Surprising facts about active fund costs

True or false: Since actively managed mutual funds have higher costs than passively managed exchange-traded funds, they tend to underperform.
Surprisingly, the answer is both true and false.

While total costs for ETFs are lower than those for actively managed funds, the higher expenses of active funds are due more to costs embedded in the mutual fund structure itself than to the way any particular portfolio is managed. In fact a recent study of performance over the 2007-2013 time period found that active managers would have beaten major benchmarks if those embedded costs were eliminated. So what are those costs?

Distribution and service fees. A mutual fund is permitted to charge distribution and service, or 12b-1, fees of up to 100 basis points of net assets annually. These fees are paid to the fund’s distributor, and generally passed through to broker-dealers and other financial intermediaries representing shareholders. Mutual funds are frequently offered with multiple classes of shares, which vary based on the assessed level of 12b-1 fees and the sales charges that apply, if any. Like sales loads, 12b-1 fees remitted to financial advisors are compensation for fund sales activity and fund-related client services.

Transfer agency fees. These fees represent the costs of administering a fund’s shareholder accounts and processing share transactions. A fund’s transfer agent is responsible for maintaining shareholder accounts, processing purchases, redemptions and exchanges of shares, and disbursing fund distributions. TA fees vary among funds based principally on average shareholder account size (larger average accounts usually translate into lower TA fees per dollar of fund assets) and the scope of shareholder services provided.

Flow-related trading costs. Mutual funds almost always issue and redeem their shares in cash. Funds experiencing net inflows generally buy securities to put invested cash to work, and funds in net outflows normally sell portfolio securities to raise cash to meet redemptions. Buying and selling portfolio securities in response to shareholder flows causes a fund to incur additional trading costs beyond what is required to implement the fund’s investment program.

Cash drag. Cash drag is the cost to a mutual fund’s performance that comes from not being fully invested. Mutual funds may hold cash in connection with their net inflows (new dollars not yet deployed), net outflows (a reserve against future withdrawals) and/or for tactical investment purposes. During periods when returns on a fund’s securities investments exceed cash returns, cash drag hurts fund performance; conversely, when returns on a fund’s investments are less than cash returns, holding cash helps fund performance and is then a negative cash drag.

Research conducted by Navigate Fund Solutions found that the annual cost of 12b-1 fees averaged 15 basis points (bps) of asset-weighted net assets for retail classes of actively managed equity mutual funds over the 2007 to 2013 study period. Retail fee-based accounts, of course, impose charge low or no 12b-1 fees.

Transfer agency fees averaged 14 bps on an asset-weighted basis. TA fees are typically assessed as a fixed, or substantially fixed, annual charge for each shareholder account. When account values rise, therefore, TA fees as a percentage of fund net assets declines.

The estimated annual cost of flow-related trades averaged 20 bps of fund net assets on an asset-weighted basis. Funds with greater positive or negative net flows in relation to net assets and high average costs of their flow-related trades showed the largest effect of flow-related trading on fund returns.

Cash drag, which varied greatly among funds, averaged 26 bps on an asset-weighted basis.

In sum, annual distribution fees, TA fees, flow-related trading costs and cash drag amounted to an average cost of 79 basis points of fund net assets on an asset-weighted basis over the seven-year study period. Absent these costs, the research found that the performance of actively managed funds compared quite favorably to ETFs over the study period when measured against three popular indices (the S&P 500, the S&P MidCap 400 and the Russell 2000), with active managers outperforming their benchmarks, except in the case of the S&P MidCap 400.

Given these findings on the impact of structural fund costs, it’s not surprising that new fund structures have emerged that eliminate or mitigate these costs. Actively managed ETFs are an attempt to marry active management with ETFs’ efficiencies, but the daily disclosure of holdings restricts the ability of active management to generate alpha. NextShares, a new SEC-approved structure, permits active managers to continue doing what they do best in a vehicle that affords ETF-like cost savings.

For investors, that kind of creativity can translate into greater investment returns.

Register for the August 25 live video webcast, How cutting the expense drag on active management will benefit clients.

For more information, download the white paper “Avoidable Structural Costs of Actively Managed Mutual Funds” now.