Fee Layering And The ETF Era

Feb 08, 2012

Is there anything more ridiculous in the financial services industry than the complicated fee structure of the products?  

An outline from a SEC report regarding mutual funds -- (you can stop reading when you get the idea):

"The typical structure for a multiple class fund includes A, B and C class shares, along with an occasional institutional or retirement class.  Class A shares often include a high front-end load with a nominal 12b-1 fee.  Class B shares have a contingent deferred sales load, plus a large 12b-1 fee.  The load decreases with each year in which the investor continues in the fund, until eventually decreasing to zero, typically about 6 years from purchase date.  After about 8 years, Class B shares convert to Class A shares, reducing the 12b-1 fee to Class A levels.  Class C shares usually have a large 12b-1 fee and a small contingent deferred sales load (1%) that is eliminated after a 1-year holding period."

So Class A is mostly a big front-end sales load -- a 5% hit before you start -- but hey, you only have to pay a small 12b-1 fee (sarcasm).  (12b-1 is a fee to re-imburse the fund company for its marketing costs).  Class B simply changes the mix of fees and Class C tends to have lower fees -- but only if you hold it long enough and therefore pay the higher dollar amount of fee that accumulates over time.   Of course, this all just relates to the expense ratios you pay at the fund level  -- it does not yet factor in any incremental fee layering done by intermediaries.  The result of all this complexity and the layering is that the end investor who doesn't take the significant time necessary to figure all this out can't possibly determine how much they are paying in fees -- think that is a coincidence?  

Below is a sampling of various fee combinations:


Now while you may just laugh at sales loads and other retail investor rip-offs that much of the mutual fund industry has piled on, have you done the actual fund of hedge funds math?  In order for a hedge fund (if sold through a fund of funds) to generate a basic 7% return, it needs to gross +13.6%.  To get a 25% return, a fully fee'd hedge fund manager would need +38.6%.   (Assuming 1+10% on top of 2+20%).  Those aren't retail folks buying those -- they are financially sophisticated people.

Back to mutual funds --- if you are an institution investing you do have access to the i Class mutual fund, which is usually not that much different than an ETF fee (ultra-low cost).   In fact, the 'i' in the iShares name effectively refers to the fund company offering institutional class fees to the public in the form of an ETF.  Still, in order to get an institutional class -- you have to pay some intermediary for the privledge.  Or just skip all that and buy ETFs, the breadth of product is aplenty.  

While some highlight the fact that ETFs are just a different wrapper -- this skips over a very important point.   When you buy a product on an exchange, the only fee the fund company can stick you with is the expense ratio.  They have no ability to assess a sales load, or a purchase or redemption fee.   It is just the expense ratio --  and then whatever your broker charges you in commission (though this has changed so that many banks and brokers are now zero commission).   The point is that the fund company loses power in the ETF structure as the product moves from off-exchange -- to be exchange-traded.

In our view, paying a low fee is just a check-off item, not a decision driver.   Don't worry about paying 59 basis pts vs 41 basis pts, it's not important -- that can be the equivalent of 5 mins of trading differential -- like buying at 9:40am rather than 9:45am after an index move of 18 basis pts during that time.   

It is however important if its 40 basis pts vs 3.29% (Advisorshares is charging an egregious 3.29% on HDGE, an ETF it markets -- that fee is worse than a lot of mutual funds).  

Don't get us wrong, anyone doing a good job is worth a material fee -- including a number of mutual fund and hedge fund managers.  But that said, never forget that the fees you pay are a direct dollar-for-dollar hit to your returns.  The more fee-layering, the higher the hurdle-rate to getting the return you seek. 



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Comments (1) -

Feb 08, 2012 20:54 #

Excellent article. I really like the part were you explain how the name iShares was named so.

Sumu United States

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