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Impact of Performance Fees on Mutual Funds and Physician Portfolios

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More Complex than Realized by Some Doctors

[By Dr. David Edward Marcinko; FACFAS, MBA, CMP™]

[By Professor Hope Rachel Hetico; RN, MHA, CMP™]dave-and-hope4

Physician-investors may find themselves paying advisory fees, brokerage commissions, and other sales charges and expenses. All of these layers of expense can reduce or eliminate the advantage of professional management, if not monitored carefully. Also, fees can have a major impact on investment results. As a percentage of the portfolio, they normally range from low of 15–30 basis points (or .15% to .30%, a basis point is one one-hundredth of one percent) to a high of 300–400 basis points or even higher.

Charges are Universal

All portfolio managers, mutual funds, and investment advisors charge fees in one form or another. Ultimately, they must justify their fees by creating value added, or they would not be in business. Value added includes tangibles, such as greater investment return, as well as intangibles, such as assurance that the investment plan is successfully implemented and monitored, investor convenience, and professional service.

Comparisons Required

Always compare investment performance of funds or managed accounts after fees are deducted; only then can adequate comparisons be made. Also, compare fees within asset classes. Management fees and expenses of investing in bonds or bond funds are much different than the fees of investing in, for example, small companies or emerging market stocks. Whereas 100–200 basis points of fees may be appropriate for an equity portfolio or fund, similar charges may offset the advantages of a managed bond portfolio. With managed bond portfolios, real bond returns have limited long-term potential, because returns are ultimately based on interest rates. For example, if a 3% real (i.e., after inflation) return is expected, 200 basis points in fees may produce a negative after-tax result: 3% real return minus 2% fees minus 10% taxes equals a negative 9% total return.fp-book22

Sales Charges

Mutual funds (and some private portfolio managers) charge sales charges to sell or “distribute” the product. Investors who buy funds through the advice of brokers or “commission based” financial planners will pay a sales load. The many combinations of sales charges fall into three basic categories: front-end, deferred (or back-end), and continuous.

Front-End Fees

Front-end fees are a direct assessment against the initial investment and are limited to a maximum of 8.5%. They usually are stated either as a percentage of the investment or as a percentage of the investment, net of sales charges. For example, a 6% charge on a $10,000 investment is really a $600 charge to invest $9,400 or a real charge of 6.4%. Many low-load funds charge in the range of 1% to 3%. Rather than pay brokers or other purveyors, these fund companies or sponsors use the charges to offset selling or distribution costs. Although rare, some funds charge a load against reinvested dividends.

Deferred Charges

Deferred charges (or back-end loads, or redemption fees) come in many forms. Often, the longer the investor stays with the fund the smaller the charge is upon fund redemption. A typical sliding scale used for deferred charges may be 5-4-3-2-1, where redemption in year 1 is charged 5%, and redemption in year 5 is charged 1%; after year 5, there are no sales charges. Sometimes deferred charges are combined with front-end charges.

Redemption Fees

Certain quoted redemption fees may not apply after a period, such as one year. Funds often use such fees to discourage the trading of funds. Frequently, these charges are paid to the fund itself rather than to the fund management company; or broker. Long-term physician investors actually benefit from this fee structure; short-term shareholders who redeem shares bear the additional liquidation costs to satisfy redemption requests.

Continuous Charges

Continuous sales charges, known as 12b-1 fees for the SEC rule governing such charges, represent ongoing charges to pay distribution costs, including those of brokers who sell and maintain accounts, in which case they are known as “trail commissions.” The fund company may be reimbursed for distribution costs as well. In the prospectus, funds quote 12b-1 charges in the form of a maximum charge. This does not mean that the full charge is incurred, however. For example, a fund with a .75% 12b-1 approved plan may actually incur much lower expenses than .75%. Compared to front-end charges, a .75% per year sales charge of this type could be more costly to investment performance, given enough time.

Sales Loads

Portfolio managers can charge sales loads as well, usually in the form of a traditional WRAP fee arrangement (the investor pays a broker an all-inclusive fee that covers portfolio manager fees and transactions costs). No-load funds can be purchased through brokers or discount brokerage firms. The broker charges a commission for such purchases or sales.

Management Advisory Fees

Private account managers and mutual funds charge a fee for managing the portfolio. These fees typically range between 25 and 150 basis points. Bond funds tend to charge in the range of 25 to 100 basis points, and equity funds charge 75 to 150 basis points. Fees charged by private account managers usually are higher because of the direct attention given to a single doctor client. These managers do not pass along additional administrative costs, however, because they pay them out of the management fee. These management fees come in many forms. Tiered fees can charge smaller accounts a higher fee than larger accounts. Mutual funds often charge “group fees”: a fund family may tier its fee structure to encompass all funds offered by the fund family or by a group of similar funds (such as all international equity funds). Performance fees, although subject to SEC regulations, may be charged as well. A performance fee may be charged if the manager exceeds a certain return or outperforms a particular index or benchmark portfolio.

Administrative Expenses and Expense Ratios

Most private managers are compensated with higher management fees, as mentioned above. Therefore, many private accounts usually do not incur separate administrative expenses. Some management firms charge custodial fees or similar account maintenance fees. Mutual funds incur a number of administrative expenses, including shareholder servicing, prospectuses, reporting, legal and auditing costs, and registration and custodial costs. Mutual funds report these expenses and management fees as an expense ratio—the ratio of expenses to the average net assets of the fund. Expense ratios also include distribution costs or 12b-1 charges.insurance-book10 

Brokerage Commissions

Almost all buyers and sellers of securities incur brokerage commissions. Private “wealth managers” usually provide commission schedules to prospective physician-investors or current clients. Some private managers charge higher management fees and a discounted commission schedule, while others charge lower fees and higher commissions. These combinations of management and commission fees make comparison of prospective managers’ cost structures a difficult task. Most portfolio managers obtain research from brokerage firms, which can affect the commission relationship between broker and manager. Reduced commission schedules exchanged for information are known as “soft dollar costs.” Mutual funds may negotiate similar reduced commission schedules. In this regard, more-competitive brokerage firms can charge lower fees to investors. Commissions are not part of the expense ratio, because they are a part of the security cost basis. Firms with higher portfolio turnover are more likely to have higher commission costs than those with low turnover. Asset class impacts such costs as well. For example, small-cap stocks may be more expensive than large-cap stocks, or foreign bonds may be more expensive than domestic bonds.

Total Cost Approach

To arrive at a relevant comparison of fees among funds and managers, and to see what the total effect of fees on investment performance is, analyze the various charges on a net present value basis. Begin with a given investment amount (e.g., $10,000) and factor in fees over time to arrive at the present value of those fees. Present the comparisons in an easy-to-use table.

Sources of Fee Information

Consult the mutual fund prospectus for fee information. The prospectus has a fund expenses section that summarizes sales charges, expense ratios, and management fees; it does not cover commissions, however. Expense ratios usually are reported for the past 10 years. Commission or brokerage fees are more difficult to find. The statement of additional information and often the annual report disclose the annual amounts paid for commissions. When the total commission paid is divided by average asset values a sense of commission costs can be determined. Private wealth managers disclose fee structures in the ADV I filed with the SEC. Managers must disclose these fees to potential and current clients by providing either ADV Part II or equivalent form to the investor.

Reporting Services

Reporting services, such as Morningstar and Lipper, provide similar information from their own research of mutual funds. These services can be extremely beneficial, because fee information is summarized and often accounted for in the reports’ investment return calculations. This helps the investor and planner make good comparisons of funds. Information services that cover private managers provide information, primarily about management fees.

Assessment

To the extent that online trading, deep discount brokerages, lack of SEC and FINRA oversight, and the recent financial, insurance and banking meltdown has affected the above, it is left up to your discretion and personal situation. Generally, all fess are, and should be, negotiable.

Disclaimer: Both contributors are former licensed insurance agents and financial advisors.

Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

OUR OTHER PRINT BOOKS AND RELATED INFORMATION SOURCES:

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8 Responses

  1. I just read that the economist, Henry Kaufman PhD, believes that the US financial system will likely require continued massive public capitalization, vastly improved financial services oversight, and much more!

    Looks like “no porfolio performance” for you!

    Cheese
    Samantha

    Like

  2. Are FAs Dumping 12B-1 Fees –or – Is it the SEC?

    The Securities and Exchange Commission just voted unanimously to propose a new framework for marketing and selling mutual funds, including replacing 12b-1 fees.

    The agency said it wants to improve the regulation of mutual fund distribution fees and improve disclosure for investors. 12b-1 fees are charged by some mutual funds and are paid to financial professionals to cover the marketing, distribution or service costs for selling their product.

    http://www.fa-mag.com/fa-news/5831-sec-aims-to-dump-12b-1-fees.html

    Will this be yet another flawed program?

    Joseph

    Like

  3. Is The Mutual Fund Industry a Scam?
    [Yes – Says Yale’s CIO?]

    When David F. Swensen, the chief investment officer at Yale University, speaks, the investing community listens. Carefully.

    As CIO of Yale’s endowment, Swensen has built a reputation as something of a genius, having generated double-digit returns for long periods of time. Everybody (or nearly everyone, it seems) has followed his advice: That liquidity is overrated and too expensive and not there when you need it.

    Thus, go for illiquid assets and non-correlating assets for alpha–ETF the market’s beta. But, recently, he ripped the mutual fund industry as one big self-interested scam.

    http://blog.registeredrep.com/von_aldo/2011/08/16/the-mutual-fund-industry-is-a-scam-says-yales-cio/

    Frank

    Like

  4. Stock mutual funds having lousiest year since 1998

    Ms. Hetico and Dr. Marcinko – Did you know that only 13% of funds have beaten benchmarks so far; and underperformance could lead to bigger risk-taking?

    http://www.investmentnews.com/article/20110902/FREE/110909988

    Jason

    Like

  5. Mutual fund fees

    Load fees are essentially an upfront sales commission paid to a broker upon the purchase of a mutual fund. The average load fee paid in 2012 was 5.13 percent, according to the Investment Company Institute. That puts a hefty hurdle on the required returns needed to make money on the investment.

    Individual investors might be better off looking for no-load index funds or ETFs, which carry fees of less than 1 percent.

    Marshall

    Like

  6. 3 bad reasons we overpay for mutual funds

    The numbers say that cheap index funds are your best bet.

    http://money.msn.com/mutual-fund/3-bad-reasons-we-overpay-for-mutual-funds

    So why are people still willing to pay fund managers so much?

    Ora

    Like

  7. 10 U.S. Equity Mutual Fund Bargains

    Looking for highly-rated U.S. equity mutual funds that don’t rip you off in fees?

    http://www.financial-planning.com/gallery/bic/ten-us-equity-mutual-fund-bargains-2690911-1.html?utm_campaign=daily-oct%2031%202014&utm_medium=email&utm_source=newsletter&ET=financialplanning%3Ae3268232%3A86235a%3A&st=email

    Here is a slide show of 10 good bargains, according to Morningstar.com

    Buddy

    Like

  8. FEES

    The average American household will pay $155,000 on 401(k) fees, according to a study from New York think tank Demos.

    http://www.msn.com/en-us/money/mutualfunds/warning-you-may-be-handing-over-dollar155000-in-401-k-fees/ar-AAa6nDw?ocid=iehp

    “Most people are so cost-conscious, but they don’t think about the inherent costs that go with a 401(k),” said Jared Snider, a financial advisor at Exencial Wealth Advisors.

    Dr. Hamilton
    http://www.amazon.com/Comprehensive-Financial-Planning-Strategies-Advisors/dp/1482240289/ref=sr_1_1?ie=UTF8&qid=1418580820&sr=8-1&keywords=david+marcinko

    Like

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