Marketing versus Investing

Keep this in mind whenever you’re considering where to invest:

The vast majority of mutual fund companies are much better at marketing than they are at investing. Most of the time, it’s not even close.
 
The primary way mutual fund companies grow is by attracting more dollars. So not only do they offer dozens or sometimes hundreds of funds, but they’ll cherry pick the best ones to highlight in glossy ads and television commercials to show as high a rate of return as possible. That’s because high returns are red meat for your average mutual fund investor.  

To get as high a rate of return as possible, it’s in the mutual fund companies’ interest to obscure as many costs as they can.

The laws are pretty specific about what costs a mutual fund can have investors pay, and which it must pay. Oddly, the oft-cited “mutual fund expense ratio” includes some expenses that investors shouldn’t have to pay, and excludes some that they do – though many investors may not realize it.

And this sort of muddying the waters can help those all too valuable 3-, 5-, and 10-year mutual fund return numbers be as high as possible.

So what numbers are hidden?  Trading commissions aren’t included in expense ratios, for one. Neither are sales loads, which, if you think about it, is particularly deceptive. And often marketing costs are hidden, too.

Many mutual fund investors, for instance, pay 12(b)-1 fees.  These are “marketing and promotion fees” that, in reality, are commissions paid to brokers who sell the funds.  

Now, let me ask:  If you are an investor in a fund, why should you pay for that fund to market and promote itself? Except in the la-la world that mutual funds inhabit, most people who pay for something want to receive something in return. The mere presence of these fees means you’re either paying for something and getting nothing in return…or you’re paying for someone to try to sell you something you already own. How much sense does that make?

Those nutty 12(b)-1 fees are currently being fought over by regulators and the investment industry.  The industry claims these fees are considered “continuing” compensation to the broker who sold the fund.  That’s understandable – as long as the broker has “continued” to service your account.  If not, that broker is literally getting paid while doing nothing.

If you have a brokerage account, you’ve also undoubtedly signed off on a lot of paperwork containing fine print. One of those things in very small font likely references “Revenue Sharing.” These are payments (does ‘kick-backs’ sound too harsh?) made by mutual fund companies to brokerage houses thanks to the old 12(b)-1 fee.

What the brokerage houses provide in return for their share of the revenue is beyond me – other than deliver unsuspecting investors to the funds, I mean. But what shouldn’t escape any of us is who is ultimately creating the revenue that a mutual fund company and the brokerage share:

Yep. The investors in the fund.

So not only might you unintentionally be paying your broker an upfront commission, but you may actually be paying him every month to sit there and do nothing. You could say he’s actually incentivized to do nothing, even. And you can see why, since it’s not at all uncommon to pay 75 basis points upfront and 25 basis points per month afterwards in just 12(b)-1 fees.

And how much of that will be disclosed to you upfront, in an easy to understand way?

I think you know the answer.

Ah, mutual funds. If only you used your powers for good instead of evil…

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

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