Rekenthaler Report

3 Times When Fund Costs Don't Tell the Full Story

John Rekenthaler

Mostly Correct
The costs of owning mutual funds/exchange-traded funds are well-specified. Auto manufacturers sticker cars with estimated fuel expenditures, and appliance dealers post anticipated energy consumption, but those are rough guesses. Actual expenses will vary widely by user. Whereas with funds, a shareholder’s costs can generally be determined precisely, multiplying the expense ratio by the investment’s size. 

Sometimes, however, the official numbers don’t tell the complete story. This column discusses three exceptions:

1)     Fee waivers.

2)     Prospectus versus annual report differences.

3)     Interest payments.

Fee Waivers
The most obvious danger with using published expense ratios to calculate current costs is that things change. This year’s ratio might be significantly different than last year’s. When that does occur, it generally is because of fee waivers. (The exception being tiny funds that suddenly become popular, thereby benefiting from economies of scale.) Most funds initially absorb some costs, so that their early expense ratios are not absurdly high, and their returns absurdly low. That, of course, is not the long-term plan. Eventually, if the fund grows as expected, those waivers will disappear.

For example,  Huber Capital Mid Cap Value (HUMEX), launched in 2016 and carrying but $2 million in assets, can’t be competitive without waiving fees. Per the fund’s latest report, it generated $106,000 in expenses from October 2017 through April 2018--an annualized rate of more than 10%--and reimbursed $97,000 worth of that amount. A footnote states that management “has agreed to reduce fees … to limit the aggregate annual expenses” for the Institutional Shares to 1.10% (the Investor Shares are at 1.40%). There is no termination date for that promise.

The prospectus is somewhat more forthcoming, stating that Huber Mid Cap Value’s expense cap will persist until at least Feb. 27, 2019--that is, the day before the next prospectus is issued. After that date, the fund’s board of directors has the right to terminate the waiver, although for business reasons is almost certainly would not, at least to the full extent.

The upshot: Monitor funds with fee waivers annually, with the prospectus being the preferred source.

Two Versions, Same Fund
With fee waivers, the prospectus and shareholder report have slightly different language, but much the same content. Not so for funds of funds. The primary expense ratio for the shareholder reports of FOFs does not include the cost of the underlying funds, while that of the prospectus does. The two figures will not match (unless the underlying funds work for free, which is rare indeed), with the shareholder-report number being unrealistically low.

The cheapest share class of American Funds 2025 Target Date Retirement Fund (RFDTX) carries a prospectus expense ratio of 0.37%. Not bad. Better yet, though, is the expense ratio shown in the annual report, which is 0.01%. Of course, the fund can’t be had for 1 basis point. That is solely the expense of its outside layer. Its underlying holdings charge an additional 0.36%, for the aforementioned total of 0.37%.

The upshot: For FOFs, refer the prospectus expense ratio, not that of the shareholder report. That will occur automatically when using this site’s information, because Morningstar pulls the prospectus ratio when filling its standard “Expenses” field. Elsewhere, double-check the source.

Investment Costs
Now things get messy. The SEC requires funds that make interest payments because they have borrowed cash, or dividend payments because they have shorted stocks, classify those expenditures as fund expenses. That is … peculiar.

First, those are investment costs. They do not come from running the portfolio, as with a management fee; nor are they operating expenses, as with answering shareholder calls; nor are they sales outlays, as with 12b-1 fees. They are instead investment expenditures. Borrow money, pay interest. Borrow stock, pay dividends. Trade a stock, pay a commission. Except … brokerage commissions do not appear in any expense ratio, on the logic that investment costs do not belong in investment.

So, this investment cost counts, and that investment cost counts, but the third investment cost does not. My mind struggles.

Second, this approach destroys comparability for funds that leverage or short. A fund that wishes to hold 150% of the S&P 500 can do so by borrowing cash and purchasing those stocks directly; or by holding cash and buying futures. Two paths, each leading to the same portfolio and the same expected returns. Yet the former approach leads to high reported expenses, because it incurs investment costs that are placed into the official ratio, while the latter does not. Using futures, it seems, is costless. (As is borrowing or shorting by purchasing ETFs.)

Consider two market-neutral funds,  Vanguard Market Neutral Institutional Shares (VMNIX) and  Calamos Market Neutral A Shares (CVSIX). You would need to smoke something very strong, or be completely unfamiliar with funds, to believe that a Vanguard institutional fund with a $5 million minimum investment would cost more than a Calamos fund with a $2500 minimum purchase and a 0.25% 12b-1 fee. Yet the Vanguard fund’s official expense ratio is 1.46%, while Calamos' is 1.28%.

Uh-huh. Strip out the investment-related charges, and Vanguard Market Neutral’s expense ratio doesn’t even match the Calamos fund’s 12b-1 fee. Once that exercise is done, Vanguard comes in at a puny 0.14%, while Calamos is 1.08%. (Which, to give Calamos credit, is relatively low for a retail market-neutral fund; it’s a pricey group.) Now that is what we expected to see from Vanguard.

The upshot: Interest and dividend payments can make frugally managed funds look like spendthrifts. Unfortunately, determining what monies went where can take some sleuthing; some fund companies make their interest/dividend costs explicit, while others put them in footnotes. Morningstar’s plan is to supplement the SEC’s official expense-ratio calculation with a “Morningstar expense ratio” figure that would remove such investment costs. May that soon be implemented.

Death is No Escape
From Morningstar’s Grant Kennaway: National Australia Bank charged fees to dead superannuation customers, inquiry told.

To translate that headline into American, the bank sold advice to Australian 401(k) investors on how allocate their funds. However, as National Australia wasn’t good at keeping track of which customers were still around, it ended up collecting a few millions from the accounts of dead customers--including one who had been departed for more than a decade.

You Australians are clever, Grant. That I must concede. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.