The portfolios we build are diversified, have a valuation orientation,
and have a meaningful exposure to the equity markets. What makes us different
from many money managers is that we believe there are superior portfolio
managers, we believe we prospect in a larger investment universe, we utilize
unconventional investments, we employ dynamic asset allocation strategies,
and we pay attention to expenses – all expenses.
We care about costs. Our typical mutual fund holding has a below average
expense ratio relative to similar funds. We don’t buy funds with loads
(sales charges). In addition, our typical holding also has a lower portfolio
turnover rate, which means that the fund’s transaction costs are likely
to be lower as well. Transaction costs don't show up in the stated expense
ratio, but they still come right out of gross returns. For taxable accounts,
we also focus on tax costs (difference between pre-tax and after-tax returns).
Expense ratios
A fund’s expense ratio is the annual expense that an investor has
to pay. It is a percentage based on the amount of assets invested. For example,
if a fund’s expense ratio is 2%, and an investor has $10,000 invested
in that fund, the annual cost is $200. Fund expenses are broken into three
categories. The largest is usually the management fee, which pays for the
investment management and marketing to operate the fund. Another category
is for back-office and administrative costs, such as paying for legal fees
and providing shareholder services. Lastly, some funds assess 12b-1 fees,
also to pay marketing costs, which include payments to intermediaries for
selling shares (more on 12b-1s later).
All else being equal, a fund with a lower expense ratio will generate higher
total returns moving forward. All else being equal, the funds we select at
Kobren Insight Management tend to have below-average expense ratios. Not
necessarily all the funds we select have below average expense ratios relative
to their respective peer groups, as there are obviously other important considerations
to take into account for fund selection, but in the aggregate that has been
the case.
The average mutual fund, according to Morningstar Principia (4/30/06), has
an audited expense ratio of 1.33%. The average domestic equity mutual fund
has an audited expense ratio of 1.39%. The average bond fund has an expense
ratio of 1.06%. The average international equity fund has an expense ratio
of 1.65%. The average KIM mutual fund, however, typically has an expense
ratio less than 1% (we have plenty of funds with expense ratios still over
1%, depending on the situation). Our fund holdings currently have expense
ratios that are 25-50 basis points lower than their respective peer group’s.
12-b1 Fees
As mentioned above, 12b-1 fees are marketing fees embedded in
the expense ratio. They are not an additional fee above and beyond the stated
expense
ratio. On some mutual fund platforms, some of the 12b-1 fee is rebated to
the shareholder. In that case, if we have to decide between two similar funds
and assuming they have identical expense ratios, we will prefer the fund
with the higher 12b-1 – since the shareholder will essentially get
some money back.
Loads
Often, there is a sales charge when buying or selling a mutual fund. If
the sales charge is applied on the purchase of the fund, it’s considered
a front-end load. If it is applied when the fund is sold, it is considered
a deferred load. If a fund has a load, it is either front end for deferred,
but not both. Front-end loads can be as high as 8.50%! Deferred loads can
be as high as 6.00%! Looking at all funds in the industry, the average front-end
load for a mutual fund is just less than 1% (0.83%). The average deferred
load is also just under 1% (0.73%). At Kobren Insight Management, we do not
buy funds with loads.
Redemption Fees
Sometimes, mutual funds have redemption fees. These fees
are charged when a shareholder sells a fund within a short time period after
purchasing the
fund (typically 30 or 90 days). The redemption fee’s primary purpose
is to discourage short-term mutual fund traders who can impair the long-term
performance of the mutual fund. Typically speaking, funds with higher cash
flow volatility have compromised returns as portfolio managers are spending
more time buying and selling securities to meet investor cash flows instead
of taking advantage of genuine investment opportunities.
Given the purpose of this fee, this is actually something that we like to
see on the funds that we own at Kobren Insight. Though we obviously don’t
like paying the fee, we also know that our average holding period for mutual
funds is approximately two years or more. This is more than long enough to
clear most redemption periods.
Portfolio Turnover Ratios
When a mutual fund buys or sells securities, it
generates transaction costs. Transactions costs can include items such as
commissions, slippage, and market
impact costs. These transaction costs are NOT reflected in the fund’s
expense ratio.
How much is this hidden expense? It depends. It depends on a variety of
factors, including the liquidity of the asset class or the part of the market
that the manager is transacting in, it depends on the size of the fund, and
it depends on the style of investing (value vs growth). As a very general
rule of thumb, every 1% of transaction costs equates into about 1 basis point
(0.01%) of expense. There have been a variety of articles and studies on
costs from portfolio turnover and the rule of thumb ranges from higher to
lower numbers, but again, it really depends on the way the money is being
invested by the mutual fund in question.
All else being equal, a fund with a lower turnover ratio will generate lower
transaction costs moving forward. All else being equal, the funds we select
at Kobren Insight Management tend to have below-average turnover ratios.
Not necessarily all the funds we select have below average turnover ratios
relative to their respective peer groups, as there are obviously other important
considerations to take into account for fund selection, but in the aggregate
that has been the case. The average KIM mutual fund typically has a portfolio
turnover ratio that is 20 percentage points lower than their respective peer’s
.
It is often noted that portfolio turnover also has an impact on taxes, another
important cost of fund ownership. It does have an impact, but it should be
stressed there are multiple factors that are typically more crucial to determining
how tax efficient a fund may be, what upcoming distributions may look like,
or both. These factors could include management’s stated and historical
tax awareness, the securities held, tax loss carryforwards, current unrealized
gains or losses, cash flows in and out of the fund, and more. Turnover can
actually be positive for tax efficiency if a manger is actively harvesting
tax losses to offset gains.
Tax Costs
For taxable investors, the most important return is the after-tax
return, given an appropriate level of risk of course. It is not pre-tax return. “Tax
costs” is a common way of measuring the tax bite a fund may have. This
is the difference between the pre-tax return and the after-tax return of
a fund (often incorporating the most conservative tax assumptions). For example,
if a fund generates a pre-tax return of 10%, but has an after-tax return
of 8%, then the tax cost is 2%.
Quick sidebar. Some mutual fund analysts use “tax efficiency” instead
of “tax costs” when trying to measure tax awareness of a fund
and its management. For instance, in the example above, we would say that
the fund was 80% efficient (8% / 10%). We are not fans of this approach.
First, selecting the most tax efficient funds doesn’t necessarily help
us get to the highest after-tax returns. For example, using highly inefficient
taxable corporate high yield bond funds can make sense for taxable investors
in certain situations. Given their portfolio risk reduction properties, coupled
with strong after-tax return expectations (which is currently NOT the case);
high yield bonds can make a lot of sense in certain situations in helping
to maximize risk-adjusted after-tax returns. Second, tax costs are expressed
in similar terms as an expense ratio so it’s easier to grasp the slippage
in return.
When selecting funds for taxable portfolios, we take into consideration
various tax issues. How we manage each client portfolio depends on that client’s
particular taxable situation.
Summary
In sum, costs matter. While directly meeting and communicating with
managers (that we believe are honest, competent, and have a process we believe
will
add value) is critical to how we manage money, we also recognize how important
costs are to maximizing risk-appropriate returns.
Sincerely,
Rusty Vanneman, CFA
Director of Research
Co-Portfolio
Manager
