Tacoma, Washington (PRWEB) November 19, 2012
Hidden costs are one of the best kept secrets in the mutual fund industry.
Now, a new research paper points out that investors in equity funds are incurring trading and market impact costs of up to $ 10 billion annually and considerably more if you include all mutual funds. This is due to the current unfair pricing of mutual fund shares.
In practice, new, liquidating shareholders in mutual funds are not paying their portion of trading commissions that are deducted when they build their current portfolios. But the way the fund industry is structured, long-term buy-and-hold investors assume these costs over time, thus transferring their wealth to new and liquidating shareholders, many of them who are short-term traders. As a result, wealth is transferred to new and liquidating shareholders, many of whom are short-term traders.
In practice, long-term holders, many of whom are saving for retirement, pay an unfair amount of the portfolio brokerage and market impact costs. Shareholders who trade frequently should pay for the churning and the additional costs they create.
The most equitable solution is for the funds accrued commissions to get added to the funds net asset value (NAV) per share for new purchasers and subtracted from net asset value per share for liquidating shareholders.
But while this would be a fair practice for all shareholders, it is complicated by the fact that fund management companies are compensated based on the assets under management (AUM) of their funds. Since there are many high-frequency short-term traders, many fund companies recognize that correcting this problem could reduce fund AUMs, which, in turn, would reduce fund company revenues.
In the paper, http:// Mutual Fund Liquidity and Fiduciary Conflicts of Interest, professors Miles Livingston of the University of Florida, and David Rakowski, associate professor of finance at Southern Illinois University, address this important, but esoteric, problem and suggest that fund companies begin to charge fees for purchasing and redeeming mutual fund shares. These fees would then become part of the funds assets and compensate long-term, buy-and-hold investors, who provide liquidity for more active traders. This procedure reduces the incentives for the use of mutual funds as short-term trading vehicles, the professors write.
This proposal also addresses the conflict-of-interest that exists between portfolio managers and their non-trading fund shareholders. Because fund managers are compensated based on the funds AUM, long-term buy-and-hold, non-trading investors, who do not purchase or redeem shares, unfairly bear the majority of these costs, the paper states.
This conflict of interest between non-trading investors and trading investors exists because mutual fund advisers compensation is usually a percentage of net assets under management and because providing liquidity tends to increase the average amount of assets under management. But there is also a conflict of interest between advisers and non-trading investors. As a result the non-trading investors bear the cost and the advisers receive benefits from increased management fees – a clear conflict-of-interest.
But under existing fund industry practices, since buy-and-hold investors do not know the revenue generating role they serve in complex mutual fund organizations, they are compensated for their critical role. This is one way fund managers receive large salaries based on fund AUMs, which are being supported by passive, na