Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC and InvestingAudit.com
The January 2010 issue of Consumer Reports had an interesting survey about complaints. 1125 Americans were asked to score 21 gripes on a 1-to-10 scale, 1 meaning an experience "does not annoy you at all" and 10 meaning it "annoys you tremendously." Hidden fees scored 8.9 overall. It was the most annoying gripe in survey.
Direct mutual fund expenses have generally been well publicized, studied, and analyzed by academics and the press. But recently other investment costs have started to draw more attention in the press and academic community. There are many costs that investors may incur depending on their investment vehicles, specific securities, and various advisory services. Some are transparent and well known, but many are more difficult to determine and/or are frequently ignored. Both individual do-it-yourself investors, as well as investors using one or more services face many of these costs.
Investment costs that investors may incur include
- Asset based fees (% of assets)
- Financial planning and/or consulting fees
- Administrative fees
- Loads/12-b1 fees
- Mutual fund (and ETF) expenses
- Trading costs, including
- Impact and/or bid/ask spread
- Opportunity costs
- Performance based fees
- Tax effects
Investors in Retirement Accounts (IRAs, 401(ks), etc.) generally face 1) Management and administrative costs as well as 2) Mutual fund expenses. Investors using Investment Advisers/Financial Planners generally face either asset based fees or hourly fees (although some advisors charge fixed rates) in addition to the costs related to the actual products and/or securities. Investors using full service brokers potentially face additional broker commissions and/or other fees like wrap fees. High net worth and institutional investors tend to have access to lower cost products and services, but may pay additional consulting fees, while those that invest in venture capital, private equity, and hedge funds may face additional performance fees and or additional layers of fees (for instance from funds of funds).
A useful exercise for investors is to start with theoretical expected returns (usually based on historical returns and current interest rates) and then subtract expected costs. The term "Implementation Shortfall" was coined by Harvard professor Andre Perold. The simple definition is the difference between theoretical paper portfolios and real-money portfolios. Perold and others have also suggested that generally the larger a portfolio is, the harder it is to exploit any informational advantage.
For an investor, once an asset allocation has been determined, the next step is to invest in specific funds and/or securities. Some investments like government bonds can be purchased with no direct costs, while others like Hedge funds may have multiple layers of costs. Passive investors generally purchase diversified funds, while active investors attempt to improve on index or asset class returns by holding specific securities or subsectors and/or timing those investments.
On the specific issue of what is the cost to society from active management (relative to passive/index investing), Professor Ken French published an extremely informative paper titled The Cost of Active Investing in the Journal of Finance (August 2008). A one hour presentation is also well worth watching (Presidential Address Video see 2008).
Using multiple sources of data, French conservatively estimated equity costs resulting from active management (which is a zero-sum/losers game). In the process he also provides some fascinating information about the investment industry and it's evolution over the last few decades. Specifically he looked at costs for both individuals and institutions, by determining mutual fund and hedge fund management fees, and as well as the costs of the trading. The cost differential between active and passive was .67 basis points (the number was surprisingly stable at between 61 and 74 basis points in 24 of the 27 years from 1980 to 2006), which equates to 10% of an assumed 6.7% market return (some believe that return is a high estimate). He did not include tax costs, nor typical investment advisory fees, and some other costs (as well as costs for time spent) that investors often incur. The overall costs by his calculations have been relatively steady, but drops in some categories (mostly from decreasing use of load fees and investors switching to passive investing) have been offset to some extend by increases in hedge fund costs.
Particularly striking in the study is the turnover information. Annual turnover of US stocks multiplied from 20% in 1975 to 215% in 2007 (284% with ETFs) in 2007. Despite that increase in trading, the total amount investors pay to trade declined from $50 billion in 2000 to $32 billion in 2006. French also supplies estimates of the percentage of investors investing passively. Open-End Mutual Funds went from .8% passive in 1986 to 12.6% in 2006. He estimates that 26% of Public plans were passive in 1986 rising to 52% by 1997. DB, DC and Non-Profits are estimated to be between 29-36% passive as of 2006.
Other findings included
- No major group of investors covers their costs (at the expense of other groups).
- Direct holdings by individuals has dropped while mutual funds holdings have been rising. This is a positive for the investing public since they are decreasing risk through diversification (plus more are diversifying internationally).
- Huge growth in Hedge funds. The average annual hedge fund fee for 1996 to 2007 was 4.26% of assets, and the average for clients who buy through funds of hedge funds was 6.52% per year (because they pay two layers of fees). In 2007, 45% of all hedge fund assets were invested in funds of funds.
French notes that the benefit of active investing is active investors almost certainly improve the accuracy of financial prices, which improves society’s allocation of resources. To the blunt question of why do active investors continue to play a negative sum game, French suggests 1) lack of education about the advantages of passive investing 2) and overconfidence.
John Bogle takes a broader look at the financial industry in his 2008 book Enough. See Bogle's Presentation, which covers similar material to his Winter 2008 Journal of Portfolio Management article titled A question so important that it should be hard to think about anything else. Bogle estimated society’s cost of investing in 2007 was $528 billion. He points out in the book "No one knows the exact number. All that can be said for certain is that, one way or another, these billions are paid by investors themselves."
- Lower Mutual Fund Fees? Yes, If the SEC Has Its Way By Jane Bryant Quinn (8/26/2010)
- How Expense Ratios and Star Ratings Predict Success from Morningstar (8/9/10)
- A Fund Fee That Keeps On Taking by Jason Zweig (7/31/10) - "investors have paid $106 billion in these 12(b)1 fees. "Load" funds sold by brokers can charge up to 0.75% a year in distribution fees, plus 0.25% in service fees; funds sold directly to investors can charge up to 0.25% and still be called "no load."
- What Exactly Are 12b-1 Fees, Anyway? from WSJ (7/6/2001) - Mutual-fund investors paid about $9.5 billion last year in 12b-1 fees.
- Buyout fees decline from P&I (6/21/2010) - Buyout pools currently raising $1 billion or more are asking for an average management fee of 1.6%, down from a peak of 1.9% in 2008, according to a Preqin study.
- The Fight Against 12(b)-1 Fees Hits a Snag (6/15/2010) from SeekingAlpha
- Investment Fees - Investors Send Strong Message to Wall Street by Allan Roth (6/14/10)
- Schwab Reduces Fees on Six Proprietary Exchange Traded Funds (6/14/2010) - see also ETF Price Wars? Schwab Cuts Expense Ratios from SeekingAlpha
- What Your 401(k) Really Costs You from US News (5/27/10)
- Now You Can Buy Load Funds Commission-Free from Kiplingers Personal Finance (05/2010) describes how to use Investforless.com, which has a $250 annual membership fee.
- CalPERS wants all its private equity firms to cut fees (by following the lead of Apollo Global Management) from P&I (4/27/10).
- The Decline of Funds of Funds from Institutional Investor (4/23/10). Some of the highest costs investors can incur are via so-called funds of funds investing in hedge funds. This article discusses the deterioration in that business. "The industry is contracting as investors have lost interest in this way of investing in hedge funds. And you can't blame them. Total assets slipped to $570 billion at the end of the first quarter, and are now down nearly 29 percent from their peak, even though they staged a brief rally in the last two quarters of 2009." According to HFR, over a 20-year period, the funds underperformed the S&P 500's before survivorship bias (the index does not include funds that went out of business or simply chose not to report their performance if they do lousy). In addition to the typical charges by the underlying funds, the fund of funds charges, on average, a 1.27 management fee and 6.94 percent performance fee, according to Ken Heinz, President at Hedge Fund Research.
- Money managers could escape big 12b-1 fee changes from P&I (4/1/10). Many investors do not fully understand the fees (see academic paper "Use and Abuse" below), which have averaged more than $10 billion a year over the past five years. The biggest players in 12b-1 fees are Blackrock ($1.1 billion in 2009), followed by Franklin Resources ($596 million), Legg Mason ($412M), and AllianceBernstein ($361M). The article suggests that if the fees are eliminated, more investors could shift to brokerage wrap programs, which would benefit money managers such as BlackRock, Legg Mason and Nuveen, which have the greatest penetration to those programs.
- The Battle for 401(k) Accounts from InvestmentAdvisor (3/1/2010) notes that while ETFs tend to have low costs investors still must pay a brokerage commission to buy ETF shares, which could become a significant cost if the purchase involves frequent purchases of a relatively small number of shares, as 401(k) accounts usually do. All 401(k) accounts—whether or not they include ETFs—incur administrative costs for services such as record keeping, accounting, legal, and trustee services.
- The Hidden Costs of Mutual Funds from the WSJ (3/1/10) discusses the regulatory debate about trading costs disclosures and methodologies and notes that some experts come up with different estimates.
- Take a Load Off from the WSJ (3/1/10) discussed the fact that a number of traditionally load fund managers have been offering funds without the loads through some brokers.
- 8 Factors that Determine Your Final 401(k) Balance from US News (2/22/10) mentioned costs and their impact on 401(k) balances.
- In Fund Fees on Trial from Kiplinger's (Feb 2010), Russell Kinnell of Morningstar discusses a US Supreme Court case revolving around differences between what managers charge to run institutional accounts versus mutual funds.
- Model ETF Portfolios Fees article from Richard Ferri in Forbes (1/19/2010). Watch out for advisor and sub-advisor fees on top of ETF fund expenses.
- Bloomberg Article about Broker Performance (1/29/10)
- Wal-Mart 401(k) Pays Retail - Forbes (1/18/10) discusses "what's wrong with many 401(k) plans". Wal-Mart's 401(k) plan has 1.2 million participants, representing 86% of its U.S. staff. Yet it apparently pays retail fees, unlike IBM, Boeing and Lockheed which worked for lower costs with their 401(k) plans.
- Take of the Blinders when it comes to Fees from Jason Zweig in the WSJ via Vanguard (10/17/2009).
- The Costs of Active Management (9/7/9) By Larry Swedroe.
- Morningstar to offer predictive power from FT (6/3/9) and Morningstar to Shine Light on Fund Trading Costs from Ignites, both via Reflow.com.
- Fund trading costs higher than many items - studies (6/3/9)
- Trading costs on mutual funds outweigh commission fees for investors, experts say from InvestmentNews (5/29/9).
- How Much Does Your 401(k) Cost You? from WSJ (9/10/8) discusses Stable Value costs. A typical guaranteed-investment-contract fund has an expense ratio that ranges from about 0.4% to about 0.8% depending on whether administrative fees are included.
- How much you really pay for advice from "The Mole" at Money (6/25/8).
- Can You Beat the Market? It’s a $100 Billion Question from Mark Hulbert in NYTimes (3/9/8).
- 401(k) costs summarized by Fred Reish via Fiduciary360 (2/21/08).
- How a Fund's Expense Ratio Can Predict Its Success by Russel Kinnel from Morningstar (04/24/07)
- Peekaboo by William Baldwin’s Forbes (9/24/04) discussed mutual funds commission costs.
- Costs matter: Are fund investors voting with their feet? from Vanguard (May 2010). For the decade ending 12/31/09 funds with lower expense ratios received the lion’s share of investor dollars.
- ICI fees study (4/13/10) Trends in the Fees and Expenses of Mutual Funds from Investment Company Institute.
- In Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry, (later published in the Review of Financial Studies, December 2009) Daniel Bergstresser, Peter Tufano, and John Chalmers studied broker-sold and direct-sold funds from 1996 to 2004, and could not find that brokers deliver substantial tangible benefits (despite the huge fees they are paid). In 2002, they estimate mutual fund investors paid $15 billion in distribution channel fees: $3.6 billion in front-end loads, $2.8 billion in back-end loads, and $8.8 billion in 12b-1 fees (compared to $23.8 billion spent on investment management fees and all other operational expenses).
- Investment Performance and Costs of Pension and other Retirement Savings Funds in Canada: Implications on Wealth Accumulation and Retirement By Dr. Vijay Jog (12/2/2009). Using 2007 data, the estimated overall cost of investment is 78 bps per retirement assets totaling $17.7 billion for $2.1 trillion of total assets. Of that $17.7 billion, the costs associated with investment advice, administration and active management account for $9.3 billion, almost 50% of the total costs.
- Stable Value Funds: Performance from 1973 through 2008 from David F. Babbel and Miguel A. Herce (9/12/9). Stable Value funds have close to $1 trillion of assets and are offered as an investment option in almost half of all defined contribution (DC) plans and by February 2009 reached 36.7 percent of their assets.
- Defined Contribution / 401(k) Fee Study from Deloitte ICI June 2009 - Excellent Summary and Details on 401k costs.
- The Structure of 401(k) fees (Feb 2009) from Center for Retirement Research identifies typical 401(k) plan costs. In Figure 1 they list .1-.2% marketing and administrative and 1.3-1.4% asset management costs (manager, and trading costs). "This brief ... finds that 401(k) fees are so complex, confusing, or obscure that many sponsors and participants report that they do not understand either their magnitude or their consequences."
- A question so important that it should be hard to think about anything else by in The Journal of Portfolio Management (Winter 2008) (Presentation), John Bogle estimated society’s cost of investing in 2007 ($528 billion this year).
- The Cost of Active Investing by Ken French was the Presidential Address in the Journal of Finance (August 2008).
- The Use and Abuse of Mutual Fund Expenses from Todd Houge and Jay Wellman in the Journal of Business Ethics (Spring of 2006). They find that the industry has become more adept at segmenting customers by level of investment sophistication and that load mutual fund companies take advantage of this ability and charge higher expenses to their target customer: the less knowledgeable investor. Over time the industry has regarded 12b-1 fees as a substitute for sales loads, shifting a portion of these up-front charges to the annual expense ratio where they are less likely to be noticed by investors. They also find growing abuse of sales distribution or 12b-1 fees by funds that are closed to new investors, almost all of which are load funds.
- Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows from Brad Barber, Terrance Odean, and Lu Zheng (later published in The Journal of Business in 2005). (or here). The proportion of diversified U.S. equity mutual fund assets invested in front-end-load funds has dropped from 91% in 1962 to 35% in 1999. In contrast, asset-weighted operating expenses for these funds increased by more than 60%, from 54 basis points to 90 basis points, despite the great increase in total assets under management. Marketing and advertising, the costs of which are often embedded in funds’ operating expenses, account for their finding that Investors buy funds that attract their attention through exceptional performance, marketing, or advertising.
- Measuring the True Cost of Active Management by Mutual Funds by Ross M. Miller (June 2005)
- Portfolio Transactions Costs at U.S. Equity Mutual Funds and Mutual Fund Brokerage Commissions (January 2004) from Jason Karceski, Miles Livingston, and Edward O'Neal
- Equity trading costs in-the-large by Hans Stoll (Summer 1993), Journal of Portfolio Management.
- InvestingAudit.com is a service (free for simple cases) for investors seeking assistance in evaluting their investment costs and performance.
- Brightscope ranks 401K plans.
- PersonalFund Cost Calculator
- There is a classic Dilbert featuring Dogbert Investments leading to a 3% cost. See this page in Burton Malkiel's Random Walk, or fourth cartoon here.
Last update 8/25/2010. Copyright © 2010 Investor Home. All rights reserved. Disclaimer