Let's get one thing out of the way at the outset. I've started mutual funds. I continue to run a family of mutual funds. The point isn't disclosure. The purpose of my mea culpa is to leave you with this thought: I know where the skeletons are buried.
When it comes to mutual fund expenses, believe it or not, there are good fees, bad fees and even a fee paradox. If you're a fiduciary or an investor trying to identify those mutual funds most suitable for your retirement plan, you better know the ins and outs of fees.
First, let's dispel a myth. Cheaper funds do not necessarily offer you the best investment. We all know that index funds have (or should have) the lowest expense ratio. We also know, despite the mantra often heard from index fund salesmen, academic studies have shown index funds do not consistently outperform active funds, sometimes for extended periods of time. As a fiduciary, you can't rely simply on the lowest price to protect you.
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Liken this to what the SEC wants investment advisers to do when buying stocks. The SEC doesn't want the adviser to merely seek the lowest commission. The regulator wants the adviser to obtain the best execution. Even though it's easier to measure commission compared to execution, any fiduciary understands the attractiveness of buying 1,000 shares of XYZ Corp at $25 per share and paying a $50 commission versus buying 1,000 shares of XYZ Corp at $30 per share and paying an $8 commission. The total cost of the first trade is $2,550 while the cost of the second trade is $3,008 – nearly a $500 difference.
So, don't be fooled by low fees.
On the other hand, don't ignore fees, either. Going back to our purchase of XYZ Corp, if you can obtain the same execution price from competing brokers, it then makes sense to go with the broker charging the smaller commission. The same can be said of mutual funds. In an apples-to-apples case, for example, comparing two S&P 500 index funds with a similar tracking error, it makes sense to go with the fund sporting the lowest expenses. It's a little bit harder to compare active funds (either against other active funds or, especially, index funds) because of differing investment styles.
Which gets us to the main question: What fees should a fiduciary or an investor pay most attention to? We can place mutual fund expenses into two categories: Direct (401k fees that matter) and Indirect (401k fees that shouldn't matter). Direct fees come out of the pocket of the investor. Indirect fees represent the cost of operating the mutual fund.
Let's talk about direct fees first. These are the easiest to measure because the plan sponsor has to authorize them. These fees can include loads and commissions. Either the retirement plan (meaning the employees) pays these fees or the plan sponsor pays them. These fees are significant for two reasons: 1) They are the easiest to negotiate; and, 2) they have the greatest negative impact on long-term performance. The best way to negotiate these fees to zero is for a fiduciary to find a fund that doesn't charge them. This saves money for both the employees and the plan sponsor. As far as the second point is concerned, it's pretty obvious if you start from day one having to earn anywhere from 1-5% just to break even,…
Ironically, while indirect fees appear to receive the most press, they matter the least. Indirect fees mostly include the components of a fund's expense ratio. If you're looking at the fund's performance, then you're already looking at the fund's expense ratio. If you're counting them both, then you're double counting the expense ratio. The SEC says you can't use past performance to determine future results (a good policy). Unfortunately, you can't consider the expense ratio without looking at performance.
This leaves us with that hybrid-fee: the 12b-1 fee. Theoretically used only for marketing, 12b-1 fees really don't have anything to do with the daily operations of the fund. Rather, they're more like an embedded commission used to pay brokers for distribution.
Finally, there's the fee paradox. I've already run out of space for this week, so I suggest you take a look at this article ("Yale/Harvard Study Reveals Disturbing 401k Fee Paradox," Fiduciary News, June 1, 2010).
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
