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Mutual Fund Fees

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Fees should be one of the primary considerations when selecting a mutual fund.  Much of investing requires dealing with uncertainties.  Fees, however, are one of the few important factors that you have complete control over.  It is almost always prudent to minimize fees, unless you have a compelling reason not to.

"Beware of small expenses; a small leak will sink a great ship." — Benjamin Franklin

Antonio Apap and John M. Griffith, "The Impact of Expenses on Equity Mutual Fund Performance," Journal of Financial Planning, February 1998. "... the results indicate that a significant inverse relationship exists between expense ratios and both abnormal and total returns ..."

John C. Bogle, "What Can Active Managers Learn from Index Funds?," Lecture delivered on December 4 2000.

John M.R. Chalmers, Roger M. Edelen, and Gregory B. Kadlec, "Fund Returns and Trading Expenses: Evidence on the Value of Active Management," Working Paper, October 15 2001. "We find a strong negative relation between fund returns and trading expenses.  In fact, we cannot reject the hypothesis that every dollar spend on trading expenses results in a dollar reduction in fund value."  "In this paper we reject the hypothesis that active fund management enhances performance.  We attribute our strong results to our more direct measure of mutual fund trading expenses.  ... we find a strong negative relation between fund returns and trading expenses, while we find no relation between fund returns and turnover."

Stephen P. Ferris and Don M. Chance, "The Effect of 12b-1 Plans on Mutual Fund Expense Ratios: A Note," Journal of Finance, September 1987, pp. 1077-1082. This paper notes that 12b-1 plan fees definitely increase current expenses and therefore decrease current returns.  It remains to be seen if they subsequently tend to allow mutual funds to realize economies of scale which then result in a net decrease in fees.  This paper is consistent with a strategy of avoiding funds that have 12b-1 fees.

Irving L. Gartenberg v. Merrill Lynch Asset Management (694 F.2d 923 (2d Cir. 1982), cert denied , 461 U.S. 906(1983). Would you like to sue your mutual fund managers for charging you outrageous fees?  This case established what you need to do to be successful (or at least, to avoid having your case dismissed): "To be guilty of a violation of § 36(b), therefore, the adviser-manager must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining."

Eric E. Haas, "Mutual Fund Expense Ratios: How High is Too High?," Journal of Financial Planning, September 2004, pp. 54-63 (135kb). This paper quantitatively answers the question, "How high can a mutual fund's expense ratio be before it detracts from, rather than adds to, the expected risk-adjusted performance of a portfolio?"  This question is central to building a portfolio of mutual funds.  If the expense ratio of a prospective additional fund is too high, it will have a negative impact on your portfolio's performance.  This paper won the 2004 Journal of Financial Planning Call for Papers Competition.

Jason Karceski, Miles Livingston, and Edward S. O'Neal, "Portfolio Transactions Costs at U.S. Equity Mutual Funds," Zero Alpha Group Working Paper, November 15 2004 (68.2kb). Here's an article about this study.  This paper quantitatively investigates the extent of "implicit" expenses incurred by mutual funds.  These expenses, not reflected in a fund's expense ratio, can be as high, or higher, than the "explicit" expense reflected by the expense ratio.

Alan Lavine and Gail Liberman, "Fund Managers are Good Stock Pickers but Expenses Kill Returns," Brill.com, January 2003.

Miles Livingston and Edward S. O'Neal, "Mutual Fund Brokerage Commissions," Journal of Financial Research, Summer 1996, pp. 273-292. "... investors can on average reduce exposure to high commissions by concentrating on larger, low expense ratio mutual funds."  "... some mutual fund managers may be charging investors high management fees even though investors finance much of the research services through soft dollar commissions."  This paper's conclusions reinforce the strategy of buying passively managed mutual funds with low expense ratios.

John Markese, "How Much Are You Really Paying For Your Mutual Funds?," AAII Journal, February 1999. "Loads and expenses decrease your mutual fund return dollar-for-dollar. Looking forward—the best direction in which to look to make judgments—loads and expenses are predictable; returns are not. Loads are sales commissions paid to sales personnel and have only a negative impact on fund performance. Fund expenses that are significantly higher than the average for a category are difficult for fund managers to overcome."

Ross M. Miller, "Measuring the True Cost of Active Management by Mutual Funds," SUNY Albany, June 2005 (92.4kb). This interesting paper derives a method for allocating fund expenses between active and passive management and constructs a simple formula for finding the cost of active management.  Computing this “active expense ratio” requires only a fund’s published expense ratio, its R-squared relative to a benchmark index, and the expense ratio for a competitive fund that tracks that index. At the end of 2004, the mean active expense ratio for the large-cap equity mutual funds tracked by Morningstar was 7%, over six times their published expense ratio of 1.15%.  More broadly, funds in the Morningstar universe had a mean active expense ratio of 5.2%, while the largest funds averaged a percent or two less.

Matthew R. Morey, "Should You Carry the Load?  A Comprehensive Analysis of Load and No-Load Mutual Fund Out-of-Sample Performance," Pace University, 2001.  This paper debunks the myth that loaded mutual funds outperform no-load funds.  It concludes that, even before loads are figured in, no-load funds tend to outperform loaded funds.

Stefan Sharkansky, "Mutual Fund Costs: Risk Without Reward," PersonalFund.com, July 2002 (189kb). "... what, if anything, can an investor do to improve the odds of selecting a winning fund, and to reduce the odds of getting stuck with a losing fund?  The answer is surprisingly simple: invest only in low-cost funds and avoid high-cost funds."

Nicolaj Siggelkow, "Expense Shifting: An Empirical Study of Agency Costs in the Mutual Fund Industry," Wharton School, January 1999 (208kb). This paper exposes 12b-1 fees as a significant detriment to mutual fund performance (i.e., the paper supports a strategy of avoiding mutual funds that charge 12b-1 fees).

Nicolaj Siggelkow, "Caught between two principals," Wharton School, May 2004 (137kb). Here's the link to the actual paper.  This paper finds that mutual funds tend, through their actions, to favor the interests of the fund company over the interests of fund shareholders.

Neil Weinberg and Emily Lambert, "The Great Fund Failure," Forbes.com, September 15 2003. An outstanding discussion of issues surrounding excessive mutual fund fees.

Greg Wolper, "Girl Scout Cookies, the Mutual Fund Way," Morningstar.com, January 27 2004. A great tongue-in-cheek article about how girl scout cookie sales might work if they were sold like mutual funds.  You may have to register (for free) to read this article.

"Division of Investment Management: Report on Mutual Fund Fees and Expenses," U.S. Securities and Exchange Commission, December 2000.  A comprehensive study of trends in mutual fund fees and expenses.

"Mutual Fund Fees and Expenses," U.S. Securities and Exchange Commission, October 19 2000. A brief tutorial on the major types of fees associated with mutual funds.

"Funds With Low Expense Ratios Outperforming Their More Expensive Peers Over Long Term, Says S&P," Standard & Poor's, June 11 2003. An excellent short press release which makes the case for minimizing a mutual fund's expense ratio, all else being the same.  Interestingly, you'll note from studying the data that the difference in expense ratios has a strong correlation with the difference in returns (implying that, for every dollar of additional expenses paid, you lose a dollar in returns).

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