Distribution of Mutual Funds The Cost of Fund

Distribution of Mutual Funds & The Cost of Fund Ownership

Mutual Fund Fees “But it is the long-term merits of the index fund—broad diversification, weightings paralleling those of the stocks that comprise the market, minimal portfolio turnover, and low cost—that commend it to wise investors …the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. ” John Bogle (the founder and retired CEO of the Vanguard Group) “For many individual investors, cost is the most important determinant of portfolio performance, not asset allocation policy, market timing, or security selection. ” William Jahnke (Chairman and CIO of Financial Design Educational Corporation)

Mutual Fund Fees WSJ Article: Wrong mutual fund can rob years of retirement income “Fees are one of the biggest drains on your retirement savings. On a $200, 000 onetime investment, the difference between a 0. 25 percent annual fee and a 1 percent annual fee totals over $210, 000 after 30 years, assuming a 6 percent average annual return. If you pay a front-end load, a percentage of your initial investment goes toward that cost rather than into the fund, meaning that money doesn't make it into the market at all. ”

Cost Matters!!! Fund Name Annual Performance Expense Ratio After-Fee Performance High Fee 7% 0. 5% 6. 5% Medium Fee 7% 1% 6. 0% Low Fee 7% 1. 5% 5. 5% Value of Initial $10, 000 over 30 years Value of $10, 000 Annuity invested each year over 30 years

Value of Initial $10, 000 70000 60000 50000 40000 30000 20000 10000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 time H M L

Value of $10, 000 Annuity 1000000 900000 800000 700000 600000 500000 400000 300000 200000 100000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 time H M L

Costs of Mutual Fund Ownership and Distribution Channels for Mutual Funds Cost of Mutual Funds is directly related. Overall, Mutual funds are sold through 3 principle channels: the intermediary channel, the direct channel and the retirement channel. Retail distribution occurs through the intermediary and direct channel. Distributors get paid for selling fund shares in 3 ways: directly by investors, indirectly through the fund and by the fund management company. Mutual fund supermarkets and open architecture have each had a significant impact on the fund industry.

Distribution Channels for Mutual Funds

U. S. Households

Sources of Ownership

Sources of Ownership

Role of Advisors

Role of Advisors “Transaction-based professionals may provide quality advice, but their firms may set sales quotas or offer bonuses or other rewards that encourage them to put their own self-interest ahead of the client’s. ” WSJ Article: How Should You Pay for Financial Advice? “If the market were to return 5% and you were paying an adviser 1% [of assets under management] a year, that’s like giving the adviser 20% of your returns. When you invest in the market, you are taking on a lot of risk, while the adviser gets paid for sure. ” WSJ Article: How Should You Pay for Financial Advice? “When funds picked up a fifth star for the first time during the period included in the Journal’s analysis, half of them held on to it for just three months before their performance and rating weakened. ” WSJ Article: The Morningstar Mirage “Some brokerage firms warn that they may put their interests ahead of yours regardless of whether your adviser happens to be a CFP. ” WSJ Article: The 19 Questions to Ask Your Financial Adviser

What Sells Mutual Funds? Outstanding investment returns. Though this is rarely a successful investment strategy. High Morningstar ratings are particularly valued. Some investors look for funds with high yields or low expenses. Advertising. The recommendation of a financial adviser.

The Intermediary Channel Advice is the key selling proposition of the intermediary channel. Firms in this channel work through representatives who provide investment advice. Representatives may be local but increasingly leverage technology for service delivery.

Intermediary Channel Segments (1)

Intermediary Channel Segments (2)

FAs vs. RIAs

Overview: Fund Expenses Mutual fund investors incur two primary of expenses and fees: (1) Ongoing expenses It covers portfolio management, fund administration, daily fund accounting and pricing, shareholder services, distribution charges (12 b-1 fees) These expenses are included in a fund’s expense ratio: fund annual expenses expressed as a percentage of its assets. Since expenses are paid from fund assets, investors pay these expenses indirectly. (2) Sales Load Sales loads are paid at the time of share purchase (front-end loads), when shares are redeemed (back-end loads), or over time (level loads).

Selling through Broker-Dealer When selling through broker-dealers, mutual fund management companies try to increase the visibility of their funds by: Having a large sales force, known as a wholesaling team. Participating in wrap programs when possible. Broker-dealers select funds to participate in the wrap program. Financial advisers choose funds from the program for their clients. Clients pay an annual fee to participate, but don’t pay a sales load. “broker-sold funds deliver lower risk-adjusted returns, even before subtracting distribution costs” Bergstresser, Chalmers, and Tufano (2009): Assessing the costs and benefits of brokers in the mutual fund industry”. RFS, 2009.

Compensation for Selling Fund Shares (1)

Compensation for Selling Fund Shares (2)

Compensation for Selling Fund Shares (3)

Compensation for Selling Fund Shares (4)

Share Classes Funds may offer investors different combinations of loads and 12 b-1 fees, each in a different share class. They have a claim on the same underlying portfolio. Typical classes are: Class A: traditional load shares with high front-end load and low 12 b-1 fee. Class B: high 12 b-1 fee and CDSC. No front-end load. No longer offered by many funds. Class C: level load shares that combine a high 12 b-1 fee with a modest CDSC. Class I: institutional shares with no load or 12 b-1 fee. Class R: retirement plan shares with a moderate 12 b-1 fee.

The Share Class Structure at a Glance

Comparing ABCs of Mutual Funds American Century All Cap Growth A class (ACAQX) C Class (ACAHX) I Class (ACAJX)

Direct Channel Segments

No-Load Funds A fund may call itself no-load as long as it doesn’t: Charge a front- or back-end load. Charge a 12 b-1 fee greater than 25 basis points (0. 25%). No-load funds often have two classes of shares: Class I: pure no-load, with no sales loads or 12 b-1 fees at all. Class N: no front-end or back-end loads, but with a 12 b-1 fee (which can’t exceed 0. 25%).

The Impact of Fund Supermarkets Fund supermarkets have had a tremendous impact on the structure of the mutual fund industry. They have: Boosted the growth of the registered investment adviser segment. Created opportunities for boutique firms, by providing them with cost-effective distribution. Helped blur the lines between load and no-load funds. Load funds are often sold through fund supermarkets, but with their loads waived.

Trends in Mutual Fund Expenses Understanding the Decline in Mutual Fund Expense Ratios (1) Expense ratio vary inversely with fund assets (economies in scale) (2) Shift toward no-load share classes It reflects a change in how investors pay for services from brokers and other financial professionals. (3) Growth in index funds

Trends in Mutual Fund Expenses

Trends in Mutual Fund Expenses An index fund generally seeks to replicate the return on a specific index Growth in index funds has contributed to the decline in asset-weighted average expense ratios of equity and bond mutual funds. Why do index funds tend to have below-average expense ratios: (1) Passive approach to portfolio management (2) Asset concentration toward large-cap blend funds that target US large-cap indexes, such as S&P 500 On average, larger in size, which, in turn, helps reduce fund expense ratio