We don’t all pay the same price for a lot of things. Some people buy paper towels at Whole Foods and others at Costco. Same paper towels, different price. But the stakes are far higher when we save for college or retirement. Most people pay too much, and that stunts the growth of their savings.
For example, three people buy the same mutual fund. One of them pays the fund managers 1.25% of their investment each year to operate the fund. Another only pays 0.7% and the third person only pays 0.25%.
They all own the same fund, and get the same services from the fund manager. So how can such big disparities exist? Because of fund expense ratios and high cost share classes. The higher the expense ratio, the lower the returns to the investor. Fund companies are permitted to package the same fund into various “share classes” with different expense ratios. It’s Whole Foods or Costco — same product, different price.
It’s so out of hand that the Securities and Exchange Commission tookthis year against brokerage firms for putting clients in high cost share classes when they could have saved their clients money by using lower cost share classes of the same fund. Worse, the brokerage industry’s regulator, FINRA, for allowing their brokers to sell 529 college savings plan funds with excess fees.
Why would brokerage firms do this? Because they make more selling those high cost share classes.
At EVOAdvisers, we select the lowest cost share class available for a client. That’s what a fiduciary should do — put their client’s interests before their own.
Want to know more? So what’s a mutual fund expense ratio?
The expense ratio is the percentage of your investment that a fund company keeps each year. The lower the expense ratio, the more of the fund’s gross returns the investor gets to keep.
A mutual fund is a basket of stocks or bonds. There’s a cost to bundling the portfolio together and offering slices of it for sale — basic business overhead costs like rent, technology and salaries, the legal expenses associated with offering a security for sale to the public, trading costs, custodial expenses and so forth. That’s the basic cost of the fund, and when a fund manager spreads it out evenly across all shareholders, it is expressed as a percentage, or a ratio.
Sometimes there are additional people to pay: brokers earn commissions when they sell products. Their employers often have revenue sharing agreements with fund companies — think of it as a “pay to play” arrangement. These additional distribution costs add up, making some people pay a heftier expense ratio than others, sometimes a lot heftier.
But why can one fund be available with so many different expense ratios?
Mutual Fund Share Classes
Back in the days when mutual funds were still somewhat of a novelty, mutual fund companies asked regulators if they could charge consumers differently based on the cost of serving them. This became known as “share classes” — each share class came with a different expense ratio. Big institutions didn’t require call center staffing or advertising, but mom and pop investors required that level of support, and lots of sales people to educate them about the benefits of investing in mutual funds. Think wholesale and retail — it makes sense.
40 years later, mutual funds aren’t a novelty. Why do fund companies still get to have so many share classes? It’s all about profit for fund companies, a big commission for the broker and a cut of the action for the broker’s firm.
A great example of how nuts this has become:
The American Funds The Growth Fund of America® is found in many portfolios. Financial advisors can use the F3 share class with an expense ratio of 0.33%, or choose from several other share classes with higher expense ratios, up to 1.47%.
You could invest $10,000 in a fund with an expense ratio of 0.33%. Or, you could invest $10,000 in a share class of that same fund with an expense ratio of 1.47%
If the fund returns 10% in a year before expenses. Using the lower cost share class, you should see a return of 10% – 0.33% = 9.67%
But if you had invested in the more expensive share class, you only get 10% – 1.47% = 8.53%
Which would you prefer to own? Now ask your advisor if they recommend the lowest cost share classes for your portfolio. If they do not, you may want to ask more questions.