinvestment of dividends and capital gains distributions. Suppose that the average performance of each fund is 18 percent per year. At the end of 20 years, how much would you have in each fund? The answer may surprise you. The load fund would have grown to $26,571, while the no-load fund would be worth $27,393. The $30 charged to you 20 years ago has cost you more than $800 at retirement time. On the other hand, the difference would remain 3 percent of your portfolio’s value.

Now let’s look at recurring fees and expenses. While these tend to be small numbers, they hit you year in and year out, and can have a large cumulative effect on performance. There are several kinds:

• Management fees are the fees paid by the fund to its advisor, a separate legal entity but part of the same mutual fund group, or family. The advisor is paid for portfolio management and related services such as accounting and record keeping. These fees typically range from 0.25 to 1.5 percent, with index and bond funds tending to charge the least, and small-stock international funds the most. Sometimes, a fund will voluntarily reduce or waive its management fees, either because of poor performance or simply to enhance its performance for marketing purposes. While it may be nice to benefit from such largesse, it is not a good idea to count on it to last very long.

• 12b-1 fees are paid by the fund to its distributor, another legal entity within the mutual fund group. These fees are mostly used to compensate fund salespeople, although they may also be used for marketing and advertising expenses incurred by the distributor. (The term 12b-1 refers to the section of the SEC code regulating these fees.) How high are these fees? The legal maximum is 1 percent of the fund’s average net assets for the year, but most funds charge significantly less. Service fees to fund salespeople are capped at 0.25 percent of average fund assets per year. Not all funds charge 12b-1 fees.

distributor

Company that sells mutual funds directly to public or via brokers.

• Fund expenses are costs that the fund pays for directly, including legal and administrative expenses. These tend to be higher, on a percentage basis, for small funds that lack the economy of scale to spread fixed costs over a larger financial base. Funds that participate in mutual fund supermarkets, such as Schwab One Source, are charged service fees for assets brought into the fund through the supermarket. Supermarkets typically receive about 25 basis points, or 0.25 percent, as a service fee. These fees are passed on to all shareholders, not just the ones who purchased the fund from a supermarket. For example, if 80 percent of the assets of your no-load fund came in through supermarkets, shareholders would be penalized by about 20 basis points—though they might not realize that the fund’s higher expenses were eating into its performance.

basis point

One-hundredth of 1 percent.

Recurring fees and expenses are added together to determine the expense ratio of a fund. The expense ratio is a measurement of the actual ongoing fees and expenses charged to shareholders by the fund. It does not include any sales charges or early-redemption fees.

How does the impact of recurring fees compare with one-time charges? What, for example, would be the impact of a half percentage point (0.5 percent, or 50 basis points) increase in the expense ratio on the performance of the no-load fund in the previous example? Its average performance would decline from 18 to 17.5 percent. The result? The $1,000 invested in the fund would now grow to only $25,163. The 50 basis points in annual expense cost you $2,230 over 20 years. Even though the difference in fees is much smaller than the sales charge, its cumulative effect is more than twice as great.

Where Does 12b-1 Money Go?

Most of this money typically goes to the broker or financial planner selling the fund. This provides him with a financial incentive to retain the assets for the mutual fund group, so that the advisor can go on earning his management fee. Critics point out that there is a potential conflict of interest arising from this practice. Would the broker or financial planner who receives 12b-1 fees from Fund A be willing to recommend a superior fund that doesn’t offer him these payments? Proponents of fee-only financial planning argue that investors are better off with planners who explicitly refuse to accept fees from anyone but the investor, eliminating potential conflicts of interest. To date, however, very few financial planners have foresworn these other sources of payment. Some describe themselves as fee-based planners, but this only means that they charge you a fee, not that they don’t accept fees from other sources. See discussion of financial planners in Chapter Eight.

Hidden Cost of Brokerage

By now, you might think we have covered all the costs associated with investing through mutual funds. But there is another cost that is frequently overlooked: the cost the fund incurs when it buys and sells securities. You might think that these trading costs are already accounted for as part of the expense ratio. But they are not. Few people realize this. Brokerage costs do not figure at all in the calculation of a fund’s expense ratio.

Indeed, it would be very difficult, if not impossible, to figure these costs accurately. Remember that the real cost of buying and selling securities goes well beyond what you are charged in commissions. It also includes things like dealer markup and spreads. It can be difficult to even estimate these costs. If commissions and other brokerage costs are not part of the fund’s expense ratio, where do they go? Commissions are added to the price of securities when they are purchased and become part of the cost basis of those securities. When securities are sold, brokerage commissions are subtracted from the proceeds. Thus, the more a firm pays in commissions, the lower its performance will tend to be. You can get an idea of how much you are paying in commissions by checking the fund’s annual report. Since 1995, funds have been required to disclose their average commission costs there.

While you’re at it, you might want to check your fund’s policy on soft dollars. Soft dollars are credits provided by brokers for the use of their services. These credits can then be used to purchase ancillary services, such as research, software, or financial data. But what if the “research” is primarily a vacation for the portfolio manager and his or her family? Critics contend that the complexity of soft dollar accounting makes it more susceptible to abuse. Proponents of soft dollars counter that they can be a good way to extend the purchasing power of the fund, helping it to buy needed research and other services at reasonable cost. Regulators have periodically attempted to restrict the use of soft dollars, as well as to publicize known abuses.

Figuring the Cost Basis: Why It Pays to Inherit Stock

Cost basis is the price used to figure capital gains. Ordinarily, this is just the price paid for an asset. When you purchase stock, the commission you pay to your broker is counted as part of the cost basis of the stock. Later, when you sell the stock, only your net proceeds are used in figuring capital gains. That way, you won’t owe any tax on money that you paid to your broker.

Inherited property is an important exception to the method for figuring the cost basis. When you inherit stock (or other property), the basis is “stepped up” to the current market value (if available). If no market value is available, a current appraised value is used. This stepping up of the basis can provide very significant tax benefits for securities that have significantly appreciated from their original cost.

Here’s an example of a soft dollar arrangement between a broker and a mutual fund. The fund buys 100,000 shares of IJK Corporation at $50 per share, paying a commission of 10 cents per share, or $10,000 in cash. The broker rebates half of this $10,000 payment, or $5,000, in soft dollar credits. The fund is now free to use those credits to purchase $5,000 in research, other portfolio management, or trading-related services from a third party who will accept that broker’s soft dollars as payment. The third party redeems his or her soft dollars from the broker at a prenegotiated rate, let’s say 60 cents on the dollar. The net effect is that the broker retains $7,000, the third party receives $3,000, and the fund gets both brokerage and other services.

Reasonable? Maybe. It seems like a good idea, however, to know what your fund’s policy is, how its commission costs compare to other funds, and, if it uses soft dollars, what it is getting for its—no, for your—money. How can you get this information? Try calling the fund and asking them. While you’re at it, you may as well request the long version of the prospectus, along with the “statement of additional information.”

Beyond commissions, how do brokerage costs affect performance? While it may not be possible to answer this question definitively, it can’t hurt to know how much trading your fund is doing. The higher the turnover of securities within a fund, the greater the impact on performance is likely to be. Recall that turnover is a measure of how many times the average share is bought or sold. For example, if the fund consisted of a round lot (100 shares) of each of the 30 stocks in the DJIA, and if the manager decided to sell everything during the course of the year, the turnover would be 100 percent. If the manager then used the proceeds to buy back those same 30 stocks in the same amounts, the turnover would be 200 percent. Several studies have shown that high-turnover funds tend to perform poorly compared to low-turnover funds. It is likely that brokerage costs account for most, if not all, of this disparity, although poor timing is also a possibility.

Another hidden trading-related cost results from the sheer size of some mutual funds. When they buy or sell large blocks of securities, they shift the balance of supply and demand in the market, raising their average cost on “buys” and lowering their average proceeds on “sells.” Sometimes, it’s better to be a small fish—you make much smaller waves when buying and selling shares. Thus, even though you probably pay a higher commission per share, there should be little if any loss due to your action in the market.

Your advantage as an individual stock trader is greatest with small, illiquid issues. So-called microcap stocks, stocks with a market value of less than $300 million, can be especially hard for fund managers to acquire and dispose of efficiently in the open market. On the other hand, as mentioned previously, fund managers often have much better access to IPOs and can benefit from an early run-up in the price of shares that may be difficult or impossible for the average investor to get into.

Some Hidden Risks of Fund Ownership

You may be paid in securities instead of cash. If the market crashes, a mutual fund can find itself without the cash (or credit) to pay all the shareholders lined up at the exit. In the worst case, funds may not pay cash but instead may pay investors “in kind,” with securities that may be difficult to sell and whose ultimate market value may be substantially less than NAV calculations suggest.

Managers may stray from their stated strategies. All too frequently, the shareholders in a supposedly low-risk fund discover that the fund manager has imprudently invested in derivative securities whose risks are far greater than advertised. As a result, such funds sometimes sustain enormous losses.

Mutual fund management companies have a strong incentive to “manufacture performance” for a new fund coming to market. There are a number of ways they can do this, including what might be called IPO juice and clever use of survivor bias. The use of IPO juice involves seeding the fund with hot IPOs that are almost guaranteed to rise in price. New funds can be capitalized with as little as $100,000, so a few carefully chosen IPOs can give the fund a great performance record in the early going. And if performance isn’t good enough for marketing purposes, the fund can be quietly closed down. By shutting down poor performers, fund groups can make the average performance of their funds look better than it really is. The CFA Institute has created a set of Global Investment Performance Standards (GIPS) that are intended to address this issue.

survivor bias

Distortion of average performance by excluding funds closed due to poor performance.

You will be subject to inherited tax basis. When you buy a stock, the price you paid for it establishes your cost for tax purposes. In contrast, when you buy a mutual fund, you join a pool of investors who share a common tax basis derived from the price the fund paid for the securities in its portfolio. For a top-performing fund, this can mean that you will get hit with capital gains taxes on shares that the mutual fund sells at a profit, even if you got little or none of the profit! In the worst case, you could see the NAV decline and have to pay taxes on top of a loss. For this reason, investors are warned against purchasing mutual funds with large capital gains toward the end of the year, just before most funds make their capital gains distributions. For example, if you bought a fund for $10 per share on November 1 and received a capital gains distribution of 50 cents in December, you could owe taxes on that distribution even though the fund’s value did not increase after you bought it.

On the other hand, this will occasionally work in your favor. If you purchase a fund that has suffered significant losses, you may receive the tax benefit of those capital losses even though you didn’t suffer them (but you may be taking a risk in buying a mutual fund with a poor performance record).

Same Fund, Different Performance

A fund’s performance can be very different before and after taxes. This has led fund companies to create funds that modify their investment strategies to minimize taxes. Sounds good, but what if you invested in that fund for your 401(k) or other tax-deferred account? Then you are unlikely to get any benefit from the fund’s tax strategy, but you may give up some performance. Wouldn’t it be nice if funds were clearly divided into two groups, corresponding to the tax-deferral status of the investment?

You will have less control. This includes lack of ability to tailor your tax strategies. Even in the absence of cost-basis problems, ownership in a mutual fund may make it difficult or impossible to tailor your investment strategy to minimize your tax liability. Some fund managers, sensing a market opportunity, have made changes to their investment strategy to reduce the overall tax liability passed on to shareholders, but even this commendable innovation may not address an individual shareholder’s timing issues with regard to taxes.