"Should I sell my mutual funds and buy ETFs?" I have had this question posed to me on multiple occasions. Unfortunately, the answer is not simple and clear cut.

The question of selling mutual funds in order to buy ETFs has been a fairly common question, but, in most cases, the question is asked for the wrong reasons. The question may be asked for the following (wrong) reasons:

"I heard that ETFs outperform mutual funds."

"I heard that ETFs are cheaper that mutual funds."

 "ETFs are more liquid than mutual funds. I can sell them and avoid a market crash."

I have tackled the above issues in previous blog posts and articles. I believe the overriding reason for these continued questions and comments is due to the grinding of axes. In other words, the $1 trillion dollar ETF industry has much to gain from the $10 trillion mutual fund industry. To quantify, they have $10 trillion to gain.

If you want to learn more about mutual funds vs. ETFs read:

Do You Understand the ETFs vs. Mutual Funds Debate?

5 Disadvantages of Mutual Funds

Why do you have to pay those 12b-1 fees? Some folks think these fees are no good, hidden fees that are unnecessary. Others will argue that they deserve to make a living, so keep 'em coming (think: the person who sold you the fund). The truthful answer is probably somewhere in the middle.

There's been so much press on these so-called hidden fund fees lately that I posed a few questions to Morningstar. I asked Russel Kinnel, director of fund research at Morningstar, to weigh in on the argument. 

Lee McGowan, Guide to Mutual Funds at About.com:  "12b-1 fees have been a hot topic on blogs, in the media and in the courtroom. Will the recent court cases coupled with the SEC's 'rethinking' of 12b-1 fees lead to lower fees?"

Russel Kinnel of Morningstar:  "It's possible, but very hard to predict. There are some parts of the fund sales chain that prevent true competition on costs. Will the court or SEC unleash competitive forces? Probably not enough to have a big impact."

Lee: "Individual investors may not understand the need for these fees. Many investors simply don't see the value of this ongoing fee that many feel is a hidden fee. They see the 12b-1 fee as a simple reduction of their net returns."

Russel Kinnel: "The SEC is taking a long look at them. They are messy for a couple of reasons. First, the stated reason for collecting them is often different from the real reason. Second, there are no breakpoints in it based upon volume. That said, there are legitimate account services being provided in exchange for 12b-1s, so simply killing them off isn't the answer, tempting though it may be."

More from the interview with Russel Kinnel of Morningstar

More on Hidden Fund Fees

My previous blog post attracted some attention - both positive and...constructive.

I will add a few points to my previous post.

1. Lipper may have completed the "average mutual fund fee" study, but they also completed a study (by Andrew Clark "How Well Do Expenses and Net Returns Predict Future Performance?") showing that screening for low-expense  mutual funds (when searching for actively managed funds) will not necessarily improve your odds of finding an index-beating mutual fund. So, what's the use of the aforementioned average fee study? It depends who is using it -- it could be used by someone selling ETFs or other products.
2. I reiterate that any average fee issue that includes all share classes of the same fund is not an accurate measure (or useful one).  Why? Well, an investor would not be able to buy a mutual fund that has both an upfront sales charge and a surrender charge and both are included in the these studies. Most of the replies to my previous post understood this point.
3. The 12b-1 fee is a hot issue with the SEC and Mary Schapiro -- and it has been for quite some time.  In a perfect world (as defined by me), this fee would either be eliminated or shown clearly on an investor's statement as a quarterly fee deduction rather than being subtracted from the NAV on a daily basis. There is a lack of transparency unless an investor reads the prospectus or researches fund fees in another manner.
4. If an investor is against paying the 12b-1 fee (if they do not see the value of the broker that sold the fund), then buy a no-load, no 12b-1 fee fund. There are plenty. Start with Vanguard...
5. ICI's studies indicate that while front-end loads, or sales charges, averaged 5.3% in 2008, the front-end loads that stock fund investors actually paid was only 1.1% in 2008. In other words, many of the funds are "load-waived" in retirement plans, load-waived by fee-based advisors, or investors receive a breakpoint discount. It's unclear whether or not Lipper's study included or excluded these issues, but it appears these potential discounts were ignored.
6. Caveat emptor. Buyer beware. There are many sites, advisors and other resources (from mutual fund companies to ETF purveyors) that would benefit from selling you an investment strategy or product. Do your research or hire a professional that does not benefit from selling a particular product.

The important point is that we all may benefit from reading research, such as the Lipper study that is mentioned, but be cautious of how the research is used for another's benefit. The more than $10 trillion mutual fund industry is a target for those looking to gather assets.

Suggested Reading

Mutual Fund Class B Shares: Good Buy or Goodbye?

3 Pitfalls of Mutual Funds and How You Can Avoid These Pitfalls

Hope You Like Paying 12b-1 Fees

The Wall Street Journal ran an article a couple of days ago regarding mutual fund fees. The WSJ outlines the topic quite well. I recommend reading the Mutual Fund Fee Debate Heats Up.

The article discusses the debate of total fund fees. Many industry observers, advisors and individuals believe that mutual funds carry unnecessarily high hidden fees. Investors deserve to understand fund fees, and they should try to get their arms around these so-called hidden fees, but they deserve to understand the truth about fund fees with no embellishment from folks who have an ax to grind. Let's take a closer look at the total fees of mutual funds as discussed in this debate.

On one side of the debate is KaChing. The assertion by KaChing that actively managed mutual funds cost 3.37% per year is simply not useful. Why? Well, for starters, if you have money to invest, you will not invest across all actively managed funds (there are more than 8,000 mutual funds including index funds). Instead, investors will screen for mutual funds based on several factors including expenses.

Hopefully you get my point that averages do not matter. Would you base your decision on buying a car on the average cost of available cars in the universe? No, you might ignore the cost of a Bugatti Veyron (you can pick one up for $1.7 million), among others. There are many, many inexpensive mutual funds that one can buy. Investors should not be swayed from mutual funds due to this so-called average fee.

Also, if you own mutual funds within a tax-deferred retirement account (e.g., 401k, IRA), then you can ignore the 3.37% total fee. The study quotes that .94% of the 3.37% is a result of "embedded tax liabilities." Retirement plan investors can ignore this .94%. They are not affected by these embedded tax liabilities. There are several other problems with assuming such a high cost of these embedded tax liabilities. Tax-loss harvesting, the addition to your tax cost of cap gain distributions, planning for cap gain distributions, and investing in tax-efficient funds are a few reasons we should dismiss this assertion.

Several other numbers stand out. The marketing fee (12b-1 fee), front-end loads and back-end loads total 1.07%. An informed investor can easily avoid these sales-type charges.  So, with these expenses taken out of the equation, and excluding the embedded tax liabilities, average mutual fund fees stand at 1.36%.

The 1.36% might be a number that is closer to a starting point, but, then again, the economies of scale are not taken into consideration (as pointed out by ICI in the WSJ article).

Tell me what you think about the WSJ article and fund fees. You can email me or leave a comment below. The assertions made by various product pushers (and industry groups in favor or not in favor of mutual funds) deserves more attention and more critique.

Articles of Interest

Understanding Fund Fees