The relationship between mutual fund fees and expenses and their effects on performance

Fees charged by mutual funds include front-end load charges, deferred sales charges that decrease over time, redemption fees that are imposed whenever shares are sold, and 12b-1 fees. Fees may be justified if they allow the fund to lower other costs or improve performance. In this paper, we find that, on average, 12b-1 fees, deferred sales charges, and redemption fees increase expenses whereas funds with front-end loads generally have lower expenses. We also find that funds with 12b-1 fees and redemption fees, on average, earn higher risk adjusted returns but funds with front-end load charges earn lower risk adjusted returns.     

MUTUAL FUND MORTALITY, 12B‐1 FEES,AND THE NET EXPENSE RATIO

The Securities and Exchange Commission is currently reviewing Rule 12b‐1, which governs how fund advisors may pay for the distribution of fund shares. We provide evidence that even after adjusting for economies of scale, funds with 12b‐1 fees have higher expense ratios net of the 12b‐1 fees than do funds without such fees. This finding suggests that 12b‐1 fees are more than just a deadweight cost. We also demonstrate that 12b‐1 fees are highest for funds that ultimately fail, that the proportion of funds with 12b‐1 fees is increasing over time, and that the level of those fees is also increasing over time.     

Why Do Foreign Firms Leave U.S. Equity Markets?

Foreign firms terminate their Securities and Exchange Commission registration in the aftermath of the Sarbanes–Oxley Act (SOX) because they no longer require outside funds to finance growth opportunities. Deregistering firms’ insiders benefit from greater discretion to consume private benefits without having to raise higher cost funds. Foreign firms with more agency problems have worse stock‐price reactions to the adoption of Rule 12h‐6 in 2007, which made deregistration easier, than those firms more adversely affected by the compliance costs of SOX. Stock‐price reactions to deregistration announcements are negative, but less so under Rule 12h‐6, and more so for firms that raise fewer funds externally.     

Regulation And The Rise In Asset-Based Mutual Fund Management Fees

In this article I explain why asset‐based fees are common for mutual fund management companies and why the average fee has increased recently. I argue that Securities and Exchange Commission fee regulations make alternative fee types illegal or unattractive. Management companies can maintain higher fees because regulations and brand‐name capital partly insulate them from competition and because investors cannot easily distinguish between performance‐oriented and marketing‐oriented fund companies. Index funds and unit investment trusts may offer competition to mutual funds in the future because they are designed to minimize management fees.     

The Importance of Business Risk in Setting Audit Fees: Evidence from Cases of Client Misconduct

Previous research provides evidence that, for the clients of a large audit firm, audit clients with higher perceived business risk bear the expected costs of this risk with higher audit fees. We extend the literature, which focuses on the relation between litigation risk and audit fees, by examining alleged client misconduct that is not illegal but possibly increases business risk. In particular, we examine the relation between audit fees and business risk for audit clients doing business in developing countries where bribery of top government officials has been an accepted business practice. We hypothesize that bribery‐paying clients are riskier because of both client business risk and audit business risk. Using data collected from Securities and Exchange Commission filings and audit fee data in the 1970s, before the passage of the Foreign Corrupt Practices Act, we provide evidence that audit fees were higher for clients that disclosed paying bribes. This evidence is consistent with an audit market where auditors assess business risk at the client level, then pass their expected costs to the client in the form of higher audit fees.     

Determinants of cost efficiencies in the mutual fund industry

We evaluate determinants of cost efficiencies in the U.S. mutual fund industry for 1998-2003. Our empirical results show that cost increases in this industry have been less than proportional to increases in assets. We find that funds without a 12b-1 plan show larger economies of scale than funds with a 12b-1 plan; institutional funds show greater economies of scale than do retail funds; and that fund families that are more focused in their investment objectives reap benefits of lower fund management costs than do fund families that are more diversified in their investment objectives.     

AN EMPIRICAL ANALYSIS OF MUTUAL FUND EXPENSES

Mutual fund investors are subjected to many fees and expenses related to both the management of the fund assets and the sale and distribution of the fund's shares. In recent years these expenses have increased as a percentage of assets. The preoccupation of mutual fund investors with using performance evaluation as a selection criterion is misguided because of the volatility of investment returns. Whether the fund's performance is due to superior management or just good luck is difficult to determine. On the other hand, mutual fund expenses are stable. As such, the mutual fund investor should pursue a policy of choosing funds with low expenses. In this paper we conduct an empirical analysis of these expenses. The results of our analysis of equity funds suggest that expense-conscious investors should look at the fund size, age, turnover ratio, cash ratio, and existence of a 12b-1 fee as key determinants of expenses. Our analysis of bond funds suggests that the key factors are the fund's sales charge, weighted average maturity, size, and existence of a 12b-1 fee.     

Mutual Fund Performance: Measurement and Evidence1

The paper provides a critical review of empirical findings on the performance of mutual funds, mainly for the US and UK. Ex‐post, there are around 0‐5% of top performing UK and US equity mutual funds with truly positive‐alpha performance (after fees) and around 20% of funds that have truly poor alpha performance, with about 75% of active funds which are effectively zero‐alpha funds. Key drivers of relative performance are, load fees, expenses and turnover. There is little evidence of successful market timing. Evidence suggests past winner funds persist, when rebalancing is frequent (i.e., less than one year) and when using sophisticated sorting rules (e.g., Bayesian approaches) ‐ but transactions costs (load and advisory fees) imply that economic gains to investors from winner funds may be marginal. The US evidence clearly supports the view that past loser funds remain losers. Broadly speaking results for bond mutual funds are similar to those for equity funds. Sensible advice for most investors would be to hold low cost index funds and avoid holding past ‘active’ loser funds. Only sophisticated investors should pursue an active ex‐ante investment strategy of trying to pick winners ‐ and then with much caution.     

THE COST OF MUTUAL FUND DISTRIBUTION FEES

Many individuals purchase shares in mutual funds as investments. With a lack of evidence supporting performance persistence in fund returns, investors should consider expenses as a fund-selection tool since fund expenses have a negative effect on fund returns. One of the largest expenses incurred by fund investors is distribution expenses, which include both load charges and annual fees. Close to two-thirds of all equity funds charge investors for fund distribution. The true cost of these distribution fees to investors is hard to measure because a myriad of distribution arrangements have evolved that vary both the timing and magnitude of distribution charges. We derive a simple methodology that expresses the present value of distribution costs as a percentage of the original investment in fund shares for any expected holding period. This methodology allows direct comparison of the effect on investors of distribution fees for mutual funds with different types of sales arrangements.     

The impact of the Multi-jurisdiction Disclosure System on audit fees of cross-listed Canadian firms

The Multi-jurisdiction Disclosure System (MJDS), a treaty between Canada and the United States (U.S.), was intended to facilitate the cross-listing of a firm's securities in the neighboring country. Under this system, eligible Canadian companies are allowed to use home-country documents to meet U.S. disclosure requirements and these documents are generally not reviewed by the Securities and Exchange Commission (SEC). We posit that the single-reporting requirement and lower SEC scrutiny may result in lower audit fees for MJDS firms. Based on audit-fee disclosures mandated by the SEC rule-making authority granted by the Sarbanes-Oxley Act of 2002, we find a negative association between audit fees paid by U.S. cross-listed Canadian companies and their use of the MJDS. This result suggests that the lower audit fees provide an economic incentive to use the MJDS. Thus, our study provides evidence that the implementation of the MJDS may help facilitate cross-border listings by reducing audit costs. Additionally, this study confirms, for Canadian firms, some of the audit-fee determinants reported in earlier studies.     

An Empirical Investigation of Short-Selling Activity Prior to Seasoned Equity Offerings

We investigate the nature and magnitude of short-selling activity around seasoned equity offerings, the relation between short-selling activity and issue discounts, and the consequences of the Securities and Exchange Commission (SEC's) adoption of Rule 10b-21 in response to concerns about manipulative short-selling practices. Seasoned offerings are characterized by abnormally high levels of short selling and option open interest. Higher levels of such activity are related to lower expected proceeds from the issuance of new shares. Where it could not be circumvented, Rule 10b-21 appears to have curbed short-selling activity and reduced issue discounts.     

The Only Fund in Town? Geographic Segmentation in the US Mutual Fund Industry

We find that mutual funds located in regions with more competing funds charge lower management fees, but higher fees related to sales and distribution (12b‐1 fees), sales loads, and other nonmanagement fee expenses. There is some evidence that funds in more competitive regions have higher total expense ratios than similar funds in less competitive regions. Our results indicate that while increased competition drives down fund profits, it creates a negative externality by way of increased sales expenses. Overall, our results suggest the mutual fund industry is characterized by monopolistic competition determined at the local level.     

THE DETERMINANTS OF BROKERAGE FEES IN A COMPETITIVE ENVIRONMENT

A Trade Practices Commission ruling, which came into effect on 1 April 1984, prohibited the Australian Associated Stock Exchanges (now known as the Australian Stock Exchange) from fixing brokerage fees. The expected consequence was a move to competitive pricing. Specifically, it was expected that brokerage fees would more accurately reflect the costs of providing brokerage services. This study analyses the evolution of the pricing mechanism since deregulation. In particular, it tests the influence of factors such as order size, broker quality, broker size, inventory costs, search costs, broker specialisation and broker learning on brokerage fees.     

Trends and determinants of Australian managed fund transaction costs

The present paper examines the often-overlooked managed fund fee that is incurred when investors enter and exit managed fund products. The present paper documents that transaction costs for investors, measured by the application-redemption spread, are above stock market brokerage rates although they have declined since 1995. The study analyses the relationship between this transaction fee and several variables. In summary, retail fund transaction costs are positively related to retail funds’ assets under management, whilst this relationship is negative for larger wholesale funds, consistent with economies of scale. Direct entry and exit fees and initial commissions are positively related to transaction costs which raises the possibility that the commissions are used to levy soft-dollar payments. The paper also documents a relationship between transaction costs and fund flows which differs between retail and wholesale funds. Overall, the findings are consistent with the proposition that the various fees are used by managers as interchangeable and the different fee regimes reflect different products and markets.     

On the Choice of Superannuation Funds in Australia

Using a sample of Australian retail and wholesale superannuation funds to proxy for choice and limited choice alternatives, respectively, we investigate the costs and benefits of providing choice to investors. We find that investors who have choice don't respond to fees. Also, loads - typical of the choice environment - are likely to be a dead-weight loss borne by investors. Employees who involuntarily contribute to (employer) funds, tend to pay the lowest fees. Given these results, the advantages of choice become questionable. Our results show that managers of limited choice funds achieve greater positive abnormal returns than retail fund managers. The analysis of flows provides insight into why choice funds do not perform better than limited choice funds. Investors are not responding to historical performance as predicted.     

Incentives for voluntary disclosure

Rule l0b-5 of the 1934 Securities and Exchange Act allows investors to sue firms for misrepresentation or omission. Since firms are principal-agent contracts between owners – contract designers – and privately informed managers, owners are the ultimate firms’ voluntary disclosure strategists. We analyze voluntary disclosure equilibrium in a game with two types of owners: expected liquidating dividends motivated (VMO) and expected price motivated (PMO). We find that Rule l0b-5: (i) does not deter misrepresentation and may suppress voluntary disclosure or, (ii) induces some firms to adopt a partial disclosure policy of disclosing only bad news or only good news.     

Measuring bond mutual fund performance with portfolio characteristics

This paper studies the performance of U.S. bond mutual funds using measures constructed from a novel data set of portfolio weights. Active fund managers exhibit outperformance before costs and fees generating, on average, gross returns of 1% per annum over the benchmark portfolio constructed using past holdings (approximately the same magnitude as expenses and transaction costs combined). This suggests that fund managers are able to earn back their fees and costs. There is evidence of neutral ability to time different portfolio allocations (sector, credit quality, and portfolio maturity allocations) and only a subgroup of bond funds exhibit successful timing ability. One performance measure based on portfolio holdings predicts future fund performance and provides information not contained in the standard measures. These results provide the first evidence of the value of active management in bond mutual funds.     

Fund selection,style allocation,and active management abilities: Evidence from funds of hedge funds’ holdings

This study examines whether funds of hedge funds (FOHFs) provide superior before-fee performance through managers’ fund selection, style allocation, and active management abilities. Using reported holdings of Securities and Exchange Commission–registered FOHFs, we find that FOHF managers have fund selection abilities, as hedge funds held by FOHFs outperform their style indices and over half of the individual hedge funds in the Lipper Trading Advisor Selection System (TASS) database. We also find that FOHF managers add value through active management of FOHFs’ holdings, while evidence on their style allocation abilities is mixed. Our findings suggest that FOHFs generate superior before-fee performance and that FOHF managers’ skillset is broader than previously documented. Thus, our study helps explain why FOHFs continue to survive and suggests that FOHF fee structure reform merits consideration.     

The effect of country-specific index trading on closed-end country funds: an empirical analysis

The American Stock Exchange initiated trading in 17 World Equity Benchmark Shares (acronym “WEBS”™) in April 1996. WEBS are index funds designed to track the Morgan Stanley Capital International (MSCI) indexes. We examine the effect of this event on closed-end country funds (CECFs) and find that percentage discounts increase. CECFs with a corresponding WEBS index experience the largest increase and also show a decline in trading volume. We attribute these results to (1) the effects of increased competition and (2) a reduction in the market segmentation premium. Since additional WEBS have begun trading, and other approvals may follow, similar effects could be experienced in the future.     

Subsidizing Liquidity: The Impact of Make/Take Fees on Market Quality

Facing increased competition over the last decade, many stock exchanges changed their trading fees to maker‐taker pricing, an incentive scheme that rewards liquidity suppliers and charges liquidity demanders. Using a change in trading fees on the Toronto Stock Exchange, we study whether and why the breakdown of trading fees between liquidity demanders and suppliers matters. Posted quotes adjust after the change in fee composition, but the transaction costs for liquidity demanders remain unaffected once fees are taken into account. However, as posted bid‐ask spreads decline, traders (particularly retail) use aggressive orders more frequently, and adverse selection costs decrease.