Morningstar Magazine - February/March 2015 - 36

Spotlight: Fees

so-called shareholder services. Still, as with
an all-inclusive vacation package, it can be hard
for the buyer to determine what he or she
is getting for a dollar spent-and that goes for
both an individual investor with $10,000
to invest and a more sophisticated institutional
investor with $10 million.

components may be above or below those of
its peers, discrepancies (especially those
on the high side) could be overlooked as long
as the grand total, the fund's net expense
ratio, was within an acceptable range. In the new
world, several developments are challenging
this complacency.

Even if investors can figure out what they
are paying for, it's difficult to determine if they are
getting a good deal relative to the fund's
peer group or if they're getting overcharged.

First, assets continue to flow to passive
funds, making it harder for active managers,
particularly those operating in the "core"
part of the market, to justify their fees. Exchangetraded funds using strategic beta combine
a well-defined approach to buying and selling
securities at a cost closer to that of purely
passive funds.

First, investors have to determine the peer
group-a task that depends not simply
on the fund's advisor fee, which is the same
across share classes, but also on its
operational fees, which vary by share-class
type. Today, it's entirely possible to find
two share classes of the same fund from the
same family with the same net expenses,
but with varying allocations of those expenses
to different types of fees.
Then, there is the problem of how expenses are
calculated and displayed to the investing
public. Just look at how returns are presented
as opposed to fees. An annualized return
represents compounded results; an expense ratio
is a point-in-time snapshot. But like returns,
the effects of expenses are magnified
over time.
Performance is also shown as a trend, relative
to a benchmark. Fund expenses, on the other hand,
are shown without context: Is that expense
ratio above or below average, and is it part of a
downward trend or an upward movement?
Finally, there is the statement of expenses
in percentage terms, relative to assets or, even
less clearly, as basis points. Yet investors
pay for fund management, just as they pay for
other goods and services, with their hardearned dollars. Why not express fund expenses
in dollars and cents?
Not All Is Well That Nets Well

If there is a defining characteristic of this way
of doing fees-which we'll dub Expenses 1.0-
it is that while a fund's individual expense

Morningstar February/March 2015

On the fixed-income side, low yields continue
to make it difficult for funds to beat their
peers if they suffer from an expense disadvantage,
as fees come out of a fund's income.
Even for alternative funds, there is the threat
of replication strategies and pressure from
an increasing number of entrants, as well as the
negative perception of hedge-fund costs.
Finally, Morningstar research shows that lowercost investments are more likely to outperform
higher-cost investments. This finding is
not surprising given that fund expenses, unlike
the expenses of any other consumer product,
directly reduce performance.
All of this is to acknowledge that while fund
expenses should get as much attention
as performance, they don't. It is time for a change.
The industry should make fund expenses
simpler, easier to compare, and more relevant
to investors. How do we get there? We
propose that the industry take three steps.
We call this proposal Expenses 2.0.

To this end, my colleague John Rekenthaler
and I suggest the creation of five fee categories.
These basic components would be listed
in every fund's prospectus.
1 Portfolio Management: Security research and
investment management.
2 Administrative: The fund company's business
costs, aside from investment management (No. 1)
and sales/distribution (No. 4).
3 Operational: Direct costs of serving shareholders
in a mutual fund, including custodial fees,
transfer agent fees, customer service, statements,
reports, and so forth, as well as the cost of
fund boards.
4 Distribution: What the fund company spends to
grow its business, except for compensating
financial advisors (No. 5). Examples include the
salesforce, advertising and marketing, and
platform fees.
5 Advice: The costs of paying financial intermediaries for serving clients-whether that
service takes the form of help in selecting and
monitoring an investment (or a portfolio of
which it is a part) or providing useful information
to clients, fund shareholders, platform investors,
or qualified plan participants.

Rekenthaler recommends these numbers should
be accompanied by an industry average
to give context. He suggests the calculation would
be an equal-weighted mean of funds sharing
the same broad asset class, such as diversified U.S.
equity or taxable bond. EXHIB IT 1 shows what
the result could look like.
Putting fund fees in these categories would
allow direct comparison between the core
function of a mutual fund-the professional
management of a portfolio-and that
same function carried out in different vehicles,
such as a separate account, ETF, collective
trust, or some other format.

Step 1: Tell Investors What Fee Is for What Service

While mutual fund fees are classified into
accounting categories, investors pay for a different
set of services. To put it more bluntly, just
tell investors upfront what they're paying for,
in a language they might understand
and in a way that allows them to more easily
comparison shop.

It would also clarify matters for shareholders
and the U.S. Supreme Court (as in Jones v.
Harris)-who are understandably confused by
three overlapping terms: advisor, administrator,
and management. Questions about how
much of the difference in costs between mutual
funds and other vehicles is due to account size,

Morningstar Magazine - February/March 2015

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