Determining a Mutual Fund’s Advisory Fee

Price, for a mutual fund, is expressed as the fund’s expense ratio, defined as the sum of a fund’s expenses divided by the fund’s net assets. The advisory fee, paid to the adviser for managing the fund’s portfolio, is one component of a fund’s expenses.  As adviser to a mutual fund startup, you have likely given some thought to advisory fees. If you are already managing the proposed portfolio strategy in another structure, such as an SMA or private fund, you may even have a benchmark for advisory fees in mind.

But there are other factors to consider in setting the advisory fee. Chief among these is the fund’s board of trustees, which has a duty to shareholders to ensure that expenses borne by the fund are reasonable.  For example, as adviser you want to set an advisory fee that allows you to make a profit but also sustains the fund. The trustees want that too, but they also expect you to pass along some of the economies of scale the fund may realize as assets reach certain levels. To that end, the trustees may ask you to consider adding breakpoints to your fee schedule.

If the advisory fee you propose for the new fund differs significantly from the fees for a similar product you manage, such as an SMA with the same strategy, the board’s trustees will expect you to be able to explain and justify that difference.

The trustees will also expect the new fund to be competitive with its peers and fair to shareholders. The trustees will review your advisory fee against a peer group independently identified by a rating agency such as Lipper or Morningstar. If your fee is higher than your peers, you will be asked to explain why.

After an in-person meeting with the board, the trustees will approve the advisory fee for an initial two year period and annually thereafter. You may lower your advisory fee with board approval. If, however, you want to raise your advisory fee, a shareholder proxy is required.

Mutual Fund Operating Expenses and Expense Limits

Fund assets may be used to pay other expenses of the fund, such as administration, audit, custody, and other mutual fund service providers.  These operating expenses may be asset-based or fixed, and are included in the calculation of the fund’s expense ratio. This ratio may be subject to a limit, or fund expense cap, as defined in an expense limitation agreement between the board and adviser. Expenses up to the cap, but not greater than the cap, are paid by the fund.

The factors that you and the board will consider when setting the expense cap are similar to those for the advisory fee.  Certain funds are more costly to operate and therefore a higher expense limit may be justified.  You should also be able to justify any difference in net expenses between the new fund and any similar product that you manage. Finally, you should be able to show that expense ratios for the new fund are competitive with its peers.  The board will perform these comparisons as well.

If you plan to offer the fund through intermediaries, you should take steps to ensure that the new fund will pass through the intermediaries’ expense ratio screens.  For example, certain intermediaries may only offer products with an expense ratio less than 100 basis points.  If you are planning on setting your expense cap at 100 basis points, you may want to reconsider and set it at 99 basis points so that the new fund will be offered to investors.

When a fund is small, between $15 million and $25 million, the expenses allowed by the fund’s cap will be less than actual fund expenses.  The fund’s adviser, or sponsor, will waive the advisory fee, all or in part, to reduce fund expenses.  If this waiver does not reduce the expenses to meet the expense cap, the adviser or sponsor will reimburse the fund for the remaining difference to bring net expenses below the cap.

Break-even assets, defined as the level of assets where the adviser no longer reimburses the fund, will vary depending on the fund’s advisory fee, expenses and expense cap, but generally range from $15 million to $25 million. Full-fee assets, when the fund’s expense ratio is less than its cap and the adviser no longer waives any portion of its fee, will also vary widely depending on the advisory fee, expenses and expense cap. The low end of the range is $100 million.

12b-1 Fees

12b-1 fees are asset-based fees which are charged to a fund at the share class level. They are used to pay for the services of financial intermediaries as well marketing and sales.  12b-1 fees are included in the expense ratio and increase it. Whether you decide to charge 12b-1 fees will depend on the investor you are targeting and how you plan to structure the share classes.  A basic fund structure may include an institutional share class, which typically does not charge a 12b-1, and a retail share class, which does. The fee for the institutional share class without a 12b-1 may be capped at 99 basis points, for example, while the retail share class might include a 12b-1 fee of 25 basis points, resulting in a fee cap at 124 basis points.

Summary

Pricing your fund to cover costs and allow for profit while treating fund shareholders fairly is essential to your success.  Mutual fund service providers, such as Apex Fund Services, are ready to work with you as adviser to a mutual fund startup to provide transparency into fund expenses and guide you through the board approval process.

To learn more about launching a mutual fund and determining your advisory fee and expense cap, please contact Jessica Chase at 207 347 2016 or submit an inquiry via Contact Us.