1. Distribution of Mutual Funds & The Cost of Fund Ownership

2. U.S. Households

3. 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 , Financial Crisis 2008
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Multimillion-dollar business (and it is really effective)
Ratings (i.e., Morningstar, Lipper)
Financial Adviser
60% of purchases made with professional help
Retirement Plans

4. Distribution Channels for Mutual Funds

5. 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.

6. 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)

7. Intermediary Channel Segments (2)

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

9. Sources of Ownership

10. Sources of Ownership

11. Role of Advisors

12. 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.

13. 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

14. 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

15. 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.​

16. 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.

17. 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.

18. 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).

19. 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)

20. 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.”

21. Compensation for Selling Fund Shares

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

23. 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)

24. Compensation for Selling Fund Shares (3)

25. 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

26. 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.

27. 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%).

28. The Share Class Structure at a Glance

29. 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.

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

31. Expenses Incurred by Fund Investors (1)

32. Expenses Incurred by Fund Investors (2)

33. 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

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

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

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

37. 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

38. Trends in Mutual Fund Expenses

39. 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

40. Typical Fund Expenses

41. Mutual Fund Fees

42. 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.

43. 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.

44. 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

45. 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