In my first article on the issue of understanding mutual fund fees, I expounded on what management fee is, how to calculate it and how to reduce the burden by negotiating better rates if you are in a position to do so.
In the second article, I explained incentive or performance fee, what it is, why it is required, when and how it is calculated, as well as how to watch out for benchmark indexed incentive fees that may require you to pay the fee even when your fund loses money.
Although management and incentive fees are the two major components of a fund’s expense ratio, they are by no means the only fees that investors should worry about when investing in mutual funds. Among the other fee components of the expense ratio, which I have decided to classify as miscellaneous fees, are Administration fee, Audit Fee, Legal Fee, Custody Fee, Investor Services fee, Tax fee, and a lot more. The need for these miscellaneous fees arises from the fact that fund managers, in an attempt to focus on fund management functions, utilize the services of multiple third-party service providers to get their job done to the satisfaction of their investors.
Not all funds, however, charge all the miscellaneous fees because those fees depend on what services the fund manager engages a third party to render. I will explain all or some of the miscellaneous fees below.
Administration Fee: Some fund managers, especially those in more advanced and developed markets, engage the services of third parties called fund administration companies, to do much of the fund accounting and operations functions of the fund managers. Such fund administration service providers carry out such functions as position, cash, dividend, interest, and other reconciliations for the fund managers. The operations arms of such fund administration services providers book the trades for fund managers by essentially keeping the books for the fund managers.
The synergy here is that by outsourcing such functions to fund admin service providers, fund managers can concentrate their time and effort on conducting investment research aimed at uncovering mispricing and selecting “profitable” investments without worrying about the operations part of their functions.
Expectedly, the fund administration services providers charge for the services, and it is that charge that is classified as Admin fee in the calculation of a fund’s expense ratio and in a fund’s financial statement.
Most admin fees are charged based on the Net Asset Value (NAV) of funds. Notable Fund Administration companies worldwide include Citco Fund Services, SS&C Technologies, JP Morgan Fund Services, and State Street Fund Services. Fund managers in Nigeria do not seem to be outsourcing their operation’s functions, at least for now. As such, they do not seem to charge admin fees.
Custody Fee: For your protection as a mutual fund investor, it is required that the fund management and the fund’s assets remain with separate entities. It is this separation that created the need for someone or an entity that will safeguard and protect a fund’s assets. That entity is the custodian.
Custodians are those financial institutions that are engaged to render safekeeping services for fund managers, among others. Ordinarily, when you invest in a mutual fund, the fund manager uses your investment to buy stocks, bonds or any other financial instrument that the fund’s prospectus, its investment policy or strategy, and Government regulation allows it to buy. After buying the financial instruments, the fund manager receives the physical certificate if required. Where no physical certificate is involved due to dematerialization, the securities bought are “kept” in a custodial account with a custodial bank.
The custodial bank ensures that the assets are safe, collects the dividends and interests arising from the assets, handles any corporate actions like stock splits, spin-offs, and making elections for cash or stock, based on fund managers’ instructions if there are mergers and acquisitions.
Again, as expected, such custodial services are paid for. It is this custody fee that forms part of the total expense ratio of a fund. You will see this expense in the income statement of your fund if you look closely. However, you will not see it on your investor statement.
According to the Central Bank of Nigeria’s list of Licensed Custodians, there are eight licensed custodians in Nigeria: First Pension custodian, UBA Nominee, Stanbic Nominee, Zenith Pension custodian, Diamond Pension Custodian, FCMB Nominee, Nigeria International Bank Nominees Limited, and Standard Chartered Nominees Limited. They have an association, the Association of Asset Custodians of Nigeria.
Audit Fee: You may have seen some of the audited financial statements of the mutual funds on the websites of the fund managers or as one of the releases by the Nigerian Stock Exchange. The auditors attest to whether the financial statements are prepared in accordance with the required accounting principles, standards, and other modifications. Though it is not the responsibility of the auditor to prepare the financial statements, their opinions, when unqualified, add credibility to the financial statements and give the investor some rest of mind. Like fund admin service providers or custodians, auditors need to be paid and that is where audit fee, as part of the expense ratio comes from.
Accounting Fee: Some fund managers engage the services of accounting services providers to prepare the annual financial statements of their funds for them. Financial statement preparation is not as easy as the three major reports that are known as the Statement of Assets and Liabilities or Balance Sheet, Statement of Operations or Income Statement, and Cashflow statements. Those are actually the final product of a series of reports, schedules, and reconciliations usually done at the back, not to talk about the accounting footnotes that have to be made in compliance with relevant accounting standards and pronouncements. As these standards and pronouncements change, the content and presentation of financial reports follow suit. These services are paid for as accounting fee.
Legal Fee: When a fund is given birth to by the fund manager, it involves a series of legal drafting of the prospectus and other partnership agreements. In some cases, this is paid for from the proceeds of initial subscriptions to a fund. Often times, fund managers also retain some law firms or lawyers on an ongoing basis so that they can be handy for legal advice and services when the need arises. This is more so in litigious societies like the US and in markets with complex securities, trading laws, and regulations like insider trading rules, wash sells, hot or new issue rules, etc. The payment for this retainership gets translated into the expense ratio as legal fee.
Now you Know: There are still other fees like investor services fee, pricing or market data fee, (paid to such entities like Bloomberg, Reuters or the Nigerian Stock Exchange, MarkIT or Factsheet). These may be charged depending on if the service providers are used. Now you know what you are paying for by investing in mutual funds.