Investing

Mutual Fund 101

Eyes Wide Open

Most investors understand the value of a low fee investment strategy. However, I continue to meet with prospective clients that are invested in mutual funds with above average fees, sales commissions (a.k.a. loads) or distribution fees (a.k.a. 12b-1 fees). Most investors are outraged when they discover they’re paying a 5% commission just to get into a mutual fund. In other words, for every $1,000 an investor puts into a mutual fund with a 5% front-end load, they’re paying a $50 commission, to their adviser most likely. So they’re already in the hole 5% before they even have a chance to let their money work for them.

I also find that many of these prospective clients are in a smattering of mutual funds of up to 10 or 12 at times that don’t fit into a reasonable asset allocation or strategy. There’s no rhyme or reason to the funds that were selected and included in a given portfolio. I’m not sure if this type of portfolio construction is due to indifference, a lack of understanding or just plain incompetence on the part of the adviser.

Mutual Funds

According to Investopedia, “a mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Fees

For their services, mutual fund managers charge a management fee, which is calculated as a percent of the money invested. The level of the fee charged usually depends upon the complexity of a fund’s mandate. Equity mutual funds usually charge more than bond mutual funds. International focused mutual funds usually charge more than domestically focused mutual funds. The theory is the more effort required on the manager’s part to select investments and manage the fund the higher the fee. Fees have been coming down for several years as competition increases and more lower cost alternatives, such as exchange trade funds, come to market.

Share Classes

Mutual funds are offered via share classes to investors. The share classes available to an investor depend on the type of investor or the platform an investor is using to invest. The number and size of fees vary with each share class.

A-shares are a fairly common share class that charge what’s called a front-end load, or a sales commission, at purchase. Additionally, A-shares can charge ongoing distribution fees known as 12b-1 fees. The commissions and distribution charges are on top of the annual management fee. So all in, investors can really see a lot of their returns eaten by fees in A-shares. Furthermore, A-shares can present conflicts of interest for advisers as advisers may encourage clients to invest in funds with a higher sales commission, to the adviser’s benefit, versus a lower cost, more suitable option.

B-shares are less and less common today. They charge fees when investors sell their shares.

C-shares don’t charge any load but usually have 12b-1 fees, which most often are built into the fund’s expense ratio. Most investors don’t realize there are fees embedded in the fund’s expense ratio that get paid out to their adviser, usually.

It’s important to note these fees are incurred when an investor purchases or sells mutual fund shares through an intermediary. Sometimes investment companies will sell fund shares directly to investors, which results in no commissions or sales charges. These types of funds are often referred to as no-load funds.

Active vs. Passive

There are two principal types of mutual funds, those that are actively managed, attempting to perform better than a benchmark (i.e., S&P 500) and those that are passively managed, or hold all the stocks or a representation of the stocks in a benchmark or index, attempting to replicate the performance of the benchmark. Naturally, the actively managed funds are going to have higher fees because they’re more labor intensive to manage. There is sort of a romantic vision of active managers generating out-sized returns for investors, making both themselves and their investors rich. While there are a handful of funds that do accomplish this, the majority, especially in the mutual fund universe, do not.

In Morningstar’s annual active vs. passive fund analysis for 2018, it found only 38% of actively managed US funds outperformed a comparable passive fund peer. In other words, sticking with a fund that tracks the relevant benchmark versus deviating from the benchmark led to better performance than 62% of actively managed US funds.

Morningstar also found that just 35% of active funds beat the composite for their category (growth, value, etc…) in 2018.

Finally, the analysis also found that only 24% of all active funds topped their average passive rival over the 10-year period ended December 2018. Furthermore active funds fail to survive over longer time horizons.

In the end, your odds are better by going with a passively managed fund that is designed to track a benchmark or index. For the 10 years ended December 2018, 76% of active funds performed worse (after all fees) than their average passive counterpart. You may get lucky and pick funds that fall in the 24% that outperform but the odds of you doing that consistently are pretty low.

Sources for all charts: Morningstar