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Q: Determining Daily Mutual Fund Expense Charge ( Answered ,   1 Comment )
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 Subject: Determining Daily Mutual Fund Expense Charge Category: Business and Money > Finance Asked by: jeffbhc001-ga List Price: \$200.00 Posted: 08 Jun 2004 21:12 PDT Expires: 08 Jul 2004 21:12 PDT Question ID: 358471
 ```I am trying to calculate a highly accurate gross-of-fee daily rate of return for a mutual fund. I am interested in knowing by how much to adjust the daily return (based on NAV) to reflect management fees. Mutual funds charge a fee to the fund each day for the management of the fund -- the expense ratio. How do they (a mutual fund company) determine what the charge should be for each day in the current period? I am not interested in 12b-1 fees, etc. If the expense ratio as of 12/31/2003 is 1.30% as shown on the annual report in EDGAR, (On a annual report in the Financial Highlights section, they show ratios. One of them is the "Total Operating Expenses (with reimbursements) as a percent of fund assets" and this amount equals what Morningstar lists as the expense ratio.) But the calculations for the total expenses etc. look like they relate to the period prior to the statement date, such as the 12 or 6 months before Dec 31, 2003. Going forward, do they use last year's expense ratio to determine the daily charge for the next days, for example January 5, 2004? Do the funds need to file a statement with the SEC about what the charge will be for the current period? Like, "We are budgeting a daily fee of "X%" that will equate to what we believe the total expenses will be for the coming six months." I am not interested in figuring the daily equivalent of 1.30% per year. Does the fund's board of directors determine that the charge will be "x" and the fund assumes the risk of the "x" not being able to cover expenses? My guess is that the MF boards make a determination based on the advice of the fund company and fund company assumes the risk. But I cannot find any filing at the SEC that says such and such a daily charge will be made. Because of this lack of SEC documentation, I suspect that they charge the most recent ratio or some amount and hope that it is right. How is this amount budgeted and disclosed to the public?```
 ```Hi jeffbhc001-ga! You posed a very interesting question. This was a tricky area because it is not regulated by the SEC. Due to this lack of regulation, information was especially difficult to find as it seems as though no one has ever even bothered to ask these questions before you. Also, as you might expect, companies are not exactly jumping to explain their fees to potential customers when not required to. I have spent quite a bit of time reading about mutual fund expenses and contacting mutual fund companies in search of an answer for you. I have compiled the knowledge I have gained over the past few days for you: --------------------------------------------------------- As you may know, the management fee is only one component of the Total Operating Expenses (also known as the expense ratio). It is generally the largest component, but there are others. The TOE is the sum of the following fees: - Management fee: the money paid to the fund management company as compensation for their services - 12b-1 fees: money used for advertising and distributing the fund, this is legally limited to 1.00% of the fund's assets - Adminstrative fees: the costs of registering the fund and complying with securities laws, i.e. creating and distributing the prospectus, shareholder reports, and trading costs These costs make up the expense ratio and represent the total of all costs paid out of the fund. However, this does not take into account sales loads and fees paid directly by the investor. The management fee is generally pretty consistent from day to day, while the administrative fees, while small, can be somewhat variable. As you expressed that you were not interested in 12b-1 fees, etc, I will focus on providing information about the management fee. --------------------------------------------------------- Before I start, I should explain that management fees are regulated by competition and the market, not the SEC. Thus, the way fees work are different between funds. Your first question asks how a mutual fund company determines what the charge should be for each day in a certain period. The short answer is any way they want. There is no regulation or even a single industry standard for choosing this. However, the long answer is a bit more complicated. A store could technically charge anything they wanted for a product, but they would not be around very long! Similarly, funds must deliver fees that keep them competitive. The Investment Advisory Agreement is the contract created at the inception of the fund which gives the fund a foundation. (Any changes to it must be approved by shareholders and signed by the fund's board of directors) A mutual fund is special kind of corporation which holds securities. Investing in a mutual fund is buying stocks in that corporation and giving yourself partial ownership of its assets. The mutual fund management company (i.e. Goldman Sachs, Morgan Stanley, etc.) acts as a financial advisor to this company, bound by the Investment Advisory Agreement. It is in this document where the management fee structure is laid out. Some funds have a stepped-fee function based on the fund's assets; that is, they may charge 1% on the first \$5 billion, 0.8% on the next \$10 billion, 0.5% on the next \$20 billion, etc. Other funds use mathematical formulas which take into account the performance of the fund, the assets of the management company, and other factors. Really, it is up to mutual fund company to decide how to set this up. They need to find a fee structure that allows their fund to compete with other funds as well as make them a profit. This is the domain of investment analysts with years of experience. I have some examples for you: Aim Investments ( http://www.aiminvestments.com/navigation/gateway?CGI_PATH=%2Fpdf%2FGHC-AR-1.pdf ) uses a staggered fee system which you can read about. It is on page 14 under 'Expenses', hidden away in the 'Notes' section. MetaMarkets ( http://www.metamarkets.com/funds/openfund/literature/sai.html#arrangements ) uses a similar scheme. Fidelity Investments ( http://content.members.fidelity.com/epro/PROS/316389303/?format=HTML&app=RETAIL&part=CONTENT#ref2747 ) uses a rather complicated scheme, the details of which are obscured by this document. I have linked to the appropriate section which is also very deeply hidden in the prospectus. Note that under this scheme, the management fee will change every month; perhaps more often. In these sections I have linked, you may also see some references to voluntarily waiving fees at any time. More on that later. There are a few general trends that relate various aspects of a fund with its management fee that could give you an idea of how this decision is made: - Fund Assets: As fund assets increase, a class's operating expense ratio decreases. - Fund Family Assets: As fund family assets increase, a class's operating expense ratio decreases. - Number of Funds in a Fund Family: As the number of funds in a fund family increases, a class's operating expense ratio decreases. - Fund Category: Equity funds have higher operating expense ratios than bond funds; specialty funds have higher operating expense ratios than equity funds; international funds have higher operating expense ratios than comparable domestic funds. - Index Funds: Index funds have lower operating expense ratios than other funds. - Institutional Funds: Institutional funds and classes have lower operating expense ratios than other funds and classes. - Load: Funds or classes with front-end loads have lower operating expense ratios than no-load funds and classes. - 12b-1 Fees: Classes that are authorized to have 12b-1 fees have expense ratios that are higher than other classes by an amount equal to about 93% of the maximum authorized 12b-1 fee. - Portfolio Turnover: As portfolio turnover increases, a fund's operating expense ratio increases. - Portfolio Holdings: As the number of portfolio holdings increases, a fund's operating expense ratio increases. - Multi-Class Funds: Multi-class funds have higher operating expenses than single class funds. - Fund Age: Older funds have higher operating expenses than younger funds. These descriptions are from an SEC report on trends in management fees: http://www.sec.gov/news/studies/feestudy.htm . This report also gives detailed causes for these trends. In addition, a recent SEC mandate proposal "require directors to explain in annual reports to shareholders how they determined that management fee levels were appropriate." Thus, more insight into the decision process behind how management fees are arrived at may be gleaned from future annual reports. Source: http://www.thompson.com/libraries/finance/mony/samplenews/mony0401b.html To sum up, a mutual fund company determines what to charge daily in terms of management fees by what has already been agreed upon, which is different from fund to fund. Information about this can be found in the fund's Prospectus or Statement of Additional Information, but the investment advisory agreement is the definitive source. The fund company originally determines how to structure fees based on a wide variety of factors as outlined above, but ultimately by the drive to be competitive and turn a profit. No two fund companies use the same system to determine a management fee scheme, so I'm afraid I cannot be any more specific than this. There are some additional complications which makes predicting a given day's management fee a bit harder than simply applying the rules in a contract. Somtimes, a fund manager will choose to waive or reimburse the management fees for a short period, in order to lower costs and boost performance. This way, a fund may be able to remain competitive. Some management companies promise to keep total expenses below a certain level, and so this may be their only option to honor that, since other costs are uncontrollable. When such a promise is made, it is the management company which assumes the risk of not being able to cover expenses. Depending on the company and the contract, the company could choose to end their fee waver at any time, or be reimbursed at a later time for the fees they gave up which would shortly and unpredictably increase fees at some point. For a general fund, the management fee for the future could not be perfectly predicted from past year's expense ratios for a number of reasons. Firstly, the management fee might be artificially raised or lowered as I explained. Secondly, if the fee structure is stepped, then the management fees could change if the assets of the fund pass a certain milestone; for example, a hypothetical fund in 2002 may be worth \$4.5 billion and in this case the management fee would be 1%, but the next year, it may be worth \$5.5 billion, and the management fee would be different for the last \$500 million. Other companies use even more complicated fee structures which are almost guarunteed to change from year to year. Barring any situations such as these, the management fee will generally be consistent day-to-day and predictable using information found in the fund's literature. This would likely require finding the daily equivalent to a certain number. While this is true of the management fee, it can get even hairier when one considers the expense ratio in its entirety. --------------------------------------------------------- I realize that you are primarily interested in the management fee, but other ongoing fees can makes the expense ratio more unpredictable from day to day. While the management fees have a tendency to reamin constant from day to day, this is not true of administrative fees. While some companies regulate administrative fees via a contract in a similar manner as management fees, they are not required to do so. Administrative fees can change daily. However, as a result of the routine nature of administrative tasks, they are usually pretty consistent. They are also usually very small compared to other fees and so, their variability doesn't have as much of an impact on the overall expense ratio. Fund companies have a strong incentive to keep administrative fees to a minimum. It is money paid out of the fund that does not go to them, and this has an impact on their profit. Secondly, high administrative fees inflate the expense ratio, reducing the fund's competitiveness. Why willingly make your product more expensive if you aren't recieving that extra money? This is why regulation of administrative fees is unnecessary. The SEC does not require fund companies to publish expense ratios on a daily basis or provide planned future expenses. The mutual fund companies I contacted do not do this voluntarily either, as they claimed it would be far too much work. All that is required of them is a semi-annual report which expresses the expenses of the past six months as a ratio of the fund's assets; this is available on EDGAR. They also require the past year's expense ratio to be pulished in the fund's prospectus which must also be publicly available. More detailed information can be found in the fund's Statement of Additional Information, which must be provided to investors upon request. So, the answer to your second question is no, they generally do not use last year's expense ratio to determind the daily charge for the next days. Neither are they required to file a statement with the SEC about daily expense ratios (rather, they must file a statement about these expenses over a 6 or 12 month period). --------------------------------------------------------- To answer your last question, mutual fund companies are not required to announce their future daily charges in advance and therefore are not required to budget it. Decisions about waiving fees, or changing the administrative costs can be made daily. Fund companies are also not required to disclose their daily charges. They are only required to disclose the cumulative expenses over 6/12 months. --------------------------------------------------------- I am sorry that my answer is pessimistic about the prospects of adjusting a fund's NAV to find its gross-of-fee return rate. This is just the way the fund market is. It seems to be that it would be a very difficult task, unless a fund had a very simple fee structure, (perhaps with a guarunteed daily fee), or if a management company were willing to provide daily updates of expenses charged. I'm not sure how feasible finding the gross return rate by taking the past day's assets, adjusting for change in the assets' market value over the day, and subtracting the final NAV is, but it may warrant looking into. I hope I have addressed all your questions, although I understand that all this information may have opened new questions. If you would like elaboration on any part of what I have presented, please feel free to ask for clarification before closing and rating my answer so that I may best help you. Cheers, tox-ga``` Request for Answer Clarification by jeffbhc001-ga on 18 Jun 2004 07:56 PDT ```Interesting. We have evaluated the expense ratios of several funds. For many (not all) the expense ratios have not changed for 6 years, which suggests they are "managed". Based on your research, we could conclude this stability is the results of any or all of a cap set on expense ratios and the management company accepts the risks of the cap being adequate to cover costs, or stable assets and administrative costs. The first seems more plausible. Do you agree? When you say management fees are paid monthly, does that really mean calculated monthly with a portion paid each day? Otherwise, the day on which those fees are paid will have lower returns. Any clarification on this? For those funds with stable expense ratios over say 6 years, could we assume that rate charged each day is roughly the same?``` Clarification of Answer by tox-ga on 18 Jun 2004 10:03 PDT ```Hi, I believe you are correct regarding the cause of the stability of the funds you have evaluated. In fact, in my research, I came across a fund which charged a 1% management fee, but also capped total expenses at 1%, which is essentially the same as guarunteeing a constant expense ratio at 1%. It is also possible that a fund with a more complicated fee structure could keep a consistent rate, assuming that the fund stayed within the same parameters over several years (i.e. stable assets and administrative costs, etc., as you mentioned). This seems less likely to me than the first possibility. This could be settled by checking the prospectus of the fund you are interested in, but may also require checking the Statement of Additional Information or the Investment Advisory Agreement. I'm sorry, I did not mean to say that management fees are always paid monthly. I believe you are referring to when I mentioned that under Fidelity's price structure, the fee could change monthly. In fact, management fees are generally accrued daily, but Fidelity recalculates the daily expense on a monthly basis. While researching funds, I found that most accrued and collected fees on a daily basis, although I did find some which accrued daily, but collected on a monthly basis in arrears. This again is up to the fund companies and stipulated by contract. It is possible that for some funds with stable expense ratios, the daily fee is consistent. However, this is not necessarily the case. Remember that the expense ratios you read in Morningstar or in an annual report are averaged over a year. A cap on fees would only need to guaruntee that the final, averaged expense ratio of a year is a certain rate. A company could collect different fees from day to day and then, at a certain point in time, reimburse the fund in the amount of fees which are in excess of the cap. This would still cause the final expense ratio to be the same as if the fund charged the capped fee every day. I hope I have answered your questions with clarity. If you are unsure about anything I have said, please feel free to ask. Cheers, tox-ga``` Request for Answer Clarification by jeffbhc001-ga on 18 Jun 2004 11:15 PDT ```What portion of the funds you looked at charged fees to the fund monthly and where is this disclosed? I realize you did not do an exhaustive survey, but wast it 1 out of 3 or 1 out five, etc., that charged the fees monthly.``` Clarification of Answer by tox-ga on 18 Jun 2004 12:56 PDT ```From my reading, it seemed like the industry standard was to charge fees daily. However, among the funds I closely examined, the proportion which charged monthly approached almost a half. If I had to venture a guess, I would think that in general, perhaps about 1 to 2 out of 5 stocks charge on a monthly basis. This is usually disclosed in the Propsectus. Be warned that it may be hidden deeply inside, perhaps in the ending notes. Also, the prospectus is meant to be abbreviation, so this tidbit could be in the Statement of Additional Information or Investment Advisory Agreement.``` Clarification of Answer by tox-ga on 18 Jun 2004 15:13 PDT ```Hi jeffbhc001-ga! Many thanks for your generous compliments, rating, and tip. It is certainly appreciated. I'm glad your experience with Google Answers was a positive one. In the future, you are welcome to request me specifically. (Like this client has done, as an example: http://answers.google.com/answers/threadview?id=360976 ) It would be my pleasure to work with you again. Cheers, tox-ga```
 jeffbhc001-ga rated this answer: and gave an additional tip of: \$75.00 ```This answer was just great! It showed research, good thinking, and honesty. I am extremely pleased with this exchange of ideas and will be using this service again. I do hope I get the same researcher -- he/she has my respect and gratitude. THANKS! PS Tox is perhaps justification for human cloning```
 ```Check the annual report of the fund you are interested in. I have one of mine in my hand, and on the page titled: Statement of Operations, there is a listing of all the expenses accrued by the fund. In the notes section it refers to is the following: ...the management fee is computed at the annual rate of .25 of 1% of the value of the fund's average daily net assets, and is payable monthly. That should give you a good start. Find an annual report, it may provide the answers you are looking for.```