Distribution of Mutual Funds & The Cost of Fund Ownership

U.S. Households

What sells mutual funds? Past performance Past performance is no guarantee of future results. The strategy of buying funds with exceptional past performance is rarely successful. Internet Bubble 1990s, Emerging Market Crash 2005-2006, Financial Crisis 2008 Advertisement Multimillion-dollar business (and it is really effective) Ratings (i.e., Morningstar, Lipper) Financial Adviser 60% of purchases made with professional help Retirement Plans

Distribution Channels for Mutual Funds

The Intermediary Channel A third party (intermediary) stands between the fund management company and investors 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. Financial advisors work one-on-one with clients Identify financial status and goals of the client Personalized recommendations Ongoing relations with the client.

Intermediary Channel Segments (1) Wirehouses vs. Independent Employment status Client Ownership Product choices Brand Income (overhead cost) Wirehouses-Morgan Stanley, UBS wealth management Banks-wells fargo, Merrill lynch (bank of America) Independent-Edward jones Differences in wirehouse and independent: employment status, client ownership, product choices, brand, income (overhead cost)

Intermediary Channel Segments (2) https://www.forbes.com/sites/advisor/2012/08/01/is-your-financial-advisor-independent-an-ria-or-wirehouse-rep-you-have-no-idea-but-you-should/#6ff83749658d

FAs vs. RIAs From regulatory perspective, there is a clear difference between advisers that are broker-dealer and registered financial advisers.

Sources of Ownership

Sources of Ownership

Role of Advisors

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.

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.” “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 https://www.wsj.com/articles/how-should-you-pay-for-financial-advice-1489975201 https://www.wsj.com/articles/the-morningstar-mirage-1508946687?mg=prod/accounts-wsj https://blogs.wsj.com/moneybeat/2017/08/25/the-19-questions-to-ask-your-financial-adviser/

Fund Platforms Direct Channel Segments Provide access to a group of mutual funds from a variety of fund families Attempt to achieve meeting a consumer need (i.e., tax, convenience etc.) Direct Channel Segments

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.​

Fund Family Level Distribution Strategy Product Strategy Fund management companies decides and constantly evaluates the products Product decisions are the single most important factor driving success at asset managers (McKinsey Report-available in my website) Subadviser decision (fund management companies with strong access to distribution) National Account Strategy Choose the distribution channel. National Account Team: Cost (fund management companies pay for placement on certain platforms) Wholesaling Strategy A strategy for selling their products to the financial advisers who can recommend them to clients. Advertising and Branding Strategy Investment opportunities, personal financial planning, educational, and performances, product strengths.

Fund Expenses: Overview Most expenses paid through the fund are included in the expense ratio (or total expense ratio) Percentage figure Note that expense ratio does not capture all fund-related fees. SEC regulations require funds to display expense information in all material presented to shareholders and prospective buyers.

In General, Fund Expenses Fund shareholders can pay a wide variety of fees. Mutual fund investors incur two primary of expenses and fees: (1) Ongoing expenses Distribution expenses (12b-1): distribution charges (12b-1 fees) Management Fees: portfolio management Operating Expenses (transaction fees, custodian fees, shareholder communication expenses, shareholder services): since these 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).

Mutual Fund Fees Cost of Mutual Funds is directly related to performance. “For many individual investors, cost is the most important determinant of portfolio performance, not asset allocation policy, market timing, or security selection.” William Jahanke (Chairman and CIO of Financial Design Educational Corporation) “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)

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 one-time 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.” http://host.madison.com/wsj/business/wrong-mutual-fund-can-rob-years-of-retirement-income/article_2d96763f-7207-5194-97f9-566570bc4d79.html

Compensation for Selling Fund Shares

Compensation for Selling Fund Shares (1) A sales commission to intermediary

Compensation for Selling Fund Shares (2) Controversial: Critics: does not help shareholders Supporters: Eventually help fund to reduce cost (due to increase in economies in scale)

Compensation for Selling Fund Shares (3)

Distribution Expenses Distribution expenses are significant component of fund costs for all investors who use the services of a financial adviser. Remember, 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.​ IMPLICATIONS???? Different fund classes

Share Classes Funds may offer investors different combinations of loads and 12b-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 12b-1 fee.​ Class B: high 12b-1 fee and CDSC. No front-end load. No longer offered by many funds.​ Class C: level load shares that combine a high 12b-1 fee with a modest CDSC.​ Class I: institutional shares with no load or 12b-1 fee.​ Class R: retirement plan shares with a moderate 12b-1 fee.

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 12b-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 12b-1 fees at all.​ Class N: no front-end or back-end loads, but with a 12b-1 fee (which can’t exceed 0.25%).

The Share Class Structure at a Glance

Management Fee The management fee is usually the largest component of a fund’s ongoing expenses: It pays for investment management services It compensates the management company for the use of its brand name, for taking the risk of setting up the fund, and for organizing its distribution. It depends on the type of assets the fund invests in. There is considerable debate about whether the management fee is too high.

Operating Expenses It is related to operating a fund: Trading securities Providing service to shareholders Keeping the books.

Expenses Incurred by Fund Investors (1)

Expenses Incurred by Fund Investors (2)

After-Fee Performance Cost Matters!!! Fund Name Annual Performance Expense Ratio After-Fee Performance High Fee 7% 0.5% 6.5% Medium Fee 1% 6.0% Low Fee 1.5% 5.5% Value of Initial $10,000 over 30 years Value of $10,000 Annuity invested each year over 30 years

H:66,144 M:57,435 L:49,840

H:929,892 M:848,017 L:774,194

Comparing ABCs of Mutual Funds Today most funds offer several share classes Fund analyzer: https://tools.finra.org/fund_analyzer/ GSXAX vs. GSXCX American Century All Cap Growth A class (ACAQX) C Class (ACAHX) I Class (ACAJX)

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&P500 On average, larger in size, which, in turn, helps reduce fund expense ratio

Typical Fund Expenses

Mutual Fund Fees

The Management Fee: Why Critics Say It’s Too High Insufficient benefit from economies of scale.​ Growth in assets should have led to lower fees.​ Other investors pay less.​ Fund managers charge institutional clients less.​ ​ Noncompetitive markets.​ Investors are unaware of fees or unable to switch funds.

The Management Fee: The Rebuttal to the Critic’s Case Fees decline with increasing assets.​ More than 80 of the 100 largest funds have management fee breakpoints.​ No fee discrimination.​ Fund managers charge the same fees for the same services.​ Institutional clients want different services.​ Competitive markets for funds.​ Investors are aware of fees; they favor lower fee funds.​ Management companies voluntarily limit fees.​ Boards of directors negotiate  breakpoints and caps.​ The industry isn’t concentrated.

Fund Expenses and Another Trend: the Active vs. Passive Debate Passive Funds: What are they doing? Why? Expense Advantage Market Efficiency Tax Efficiency Lack of Performance Persistence

Fund Expenses and Another Trend: the Active vs. Passive Debate Active Funds: What are they doing? Performance Persistence Cycles of Performance Tax time bomb Free Riders Irrational Markets