The Cost Of Mutual Funds Vs. SMAs

Most of the advisors I have spoken to who "can't justify the fees" associated with SMAs develop portfolios for their clients using mutual funds. Some use mutual fund wrap programs, and some take a do-it-yourself approach: selecting funds, constructing portfolios and producing performance reports themselves. In comparing these alternatives to SMAs, it is very important to make sure that the comparison is done on an apples-to-apples basis. Many comparisons I have seen are not.

Let's look at mutual fund wrap programs first. There are four components to the cost of these programs that roughly equate to the four components of the SMA fee. The first is the expense ratio of the funds that are used in the program. The expense ratio covers the cost of investment management and certain other fund expenses. The average expense ratio for a domestic equity fund is somewhere between 125 and 145 basis points. Of course, there are outliers on both sides, just as there are with SMAs.

The next component is the program sponsor's fee. Sponsor fees for mutual fund wrap programs typically range from 20 to 40 basis points, a bit lower than for SMA programs. In some cases the sponsor's fee is buried inside the fund expense ratio and is not broken out separately. But be assured, whether you see the fee broken out separately or not, the program sponsor is being paid for its efforts.

Investors who use mutual fund wrap programs also pay for brokerage and custody. The cost of brokerage and custody usually falls in the 10-to-25 basis point range, in the aggregate. The first part of this cost consists of brokerage costs incurred by the funds when they purchase and sell securities. This cost can be hard to determine because it is never shown on a program's fee schedule and is not even included in the fund's expense ratio. But a fund's brokerage expenses are an actual cost to the fund's shareholders. Custody charges are usually easier to determine because they are often stated separately in a program's fee schedule and are visible on the client's monthly statement.

As with SMA programs, advisors are usually paid around 100 basis points for their services in connection with a $250,000 mutual fund wrap account. This fee covers the advisor's ongoing advice and consulting services to the client.

How do these expenses compare with the cost of using SMAs?

Well, using these figures, the total cost of the typical mutual fund wrap program would range from 255 basis points on the low side to 310 basis points on the high side. The fact is, however, that most mutual fund wrap programs use funds that have below-average expense ratios. For this reason a fairer range is probably somewhere in the area of 215 to 250 basis points.

But wait! That means that the cost of using a mutual fund wrap program may be about the same, or maybe even a little higher, than the cost of using an SMA. And the SMA has customization, tax and transparency benefits that mutual funds don't offer. Maybe SMAs aren't so expensive after all.

Now let's compare them with the cost of the do-it-yourself approach, where the advisor builds the mutual fund portfolio herself and there is no program sponsor to pay. If we subtract the sponsor fee from the equation and continue to use the average fund expense ratio, the total cost of using mutual funds ranges from 235 to 270 basis points. If we use a lower expense ratio, say 85 basis points, and assume a low brokerage and custody cost of 10 basis points, the cost of the do-it-yourself approach might be as low as 195 basis points. But a more realistic brokerage and custody fee is probably in the 15 to 20 basis point range, putting the cost of the do-it-yourself approach closer to 200 to 205 basis points-about the same as using an SMA. And the advisor using the do-it-yourself approach doesn't get any of the services that the SMA program sponsor provides.

So What's The Point?

The point of this exercise is not to prove that SMAs or mutual funds are superior to the other based on price. Rather, the first point is to give you a framework for comparing SMAs to other investment vehicles on an apples-to-apples basis. You can plug your own variables into the equation, but I think you will find that most SMA programs are reasonably priced relative to the alternatives.