Unbundling the Expense Ratio: Hidden Distribution Costs in European Mutual Fund Markets

• DOI: http://doi.org/10.1111/eufm.12078
• Author: Giacomo Nocera,Marco Navone
• Date: 01 September 2016
• Published date: 01 September 2016

Unbundling the Expense Ratio:

Hidden Distribution Costs in

European Mutual Fund Markets

Marco Navone

University of Technology Sydney, Business School, Ultimo NSW 2007, Australia

E-mail: marco.navone@uts.edu.au

Giacomo Nocera

Audencia –PRES LUNAM, Centre for Financial and Risk Management, 8 route de la Joneli

ere, Nantes,

44312, France

E-mail: gnocera@audencia.com

Abstract

Using data on more than 5,000 mutual funds domiciled in four European countries

in 2006, we investigate whether distribution costs embedded into the expense ratio

can be held responsible for the differences of expense ratios of mutual funds in

different countries. We confirm the existence of relevant country effects in the

pricing of mutual fund management services. Comparing load and no-load funds

and using survey data on fee retrocession to the distribution channel, we provide

evidence that these effects are heavily influenced by the cost of the distribution

embedded in the expense ratio.

Keywords: mutual funds, expense ratios, distribution costs

JEL classification: G11, G23

1. Introduction

A recent empirical stylised fact d ocumented by academic researc h on mutual fund

fees is the presence of relevant count ry effects not fully explained b y observable

The authors thank an anonymous referee for constructive and extensive comments. They

also thank John Doukas (the Editor), Andrea Beltratti, Donato Masciandaro, Marco Onado,

Andrea Resti, Alessandro Rota, and other participants at the Paolo Baffi Centre Seminar at

Bocconi University (Milan), Apostolos Kourtis, and other participants at the Financial

Engineering and Banking Society Conference (Paris), Emilia Garcia-Appendini, Giovanni

Puopolo, and Gerry Drives for helpful comments and suggestions. Finally, the authors

would like to thank Clara Galliani for excellent research assistance. All errors remain those

of the authors. Financial support from the Paolo Baffi Centre of Bocconi University is

gratefully acknowledged.

European Financial Management, Vol. 22, No. 4, 2016, 640–666

doi: 10.1111/eufm.12078

© 2015 John Wiley & Sons, Ltd.

differences (such as size, co ncentration and maturity) in t he national asset

management industries. K horana et al. (2009) show that, depe nding on the country

where an investor lives, the pr ice paid for a similar mutual f und can be 100 basis

points higher or lower. The aut hors try to reconcile these di fferences showing that

factors such as the investor protection guaranteed by the national regulations and the

sophistication of the aver age mutual fund investor, af fect the cost of investing in

mutual funds. They also find that less obv ious factors (such as the concentr ation of the

national banking industry) play a role. They finally show that these effects may persi st

even among highly integrat ed national financial systems, such as most of the Europ ean

countries.

In this paper we argue that the analysis of these country effects is made harder by the

fact that in many countries management and distribution costs are bundled together with

production costs (portfolio management, administration, etc.) in a unique measure of

annual operating expenses, the so-called ‘expense ratio’, and cannot be observed

separately. Using a sample of 5,357 mutual funds registered in four European countries

(France, Germany, Italy, and United Kingdom) in 2006, we confirm the existence of

relevant country effects and show that they are largely due to differences in the national

costs of mutual fund distribution services.

According to Cerulli Associates (2005), mutual funds in the four countries analysed

are sold through a significantly different mix of distribution channels: for example,

independent financial advisors account for 47% of the market (measured on the total

assets under management) in the UK, while they account only for 4% in the French

market (9% in Italy and 11.4% in Germany). Similarly, the Italian market is found to be

dominated by commercial banks that distribute 65% of the funds (but only 28.2% in

France and 8% in UK). Lastly, charity/endowment organisations and corporate divisions

managing pension obligations account for 26% of the French market, but are absent in

Italy and Germany.

Such a different channel mix is bound to generate different distribution costs

regardless of what happens on the production side of the national asset management

industries. Where distribution costs are paid separately from the expense ratio, we can

easily compare production costs of mutual funds across different countries, but, when all

the cost components are lumped together, it is harder to evaluate the ability of investment

companies to produce managed portfolios competitively. This opacity is generated by

the common practice in Europe to remunerate the sales channel not only through explicit

one-time fees like front- and back-end loads, but also through the retrocession to the sales

channel of a portion of the management fee. A periodic remuneration of the sales channel

is not unknown in the US experience, but in that setting an explicit fee, the so-called 12-

b1 or ‘distribution’fee, is charged, whereas the same information is kept confidential in

Europe.

As anecdotal evidence, it is interesting to mention that the Investment Funds Institute

of Canada formally complained to the authors of Khorana et al. (2009) about the reported

evidence of Canada having a more expensive asset management industry with respect to

a large sample of other countries. Among other issues, the complaint stated that: “Recent

research conducted in the Canadian funds market showed that 85% of Canadian

investors purchase their funds through an advisor [...] The greater use of advisors by

Canadian investors compared to the United States leads to a very different mix of

business and price structure.”And also that: “It is very rare in Canada for additional fees

to be charged over and above the MER [expense ratio, authors’note] by either the fund

© 2015 John Wiley & Sons, Ltd.

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