What Does My Fund Cost?

Frames Matter Behavioral scientists and political consultants know that small changes in presentation can lead to big changes in perception. People prefer beef that is 90% lean to that which is 10% fat. At the gas pump, they enjoy a cash discount, not a credit card surcharge. Estate taxes are acceptable, inheritance taxes are unappealing but perhaps palatable, and death taxes are an outrage.

Properly speaking, these rewordings should have no effect. Whatever the language, the beef, gas prices, and tax bills remain constant. As rational entities, people are not fooled by surfaces. They make their decisions based on the underlying content. In classic economic models, you can gild the pig all that you like, but you will never be able to pass off your swine as being a statue.

But people being people, the reality is different. One place where the surface truly does matter, and where many porkers continue to masquerade as sculptures, is with mutual fund pricing. Because expense ratios are presented as a percentage of a fund’s total assets, they appear deceptively small. There are other approaches for viewing a fund’s costs that paint quite a different picture.

Accidentally in Love The inspiration for this column, Charles Ellis, states that mutual fund industry expenses have been misunderstood from day one.

The idea of charging an ongoing fee for advice, rather than an intermittent fee for transactions, is a relatively modern innovation, dating to the early 20 century. When that invention occurred, those who charged for the privilege had no precedent on which to rely. They could have charged everybody the same flat dollar fee, a fee based on a percentage of the portfolio’s total return, a fee based on a percentage of the portfolio’s yield, or several other ways. The field was open.

They settled on charging as a percentage of fund assets. The initial amount was 0.25% per year. Quickly, the advice-givers began to realize that they could ask for more. Unknowingly, they had stumbled onto a wonderful business model--indeed, claims Ellis, “the most profitable business in the history of the world.” Not only were their fees steady and ongoing--meaning that they had converted activity-based revenues into subscription revenues--but, because of how those fees were levied, customers believed that they were paying very little. The early fund companies began to raise their prices to see what the market would bear.

Dollars and Sense As it turned out, the market would bear a lot. As Jack Bogle is fond of saying, 75 basis points sounds like very little--three fourths of 1%, you can barely see it!--but $375 million is a very big deal indeed. We can push that point further. At a 4% interest rate, you would need to buy almost $9.5 billion in bonds to generate an annual $375 million. Which seems larger--0.25% or $9.5 billion?

Admittedly, converting a fund’s annual payments in expenses into a bond equivalent is tilting the scale in the other direction; it is an attempt to make fund expenses look very large, rather than very small. Thus, I do not advocate that calculation (although it does hold a useful shock value). But I do recommend thinking of fund expenses as dollar amounts.

The exercise not only turns the abstract percentages into something tangible but also highlights the fact that the fund industry, unlike almost all other competitors, has no volume discount for larger buyers--even though it has among the lowest marginal costs in existence. That, too, defies basic economic principles. There is much in the fund industry to confound rationality.

On the Margins Another suggestion, this one from Ellis: Measure fund expenses by what funds attempt to achieve. Funds do not attempt to grow net assets (that might well be the fund company's goal, but it is not that of shareholders), so the standard computation of an expense ratio is, strictly speaking, beside the point. Nor, unless it is an index fund, does the fund attempt to match a benchmark. It pursues incremental returns, above and beyond what a fund that invests in the benchmark provides.

Consider an actively managed fund that gains 8%, with a 1% expense ratio. The fund’s gross return is 9%: 8% coming from its published total return, which is always stated after the effects of ongoing costs, plus 1% from the expense ratio. The index fund that it competes against--not the theoretical benchmark, which cannot be owned, but rather a fund that can be substituted for the actively run fund that is being evaluated--appreciated 8.4% on the year. How should we think about that?

Incremental returns provide the answer. Subtracting the 8.4% gain registered by the index fund from the actively managed fund’s gross return gives 0.60%. The fund’s incremental return, from the perspective of the managers who run the fund, was 60 basis points. That can and should be compared against the fund’s expense ratio.

The interpretation is straightforward--

1) If the incremental return is more than twice as large as the expense ratio, then the active fund not only delivered returns above and beyond what an index fund would have provided but also permitted shareholders to have most of the profits.

2) If the incremental return is exactly double the size of the expense ratio, then the fund exactly split its profits with shareholders. For every dollar that shareholders received, the fund took a dollar in expenses.

3) If the incremental return is greater than the expense ratio but less than double its size, then shareholders were still better off than if they had been in an index fund. However, the fund took the lion’s share of the profits.

4) If the incremental return exactly matches the expense ratio, then fund investors were no better or worse off than if they had owned an index fund. However, the fund company that sponsored the active fund most definitely fared well!

5) If the incremental return was positive but lower than the expense ratio, then the managers of the active run fund added value, but all their contributions and more were consumed by expenses. The fund trailed the index fund after costs were paid. Such was the case in our example, with an incremental return of 60 basis points and an expense ratio of 1%.

6) If the incremental return was negative, then the fund failed completely. Its decisions cost shareholders money, then it charged for making those very decisions. Lose, lose.

Of course, as with any fund evaluations, a time period as short as one year is for measuring, not judging. Also, such measurements could--and probably should--be run on risk-adjusted return calculations, rather than risk alone. But those things said, comparing fund expenses to incremental return is an idea worth pursuing. It offers a very different view from what is customarily given by reports on fund expenses.

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.