Making Sense of Mutual Fund Fees

Posted by Susan Mangiero on June 10, 2012

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Following the ruling in Gartenberg v. Merrill Lynch Asset Management, many people look to the six factors discussed therein in determining the reasonableness of fund fees. To recap, the Gartenberg factors are listed below:

  • Nature and quality of services rendered;
  • Profitability of fund to the advisor;
  • Scale considerations that impact the cost of managing a fund;
  • Fees charged by peer funds;
  • Independence and thoroughness of the board; and
  • "Fallout benefits" which indirectly accrue to the advisor because a particular fund exists.

Since no one wants to be in business unless they can earn a risk-adjusted return, it is no surprise that the profitability factor is given considerable weight by investment company directors and advisors alike. For those on the outside however, it is not always an easy task to evaluate any gains or losses realized by one or more invesment companies.

As explained in "Deciphering Fund Fees: Advisors need to understand when fund management fees are excessive" by Sasha Franger (onwallstreet, June 2012), one information source - Lipper's "Investment Management Profitability Analysis" - includes complete data for only public entities. This means that the report reflects data for "26 investment managers representing 23% of the mutual fund industry's assets." Other complexities include the following:

  • Not all companies report marketing expenses as a separate item;
  • Not all firms report "total revenue" in the same way;
  • Some companies included in the study manage a broader array of funds in addition to mutual funds;
  • Some companies included in the study offer other services in addition to asset management; and
  • Revenue varies by type of funds that an investment company offers.

To better understand the structure and financial conditions for various funds, visit the website for the Investment Company Institute to download the 2012 Investment Company Fact Book: A Review of Trends and Activity in the U.S. Investment Company Industry.

Figure 5.2 shows that expense ratios typically fall as assets under management go up. Figure 5.6 shows a downward trend in expense ratios between 1997 and 2011 for active versus passive funds. Not surprisingly, expense ratios for actively managed equity funds are higher than index equity funds. Figure 5.7 shows that median expense ratios are highest for funds with growth, sector, international equity and aggressive growth investment objectives, respectively.

Given the preponderance of regulated investors such as ERISA pension plans that allocate to members of the $12.97 trillion mutual fund industry and the frequency and severity of 401(k) plan lawsuits that allege "excessive fees," investment company financials are being carefully watched and monitored.

Having worked on fee litigation matters, I would add that a parsing of numbers requires care for various reasons.

$200 Million Settlement Paid Relating to Mortgage Backed Security Valuations

Posted by Susan Mangiero on July 06, 2011

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Investors rely on the net asset values ("NAVs") provided to them as a way to make all sorts of financial decisions such as asset allocation, rebalancing, hedging and possibly exiting a particular money pool.

In a recent case, the bear invaded the tent, eventually denying investors for several funds any illusion about security related to being able to use "good" valuation numbers. According to a June 22, 2011 cease and desist order against Morgan Asset Management, Inc. and other respondents, the way that valuation numbers were assembled for purposes of providing daily NAVs "inaccurately inflated the prices of certain securities, contrary to the Funds' valuation procedures." In addition, several accounting professionals failed to "document justifications for such pricing adjustments."

At stake with any of these valuation cases is a legitimate desire on the part of the investing public to understand how the numbers come to be. In this particular case, Morgan funds held subprime mortgages that had to be "fair valued" with market quotations not always readily available. When broker-dealer confirmations were available, they were not always used and sometimes discarded.

Besides the payment of $200 million in disgorgement and civil fines, Morgan Asset Management Inc. and Morgan Keegan & Company agreed to be censured, fully cooperate with the SEC in any other investigations that relate to trading and/or valuing a fund's portfolio or its components and a prohibition against fair valuing any fund portfolio instruments for three years. Click to download the SEC Cease and Desist Order "In the Matter of Morgan Asset Management" et al, June 22, 2011. 

The harm to investors should be clear. For one thing, in bad markets when it became harder to liquidate complex instruments, inflated valuation numbers may have incorrectly dissuaded some investors from redeeming had they known the truth. Additionally, better than real numbers line the pockets of fund personnel when investors end up paying "higher" fees for "artificially" better performance.

Attorney Robert Robertson at Dechert has an interesting article about this case, laying out the facts, the violations and related cases. His conclusion from a review of various SEC cases involving the valuation of fund portfolios is that sound procedures must be adopted and followed. Moreover, he adds that procedures need to be properly documented and that "there should be checks and balances so that one person does not have the ability to circumvent the system." Click to read "Morgan Keegan Settles SEC Fraud Charges Related to Mortgage-Backed Securities Valuations in its Registered Funds," Dechert On Point, July 2011.

The terms of the settlement are far from trivial and may have influenced the decision to find a suitor for the Morgan Keegan enterprise. According to "TARP pressure behind Regions putting Morgan Keegan up for sale" by Ted Carter (Mississipi Business Journal, June 27, 2011), raising capital and regulatory costs are proffered explanations for why Regions Bank (owner of Morgan Keegan) has hired Goldman Sachs to "review 'strategic alternatives' for Morgan Keegan."

Looking For Hidden Mutual Fund Fees

Posted by Susan Mangiero on April 04, 2011

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In "Numbers You Can't Count On," Wall Street Journal reporter Michael A. Pollock (April 4, 2011) informs readers not to consider published reports as the definitive source of mutual fund economics. For example, peer group rankings may be of limited use if a particular mutual fund does not readily fit into a stated category. Then there is the issue of survivorship bias which can distort historical numbers for a given cohort. The expense ratio is another metric that only tells part of the tale. It is calculated by dividing a fund's annual operating expenses by the average dollar value of assets being managed. However, investors still have to pay load fees and redemption fees, as applicable, even though they do not show up in the expense ratio. Since these fees can vary across funds, an investor has to be diligent about comparing apples to coconuts instead of apples to apples.

As I've written many times, history is not necessarily a bellwether for the future. An examination of total returns for a few years may ignore how a fund performs during different phases of the economic cycle. Portfolio managers can come and go. If a superstar says au revoir, investors may be exposed to a newbie or someone who does not have the same savoir faire. Key person risk is nowhere included in any mutual fund numbers.

Additionally, some funds allow tremendous latitude to shift from one sector to another. I recall being invested in a well known mutual fund that continued to lag others in the last equity bull market. When I inquired as to why the reported returns were "so low," I was told that the portfolio manager had parked a lot of money in cash and had unfortunately missed out on some golden opportunities.

Hedging is another source of "what you see may not be what you get." If a fund manager can hedge interest rates or currency prices let's say, he or she may be protecting the downside but truncating the upside. Individuals who allocate to a fund in anticipation of capital gains need to check how much of the portfolio might be hedged at any one time. Moreover, not all derivatives are created equal in terms of their respective risk-return tradeoff. On March 25, 2010, the U.S. Securities and Exchange Commission ("SEC") stated its intent to review how derivative instruments are used by mutual funds. According to "SEC Staff Evaluating the Use of Derivatives by Funds," the regulatory body will examine (1) the impact on mutual fund and exchange traded fund ("ETF") leverage as a result of the use of futures, options, swaps and hybrid instruments (2) what risk management policies, controls and procedures are in place (3) the extent to which existing prospectuses adequately disclose risk-taking and (4) whether mutual fund directors are doing a good oversight job.

Given the onslaught of arbitration, regulatory enforcement and litigation that focuses on poor and/or incomplete risk disclosures, don't be surprised if mutual fund fiduciares are asked about murky numbers and opaque process if their investor communications are less than forthcoming.

Swaps Can Bite Investors

Posted by Susan Mangiero on February 07, 2011

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In "'Swaps' Add a New Risk" (February 7, 2011), Wall Street Journal reporter Ari I. Weinberg writes that little is known about the use of over-the-counter derivative instruments by mutual funds and that the risk of non-performance by a swap counterparty must be considered.

Having worked on several derivative trading desks, I have direct experience dealing with swap contracts, pricing, hedging and counterparty risk. As the saying goes, there is no free lunch. The use of an interest rate, credit and/or currency swap can help an asset manager hedge price variability or enhance returns. The ex-ante economics must consider the riskiness of the party on the opposing side of the contract and much more.

Since Enron and other mammoth bankruptcies of companies that used swaps in large amounts, U.S. bankruptcy law has changed to allow for netting of bi-directional cash flow obligations. Additionally, collateral is often posted (with the amounts being determined by a host of factors such as creditworthiness of the posting entity, type of collateral, existing borrowing facilities, deal structure and so on). New regulations mandate the use of a central clearing house for swaps, heretofore traded privately among mainly large global banks. Even with all of the so-called reforms, work remains.

Attorney Rose DiMartino with Wilkie Farr & Gallagher LLP is quoted in the Wall Street Journal article about her observation that the quality and quantity of disclosure about the use of swaps by investment funds can vary considerably. Attorney Mark Perlow with K&L Gates LLP urges guidance from the regulators about the use of swaps as a leverage creation mechanism. I concur with both sentiments but add that measuring leverage is part of the challenge. Moreover, with respect to disclosure, it's critical to understand what derivative instrument has been used and how, along with understanding more about collateral posted and the nature of the counterparty involved. Consider the following example:

  • An equity swap is used by Investment Fund A to hedge its long positions.
  • The same structure swap is used by Investment Fund B to take an activist stake in Company X, in anticipation of a management reshuffle and an increase in share price sometime soon.
  • Yet another asset pool managed as Investment Fund C may employ the identical type of swap as part of a multiple leg transaction that allows it to gain exposure to a sector not otherwise available by investing directly.

The  risk-return profile is going to differ across funds. Even if all three mutual funds reported the identical swap on its filings, one would still need to play financial detective (assuming he or she had access to further details) to understand how the use of swaps is likely to change things.

In addition, there is the issue of valuation. Some swaps are straightforward to price and some are not. You could have the same over-the-counter swap valued by two or more independent pricing services and get different numbers that are far apart if the derivative has a complex structure that veers from the standard fixed to LIBOR arrangement.

Investors do need more information about the use of derivatives by mutual funds. The question is whether they will get sufficient clarity to properly assess risk.

Interested readers can link to "SEC Proposes Joint Rules with CFTC to Define Swap Related Terms" (December 3, 2010) and/or "SEC proposal would give customers clarity on pricing" by Sarah Nl. Lynch, Reuters, February 2, 2011.

Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments" by Susan Mangiero, Expert Evidence Report, BNA, 2004. Note that BVA, LLC is now known as Fiduciary Leadership, LLC.