You Get What You Pay For--Right?

by By Ann C. Logue

Every day, in every grocery store, Americans willingly spend more money than they have to on ketchup. The shoppers and their families believe that Heinz is superior to any other ketchup on the market and they gladly pay the premium. I'm a cheapskate, so bring I home the store brand, but I understand that others have good reason for buying Heinz over President's Choice or Safeway Select. To them, the taste is worth the higher cost. 

As long as there is value in a higher price, then it's worth paying for. Mutual funds carry a huge range of fees, covering everything from compensation to financial advisors to the flight the analyst took to China to research investment opportunities. You want your fund to carry some fees, because you want research and you want service, and you, the fund shareholder, the owner of the fund, have to pay for those things. But how much is the right amount to pay? 

The first consideration is what the fees cover and whether or not those services are important to you. For example, some funds carry upfront sales charges--called front-end loads--and some don't. If you work with a financial planner or broker, you'll almost definitely be paying a load. That's perfectly fair, if your advisor helps you establish and manage a financial plan and gives you ongoing education and support. In fact, the value of the advice might well outweigh the load you pay. But if you work independently, you're getting nothing for your load. 

A 12b-1 fee is trickier to value. It's a fee that the fund charges every year for marketing and administrative costs, and it's usually between 0.25% and 0.75% of the fund's assets. Some fund companies use this to help compensate brokers and financial planners for ongoing advice, to add sophisticated features to their websites and to produce informative financial publications for investors. Others use it to boost profits by offsetting normal costs of marketing and administration, with no value added for the shareholders. Before paying a 12b-1 fee, ask yourself if the fund's great marketing helped you make the investment decision. If the website was difficult to use but the TV commercials were lush and exciting, maybe the 12b-1 fee isn't worth it. 

Although not all funds will have loads or 12b-1 fees, they all will charge management fees. These will vary greatly depending on the type of fund. An index fund, which simply buys all of the stocks in a market index, should have a low management fee because there isn't that much research and analysis involved. The index company publishes the list of securities in the index, and then the fund manager buys them. An international fund, a small cap fund, or one pursuing an unusual investment strategy will have a high management fee because it will need to spend more money on research, travel, analysts, and fund managers. Finding good investments will require the fund's staff to travel to meet company managers, observe business conditions first-hand, and learn complicated investment techniques. Because management fees can vary so much with the fund's investment objective, it's best to compare the fees of funds within the same objective rather than the fees of actively managed funds with those of index funds.  

But at the same time, you may want to see how a high-fee, actively managed fund performs after fees relative to an index fund. In the world of academic finance, "beta" is the performance of the market itself and "alpha" is any performance over and above that of the market that goes into a portfolio because of the portfolio manager's skill. (Note that alpha can be negative; some portfolio managers are so bad that they take value from the fund, although these people rarely stay employed.) It's clear that some people are better, or at least luckier, when it comes to managing money than others. However, these same folks are very good at negotiating salaries and bonuses that reflect their abilities, and that affects the fees that their funds charge--which in turn affects the performance after fees that the funds post. In other words, portfolio managers and investment companies that generate alpha may keep it for themselves, leaving their shareholders with an average fund after the fees are paid. 

So what's a mutual fund investor to do? First, compare fund performance on an after-fee basis. The fund companies make this information available. Second, evaluate fees on their value to you. The amount of value will differ from person to person, obviously; I notice the difference in taste in various brands of ketchup, but I can't say that any of them are better. Likewise, I make my own investment decisions, so I don't pay loads, but that doesn't mean load funds are a bad idea for someone else. Finally, remember that fund managers are different, but that doesn't mean they all generate value after they're paid.

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