The Right Way to Show Fund Expenses

Three Steps Forward
Morningstar's Paul Ellenbogen believes that mutual fund (and exchange-traded fund) expense reports could stand some improving.

In fairness, the current format for displaying expense data isn't bad. Over the past two decades, the SEC has improved fund disclosure by requiring that expense ratios be translated into dollar amounts, for hypothetical accounts. In addition, while prospectuses paint the cost picture only with broad strokes, fund shareholder reports offer detail for those willing to do the work.

More can be done, though. Not by creating additional presentations, but rather by enhancing current forms.

Paul has several ideas (currently in an unpublished, draft proposal). These are three of my favorites:

1. Grouping fund costs into relevant elements
2. Providing context
3. Providing individualization on financial statements

The first is particularly powerful--and long overdue.

Today, expense ratios are sorted into management fees, 12b-1 fees, and "other." Those labels are imprecise, to be generous. "Management fees" can pay for pretty much anything, from investment activities (the item most people associate with the label) to the company's salesforce to fees charged by brokerage firms to be on platforms. The 12b-1 bucket is equally vague, covering not only the aforementioned platform fees, but also direct advertising costs and indirect fund sales charges. The last bucket, of course, is worst of all.

Here's how things look today:

Paul replaces that mess with four groupings, which I have expanded to five.

1. Portfolio management fees: The investment function. This would cover research and portfolio management, and it would typically be a much smaller figure than the current management fee.
2. Administrative fees: My addition. What the fund company charges to run its business, aside from investment management (found above) and sales/distribution (in the fourth group). This would be similar to the G&A line in a corporate financial statement.
3. Operational fees: The direct cost of serving shareholders. Custodial fees, transfer fees, conducting customer service, statements, reports, and so forth. It would also include the costs of fund boards.
4. Distribution fees: Everything the fund company spends to grow its business, except for compensating financial advisors. Examples would be maintaining an internal salesforce, advertising and promotion, and platform fees.
5. Advisory fees: The costs of paying financial advisors for selling new shares; that is, the portion of the 12b-1 fee that is not used for general purposes, such as getting onto a platform or buying advertising, but which instead is used to compensate financial advisors for selling that fund's shares. Only funds that have 12b-1 fees will have advisory fees.

There is some devil in the allocation details, to ensure that organizational costs that cannot be attached to any particular fund are intelligently disbursed among funds of different sizes. But such is accounting.

The numbers, shown in the summary prospectus, would be accompanied by an industry average, to give context. My suggestion for the industry-average calculation would be an equal-weighted mean of funds sharing the same broad asset class: for example, diversified U.S.-equity funds or taxable-bond funds. But other approaches are possible.

The result would look like this:

Our Example Fund has typical portfolio management, administrative, and operational fees. It spends about as much running its organization and serving its shareholders as do other fund companies. However, its distribution fees are almost double the norm and advisory fees nearly triple. The company is aggressively spending shareholder monies on distribution efforts to grow its asset base, and it redirects 75 basis points per year to financial advisors as sales compensation.

The lesson would be different if the fund reached its high 1.86% expense ratio through a different path--say, through average distribution and advisory fees, but with administrative and operational fees that were well above normal. In that case, the expenses issue would not be the firm's sales efforts, but instead its struggles with cost controls. That might be due to the organization lacking scale, or it might be spendthrift management.

The point is, the five cost elements and the context permit investors to understand how a fund stacks up against the competition, where it is better, and where it is worse. That knowledge cannot be found in fund documents currently. To compare expense ratios, prospective fund buyers must look to outside sources. And there really are no sources--Morningstar included--where the cost elements can be analyzed.

The third item of individualization concerns financial statements. It's a simple matter to translate expense ratios into dollars paid, and then to display the results in the same format as shown in the prospectus. The basic version, showing only total expense dollars, would be in the basic statement. The detailed view would appear as an appendix and would look like this:

None of these changes are burdensome. Determining the elements and accounting procedures is a one-time decision; after that, the costs are automatically coded, processed, and calculated. Gathering the data for peer comparisons is an easy task. Finally, showing fund expenses as dollar amounts is a trivial calculation.

This column, of course, is far from a complete proposal. It is instead directional. The recommendations, however, are clear: Make expense components meaningful, provide context, and translate actual investor costs into dollars. That fruit should be easy enough to pluck.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.