Zaks Investment Advisory Service

Mutual Funds: fees and expenses

Last time we talked about Mutual Funds. Mutual Funds have many features and we will certainly discuss the most significant ones, but we will begin with their expenses. And we will do so by using an example. There are certain funds called Index Funds that imitate various stock market indexes. How they do this any why will be discussed in detail next time. But at the moment, what concerns us is that since they imitate the same indexes, the Index Funds are all very similar to one another. For example, the Vanguard fund company sells an Index Fund that imitates the S&P 500 index. The BlackRock company does the exact same thing – it also has an Index Fund, several in fact. All of these funds are comprised of virtually the same stocks. Imagine that three people each purchased an S&P 500 Index Fund – practically the same item. But one of them went directly to Vanguard and bought the fund through them (the fund’s ticker is VFINX), the second followed the advice of a broker who works with BlackRock and purchased their A Series Index Fund (ticker CIEAX), and a third talked to a different BlackRock broker and bought a third type of index from the same company, the B Series Index Fund (ticker CIEBX). Imagine that all three kept their money in the fund for 10 years, and that the average annual returns over that period were12 percent. After 10 years, the Vanguard fund owner would have had $30,563. The owner of the BlackRock Series A fund would have had $28,042, or $2,521 less, and the owner of the BlackRock Series B fund would have had $27,684, or $2,877 less than the happy owner of the Vanguard fund. How could this have happened? After all, I just said that the three funds themselves are virtually identical. Yes, this is in fact the case, but their fees and expenses are different.

To begin with, the fund purchase itself may include accompanying expenses. For example, BlackRock has placed a so-called front-end load, or sales load, on its Class A shares. This means the following: if you bought shares of a Series A Index Fund through a broker, you had to pay the fund 5.75 percent of the invested amount (and the fund used that money to pay the broker who sold you the shares. By the way, the front-end load was later reduced to three percent, and the fund itself recently closed to new investors: apparently, the fund turned out being uncompetitive. Nevertheless, for a certain period, the front-end load was 5.75 percent.) And so, supposing you invested $10,000. You immediately had to pay $575. This was deducted from the $10,000, which meant that only $9,425 was left “working” for you instead of $10,000. In our case, there are no sales loads for either the Vanguard fund shares or the BlackRock Series B Index Fund shares. But the Series B Index Fund does have a deferred load (or back-end load). It works in the following manner: if you sell the fund’s shares before a certain period (usually, within five years of the initial purchase), the fund may require you to pay a deferred load. The fund does this to try and force you to keep your money at the fund as long as possible. In our example, we assumed that you kept your money for 10 years, so the deferred load was not applicable. And still, the Series B Index Fund owner ended up with the least amount of money. Why?

In addition to a sales load and deferred load, all investment funds also charge a management fee for their services. As we have mentioned, the funds are run by professional managers. The funds hire them and pay for their services. An annual management fee compensates these expenses. One should keep in mind that these management fees are deducted automatically, regardless of the fund’s performance – even if it falls, the managers still get paid, and the fees are deducted from the fund’s assets. The BlackRock Series B management fee is 1.28 percent, Series A – 0.48 percent, while that of the Vanguard Index Fund – just 0.18 percent. In other words, compared to the BlackRock Series B Index Fund, the Vanguard fund is growing faster by (1.28 percent less 0.18 percent) = 1.1 percent. And this happens every year! The Series A Index Fund management fee is less expensive, at 0.48 percent (but still more expensive than Vanguard’s), yet as we recall, it also charged a sales load, i.e. the second investor was initially “working” with $9,425 instead of $10,000.

This raises the question of why people would invest money in the BlackRock Index Funds to begin with, when they could have been investing in Vanguard (which, by the way, is a company renowned for its low expenses). I honestly believe that if investors had a chance to look around and compare the various Index Funds, they would have probably avoided BlackRock. And most in fact did just that – investors placed $107 billion in Vanguard and only $1.2 billion in BlackRock. Nevertheless, someone did end up investing in BlackRock.

Of course, there are specialized funds with justifiably high expenses. For example, funds that invest in foreign companies and the so-called emerging markets: expenses for managing such funds really are high. But in either case, our advice to investors is: carefully read the prospectus and make sure you clearly understand which expenses are being charged by the fund. There are many different funds around, and each one is after your money. Try to find a fund whose investment policies match yours, but whose expenses are reasonable at the same time.

With this, we draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.