Taking Costs of Funds Out of Baking Cake
July 27, 2012
Sy Sacks is on a crusade.
He believes that the costs of putting together and operating a mutual fund aren't being shared equally.
And he wants to do something about it.
The former financial consultant for Merrill Lynch and Bear Stearns, who also once served as a vice president at Ladenburg, Thalmann & Co., has patented an algorithm that attempts to rectify the wrong. Naturally, he wants to license it to mutual funds, because he thinks it will benefit both the operators of and investors in the funds.
Here's the deal, by his calculations:
Investors who buy into funds at the outset get shortchanged. They may put $20 million into a fund. But they may wind up with a net asset value of only $19.9 million, because they have to front the brokerage fees that the fund has to pay to buy the securities that it will hold.
"It's baked into the cake, on average,'' said Sacks.
Future shareholders should share those costs. And shareholders who move in and out of funds repeatedly, in particular, should pay for the churning they create.
So, he proposes that the commissions that are amassed get added to the net asset value per share of a mutual fund, before the next purchase of shares in the fund.
That way, no one gets a free ride and everyone shares equally in the expense.
By his estimation, this procedure would save existing mutual fund shareholders roughly $10 billion a year.
So Sacks, now retired, has developed what he calls the Sacks Equalization Model and embedded in a mathematical algorithm that can be used to calculate a daily surcharge per share that would cover the fees.
The basic math:
The Fund Opens Up: Original investors in a new mutual fund buy 1,000,000 shares at $20.00 per share. The mutual fund manager invests the full $20,000,000 on the first day. The stock brokerage fees to assemble the portfolio total three-tenths (.3%) of a percent. The net asset value per share at the end of the trading day is $19.94.
The Problem: Invests buying shares the next day pay only $19.94 per share, avoiding the cost of assembling the original portfolio. In addition, the costs generated from investing money put in by the new shareholders are borne by all shareholders. This increases the cost to the original shareholders.
The Sacks Solution: Put a surcharge of .3% on every investment, to pay for the brokerage fees. This would keep the share price at $20.00.
That's a representation. Sacks says the percentage charged would change daily, based on the actual brokerage fees that pile up each day.
Mutual funds, he contends, would derive other benefits from using the algorithm that embodies this model. Most notably, he believes the performance of a fund that charges directly and equally for brokerage fees would experience a half-percent to full percent of increased return on assets held, each year.
The surcharge would discourage short-term investing. Firms or individual investors moving in and out of funds repeatedly would see their costs increase, proportionally.
Also, portfolio managers would be discouraged from turning over their holdings needlessly. Sacks asserts that portfolio turnover is more than 100% a year, on average.
So far, Sacks has not succeeded in licensing use of his patent to any mutual fund complex.
That may be due to the chicken-and-egg fact that there is not yet any empirical evidence that the performance of funds that use the formula will get better returns on their assets. Because no funds are using it and tracking results.
Sacks points, however, to academia for an initial proof point to his argument.
He cites a paper published in May by Miles Livingston, the Bank of America professor of finance at the University of Florida, and David Rakowski, associate professor of finance at Southern Illinois University, on the effect of transaction costs on the value of fund shares.
The paper, titled "A New Method for Computing Mutual Fund Net Asset Value in Light of Liquidity-Induced Transaction Costs,'' specifically analyzes the Sacks Equalization Model and its "simple algorithm for requiring new purchases and redemptions to bear the costs of providing liquidity to the fund."
The paper notes that adoption of the model by a mutual fund would increase the cost to new investors and increase investors' redemption costs, with the additional monies going into the "general assets of the fund."
For new inflows and redemptions, it says, the general assets of the fund would not have to be used to pay "portfolio adjustment costs."
"This arrangement is far more equitable for shareholders who do not trade in and out,'' the professors write.
This has two advantages, they say.
First, the long-term investors do not bear the costs of adjusting the portfolio for inflows or redemptions.
Second, mutual funds can reduce the cash they keep on hand.
And, third, "since the returns on equity are higher in the long run than the returns on holding cash, long-term investors should benefit by the higher returns" generated by keeping cash balances down.
The paper estimates that the brokerage commissions and "market impact fees" incurred by existing shareholders in mutual funds in a given year are somewhere between $10 billion and $17 billion. That does not count, the professors say, the lost returns from funds carrying excess cash.
The overall costs of handling inflows and redemptions is much larger, they contend, but do not stipulate a figure.
They note, however, that total inflows and redemptions in 2010 were $36 trillion, using figures from the Investment Company Institute's 2011 industry factbook.