Freedom From Mutual Fund Fees

Posted By: Advisor Analyzer Team

Regardless of your sweet tooth, we all would like to have our cake and eat it too.  Of course, with each passing day, we’re disappointed to learn this is easier said than done.  You can have brains or beauty, strength or speed, money or love, soup or salad.  In fact, in the world of investments, it was often the case that the only way to have your cake and eat it too, was to sell your soul to the devil for another slice.    

 

While potentially great long term investments, open end mutual fund classes are notorious for their fee structures.  Sometimes the investor pays the fees up front, other times the fee is paid at liquidation.   These charges are paid to the introducing broker or advisor.  Closed end funds are different, but still very much the same.  While there are no sales or redemption charges, like open end funds, there are fee’s that must be paid to the mutual fund company annually for the overall administration of the portfolio.  More importantly, closed end funds often run the risk of trading at a discount to the underlying assets in the portfolio.

 

It may leave many investors to wonder: is it really impossible to have my money professionally managed without the catches?  Are there investments with no fine print?   In short, yes.  There are some truly noble and innovative products that are freeing investors from unnecessary fees and charges: mainly no load funds and exchange traded funds.

No-Load Funds

While cheaper than their load bearing cousins, don’t let the price fool you.  No loads are managed by some of the industry’s most reputable and well known firms.  As the name suggests, they are non load bearing, meaning there are no front or back end charges paid by the investor.  Note: they are not called no-fee funds, since there are annual charges and the likes that still apply.  Usually, the advisor that recommends the investment is paid the sales charge, and administrative fees are paid to the investment management company.  While not absent of fees, the cost to purchase these investments can amount to significantly less than their fee charging peers. 

To illustrate the impact of fee’s, suppose you have a $100 to invest.  If you were to purchase an A share class fund, you may pay $5 up front and can liquidate the position at any time.  The remaining $95 is invested by the fund company, thereby reducing your overall initial investment principal.  Back end funds do not have up front fees, so the whole $100 is invested, however there may be over a 5% redemption fee for early withdrawal of your funds.  Therefore, if an investment had no gains or loss, the investor may still lose upwards of 5% for liquidating the holdings.

 

No load funds are often purchased directly from the fund company, without the use of a third party intermediary, such as a broker or advisor.  Therefore, in addition to the benefit of professional money management, investors are able to allocate 100% of their investment capital while maintaining the flexibility to liquidate without burden.  

Exchange Traded Funds (ETF)

So far, the focus of discussion has been on actively managed funds: funds that endeavor to beat an index or market it tracks.  However, there are passively managed funds such as Exchange traded funds that are designed to mimic a specific index.  The objective of these funds is not to outperform the benchmark, but to replicate the returns tick for tick.  Therefore, if you own a Dow Jones Industrial ETF, your returns should be very close to the Dow. 

 

Investors often confuse ETF’s with closed end funds.  Like closed end funds, there are no sales charges or redemption fees and both are traded on an exchange or market.  However, due to the way ETF’s are structured, their prices do not deviate much from the net asset value of the underlying investments.  Like open end funds, ETF’s are a continuous offering, thus allowing the fund to maintain its price integrity relative to NAV. 

 

However, ETF’s do not perform identically to the index it tracks.  Part of the reason is due to administrative fees.  However, two funds tracking the same index with identical fee structures can perform differently.   The total amount of deviation from the benchmark being replicated is known as tracking error. 

 

Tracking error is defined as the standard deviation of the difference in returns between the investment and the specified target index.  It essentially measures how closely the investment performs relative to the benchmark.  Beta can be used to measure the how closely the returns of the ETF and the benchmark move in unison.  A Beta =1 would imply the ETF does not deviate at all from the index, on average. 

However, tracking error relies on the assumptions of normal distribution, and it does not distinguish between positive and negative deviations.  While I won’t go into it deeply, the general idea is that tracking error is created regardless if you out or underperform the markets.  When all’s said, there are no good surprises with an ETF.

Conclusion

While there is maliciously evil about load bearing funds, they are definitely not without flaw.  For investors who’ve paid sales commissions to their advisors, changed their minds and paid redemption fees do not give up on funds.  Before you spend hours pillaging through those 10Q’s and charts, it may not be a bad idea to glance at a few no load funds or ETF’s.  They may be one of the few investment vehicles available today that lets you have your cake and eat it too, well at least most of it.