the SEC proposes new rules to limit fund sales charges, improve transparency of fees for investors, encourage retail price competition, and revise fund director oversight duties.

Regarding fund sales charges, the SEC proposal would restrict ongoing sales charges and would allow funds to keep paying 0.25% per year from their assets for distribution as marketing and service fees to cover expenses such as advertising, sales compensation and services.

As I read it, they are just getting rid of the term “12b-1 fee.” I’m wondering what this means for all those funds that are STILL CHARGING 12b-1 fees on mutual funds that are closed (hence no new marketing needed). There’s a chapter in the book I mentioned a couple of weeks ago, Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship (Robert W. Kolb Series)*, that discusses this very topic. In a table on pages 60 and 61, there is a listing of 102 funds that charge 12b-1 fees on mutual funds that are closed to new investors. The reason mutual fund companies still charge these fees is because they bring in a lot of money. The table shows nearly $295 million in these fees.

I’m also curious about the rules to limit fund charges. How is that going to work and what is it going to look like?

For those of you not familiar, an a-share mutual fund is a front-load mutual fund. That means when you purchase an a-share, a percentage (usually around 5%) of your purchase goes to pay the front-load. The more money you invest, the smaller the front-load is as a percentage (called breakpoints). For instance, ICA’s maximum load is 5.75%. But, if you invest $100,000, your load is reduced to 4.5%. A-share mutual funds also charge a 12b-1 fee (also called a trail) that is used to compensate the broker. The 12b-1 fee for the ICA a-share is .23% per year.

A c-share is much different. There is no front-load but in order to compensate the broker, the fund charges a higher 12b-1 fee. In the case of the ICA c-share, the 12b-1 fee is 1%. This 1% is charged for as long as you own the fund. There also are no breakpoints for investing more money in the fund.

As you can probably imagine, the c-share ends up being more expensive to own over the long-run. But, that doesn’t necessarily make it a bad product. Why?

Well, when a broker is making 1% per year, there is an incentive for him (or her) to take care of the client. As their c-share business grows, there’s also less pressure for the broker to have to find new clients. Contrast that to an a-share that pays a big commission up-front. As soon as the broker earns that commission, they have to either pursue more money through that client or they have to go out and find more clients so they can earn more up-front commissions. There’s not nearly as much incentive to take care of the existing client. Sure, not all brokers work this way but some do and it is a risk of purchasing an a-share mutual fund.

So, let’s look at a numbers comparison of ICA’s a-shares and c-shares. The ICA c-shares have only been around since 2001. I like to look at round numbers so I began the comparison on December 31, 2001 through December 31, 2009. I assumed that the 12b-1 fees (I divided the annual 12b-1 fee by 4) were charged on a quarterly basis based on the account value on the last day of each quarter. Here are the results I got:

It’s not a lot of difference but keep in mind that this was for only 7 year’s worth of data. The gap will grow with time (assuming all else stays equal). Most brokers I knew NEVER sold c-shares because they needed the big up-front commission and didn’t want to take the risk of the client leaving before they could make up the lost up-front commission in trailing commissions.

Some questions were raised about my methods:

Why did I choose a 10-year period? Well, I wanted to compare American Funds’ Investment Company of America with Vanguard’s S&P 500 Index Fund. My source for daily data is Yahoo! Quotes. Their data only went back to the mid-to-late 1990s. Since I was calculating the reinvestment of dividends on my own, I wanted to have daily data.

Did I “data mine?” No, I did not. I did not search for a mutual fund that would support my position (because I did not have a position). I would have posted the results REGARDLESS of the outcome. As I stated in my previous post, I chose American Funds’ ICA because I was familiar with them and knew that they had been around a very long time.

So…

Since I didn’t have daily data going further back than the mid-1990s, I decided to switch to annual data provided in the ICA’s Annual Report and data that I have for the S&P 500 Index*. Here is a year-by-year comparison (you can click on the graphic to see a bigger version):

Those figures do not include a sales load. They also do not include a management fee for the S&P. So, to get a little more accurate picture, I assumed a $1,000 investment in each and deducted the maximum up-front sales charge of 5.75% for ICA. Then, I calculated the returns for the last 5, 10, 20, 30, and 40 years. Here are the results:

Remember, these numbers DO NOT include any sort of management expense for the S&P Index, which favors the index. Another thing to note is that looking at the data, I’m sure there were rolling periods in which the index beat ICA.

These figures all go to hell if you look at dollar-cost averaging since each investment in ICA would take a haircut. It would be hard for ICA to overcome that obstacle. That’s why I would ONLY consider a load mutual fund if I was investing a lump sum.
*Although I refer to it as the S&P 500 Index, the index was composed of 90 stocks prior to 1957.

After I left PaineWebber, I quit following American Funds until the other day when I came across some old fund literature I had kept (yeah, I’m a recovering pack rat). Their numbers looked pretty solid so I decided to look them up to see how ICA performed over the last 10 years. Turns out they did pretty well considering what we went through over the last ten years. I decided to compare ICA’s performance with Vanguard’s S&P 500 Index Fund.

I assumed the following:

• a $100,000 lump sum investment placed on December 31, 1999 and held through December 31, 2009.

• a 4.5% front load on the ICA shares.

• the funds were held in an IRA so taxes were not an issue.

• all dividends were reinvested.

Here is the chart of the comparison:

The value of the ICA (Class A) shares (after the 4.5% front load) was $122,257 at the end of 2009 while the value of the Vanguard S&P 500 Index Fund shares was $90,165. That’s a $32,000 difference. Had the ICA shares not had the front load, the end value would have been over $128,000.

Now, the numbers would have been totally different had you used a different share class. I’ll rerun the numbers using the C-Shares, which do not have an upfront load but carry a 1.46% management fee compared to .66% for the A-Shares. Unfortunately, it can’t be an exact comparison because the C-Shares haven’t been around as long. I’ll use the last five years as a comparison.

The numbers also would have looked much different under a dollar-cost-averaging scenario since every purchase of the ICA shares would have been subject to the sales load.

Also, it’s important to note that not all load mutual funds are created equal. American Funds has a great reputation of holding costs down. Not all mutual funds take the same approach that American Funds does. I just wish their funds didn’t levy sales loads.

“…the average equity fund pays approximately 0.30% of assets a year [in trading costs]. That’s roughly 30% of the average no-load large-cap fund’s expense ratio. Thus, brokerage commissions can take what looks to be 0.90% paid in expenses each year up to 1.20%.”

This topic has been receiving more attention over the last couple of years. John Bogle has written about it in his books and I have seen more articles on this topic recently. It’s a good thing.

One of the funds with the highest trading costs is MFS Core Growth A (MFCAX), which payed out 1.2% of fund assets in brokerage commissions. Not surprisingly, the fund’s performance isn’t that great.

What’s bad is these numbers aren’t reported to mutual fund shareholders as part of the management expense ratio.

Should they be?

Yes, mutual fund net returns take into account such fees, but the information on these fees is usually buried in the mutual fund’s prospectus. The author of the article does mention that Morningstar plans to start tracking and publishing this information in the future.

Mutual Fund Fees Jump 5 Percent

It’s an interesting article. Check it out.

What is the profit margin on a bag of cheetos, 50%?? The margin on the gel for my hair is over 100%. Why do we quibble over 1%? Do we expect money managers to work for free? I know it sounds like a lot of money (and it is), but 1% is less than grocery store margins.

The definition of Profit margin (“margin of profit”) according to the Barron’s Finance & Investment Handbook:

The relationship of gross profits to net sales. Returns and allowances are subtracted from gorss sales to arrive at net sales. Cost of good sold (sometimes including depreciation) is subtracted from net sales to arrive at gross profit. Gross profit is divided by net sales to get the profit margin, which is sometimes called gross margin. The result is a ratio, and the term is also written as margin of profit ratio.

In other words, the 1% management expense ratio should not be confused with gross margin. It is simply the fee charged to manage money and is not a margin.

For instance, let’s say I manage a $200 million portfolio for a 1% fee. Not including any other fees, my income for managing this $200 million portfolio would be $2 million per year (not counting any growth in the value of the portfolio). For simplicity’s sake, we’ll assume that the $2 million per year is my net sales. Now lets say my cost of goods sold is $1.5 million per year (seems a bit high to me but I like round numbers), making my gross profit $500,000 per year. Dividing $500,000 by $2 million, makes my profit margin 25%. Not a bad margin, if you ask me.

The aggregate numbers on the magnitude of investment fees are sustantial. For example, look at the fees charged by mutual fund companies. According to the Investment Company Institute (an industry trade group for the mutual fund industry), mutual fund assets totaled $10.4 trillion at the end of 2006 (yes, that is trillion with a “t”)**. Equity mutual funds alone held $6.6 trillion in assets. The average fee for these equity funds was 1.07 percent per year on an asset-weighted basis. This implies that investors paid over $70.6 billion in management expenses and load fees alone in 2006. In addition, there was over $1.5 tillion invested in bond mutual funds, generating an estimated $12.4 billion per year in fees. Money market fund accounted for another $2.4 trillion in assets and generated an estimated $9.6 billion in fees for hte fund industry. Adding it all up you get to a grand total of $92 billion in annual mutual fund fees—a lot of money by anyone’s standards. Putting these fees into perspective, $92 billion is equivalent to an average payment of about $300 per year for every man, woman, and child in the United States. And this estimate does not even include the many trillions of dollars managed by institutional investment managers outside of the mutual fund industry, nor the costs associated with brokerage commissions, transactions fees, custody fees, account fees, and other advisory fees. needless to say, the investment management industry is a very big and lucrative business.

That paragraph was written using 2006 data. I did a little research and found that according to the latest report, the average equity mutual fund has a fee of .99 percent. I also noticed that the 2006 numbers were adjusted downward by one basis point to 1.06 percent. According to that same report, it’s not likely that fees will continue to drop:

Recent press reports have suggested that fund expense ratios could begin to rise owing to the market downturn that began in the fall of 2007 and the attendant decline in the assets of stock mutual funds. No such increase in fund expense ratios is evident in this paper, but experience from past market cycles indicates that a rising trend is possible. During the market downturn that lasted from early 2000 to early 2003, for example, average expense ratio of stock funds rose several basis points.

Why might declining assets lead to rising expense ratios? There are a number of reasons; two stand out:

• Some fund expenses are relatively fixed. Among other things, these include transfer agency fees (which tend to be charged as a fixed number of dollars per account), the cost of mailing fund literature, accounting and audit fees, and director fees. When fund assets fall, these fixed costs will rise as a percentage of assets, tending to boost a fund’s expense ratio.

• Some fund complexes offer “breakpoints” in the management fee that they charge their funds. Such a fee structure reduces the fee rate as the fund’s assets grow, sharing with investors the benefits of economies of scale. As asset levels fall, the fund may lose some of the benefi t of those reduced rates, resulting in a higher expense ratio.

It stinks that when account values are dropping, fund expenses tend to increase. But, I suppose the opposite is true when account values are increasing. The skeptic in me wonders if fees fall as quickly as they rise? Regardless, investment management is big business.

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**Source: Research Fundamentals: Fees and Expenses of Mutual Funds, 2006 (PDF)

According to the article ($), the Value Trust is down 58% this year alone! Why? Because Bill Miller made bets on AIG, Wachovia, Bear Stearns, and Freddie Mac. OOPS!

Another reason to index?

Hi JLP,

I found your blog thru real simple magazine. Props to you. Nice.

So here is my question, 44 years old, female, broke my whole life, no savings, wanna change. Came into 18K (my Dad died) and I don’t know what to do with it. It has been sitting getting like 2% since December 07. So if you can help or have a suggestion great, if not I understand.

Thanks,

DG

First things first. If you’re broke, you probably need an emergency fund. If you don’t have access to 3 months of expenses, you need to save towards that goal first. Just make sure that you treat your emergency fund as just that: an emergency fund.

After that…

I try to refrain from giving specific advice on this blog. That said, I would DEFINITELY put this money away for the long-run by opening a Roth IRA and depositing $4,000 per year for the next 4+ years. As far as where to open your Roth IRA, I would say either a discount broker like Scottrade or a mutual fund company like Vanguard (I’m NOT necessarily recommending these companies). The easiest route to go would be a fund company like Vanguard. Vanguard offers lots of low-cost index funds as well as exchange-traded funds. The simplest route to go would be to go with a target retirement fund. Since you’re 44 years old, I would considering looking at Vanguard’s Target Retirement Fund 2030 (other mutual fund familes have target date funds that are worth looking at).

I wouldn’t stop there.

Based on some simple math, I figured that your $18,000 lump sum will be worth somewhere in the neighborhood of $65,000 at retirement (assuming a 9% rate of return minus a 3% inflation rate). That’s hardly enough for a comfortable retirement. I would make saving for retirement a big priority. If you have access for a company-sponsored retirement plan, use it. If not, you should try to save at least $4,000 per year towards your retirement. Doing so could give you nearly $184,000 at retirement (again, adjusted for inflation). It’s not a lot but it’s better than nothing.

Good luck!