NTF Platforms Can Mean Higher Costs

A version of this article was published in the October 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Convenience can be expensive.

You can see just how expensive when you look at  Charles Schwab's (SCHW) third-quarter earnings release. (We could just as easily single out Fidelity or others, but as a public company Schwab must report its financial results.) Schwab breaks out the assets and fees it collects from its massive Mutual Fund OneSource program. This program, which had its beginnings 30 years ago, has been hugely successful because it offers investors and advisors the convenience of one-stop shopping. They can gain access to thousands of funds from one platform without paying transaction fees while receiving a single statement and consolidated tax forms. Such a service certainly has a lot to recommend it.

But all that comes at a price. Schwab customers don't see directly how much they're paying for no-transaction-fee, or NTF, funds on OneSource, as those fees are paid by the underlying funds themselves. Most funds garner the majority of their inflows through such platforms. They then pay a fee for shelf space on the platform. There is no uniform way for participating funds to disclose how much they pay for this distribution, but Schwab itself reports how much it collects.

This is something Morningstar first explored in an article 15 years ago. Since then, Schwab's clout has only grown. In this year's third quarter alone, Schwab collected $216 million through OneSource. This came from an average fee of 0.32%, or 32 basis points, on an average asset base of $268 billion. In the first nine months of 2014, OneSource generated $631 million, putting it on pace to clear more than $800 million for the year.

To put those numbers in perspective, someone with a $1 million portfolio in NTF funds on OneSource would pay $3,200 each year on average for the privilege. Granted, those fees cover a host of back-office costs, but that's still a lot to pay for convenience.

Oddly, those fees have gone up since the 1990s. Fidelity, Schwab, and others operating NTF platforms have raised their NTF fees steadily. That's despite the fact that technology has made servicing fund accounts much cheaper. Most orders come via clicks on the web rather than phone calls to humans, after all. Look at the price of trading stocks or owning an index fund to see just how much cheaper investing has become in other spheres and you can see why it is so lucrative for Schwab and Fidelity to provide these services. Indeed, NTF fees may have risen to compensate for declining trading revenues.

Perhaps for this reason, the platform providers vigorously defend their turf. Fidelity and Schwab will eject a fund that offers a lower-priced share class to investors who invest with them directly. Thus, the Oakmarks, Januses, and American Centurys of the world are prohibited from pricing their funds more cheaply even though it costs them less to service accounts held directly with them. In fact, Selected American decided to charge one low management fee across all its accounts and was summarily ejected from Schwab's and Fidelity's NTF programs.

Are Non-NTF Funds Cheaper?
Based on the above, it would seem likely that the few funds not on platforms such as OneSource would be cheaper than those that are. However, that isn't always the case. There are no guarantees that any forgone fees will accrue to shareholders. For example, Tweedy, Browne's funds have Above Average or High Morningstar Fee Levels despite not being on NTF platforms. A small firm might need more than 30 basis points to service accounts, but a larger one could certainly do so more cheaply.

Still, our data show that funds that steered clear of OneSource appear to be cheaper than those on the platform. Including all no-load noninstitutional funds, the non-OneSource group has an average expense ratio of 0.88% versus 1.16% for the OneSource offerings. The difference between the two is even greater when looking at asset-weighted averages. In this case, OneSource funds have an average expense ratio of 0.92% versus 0.48% for non-OneSource options.

The averages for the non-OneSource funds are possibly distorted by the inclusion of Vanguard offerings, which are managed at cost. But even when Vanguard funds are excluded, the gap remains, albeit to a lesser extent. The average expense ratio grows to 0.91, for example. The average asset-weighted expense ratio for non-OneSource funds grows to 0.65%, but that's still 27 basis points less than the OneSource asset-weighted average.

It's worth noting that this relationship holds across broad asset classes as well. Only alternative funds are cheaper on OneSource on an asset-weighted basis.

It's impossible to know for certain whether the higher expenses for this latter group are attributable to the fees charged by NTF platforms. It's an interesting comparison nevertheless.  AMG Yacktman (YACKX) offers a potentially revealing case study. Both AMG Yacktman and  AMG Yacktman Focused (YAFFX) closed to new investors late last year. The two funds are managed by the same team using the same philosophy and with lots of holdings overlap. Yacktman Focused is essentially a more concentrated version of Yacktman. So it's easy to wonder why the expense ratio on Yacktman Focused's Service shares (1.25%) is about 50 basis points greater than Yacktman's (0.74%). One difference is that Yacktman Focused is on Schwab OneSource NTF, as well as Fidelity's NTF platform, while Yacktman is not. (Plus, Yacktman has asset-level breakpoints, while Yacktman Focused doesn't.)

Harbor offers another example, with equity funds that have a minimum of $50,000 to those who buy directly or $2,500 for those buying through an NTF. The direct funds are about 35 basis points cheaper, though admittedly a bit of that is no doubt related to the smaller account size.

Tendencies, Not Laws
Keep in mind that this discussion focuses on broad trends. Investors can't assume that a given fund will be either more expensive or cheaper than most peers simply because it is or isn't on an NTF platform. Investors need to investigate for themselves, and comparisons still must be made on a case-by-case basis. In cases where an NTF fund is more expensive than average, investors need to decide for themselves whether the convenience is worth the added cost.