One-Man Think Tank: A method for analyzing and comparing the costs and fees for mutual funds and ETFs

Elizabeth’s note: It’s interesting to read Ron’s conclusion here that fiduciaries must disclose mutual funds’ fees and costs. If, after its six-month study, the SEC does impose a fiduciary duty on broker-dealers, consumers may by in for a shock about the hidden fees they’ve been paying. Even if no fiduciary duty is imposed, the SEC seems already to be moving in the direction of requiring more disclosure.
Ron, RIABiz’s One-Man Think Tank Columnist, is writing a series of columns on risks to an RIA’s most valuable asset, his or her reputation. The previous installment in the series was one about the due diligence required of a fiduciary when investigating a REIT. See: One-Man Think Tank: Inside the due diligence that uncovered serious questions about a REIT. In this piece, he takes on a topic of current debate: fees and costs associated with mutual funds and ETFs.

Given the large use of pooled investment vehicles, including mutual funds and exchange-traded funds, in the portfolios of clients of RIAs, we would expect that most RIAs would be well aware of specific actions they should undertake to adhere to their fiduciary duties. Yet, I often find from my discussions with RIAs that only cursory due diligence has been undertaken. Often material facts regarding funds are either never disclosed to the client, or that the disclosure occurs “late.”

Weights on a Kentucky Derby racehorse

Why pay attention to fees? Many academic studies have found that mutual fund performance is severely diminished by high expenses. A recent white paper by Professors Zakri Y. Bello and Lisa A.K. Frank of Central Connecticut State University noted that high expenses [i.e., “disclosed fees”] and high turnover [resulting in “hidden costs”] “tend to hurt performance, a finding which is in line with previous studies.” [A Re-Examination of the Impact of Expenses on the Performance of Actively Managed Equity Mutual Funds (2010).]

Fees and costs can be thought of as weights placed on race horse about to run the Kentucky Derby – it is not certain that high fees and costs will result in the horse running in last place, but the likelihood of the horse winning the race diminishes each time additional weight is added.

Since the fees and costs of a fund can materially impact performance, these fees and costs constitute part of the “material facts” that should be disclosed to a client. As the U.S. Supreme Court reminded investment advisers in its seminal 1963 decision confirming the existence of broad fiduciary duties upon investment advisers, “Courts have imposed on a fiduciary an affirmative duty of `utmost good faith and full and fair disclosure of all material facts,’ as well as an affirmative obligation `to employ reasonable care to avoid misleading’ his customers.” SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963).

If investors only knew

But what are all of these fees and costs? The RIA undertaking due diligence should seek to ascertain, or at least estimate, the following disclosed fees for mutual funds, ETFs, and UITs:

(A) sales loads (commissions), and their impact over the long term in terms of affecting the annual return of the investor
(B) contingent deferred sales charges (CDSCs) common in Class B shares, including when such charges decline and by what amount
(C) fund investment management fees
(D) fund administrative fees; and
(E) 12b-1 fees.

The latter three fees are included in a fund’s annual expense ratio. Great care should be undertaken to estimate the impact of sales loads and CDSCs on the client. The impact will vary by holding period. Also, discussions should be undertaken to ensure that the client is aware that the impact of sales loads, or CDSCs if incurred, is not included in the mutual fund’s annual expense ratio. Additionally, the RIA should take note of fee waivers which may exist, but which could be terminated in future years, thereby adding to an investor’s burden.

In addition, other transaction costs associated with the purchase or redemption of fund shares should be disclosed. These include redemption fees imposed by some funds to guard against short-term trading, or to promote long-term holdings of fund shares. These also include custodial transaction fees (for fund purchases and sales) and commissions (for ETF shares). Additionally, the prudent RIA would disclose to the investor that ETF shares are often sold at a premium or discount to the ETF’s net asset value (NAV); a history of their ranges might be provided, as well as the current pricing relative to NAV.

A how-to for estimating transaction costs

But the analysis does not stop there, as there are many “transaction costs” which a fund might incur in connection with the trading of securities within the fund. These include:

(A) brokerage commissions paid by the fund to brokerage firms for trading stocks, bonds or other securities within the fund, which can be discerned in the fund’s Statement of Additional Information, and which often include “soft dollar payments” to brokerage firms
(B) bid-ask spreads
(C) mark-ups and mark-downs for principal trades
(D) market impact costs; and
(E) opportunity costs due to delayed or canceled trades. In addition, since many funds possess significant cash holdings, opportunity costs can arise from these cash holdings.

Can these “transaction costs” be quantified? Yes, and no. It is possible, through transaction cost analyses, for a fund complex to analyze each and every trade and come up with a more or less precise estimate of trading costs incurred by a pooled investment vehicle. But this is a very costly exercise. A less precise means is to discern, at least for stock mutual funds, the portfolio turnover of the fund and then estimate, using average transaction cost estimates for the stock asset classes of the fund as broken down by market capitalization (large-cap, mid-cap, small-cap).

Even then, however, care must be undertaken. “Portfolio turnover ratio” as reported in a mutual fund’s prospectus is computed using the lower of the fund’s purchases or sales of securities; the SEC permits this under the proposition that a fund’s manager is not responsible for excessive fund inflows or outflows. Yet, regardless of the cause of trading, both purchases and sales of securities result in transaction costs borne by the fund’s shareholders. Hence, the astute RIA will determine (from a fund’s financial reports) the fund’s purchases and sales, combined, as a percentage of average fund holdings, to come up with a much better “portfolio turnover ratio.”

Opportunity costs from cash holdings can also be estimated. Finally, the RIA should ascertain if the fund engages in securities lending, what revenue from such activities was derived by the fund, and the extent of sharing of that securities lending revenue with the fund’s advisor or others. Funds that retain nearly all of the securities lending revenue to benefit the fund shareholders are best, in my view, at fulfilling their fiduciary obligations to fund shareholders.

A negative expense ratio?

Once all of the data about a fund has been gathered and entered into a spreadsheet, formulas can be applied to provide an estimate of the “total fees and costs” of a fund, net of securities lending revenue. The result? There are actually some stock mutual funds out there possessing (due to extremely low turnover, low disclosed fees, and exceptional securities lending revenue, a “negative” “total fees and costs annual expense ratio”! And such an analysis also reveals that some funds that at first blush possess very low annual expenses (including many ETFs) turn out to possess very high market impact costs, and retain little of the securities lending revenue for fund shareholders (or possess no such revenue; this in turn leads to above-average “total fees and costs” for otherwise seemingly “inexpensive” funds.

Yet, some advisors are cautious about presenting such data to clients. In fact, I have spoken with several providers of data on mutual funds and ETFs, including pooled investment vehicles held in ERISA accounts. Generally, these data providers opine that, given the uncertainty of estimation, no disclosures should be undertaken of transaction and opportunity costs within funds. I disagree. A fiduciary has the duty to disclose all material facts regarding the investments recommended. A reasonable basis for estimating these fees exists, based upon the continued academic research that provides estimates of fees and costs by asset classes, dependent upon portfolio turnover within stock funds. Hence, disclosure of a “total fees and costs” estimate by the fiduciary advisor appears appropriate This estimate should be accompanied by a description of the methodology employed to provide such estimate, the sources of data utilized, and a statement that the actual costs may be higher or lower depending upon the skill (or lack thereof) of a fund’s manager, or other factors.

Timing matters

Yet, I often find that RIAs have their custodian (usually a discount brokerage firm) deliver a mutual fund’s or ETF’s prospectus to the client only after the transaction has been consummated. Only then is the client provided with “disclosed fees and costs” information. Yet, this delayed disclosure does not meet the fiduciary’s obligation to ensure timely disclosure.

In a very early case applying the fiduciary duties found under the Investment Advisers Act of 1940, the U.S. Securities and Exchange commission opined: “[D]isclosure, if it is to be meaningful and effective, must be timely. It must be provided before the completion of the transaction so that the client will know all the facts at the time that he is asked to give his consent.” In the Matter of Arleeen W. Hughes, SEC Release No. 4048 (February 17, 1948), affirmed 174 F.2d 969 (D.C. Cir. 1949).

Hence, at the time of recommendation, a fund’s total fees and costs estimate should be provided to the client. Additionally, the cautious RIA would also provide a copy of the fund’s prospectus to the client, or at least the summary prospectus or fund fact sheet, and record in the client’s record the delivery of such prospectus. Again, disclosure should occur before the client approves the purchase, as late disclosure of material facts to a client is ineffective to meet the RIA’s fiduciary duties.

No RIA is required to have a crystal ball. But …

While the lowest-cost investments need not be selected, it is important that adequate justification exist for using higher-cost products, when they are employed by the RIA and recommended to the client. There are many other factors, as well, which can affect the fund selection process. These include the financial stability or the fund company, the length of existence of the fund, the compliance history of the fund company, any history of the fund company of lowering management fees (as should occur when a fund’s net assets increase) or raising fees (as often occurred during the most recent stock market downturn), and many other factors.

How does the RIA undertake this due diligence? By the use of good judgment, adequate knowledge of funds, ETFs, and alternative pooled investment vehicles. And following a procedural process in which documentation occurs of the good judgments undertaken. No RIA is required to possess a crystal ball. However, when an RIA is called upon, after-the-fact, to justify his or her decisions, the RIA should possess detailed due diligence as to the investment products recommended, including a comparison to similarly situated investment vehicles.

Screens can be utilized to narrow the investment universe. For example, our firm never recommends any fund which possesses a non-waived sales load, 12b-1 fees, or which pays soft dollar compensation. We also look for alternatives when we find funds sharing securities lending revenues with affiliated providers or the investment adviser.

But, even after an initial screening is undertaken within an asset class (or asset classes, for multi-class investments), there is no escaping the need to “lift the hood” and undertake a thorough examination, including a comparison to other funds which pass the screening. Taxable distributions from a fund become a key consideration for funds and ETFs to be held in taxable accounts. Historical returns of the fund relative to an appropriate benchmark, manager history, adherence to style over time, and many other attributes and measures of a fund or its manager can be undertaken.

Careful documentation of this due diligence process can go a long way to proving the RIA’s adherence to his or her duty of due care. Through appropriate due diligence the RIA can seek to minimize another aspect of key risk which many RIA firms are exposed in today’s litigious environment – reputational risk.