They say you get what you pay for, but consumers of asset management services sometimes get less. That can be especially true at times like these, when good returns are hard to find.
Chances are you don't know how much you are paying the fund managers you patronize, or what exactly you are paying them for. A fund's return - how much it gains or loses in a given period - encompasses deductions for several varieties of charges and other expenses, details of which are typically buried in fine print.
Fund providers take a management fee and, in some countries, a separate one for advertising and marketing. Among the miscellaneous other costs are brokerage commissions and outlays for safekeeping of assets and for administrative functions like accounting, sending out statements to shareholders and so on.
Apart from those running costs of ownership, there is often a charge that investors should consider a deal-breaker: the sales load. This is a percentage of the investment that is tacked on and split between the fund's distributor and the buyer's financial adviser - even if he doesn't use one.
Benjamin Tobias, a Florida financial planner and someone who stands to benefit from this sort of charge, advises investors to steer clear of any fund that imposes one. "I really do not think that a front-end load should ever be paid," he said. "I would go so far as to say that the front-end load should not be allowed."
What he finds so detestable is not the load per se but that advisers receive it up front. "Regular monitoring of the investment and circumstances are the single most important aspect" of financial advice, Tobias said. "When paying a front-end load, will the adviser be there in years to come when compensation is not going to be earned?"
What is certain to be there for all the years that an investor owns a fund are the fees and expenses. Investors may ignore them because they amount to just 1 percent or 2 percent or so of their stake in a fund each year, but as Jeff Tjornehoj, senior research analyst at Lipper, pointed out, they add up. "While those fees may not seem like much," he said, "if you compound the numbers over 10 to 20 years, you're talking about real money."
It can be even more real during periods of weakness. If an equity fund has total annual expenses of 2 percent - typical for Europe but on the high side for an American product - they will reduce the return by just one-tenth in a bull market year when the portfolio gains 20 percent. In a tough year, when the fund's share value increases by, say, 4 percent, the costs will cut that in half, and during a bear market the expenses will magnify the loss.
The severity of the impact of costs during a losing run may increase because of the way management fees are structured, Tjornehoj said. A fund may charge 1 percent on the first $1 billion of its asset base, then 0.8 percent on the next $1 billion and so on. That means that as a fund shrinks in a bear market from losses and shareholder withdrawals, the management fee is likely to account for a higher proportion of assets for the remaining investors.
All else being equal, a small fund will cost more to run than a big one because fixed costs must be spread over fewer assets. That helps to explain why European funds, which tend to be smaller than American funds, are more expensive.
But there is more to the higher fees than managers merely passing along higher costs. Christopher Traulsen, head of fund research for Morningstar U.K., points out that management fees tend to be twice as high for British funds as American ones, no matter how big they are.
The industry "offers a robust selection of funds from a wide array of providers, and yet the majority of them have hit on the exact same fee for their services: 1.5 percent per year," Traulsen said in a research report.
The more data assembled about fund expenses, the stronger the case for buying index funds seems to become. It gets even stronger when you consider that there is no clear evidence that funds with higher expenses produce returns that are strong enough to overcome the extra outlay. "Certainly there are some fund managers out there who have great reputations and slightly higher fees than their peers," Tjornehoj noted. "What's unknown is whether those managers will continue to outperform. The only thing you can be sure of is that their costs will be higher."