Research Review | 3.11.2011 | Mutual Fund Expenses

Brokerage Commissions: The Hidden Costs of Owning Mutual Funds
Xiaohui Gao (University of Hong Kong) and Miles Livingston (University of Florida) | Mar 4, 2011
Brokerage commissions represent hidden costs to investors because commissions are not included, nor reported, in the fund expense ratio. This paper analyzes unique fund level data on brokerage commissions paid by U.S. diversified equity mutual funds from 2000 to 2007. There are three main conclusions. First, an average fund pays 25.72 basis points (bp) per dollar of assets, in addition to an average expense ratio of 131.96 bp, resulting in a total out-of-pocket cost of 157.68 bp. Second, a one bp increase in annual commissions per dollar of assets is associated with a decline of about 5.8 bp in a fund’s annual return. Third, our analysis yields a number of substantive policy implications, such as commissions being included in the fund expense ratio, and mutual funds detailing their soft dollar arrangements. These disclosures would enable investors and regulators to make more informed decisions.

Evaluating the Performance of Global Emerging Markets Equity Exchange-Traded Funds
David Blitz (Robeco Asset Mgt) and Joop Huij (Robeco and Erasmus University Rotterdam) | Feb 8, 2011
We examine the performance of exchange-traded funds (ETFs) that provide passive exposure to global emerging markets (GEM) equities. We find that the tracking error of GEM ETFs is substantially higher than previously reported levels for developed markets ETFs. At the same time the long-term average underperformance of GEM ETFs does not appear to be worse than that of developed markets ETFs. We find that, on average, GEM ETFs fall short of their benchmark indexes by around 85 basis points per annum, which is in line with the expected drag on return due to fund expenses and the impact of withholding taxes on dividends. Because we observe large differences in performance across funds, we argue that investing in GEM ETFs requires a careful selection process.
Paying the High Price of Active Management: A New Look at Mutual Fund Fees
Ross Miller (Miller Risk Advisors and SUNY at Albany) | Sep 2010
Financial economists have long known that actively managed mutual funds
underperform comparable index funds and that investment management fees are a major contributor to this underperformance. This article shows that the impact of mutual fund fees is even greater when one examines what funds actually do with investors’ money. Many actively managed mutual funds have returns that are closely correlated with comparable index funds and yet have annual fees that can be 100 times higher. Because such “shadow” or” closet” index funds provide minimal active management of the assets they hold, the implied annual cost of the active management can dwarf the stated cost. This article provides a simple measure of what investors are actually paying fund managers for that active management that they can compute for themselves data available for free on the Internet. A sample of 731 actively managed large-cap U.S. mutual funds analyzed for the three years ending December 31, 2009 has a mean active expense ratio of 6.44%, more than 400% greater than their mean reported expense ratio of 1.20%. This article also finds that even large, seemingly low-cost, mutual funds common in retirement plans frequently have active expense ratios above 4% a year.
Mutual fund performance: measurement and evidence
Keith Cuthbertson (Cass Business School), Dirk Nitzsche (Cass Business School), and Niall O’Sullivan (University College Cork) | May 2010
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 fund s 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.
Redemption Fees and the Risk-Adjusted Performance of International Equity Mutual Funds
Iuliana Ismailescu and Matthew R. Morey (Pace University) | Nov 5, 2010
In the wake of the market timing and late trading mutual fund scandals, many mutual funds adopted redemption fees to limit market timing. In this paper we investigate the impact of redemption fees on the risk-adjusted performance of U.S. based international equity funds, the very funds that many market timers used. We find three interesting results. First, using event study methodology we find that after the introduction of redemption fee there is a significant increase in the risk-adjusted fund performance. Second, we find that funds that introduced larger-size redemption fees have significantly better performance after the introduction of the redemption fee than other funds. Third, we find that the main reason for the improvement in fund performance after the introduction of the redemption fee is due to lower amounts of cash being held by the fund after the redemption fee. In sum our results suggest that implementation of redemption fees are performance enhancing for international equity funds. As such, long-term investors of international equity funds should actively look for international equity funds that have redemption fees.