I have written in the past that actively managed ETFs may be the game changer in the battle between mutual funds and ETFs.  When I have written such posts, I had equity ETFs in mind as opposed to bond ETFs. But it seems that these actively managed bond ETFs are picking up steam. Why?

There are several challenges that actively managed equity ETFs face that go beyond this post (e.g., holdings disclosure, track records), but more and more fund companies are launching actively managed bond ETFs. Eaton Vance is the latest to join this space --  joining Pimco, Blackrock , Grail, and others.

In the past, perhaps, more of the new bond funds would have been created under a "closed-end fund" structure as opposed to an ETF structure? This question cannot be answered, but we can make assumptions. It makes sense that the advantages of an ETF (e.g., features that allow new share creation that may reduce the impact of "discounts to NAV") may outweigh the advantage of a closed-end structure -- particularly with respect to bond funds.

Read More About ETFs vs. Mutual Funds

ETFs vs. Mutual Funds: An Active vs. Passive Debate

What Are Closed-End Funds?

"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

Morningstar has reported that Vanguard has filed "...an exemptive relief application with the SEC seeking the OK to launch an absolute return fund..."

I won't rehash Morningstar's article for you, but it's worth a read if you are a Vanguard investor -- or so-called "Bogle Head."  I have a mixed reaction to the possibility of the new fund (which would use traditional securities such as stocks and bonds, but which could also venture into futures contracts, currencies and other derivatives and non-traditional mutual fund strategies). 

My initial reaction (particularly due to Morningstar's headline mentioning "Vanguard" and "hedge fund" in the same sentence) was that Vanguard filed for the fund as pressure to introduce sexier products to its mix of passively and actively managed funds (I tend to like the ho-hum, conservative fund strategies).

Maybe they were chasing hot dollars that might migrate from the traditional relative return products to absolute return products; maybe Vanguard was attempting to broaden their investor base to more aggressive investors. 

After putting Morningstar's article aside, I decided to read Vanguard's exemptive relief application. Here comes the mixed reaction (the application didn't necessarily offer new information that Morningstar didn't report, but going straight to the source is always helpful). It appears Vanguard is brainstorming on how to build (and improve upon existing products) a more "endowment-like" strategy that may solve the income needs of retirees -- which is not only a huge market opportunity for fund companies, but a much needed product for investors.

 In other words, Vanguard is looking to add an additional strategy to their already existing Managed Payout Funds (look for more coverage on this product in a future article and blog post). This hedge fund we are mentioning would be owned across the three Managed Payout Funds (up to 20% of the Managed Payout Funds) as well as to private, high net worth investors.

Moving back to the Morningstar article, they quote Vanguard CEO Bill McNabb as saying, "We have been doing a ton of work to see whether it's something we can deliver in a consistent manner, and the jury is very much out at this point. It's not something we're going to do until we feel really great about it."

So, after spilling my initial reactions, I would sum it up as a plus that Vanguard is attempting to improve upon their line-up of products, meet investor needs and take it slow (referring to Bill McNabb's comments).

 Related Blog Post:

Be Cautious of Absolute-Return Funds

Last month, I highlighted a fund that made me go, "Huh?"  This month, I highlight a fund that makes me go, "Oh, my."

Before you read on, if you are a socially responsible investor, I will kindly direct you to About.com's Socially Responsible Investing site.

As for the rest of us, if you want to invest in your vices, or, uh umm, invest in other people's vices, there's a fund for you. As the name suggests, the Vice Fund (VICEX) invests in sin stocks.  

Directly from the summary prospectus, the Vice Fund will invest "...a significant portion of their revenues from alcoholic beverages, tobacco, gaming, and defense/aerospace. "  The majority of the fund's holdings will naturally end up in the consumer goods sector, but narrowly focused at that.

Why would any fund company create a fund such as the Vice Fund? Is it as odd, or interesting, as it may seem? Not really. It's not a novel idea.  It has been a long-held belief that sin stocks are recession proof. Why? Well, the thematic investors (investors looking to invest under a particular theme) will say that when the economy goes through a rough patch, people will turn to their vices -- creating a good investment opportunity for those who want to profit.

A combination of the sector concentration and the focus on sin stocks made me say, "Guns and gambling and beers. Oh, my."

And since the line that came to my head was taken from The Wizard of Oz, let's take another line from the movie. The Scarecrow said, "Come along Dorothy. You don't want any of those apples."

I have been told by many investors that the mutual fund prospectus is a colossal waste of trees. Others think that the prospectus is a waste of mailbox space, has a massive amount of difficult to understand information, and is, simply, something that is immediately tossed in the circular file.

Now, as of January 1, 2010, we will have relief of these unnecessarily long, complex statutory prospectuses. Mutual funds will now give investors a printed, short-form summary prospectus, written in plain English, along with the traditional full-length prospectus, available online.

So, rather than receiving three full-length prospectuses for that Vanguard 500 fund that you own in three different accounts, you will have the option of receiving email notifications that the prospectus is available online.

Aite Group has estimated that these new rules may save 42,000 trees, and more that $65 million in printing and postage.  The summary prospectus will satisfy the confused readers of the traditional prospectuses, the penny pinchers, and the environmentally aware.

Read More:

The Summary Prospectus

A Prospectus: The Owner's Manual to Your Mutual Fund

In a previous blog post, I asked what you thought was the most popular blog post of 2009.  As you can see below, posts with Vanguard in the title got the top two spots.

The biggest surprise to me was the post that generated the fifth most interest on the blog.  Maybe I can creatively link the last movie I watched to mutual fund investing? Then again, it may be more difficult to find the same inspiration from Alvin and the Chipmunks: The Squeakquel.

1. Vanguard Raises the Yellow Flag

2. Vanguard's New Funds -- Not for You

3. Game On: Mutual Funds vs. ETFs

4. Looking for Yield?

5. The Curious Case of Benjamin Button

Contango might sound like the next bop on Dancing with the Stars, but it's more closely related to mutual funds and investing than it is to song and dance.

As I have studied the CFA curriculum over the past several years, there were more than a few concepts that were less than interesting to me -- and a plethora of concepts that I thought were not pertinent to my day job. I have to admit that understanding more about contango and related concepts and calculations than I already knew, was simply something that I thought I could do without.  

But over the past year, fund managers (both mutual funds and ETFs) have been discussing a subtle risk for their funds. This risk is known as contango.

This week you might want to get your arms around the definition of contango (the boiled down version vs. the in-depth version) and over the next few weeks I will highlight why the concept should be of interest to mutual fund investors -- particularly investors who appreciate diversification.