Sitting down at lunch today and checked some recent mail. Noticed a thick-ish envelope from my mutual fund company (who will remain nameless) where I had set up an UGMA account 25 years ago that I still hold and follow for my daughter. It contained my mutual fund Annual Report that I usually toss, but for some reason I opened it up today and starting reading it with my turkey and cheese sandwich. Boy, am I glad I did!
It started with a smiling picture of the Chairman with a half-page of light economic, political and capital market commentary. I think I noticed a jab at Donald Trump thrown in, but it could simply have been that I was conditioned to expect it. Anyway, not too much to worry about. The Chairman reassured me that markets are markets and you can trust us with your money.
Boy was I wrong! Once you get past the obligatory, politically correct commentaries, the careful reader finds MANY things to worry about! The smiling chairman did nothing to enlighten or prepare the reader for what was to follow.
First off, just like most of the actively-managed mutual funds out there, this fund underperformed its S&P 500 benchmark for 2016 with an annual total return of 8.77% versus 11.96% for the S&P 500. Pretty shabby, actually, to lag by 3.19%. Of course, the 8.77% does not include the sales charge! After the Class A sales charge of 5.75%, the net total return was 2.52%! To make matters worse, there are 12 other classes of shares with different sales fees and/or expense charges. Some classes are cheaper (for large institutions) and some are more expensive (for different distributors).
Accompanying the total return information was a 10-year chart showing the cumulative value of $10,000 against the S&P 500. As expected, the fund tracked, but lagged, the S&P 500 over most of the time horizon since 2006 and ended with deficit in 2016 of about $1,000; $18k versus $19k. So, it looked like an investment in the S&P 500, but lagged it.
The cumulative value chart is careful to declare in an important footnote that "it is not possible to invest directly in an index"; in this case, the S&P 500 Index. I wonder why this footnote is shown (it is common in the industry; even Vanguard has it!). As we all know very well, it is VERY "possible" to invest in an index (with a small fee plus trading expenses). I am sure the lawyers had something to do with this.
Next comes the dreaded expense table! No surprises here; they are high. Depending on the class, they range from a low of 0.39% to a high of 1.50%! Most of the net asset value is in the Class A shares at 0.69% and very few assets in the Class R6 shares at 0.39%. Pity the poor guy who was sold the class with a 1.50% expense ratio! Last time I checked, the Vanguard 500 Index Fund Investor Shares (MUTF:VFINX) has an expense ratio of 0.16% and the equivalent ETF (VOO) charges only 0.05%!
So, why was the Chairman smiling? What is good about this picture? It must be asset growth! Nope. Hate to say it, but to no one's surprise, change in net assets from share transactions are -$1.5 BILLION. Shareholders fled this previously $7 billion fund in droves in 2016!
The only good thing about this picture that would prompt ANY smile is that there are any assets AT ALL left in the fund. There are a few good reasons why assets persist at mutual funds in a situation like this. First, of course, is the distribution network. The advisers who control these shares earned a sales commission (and perhaps also a "trail" commission) and are not incented to exchange them for lower fee classes or lowest fee index funds. This seems fair since this was the deal that was struck when the shares were sold to the investor. This is regardless of whether it was a good deal or not. The only way out is to "fire" the adviser or have the adviser shift to a "fee-basis" business model, as in the RIA fiduciary model (we will not discuss the pending DOL rules here).
The other big reason to keep the status quo is taxes. Per the discussion on the cumulative value of $10,000 above, the taxable client in a taxable account is sitting on about an $8k unrealized gain for every $10k invested 10 years ago. Most investors are rightly averse to realizing gains and paying 15% (or higher) capital gains taxes until they need the funds; delaying the payment of taxes is usually a good thing.
Significantly, the bigger the gain, the longer the breakeven time to earn back the capital gains taxes that were paid to reallocate to a lower fee/higher return fund. Without getting into the math, the lesson is to not get into a high fee fund in the first place, because reallocating after a big runup will cost a lot and take a long time to get back to be just where you were.
The Annual Report started good, but ended in a bad place. Maybe it was because I was set up by the smile and smooth introductory commentary? Digging a bit deeper found some rude surprises; and I didn't even read all the footnotes! Please, buyer beware!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.