Tag Archives: performance based fee structures

The 12b-1 Fee: The Overlooked Cost in Your Mutual Fund

  By petillo | October 27, 2010 - 6:05 am | 401k, ETFs, Mutual Fund Investing, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025
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Mutual funds, as we all know, are a group effort. The thinking goes something like this: the more investors in the fund, the higher pool of available cash for investments. To attract this pool of investors, mutual funds advertise. A 12b-1 fee is essentially the cost of this advertisement. If you are buying a fund from a broker, chances are they were compensated by this fee. On the surface, this costs seems to be one of those cost-of-doing-business fees that for the greater good of the investor pool is levied on all the owners of the fund.

But what if the fund is charging you this fee inside your 401(k)? Should you pay for something that has already been marketed to your employer? This sort of fee was first introduced in the late seventies when investor distrust of the stock market was at an all-time high. Mutual fund companies argued that in order to keep their product viable, they needed to increase the number of investors and the only way to do this was to advertise their product.

Fast forward thirty some odd years later, past the greatest bull market, past the introduction of the 401(k), past the two big bubbles of the first decade of the 21st century, past the default investment in our retirement plans, and the fees still exist. According to SEC Chairman Mary L. Schapiro, the reasoning for these fees, which are paid by the investors in these funds has passed. In a press release detailing the SEC’s examination of this fee, Ms. Schapiro writes: “Despite paying billions of dollars, many investors do not understand what 12b-1 fees are, and it’s likely that some don’t even know that these fees are being deducted from their funds or who they are ultimately compensating.” That lack of transparency at a time when we want to see what our fund dollars are doing when they are not generating returns is troubling.

So the SEC believes that the need for 12b-1 fees has passed. “Our [SEC] proposals would replace rule 12b-1 with new rules designed to enhance clarity, fairness and competition when investors buy mutual funds.” Yet, like all decisions of this nature, there are bound to be casualties. 12b-1 fees are still used by smaller fund families for the very reasons they were initially adopted: to grow the pool of investors. Larger funds families, who have household names and a firm foothold among investors still levy this cost on its shareholders.

Inside a 401(k), where you are essentially a captive audience, these fees offer no benefit. According to BIll Barker, writing for the Motley Fool “They are not used to improve the research of stocks bought for the fund, nor in any way to improve the performance of the money already invested in the fund.” And because of that, he opposes them. So do I.

Without any identifiable benefit to existing and often long-term shareholder, the cost of this fee, often $2 on every $1,000 invested should go away. Inside a 401(k), this fee is something bordering on criminal. In a closed fund, one where the fund is no longer accepting new shareholder but still allows current shareholders to contribute to the fund, 12b-1 fees are an abomination, costing their fund participants millions of dollars. (A mutual fund can close for a variety of reasons, the most popular being that they simply have too many shareholders which makes investing according to the charter difficult.)

If you have funds in your 401(k), tell your plan sponsor to do something about it. This is fiduciary responsibility they may not have been aware they had. If your mutual funds still charge these fees and you agree with the investment community – the folks who put their hard-earned dollars in, not the people who sell these products, let the SEC know. You have until November 5th to voice your opinion. You can do so here.

Mutual Fund Investing: The Group Picture

  By petillo | September 30, 2010 - 7:38 am | commentary, financial planning, Mutual Fund Investing, personal finance, Profitable Investments, Repercussions: A Retirement Review, Retirement Planning Target 2025
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I have never been a fan of the group picture.  It is always posed and despite all of the coordination needed to get more than two people focused on the fact that there is indeed a snapshot about to be taken, some folks simply miss the opportunity.  A recent group photo taken by the Investment Company Institute, the mutual fund industry cheerleader reveals that not everyone in the photo stood still, smiled or faced the camera.  In fact, they all seemed to be shaking their collective heads in blurry dismay.

First, what is the ICI? By their own admission, they suggest that they have been around since the inception of the fund industry in the forties, a time directly following scandalous couple of decades in the securities business. Investors needed to trust in the safety of their investments.   What we got instead was an industry spokes-group that takes up the mantle of the industry and defends it mission.  That mission is based on “encouraging adherence to high ethical standards by all industry participants; advancing the interests of funds, their shareholders, directors, and investment advisers; and promoting public understanding of mutual funds and other investment companies.”

Seems ironic that seven decades later, investors seem little changed in how they view their investments and the ICI is still defending their members. Mutual fund investing is based on several layers of blind trust. The first is that the fund itself will operate in the investor’s best interest. The concept behind the mutual fund, in fact its main selling point is that it will do for you what you are not able to do for yourself. The average investor sees that as “not losing money”, which is something every investor is fully capable of doing on their own.

Which has been the problem with the industry since its inception.  They make no guarantees. In fact, their disclaimers are more widely known than their promises. No one who owns mutual funds, be it in their retirement plan or outside of such a plan can say with any confidence that they trust the fund, the fund family or the fund manager to do what is best for them as individuals – unless of course, what they do is beneficial to the aforementioned group as well.

So building trust in ethical behavior, or convincing the average investor that they can trust their mutual fund to do what is best for them is not a goal that has been met.

The next layer of trust that the ICI has not do a stellar job in promoting has been the understanding of risk. In 2008, far too many investors embraced risky positions across every type of mutual fund that offered (wink, wink) promises of ever increasing returns. They didn’t actually promise that the markets would continue to go up.  But they didn’t actually suggest that they could go down either.

Comparative tools were rigged for success and the ICI sat idly by and allowed its members to sell success. Success is cash in the bank and that cash belonged to the average investor. There were doomsday predictions out there but no mutual fund manager was issuing those words of caution. No one at the ICI was suggesting that risk be moderated, that investors rein in their enthusiasm, or even suggest that diversification was much more than investments made across every winning sector.

And if they had suggested that things would be bad if the current course of action continued, they would have seen an exodus of membership.  Here we are, a couple of years after the biggest loss that investors had ever experienced and the ICI reports that investors are still focused on a fund’s performance.

Even as investment professionals are suggesting that a fund’s costs can impact the return on the investor’s dollar, funds are focusing on an offsetting strategy.  If they can make more, take greater risks and perform up to investor expectations, costs won’t matter. That is not a mark for their program of education. It is not a criticism of embracing risk.  Nor is it a suggestion that mutual funds can not be trusted to keep your investment safe.

What I am suggesting is that after all this time, investors are still floundering in a sea of information that is both tidal and turbulent. Most investors still do not have a clue how much risk their fund manager is taking, whether it is right for them or their age. Most fund managers still compare their performance with indexes that don’t accurately jive with what they are doing.

Suppose the ICI insisted that a new set of tools be deployed to help the investor. These tools would offer a risk indicator that would educate the investor about the potential gains and more importantly the potential loss. perhaps they would also help the investor who has no clue.

We could call it the 20/20 tool, a reference to the perfect vision standard. These tools would essentially be in the form of an investment contract, similar to the sort that annuities issue upon purchase.  Unlike the annuity, where surrender charges stay in place for seven years, mutual funds could offer a redemption clause that would not allow more than 20% of the portfolio to be taken from the fund in any given year and a risk suggestion of investing no more than 20% of your investable assets in the fund.

Redemptions hurt mutual funds in the most sinister of ways, forcing losses to be spread among all investors in the fund, often months later and often catching many investor totally unaware. Redemptions are the sale of shares.  Huge redemptions can be catastrophic for investor who remain with the fund as the fund manager is forced to sell what may be profitable holdings to satisfy the exiting investor. This creates a tax burden on the remaining shareholder as well as a lower exposure to what might prove profitable and worthwhile involvement in some securities.

Some rudimentary informations suggests that if investors had done nothing when the market began to tank, holding on instead to what looked to be ever-diminishing share prices, they would be almost full recovered.  They would have paid less for the shares as they fell (a principle of dollar cost averaging that seems lost on the investor) and would have been prohibited by the same concept as shares began to rise.

Limiting redemptions would also come with a risk indicator, suggesting that if you invest in a certain fund, you should not have more than 20% of your total portfolio committed to the investment. Combining these two things would also allow the mutual fund manager to invest with a certain amount of confidence and less of a defensive posture designed to plan for the worst instead of doing what investors want: strategizing for the best.

Sure its a radical approach and not one likely to be adopted without help.  But if the ICI is truly devoted to the industry and more importantly, to the investors who created it – not just the fund families who sell it – then advocating for something the protects all interests in the investment community is a course of action worth charting.

Mutual Funds Fees: Performance on the Fulcrum

  By petillo | May 21, 2010 - 5:15 am | Mutual Fund Investing, Repercussions: A Retirement Review, Retirement Planning Target 2025
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Investors talk a good story when it comes to fees. While much of the conversation is begun by those who advocate index funds or exchange traded funds (ETFs are index funds that trade like stocks), the question of fees, how they should be paid and even more importantly, how much is usually based on why they (actively managed mutual funds) charge the rate they do. If mutual fund fees are so important to the investor, why haven’t they pushed harder for performance based fees?

Often referred to as the fulcrum fee, this method of charging the investor based on how well the fund manager actually did has been attempted in the past (and is currently being adopted by the Janus fund family) but has not received much more than a luke warm embrace. Is it because we simply don’t invest the way the wealthy do?

According to an article published by Advisors Perspective recently, the adoption of this sort of payment for performance is something wealthy investors want, mimicking what hedge fund investors have been paying. Here’s the way it works. A fund earns a hypothetical 50 basis points in fees. If the fund fails to beat or barely beats the benchmark by 20 basis points, what the paper calls the null zone, the fund earns its 50 basis points. If the fund whips the benchmark by 200 basis points, the fund manager(s) earn an additional 50 basis points in fees. Miss the mark by 200 basis points and fund managers earn nothing.

This is referred to as symmetrical because the fee structure punishes as equally as it rewards. To look at buying a fund, often done when performance has been better than average would give the investor the impression that high fees were the norm. And although Fidelity, USAA and Janus all offer a version of this type of fulcrum fee, only the Dunham funds offer the fee structure exclusively and based on a 12 month average. The other fund families offer a three-year trailing charge for fees.

What this means is that should a fund do well in the previous year, beating the benchmark handily, part of the reason it may have done so was because the fees were based on a previous performance model. If the performance was not beat, then the fees against that performance would have been lower, giving the impression of having done better than they may have actually done.

Dunham believes that wealthy investors (ones the are pre-qualified) are going to embrace this type of investment with fees charge on performance – Dunham does this exclusively – in part because they do not want to pay for services that do not provide adequate returns.

According to Chuck Jaffe, it may only be the wealthy who understand this. Earlier this year, he reported the death of a similar fee structure that was ended when TFS Capital killed “off the most aggressive performance-based fee structure in the fund business”. TFS wanted to charge the investor nothing if the fund didn’t do what it promised to do.

Larry Eiben, TFS’s chief operating officer found the problem not with investors, but with the SEC. Their rules, he said, “would not allow it”. Almost sounding regretful, he bemoaned the change back saying “You’d like to have a simple structure, where you only pay the fund if it deserves it, but that’s not really possible right now.”

Without the fulcrum fee model, even if your mutual fund doesn’t do well, your fund manager will still get paid. And even if the fund may have taken on out-sized risk to achieve out-sized gains, the idea should be revisited at some point in the future. Perhaps before we experience another severe downturn, an event that always prompts either investor revolt or a flight to low-fee, conservative investments.

More on this topic…