Fees and Mutual Fund Returns

ADS The rate of return on an investment in a mutual fund is measured as the increase or decrease in net asset value plus income distributions such as dividends or distributions of capital gains expressed as a fraction of net asset value at the beginning of the investment period. If we denote the net asset value at the start and end of the period as NAV 0 and NAV 1 , respectively, then

For example, if a fund has an initial NAV of $20 at the start of the month, makes income distributions of $.15 and capital gain distributions of $.05, and ends the month with NAV of $20.10, the monthly rate of return is computed as

Notice that this measure of the rate of return ignores any commissions such as front-end loads paid to purchase the fund. On the other hand, the rate of return is affected by the fund’s expenses and 12b-1 fees. This is because such charges are periodically deducted from the portfolio, which reduces net asset value. Thus the rate of return on the fund equals the gross return on the underlying portfolio minus the total expense ratio.

Fees can have a big effect on performance. Table 4.2 considers an investor who starts with $10,000 and can choose between three funds that all earn an annual 12% return on investment before fees but have different fee structures. The table shows the cumulative amount in each fund after several investment horizons. Fund A has total operating expenses of .5%, no  load, and no 12b-1 charges. This might represent a low-cost producer like Vanguard. Fund B has no load but has 1% management expenses and .5% in 12b-1 fees. This level of charges

is fairly typical of actively managed equity funds. Finally, Fund C has 1% in management expenses, has no 12b-1 charges, but assesses an 8% front-end load on purchases. Note the substantial return advantage of low-cost Fund A. Moreover, that differential is greater for longer investment horizons.

Although expenses can have a big impact on net investment performance, it is sometimes difficult for the investor in a mutual fund to measure true expenses accurately. This is because of the common practice of paying for some expenses in soft dollars. A portfolio manager earns soft-dollar credits with a brokerage firm by directing the fund’s trades to that broker. Based on those credits, the broker will pay for some of the mutual fund’s expenses, such as databases, computer hardware, or stock-quotation systems. The soft-dollar arrangement means that the stockbroker effectively returns part of the trading commission to the fund. Purchases made with soft dollars are not included in the fund’s expenses, so funds with extensive soft-dollar arrangements may report artificially low expense ratios to the public. However, the fund will have paid its brokers needlessly high commissions to obtain its soft-dollar “rebates.” The impact of the higher trading commissions shows up in net investment performance rather than the reported expense ratio. The SEC allows soft-dollar arrangements as long as the proceeds are used for research that may ultimately benefit the mutual fund shareholder. About half of such funds have been used to purchase stock research reports. There have certainly been cases in which soft dollars were used for purposes other than the welfare of shareholders, however, and consumer advocates periodically propose that their use be curtailed.

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