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What's in a Mutual Fund? Thumbnail

What's in a Mutual Fund?

BY CLARK EVANS, VICE PRESIDENT OF WEALTH MANAGEMENT

HALL PRIVATE WEALTH ADVISORS


Ever wondered what’s in a mutual fund? Stocks, bonds, other mutual funds?

 Or, ever wondered what it costs?  It’s not free, right?

 Or, why did my broker recommend this mutual fund over the other? They both seem the same to me…

 All good questions that point toward how some of the proverbial sausage is made on Wall Street.   The concept behind mutual funds is fairly simple, unfortunately it becomes unnecessarily complicated and expensive by the time it reaches an investors’ portfolio.  Boiled down, a mutual fund is a basket of securities developed by a fund manager whose parent company then offers shares of that basket for sale to other investors, both individuals and institutions.  

Typically, a mutual fund has a theme, like U.S. consumer staples companies, which would mean that basket owns companies like General Mills, Pepsi, Kellogg’s, Clorox, and Campbell’s Soups.  But as you can imagine what passes for a theme or a strategy has ballooned into a dizzying array of concepts and sub-strategies.  For example, mutual fund managers may use leverage (debt) to grind out incremental returns, or inverse hedges so the fund will ideally produce results opposite of the broad market indices, or a mash-up of algorithms i.e. ‘factors’ to swap investments in and out of the basket based on what the computer program says to do.  

At the end of the day, it’s common to see mutual funds that have hundreds, if not thousands, of individual holdings (stocks, bonds, treasuries, etc).  And certainly, there is a case to be made for diversification, but the cousin of diversification is diffusion.  Often any meaningful gains or losses of the individual investments in these massive baskets are lost into the ether as no single investment represents more than a mere percent or two of the basket.  The impact of the fund just treading water is compounded by the fact that many mutual fund baskets also include other mutual funds – and the investor winds up paying to own baskets on baskets.

That brings us to our next question about what mutual funds cost.  It’s a healthy exercise, in any area of our lives, to get clarity on what we’re paying and unfortunately clarity on a mutual fund can be one of the most challenging tasks.  The fund manager and parent company that put together the basket must be paid and that typically happens in one of three ways.  

Some mutual funds have upfront charges that can be 5% (or higher) which is paid out of the initial amount invested.  Other funds have charges to exit the fund which can be equally as high when it’s sold.   And other funds have level charges where the investor pays these manager fees, which are typically lesser, as long as they own the mutual fund.  Now consider if a mutual fund owns other mutual funds, how easily these fees balloon when everything is finally tallied.

But that’s not all, as there are two more types of trading fees yet to consider.  The first fees can be easily detected by the investor.   These are the fees the broker or the big bank will charge as the transaction cost associated with buying or selling the mutual fund.  These fees hover around a percent and sometimes may be waived, but not all the time.   They show up on the brokerage statement as a dollar figure.

Next we need to consider the internal trading fees of the fund itself.  These are charged to the fund any time an investment is swapped in or out of the basket.  Not surprisingly, this can add up quickly.  The amount of trading in and out of the basket is typically represented under the industry term ‘turn-over ratio’ which can be very low, like less than ten percent, or very high, like over 200%.  The true cost of a mutual fund with a high turn-over ratio is difficult to accurately calculate as it involves understanding what trading charges cost the fund and how many trades the fund makes over the calendar year.  

We can turn to one of the most widely cited research papers for some clues about these internal trading fees.  Published in 2016, the paper is a collaboration between UC Davis, the University of Virginia and Virginia Tech which studied 1,578 funds over a 10-year period.  The paper concluded that the cost of high turn-over ratios was generally equal to or higher than the manager fees, and in many cases impacted performance of the fund more.

So how is an investor going to navigate all of these offerings, fees, and potential returns?  It’s common that many will turn to their broker for some advice on which mutual funds they should buy or sell.  In many cases this conversation is driven by the goals and objectives of the client, but not always as some brokers will have an incentive to recommend one fund over the other because of something called a 12b-1 fee or a distribution fee.  These fees are largely commissions that are paid to the broker for recommending which mutual funds the investor ought to have in their portfolio, but colored by which funds may have a higher payout for the broker, despite the clients’ goals and objectives.

Armed with more knowledge and context on how the mutual fund sausage is made, it’s not surprising that investors are ready for a fresh start and will go hunting for less exotic funds, less conflicts of interest and less expensive strategies.  It’s conceivable that when an investor tallies up all the fees of a mutual fund-based portfolio, the net result can show they are paying anywhere from 2 to 5%, every year.  Consider the advantage of starting fresh – reducing fees just 1% on a million dollar part of a portfolio translates into a $10,000 savings for that portfolio, every year…

Because of the high fees and conflicts of interest baked into mutual funds, they have no place at Hall Private Wealth Advisors nor in our clients’ portfolios.  There are other reasons not to work with them like their tax-inefficient structure and lack of liquidity.  But, one of the biggest positive impacts to an investors’ portfolio at Hall Private Wealth Advisors is our transparent and fair fee structure, free from any mutual funds and third parties.

If you’re looking at your portfolio wondering what’s in it, how you’re faring in the markets, or just curious for a no-obligation second opinion, we would welcome the dialogue and opportunity to get acquainted.