Meditations on Money Management

Andrew Silton: It pays to keep watch on your mutual fund’s expenses and fees

CorrespondentApril 5, 2014 

Large mutual funds are fee-generating machines for a wide variety of affiliated businesses. While you dutifully focus on the performance of your investment, mutual funds charge all sorts of fees that quietly decrease your investment balance. In fact, the total expenses incurred in running a mutual fund are usually far larger than the most critical fee: the management fee. For example, with more than $140 billion in assets, Growth Fund of America generates annual expenses of $890 million and pays the investment adviser $332 million. With $230 billion in asserts, Pimco’s Total Return Fund generates annual expenses of $1.7 billion, including management fees of $685 million. In other words, big mutual funds are big businesses.

If you shun the biggest names in the mutual fund business and invest in little-known small mutual funds, you’ll often find that the money managers waive all or part of the fund’s fees in order to keep the total expenses under control. The advisers to many bond and money market funds have had to waive their management fees because the other expenses of the fund are higher than the meager yields. In this column, we’ll discuss the businesses that are making profits on your mutual fund investments, and who is looking out for your interests.

When you see your portfolio manager discussing his latest investment on CNBC, you probably think he works for your mutual fund because the name of the mutual fund is listed below his name. In reality, your portfolio manager works for an investment adviser, which has a contract to manage your mutual fund. The contract is administered by a board of directors or trustees that you elect to represent you. I’m guessing that most of you have never read a mutual fund proxy statement, let alone voted for trustees. Nonetheless, there’s a board, which must have an independent chairman and a majority of independent trustees, and they are supposed to act in your interest.

Little authority

While mutual fund trustees review thick, loose-leaf binders and sit through endless presentations, they exercise very little authority. Unless there’s a scandal – in which case the damage has already been done – the trustees follow a script designed by the investment adviser. This script has been carefully prepared by several sets of lawyers. Although the independent directors haven’t worked for the investment adviser or any of its affiliates, they are hardly independent. These folks come from the same business and social circles as the folks who run the mutual fund. It’s a cozy relationship.

If the trustees were truly independent, you’d expect them to fire poor performing managers. However, it’s hard to imagine the trustees of a Fidelity mutual fund firing Fidelity Management and Research and replacing them with T. Rowe Price. Even though the trustees at Fidelity make $400,000 to $500,000 per year, they aren’t going to act. If the trustees aren’t going to fire an adviser, they could force the adviser to accept fewer fees. This doesn’t happen either. The trustees go through extensive peer comparisons intended to justify the fees that the money manager wants to charge. It’s largely the same methodology used to justify the compensation packages for CEOs.

Lots of fees

As I noted at the outset, management fees aren’t the majority of a mutual fund’s expenses. Someone gets paid to distribute the mutual fund, transfer shares, perform fund accounting and provide administrative services. Most mutual funds have a series of affiliated companies, each of which enters into a contract with the fund to provide services. As a shareholder with Fidelity, your money is managed by FMR or another money management affiliate, but you are also paying Fidelity Distributors, Fidelity Brokerage, Fidelity Investment Institutional Corp. – the transfer agent – and Fidelity Services Corp. If you use American Funds or PIMCO, they have their own set of affiliates that have contracts with your mutual fund. Small fund complexes have to outsource these services.

Your mutual fund’s affiliates aren’t the only ones charging you fees. The stocks and bonds owned by the fund are held in custody by one or more banks. They must be paid for their services. The fund has to be audited and taxes calculated. The accountants are expecting to make a profit on this work. The fund requires legal representation, and most independent directors want a lawyer they can call their own. As a result, at least two law firms are going to be engaged. Last but not least, your broker wants to get paid. Almost every fund has a 12b-1 marketing plan that charges shareholder as little as 0.15 percent or as much as 1 percent depending on the share class. For Growth Fund of America, these distribution fees came to over $340 million last year. Each of these relationships require a contract that is blessed by the trustees.

Limit your expenses

Whether a mutual fund has $25 million or $2.5 billion in assets under management, it has to have all the service providers and contracts I’ve just described. Since some of these expenses are relatively fixed, small funds can incur very high expenses on a percentage basis. Thus very often the adviser has to defer its management fee in order to keep the fund’s overall expenses from consuming all of your gains. The deferral isn’t permanent. At some point, it will be lifted, and you had better hope that the fund has grown substantially. If it hasn’t grown, you are eventually going to be hit with the full expenses incurred by the fund. All those fees will eat up several percentage points of your returns.

Why does all of this matter? You can’t control the financial markets, but you can limit your expenses. While mutual funds have trustees or directors who should be looking out for your interests, you are the only one who will actually look after your own welfare. Your goal should be to keep expenses as low as possible. Everyone else is looking to make money from you, so you need to be vigilant.

Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog

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