In the 1980s, Charles Schwab changed the way investors shop for funds, introducing the supermarket.
The innovation's main attraction was its ease of use. Investors could scan through dozens of fund choices and select the ones they liked best without having to contact each fund seller separately to open an account.
Today supermarkets typically divide their wares into two categories: fee-bearing funds and the so-called no-transaction-fee (NTF) funds. Investors who stick with NTF choices can buy as many funds as they want — for free. In contrast, funds outside the NTF universe come with a charge for each purchase that can range past $100. Because of the apparent cost savings, NTF choices have become popular with many investors. But for advisors, NTF choices may not be the cheapest alternative.
“The NTFs don't cost anything to buy, but they can be more expensive over the long term because of higher annual expense ratios,” says John Woodard, president of Woodard & Co., a registered investment advisor in Winston-Salem, N.C.
Bargain Hunters Need Apply
While it is possible to find moderately priced NTF funds, few come with rock-bottom expense ratios. This is at least partly due to the basic costs of NTF programs. To be listed as an NTF choice, a fund must pay supermarket revenue-sharing charges based on the assets sold. At Schwab, the fee is 40 basis points. Fidelity charges 35 points, while TD Waterhouse imposes costs of around 25 points. That is a hefty price at a time when the average domestic equity fund comes with an expense ratio of 1.46 percent, according to Morningstar.
If the revenue sharing is so steep, why bother to pay? For fund companies, NTF supermarkets offer prime exposure to millions of customers. Schwab highlights top-performing NTF funds. The supermarkets hold conferences where they publicize funds and introduce portfolio managers to advisors. The exposure is particularly important for small fund companies that are hard-pressed to afford expensive marketing efforts.
Because of the costs of revenue sharing, big fund companies with their own strong marketing efforts tend to avoid the NTF markets. Companies that usually come with supermarket transaction fees include T. Rowe Price and American Funds. Dimensional Fund Advisors, which provides passive funds aimed at advisors, typically requires transaction fees. Few index funds can consider selling through an NTF program; the revenue sharing alone would make the funds costly compared to rivals that charge less than 20 basis points in annual expense ratios. Similarly, NTF platforms don't tend to offer institutional share classes, which come with low expense ratios in return for steep initial minimum purchases.
On the Plus Side
Despite the drawbacks, NTF funds can be worth considering. No-fee transactions are especially appealing for relatively short-term trades. And NTF programs feature retail share classes of some distinctive fund families with long track records for success. Popular NTF fund families include Julius Baer, Baron and Oakmark.
Many advisors suggest holding a mix of funds, including NTF and choices with transaction fees. “We often buy institutional share classes and pay the transaction fees,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Waltham, Mass. “But there are some strong performers on the NTF side that we will consider.”
Top-performing NTF families that Tiku holds include Marsico and Hotchkis & Wiley. His biggest position is a transaction-fee choice, the institutional share class of PIMCO Total Return.
The fund supermarket business is dominated by Fidelity and Schwab, which account for more than half of the $600 billion in total assets in the field, according to Financial Research Corp. (FRC). Other players include TD Waterhouse, Ameritrade and the DATAlynx unit of Fiserv. The biggest firms tend to lead the field in developing technology. “Schwab and Fidelity are the leaders in providing back-office support,” says Owen Concannon, an analyst with the FRC.
Smaller Can Be Cheaper
While the biggest companies may excel in making transactions and helping customers track their portfolios, the smaller companies often charge lower prices to funds and advisors. A big advantage of DATAlynx is that it permits an advisor to bundle many clients into a single transaction, says Richard Bennett, a partner with Savant Capital Management, a registered investment advisor in Rockford, Ill.
Bennett has bought shares in Vanguard S&P 500 index fund for 50 clients in one purchase. For the trade, he paid DATAlynx a single transaction fee of around $35. If he made the trade at Schwab, each of the 50 clients would be billed around $15 to $30. Because the DATAlynx transaction fees are so tiny, Bennett faces no pressure to bill clients for the trades. Instead, his firm pays the transaction fees. He charges clients a flat 1 percent of all assets under management, which includes holdings at supermarkets and elsewhere. “We prefer keeping trading costs down, and we don't need the bells and whistles that the big supermarkets provide,” he says.
DATAlynx remains a small force in the industry with $12.7 billion in assets. But the firm is growing and it could be particularly attractive for advisors who rely on 12b-1 fees. DATAlynx allows advisors to collect 12b-1 fees through the supermarkets. But Schwab and some other supermarkets don't pass the 12b-1 fees to advisors.
“Some advisors are losing tens of thousands of dollars in 12b-1 fees because the supermarkets aren't willing to send along the money,” says Dean Rodewald, vice president of advisory services for Fiserv Investment.
Whether or not more companies begin passing along 12b-1 income, the supermarkets seem likely to remain growing fixtures. According to FRC, more advisors are gravitating to supermarkets for the convenience and help in such matters as preparing complicated capital gains taxes. In 2004, Schwab's supermarket reported increasing its asset under management by $25 billion. And this year Schwab and other companies are reporting healthy growth. For advisors, a greater reliance on supermarkets could be a useful development, as long as shoppers keep a close eye on prices and insist on getting their money's worth.
|Fund||Category||Ticker||Expense Ratio||1-Year Return||3-Year Return||5-Year Return||5-Year % Rank in|
|American Funds Amcap A||Large Growth||AMCPX||0.73%||2.4%||4.7%||1.2%||2%|
|Dimensional U.S. Small Cap Value||Small Value||DFSVX||0.56||8.6||11.9||15.8||26|
|PIMCO Total Return||Intermediate Bond||PTTRX||0.43||6.1||6.4||8.3||5|
|T. Rowe Price Equity Income||Large Value||PRFDX||0.74||10.5||6.4||7.6||15|
|Vanguard Morgan Growth||Large Growth||VMRGX||0.44||4.1||4.6||-4.6||17|
|Source: Morningstar. Returns through 4/30/05|