Mutual Fund Site

Without question, mutual funds need to be more transparent when it comes to the fees they charge. As it stands now, investors see what expense ratio is being charged on their funds but they have to dig fairly deep to find out what other fees, namely administrative fees, they are paying for through their investment in a particular mutual fund. It is no easy task. In fact, it is literally impossible to determine how much you are spending and for what. And because income funds will be different than equity funds and index funds and balanced funds, etc., the topic of fee transparency is a lot bigger than a lot of people think.

In an interesting piece about mutual fund fees at Morningstar (okay, an awesome piece!) a letter was published that Morningstar sent straight to the SEC as the regulatory body undergoes an examination into how they can improve fee transparency. Morningstar’s suggestion to the SEC, to lump fees into four buckets as Morningstar labels them, makes sense from a consumer protection angle, but everyone already knows just how much noise many of these mutual fund companies, industry advisers, brokers and other non-consumer organizations can and will make – even in its letter to the SEC Morningstar acknowledges just how much objections will be raised. And of course, these fund companies will not only have a right to raise their concerns, but I have to believe that many of those concerns will have merit.

So what the SEC needs to do, like an “objective” parent, is find a happy middle ground that will test both parties but ultimately result in an overall improvement. And we believe we have the solution, but before we get on to that, let’s look at the four “buckets” proposed by Morningstar:

1. Management – this bucket of fees would disclose the expenses incurred in managing the mutual fund in question.
2. Sales & Marketing – this bucket of fees would disclose how much the fund company spends in pitching its product (good luck finding that anywhere today).
3. Advice – this portion tells investors how much their adviser (including planner, etc.) earns off the “sale” of their mutual funds.
4. Administrative Overhead – other fees incurred within the mutual fund, like transaction costs, record keeping, etc..

Again, today’s fee environment is impossible. Morningstar takes a nicer view and calls the industry’s fee arrangement a “cloudy landscape.” I think if they had used the term “impenetrable fog,” they would still be going easy on the way fees are reported and I also believe that the majority of fund companies would agree. There is just no way an investor, no matter how keen and dedicated, can learn just how much they contribute to each of the four buckets above. No way. Period.

And while these buckets can certainly be figured out by the fund companies, it is also unlikely that they will willingly divulge this information. In fact, we could say it may even be unproductive for them to do so, particularly bucket #B and to a lesser degree bucket #D. Now, this is not to say that fund companies should be able to get away without revealing its total fees, but often what you have in a Sales & Marketing (Wholesale) environment is the company itself being pitched. So, if you are an adviser, your Vanguard, Invesco, Templeton, PIMCO, etc., etc. wholesaler will stop in and pitch the company. It is rare, even counterproductive to pitch a specific fund.

We wonder how fund companies would differentiate between how much each fund contributed to their overall sales and marketing efforts of the overall fund company. More specifically, if a fund company incurs $xxx,xxx per month in sales and marketing, how does each fund report this as part of the bucket #B expenses? Is it proportionate to assets under management? What if a bigger-than-life manager like Bill Gross says he does not want to see those fees as part of his fund (because let’s face it, how much sales and marketing dollars need to be spent on his funds anyway?). How does that skew the rest of PIMCO’s bucket #B expenses? Bottom line: bucket #B expenses are virtually impossible to nail down for each fund.

But bucket #D expenses are not. Each fund has got to be responsible for its administrative activities. While some resources will be shared, such as the receptionist, assistants, fixed overhead, etc., each fund is accountable for managing its trading, record keeping, oversight expenses. A big shot manager who is a constant headache is known for such things; any fund company that says it is tough or impossible to say how much Fund A contributes to the overall fixed expenses versus Fund C is telling a lie.

However, I can sympathize with why they may not want to divulge this information. Why make 1 necessary problem (like putting up with more record keeping for one manager over another) everyone’s problem? Instead, why not just lump bucket #D together with bucket #A? Make the two of them a more generic, general “Management Expense?” Sounds reasonable, right? And consumers are still wiser because they see that Fund Company A’s Equity Fund will cost them x% more than Fund Company C’s Equity Fund. Why is that? they will wonder. And quite simply, whether it is Management or Administratively related, it’s a “management expense” problem or inefficiency. That’s what it boils down to.

Oh, but why should the fund’s management team be held accountable for some expenses outside of their control? Well because that is what management is all about. They are not divas collecting gratuities, they are managers and if they do not like how some expenses make their fund(s) look frivolous, then becomes time to make a managerial decision. Consumers will like this because it makes management responsible and accountable and managers should like this because it puts more control in their hands.

Accountability brings us back to bucket #B. No matter how egotistical a manager can be, if sales are not there, they are not there. Pouring more money into other incentives, like the sales and marketing bucket or even the advice bucket should be a decision made by the manager, or the collective management team. If Vanguard managers, for instance (which is currently the country’s largest mutual fund company by assets) feel that they are spending too much on sales and marketing, then why can they not decide to scale back and use those reduced expenses elsewhere to increase efficiencies? These are management experts, they measure companies every day for their efficiencies and management talent; they are not idiots. If assets shrink, then it should come back to management to figure out how to change that (it practically does anyway).

Ultimately, these “low” fees of 0.78% on some funds will skyrocket into the 2% to 4%, but give it time. The industry will adapt. Those fees will come down as companies find ways to improve efficiency and performance. Managers, who are already accountable, may have to sharpen their pencils some, but rest assured that these are the true fees paid by investors, at minimum, today. Transparency and accountability can only help the investment decision.

That leaves us with bucket #C, Advice. This is probably one of the most important changes needed in this industry: knowing what one’s investment decision means to the person advising that person to invest in such a way is instrumental in understanding just why that recommendation is being made in the first place. This is also one of the easiest buckets to fill; it takes the onus off the fund company and places it on the adviser, who must now provide what the investor expects in the first place: objective and unbiased advice.

To summarize, we would recommend just two fees: the Management fees which encompass everything that has to do with the mutual fund (because whether it is paying a big salary to the manager or paying for staples, it comes down to how well the fund is being managed in the first place, so let the fund companies do what they will with that total mass of fees – I think asking for precise breakdowns is akin to asking McDonald’s to break down, in measurable amounts, how they create their Big Mac sauce) and the Advice fees which involves what the adviser is earning from the fund company (now this makes the adviser nervous because who want to reveal his or her salary? My advice is that it is up to the adviser to make those fees look like a bargain given the “quality of advice” the adviser is offering. In other words, only crappy advisers need to be worried; the good ones know they are still cheap).

That’s it. Just two fees — this makes the fund companies happy because it does not involve segregation of expenses. But encompass everything — this makes the consumer happy because they know what they are really paying for their mutual funds. Because today’s 0.78% expense ratio on an active income fund or equity fund tells investors absolutely nothing.