Reshaping the American financial system - Mutual Funds, part 1

New England Economic Review, July-August, 1997 by Peter Fortune

Direct Costs

Direct costs are in two forms.(16) The first is the fees and commissions paid to the agents responsible for mutual fund services - the advisor, distributor, custodian, and transfer agent. These fees include compensation to brokers for transaction services provided, but do not include the bid-ask spread paid to market makers. These fees differ widely according to the types of securities held and the fund's turnover. For example, index funds generally have lower fees and commissions than do managed equity funds because they have fewer transactions and because the portfolio trades are largely shaped by changes in the definition of the index used (new firms are added, firms are deleted, the weights of other firms in the index are recalculated), not by portfolio managers searching for high performance. High-yield bond funds tend to have greater expenses than do funds specializing in U.S. Treasury bonds. Municipal bond funds tend to have low fees because of low portfolio turnover.

A second form of direct cost is the cost of marketing the shares. The marketing cost is related to the sales channel, of which the ICI defines four: sales force, direct marketing, variable annuity,(17) and "not offering shares." The sales-force channel involves use of third parties such as banks, brokers, and financial planners, who recommend the mutual fund to their clients. The direct-market channel involves sales directly to customers at their initiative. The ICI reports that in 1995 the sales-force channel accounted for 53.6 percent of the value of shares sold while the direct-market channel accounted for 37.7 percent of the value of shares sold. This left 9.7 percent of sales to the variable annuity channel, and a minuscule proportion to funds not offering shares to new customers. Thus, the sales force channel dominates, with the direct-market channel a distant - but sizable - second avenue for selling mutual fund shares.

The sales channel differs considerably by type of fund, and the same fund may be distributed through more than one channel. Table 2 ranks the types of funds according to their reliance on the direct marketing channel. Direct marketing is extremely important in specialty funds, like precious metals and Ginnie Mae mortgage funds, which expose investors to risks that inhibit broker recommendations. It is less likely to be used in taxable and municipal bond funds, with which investors might not be familiar. Equity funds, with about 40 to 50 percent of sales through direct markets, occupy an intermediate area: Here both direct and sales-force methods are important.

The marketing channel affects shareholders not only through the costs incurred, but also through the timing of the charges to cover those costs. Third parties typically receive compensation from the fund at the time of sale, and they might also receive ongoing compensation for services to the client on behalf of the fund, such as handling client questions about whether the fund's shares should be held. The earliest form of sales-force fund, still common, is a "front load" fund for which the buyer is charged a premium at the time of purchase. This load is often in the 3 to 6 percent range but can be as high as 8.5 percent. Because the timing of the front-load charge matches the timing of the payment to third parties, the front load fund requires no continuing sales charges. Back-end load funds, once rare, charge fees at the time of redemption. For these, the gap between payment of sales commissions at time of sale and recoupment from charges at redemption requires the shareholders to cover the costs of financing the gap.(18)