New York Mutual Funds

A mutual fund is simply a managed package that holds many individual securities. These securities can be stocks, bonds or cash equivalents.

How important are expenses in considering whether or not to buy a mutual fund? That is one of the questions inquiring investors are apt to ask as they ponder their options in a broad and often perplexing investment landscape.

The short answer is that expenses matter, since they have a direct impact on total return. The slightly longer answer is that while fees are a factor, they should be weighed in the larger context of a fund’s performance record and the demonstrated abilities of its manager.

Like any business, mutual funds incur routine costs that encompass administrative, investment management, legal, accounting and marketing aspects of the operation. Fortunately for investors these costs are conveniently bundled together as a single number, the expense ratio.

Funds also generate brokerage charges, which are reported separately. This fee is of less concern because we avoid overactive mutual funds and market timers, favoring instead mutual funds that employ a value-oriented, buy-and-hold approach that implies a low turnover of holdings.

Expenses Aren’t The Only Criteria That Matters

Bear in mind that expenses are only one element in the mix. In our view, even more important are the quality and experience of the fund’s management and its track record over time. So perhaps a better way to understand the relative impact of fees is to look at how a mutual fund justifies its expenses.

Is it delivering above-average performance? Is it consistent in delivering that performance and at what level of risk? How does this particular mutual fund perform in down markets? Is the manager’s investment philosophy consistent with our value orientation?

It’s not easy to discern the answers to those questions by simply perusing a prospectus or even running fund screens on the computer. That’s why we supplement our qualitative research with interviews to determine whether a manager also has the temperament and outlook that conforms with R. W. Rogé & Company’s approach to investing. That’s why we speak with the managers of the mutual funds in which we invest – initially, before we select them, and then periodically on an ongoing basis.

The expense ratio for a typical actively managed stock fund is about 1.5%. We take note of the expense ratio, but even more, we look at a fund’s total return over time. For instance, if a fund has outperformed its index by 500 basis points, or 5%, over the past five years an expense ratio of, say, 1.75%, doesn’t have much of an impact. That’s especially true if the mutual fund’s asset base is still small because expenses are likely to come down somewhat over time. If the expense ratio is above 1.75%, we look more closely at what may justify this level of cost, frequently through direct contact with the manager.

Beyond Performance®

In considering performance history, most advisors screen for three-or five-year track records, but we like to seek out newer mutual funds with seasoned managers who have strong performance either with another fund or supervising separately managed accounts.

Newer funds have other advantages. They’re typically small and relatively unknown, providing a greater degree of flexibility to uncover profitable inefficiencies in the marketplace, what we call Valuation Anomalies.SM

That’s one of the reasons we seldom use some of the bigger fund complexes. Instead, we like some of the boutiques that are, in effect, funds and their advisors rolled into one, streamlined package. Because they don’t invest by committee, small funds are more likely to efficiently leverage the insights of a talented manager, providing an edge over other funds in the same style category. Also, they define their own philosophy, control their investment process and are often contrarian in pursuit of opportunities off the beaten path.

While such funds commonly carry higher expense ratios at least until they accumulate a larger asset base they also tend to generate better returns because it’s easier to beat market averages with a small pool of money than a big one. After all, there are only so many good ideas.

If a mutual fund is going to hover close to its benchmark and such funds do have a place in our allocation strategies – then it’s easier to simply opt for a quality index fund and benefit directly from low expenses.

A few additional thoughts on fees and performance:

  • The 12(b)-1 fee. Together with the management fee, the 12(b)-1 is the other principal component of the expense ratio. Originally intended to help with marketing efforts to grow assets and thus benefit shareholders through economies of scale, this fee is increasingly being used to pay distributor servicing expenses – essentially a sales charge. While we disapprove of diverting 12(b)-1 income for unauthorized purposes –and basically avoid large mutual funds that still charge a 12(b)-1 fee – we still view it in the larger context of performance and management ability.
  • Load funds. Loads are not fees but sales charges. Fortunately, working with R. W. Rogé & Company, Inc., our clients are able to invest in load funds, without paying these extra costs. No-load access to the universe of load funds provides exposure to even more fine money managers, further enhancing performance potential.
  • Performance-based fees. A common feature in the hedge fund world, this type of fee is now gaining some traction with mutual funds. Rather than paying a manager a fixed amount regardless of how his fund performs, this kind of fee structure rewards a manager for generating returns in excess of a stock index or other benchmark but not if the manager underperforms. It’s an acknowledgment that when a fund disappoints, the managers owe it to investors to share some of the pain. We think the concept of linking performance to fees (as long as they’re not excessive) is a useful incentive.

The bottom line is that while fees are important they should not be the only factor used in selecting a mutual fund. Sometimes a higher expense ratio is actually a modest price to pay to gain access to a bright manager with the latitude to more freely explore the market’s complexities in search of value and market-beating performance.

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