Effects of Sales Expenses and Management Expenses on Mutual Fund Performance and Flows

• DOI: http://doi.org/10.1111/ajfs.12082
• Author: Juil Ban
• Date: 01 February 2015
• Published date: 01 February 2015

Effects of Sales Expenses and Management

Expenses on Mutual Fund Performance and

Flows*

Juil Ban**

College of Business Administration, Sangmyung University

Received 24 August 2014; Accepted 4 December 2014

Abstract

By distinguishing the types of expenses in mutual funds, we examine the effects of sales

expenses and management expenses on mutual fund performance and flows using Korean

data. We find that a 1 basis point increase of management expenses is associated with a 2.3

basis point increase of risk-adjusted performance in terms of annual gross returns, whereas

higher sales expenses are not related to better performance. This indicates that management

skills cover and exceed management expenses, while sales expenses are overpriced. In addi-

tion, the results show that a 1 basis point increase of sales expenses is related to a 5.2 basis

point decrease of annual fund flows, but such a negative relation does not exist between

management expenses and flows. These findings indicate that fund investors eventually learn

to avoid excess sales expenses.

Keywords Sales expense; Management expense; Fund performance; Fund flow; Investor

learning

JEL Classification: G20, G23, G28

1. Introduction

It is well known that, on average, active mutual funds underperform passive bench-

marks. In addition, there is no clear evidence that high-fee funds are associated with

superior performance. Despite these results, why do investors keep buying high-fee

active funds?

1

This paper intends to shed more light on this issue. We hypothesize

*I would like to thank the Editor, the Associate Editor and two anonymous referees for their

valuable comments and suggestions. This work was supported by the National Research

Foundation of Korea Grant funded by the Korean Government (NRF-2014S1A5A8015333).

**Corresponding author: Juil Ban, College of Business Administration, Sangmyung Univer-

sity, 20 Hongjimun 2-gil, Jongno-gu, Seoul 110-743, Korea. Tel: +82-2-781-7586, Fax: +82-2-

2287-0059, email: ban9415@smu.ac.kr.

1

The phenomenon is referred as the high fee fund puzzle. For potential explanations, see Car-

lin (2009), Choi et al. (2010), Bailey et al. (2011), and Anagol and Kim (2012).

Asia-Pacific Journal of Financial Studies (2015) 44, 129–173 doi:10.1111/ajfs.12082

©2015 Korean Securities Association 129

that this puzzling phenomenon arises not because aggregate fund managers lack suf-

ficient skills to offset management expenses

2

(or fees) but because the fund industry

charges fund investors excessive sales expenses through marketing. This idea is

based on the United States 12b-1 fee (sales expense in the United States mutual

fund industry) controversy that has attracted the attention of the media, practitio-

ners, and financial regulatory authorities.

In 1980, the United States Securities and Exchange Commission (SEC) approved

Rule 12b-1, which allows mutual funds to deduct sales expenses directly from fund

assets. The primary argument for the adoption of the rule was that it offers brokers

incentives to sell funds and increase fund size, leading to economies of scale that

ultimately benefit investors. However, there is scant evidence that the 12b-1 fee

helps investors (Bergstresser et al., 2009). Interestingly, the Korean mutual fund

industry has encountered a sales expense controversy similar to that of the United

States 12b-1 fee. Through the media, suspicions have arisen that sales expenses are

too high in that sales expenses are about two times larger than management

expenses.

3

The Korean Financial Services Commission (KFSC) also seems to con-

sider sales expenses excessive. In December 2009, the KFSC amended the Capital

Market Act to limit fund sales expenses at 1% per year (down from the previous

limit of 5%).

4

The purpose of this paper is twofold. First, we investigate how sales expenses

and management expenses differently affect fund performance. The intuition be hind

the different effects on performance is based on the incentives of managers and bro-

kers. Given their profit-maximizing objectives, managers have incentives to improve

the returns of high management expense funds due to investor return-chasing

behavior. Managers’ incentives can be linked to greater managerial efforts. Brokers

also have incentives to sell high sales expense funds to maximize profits. If brokers

have the ability to select a good fund, high sales expenses can be rationalized. How-

ever, we expect that their incentives would have little effect on the management of

the fund itself because sales expenses are only sales incentives.

2

Although the term expense is used interchangeably with fee in the literature, we interpret fee

as a broader concept that includes expenses and sales loads. Fund expenses are gradually

deducted from the fund’s net assets as indirect payments. In contrast, sales loads are one-

time fees (deducted in a lump sum) paid by investors directly. Table 1 shows typical fund fee

structures.

3

The Korea Economic Daily, an influential economic newspaper in Korea, reports as follows

on 8 June 2009. “In 2008, fund sales companies accounted for 62.7% of total expenses in the

Korean fund market and the average sales expense ratio was 1.23%. This figure is far higher

than that of US where the maximum sales expense (denoted as 12b-1 fee) is 0.75%. Gener-

ally, more than 70% of total expenses are distributed to fund management companies in

developed countries.”

4

The announced purpose of the amendment was to improve investment performance, under

the judgment that fund sales expenses were extremely heavy. It is noteworthy that no limit

has ever been set on fund management expenses since the passage of the Capital Market Act.

J. Ban

130 ©2015 Korean Securities Association

Table 1 Typical fund fee structures

This table shows typical fund fee structures. The total fees are the sum of total expenses and the amortized total loads calculated as (total expenses +total loads/X

years) under the assumption that the average investment period is X years. Loads are one-time fees charged to investors at the time of purchase or sale (redemption)

but expenses are deducted every business day directly from fund assets. Total loads are the sum of front-end and rear-end charges as a proportion of new investment.

Total expenses are the sum of management, sales, and other expenses. Management expenses are the compensation for fund management companies. Sales expenses

are the compensation for brokers. Other expenses are the compensation for third parties responsible for other mutual fund-related businesses. All expenses are

expressed as annual expense ratios.

Major categories Sub categories Beneficiaries

Legal or voluntary

restriction (United

States)

Legal or voluntary

restriction (Korea)

Total fees Total loads Front-end Loads (sales

charge on purchase)

Selling brokers SEC : none

FINRA : maximum

8.5%

Capital Market Act

(2009.12): maximum

5% ?2%

Back-end Loads (defferred sales charge)

Total (operating)

expenses

Management expenses Management companies

(mutual fund advisors)

Sales expenses (12b-1

fees)

Selling brokers SEC : none

FINRA : maximum

0.75%

Capital Market Act

(2009.12) : maximum

5% ?1%

Other expenses Agencies responsible for

Custodial, Legal,

Accounting, and other

administrative business

affairs

Sales Expenses and Management Expenses

©2015 Korean Securities Association 131