The Significance of Basis Points

Interest rates & fees are often calculated using basis points.
Interest rates & fees are often calculated using basis points.

During meetings with investor clients, it is common to see expressions of puzzlement when references are made to the term “basis points.” Unless your daily duties include dealing with accounting or financial matters, basis points is a term that is rarely encountered. Perhaps equally confusing is the definition of a “basis point.” Simply stated, a basis point (bp) is obtained by dividing 1% into 100 parts.

Why, you ask, should I be concerned by such a small, seemingly insignificant number? The answers are: a) because basis points are the fundamental units of measure for interest rates and fees; and b) because these points subtly add up to be significant and they are subtracted directly from the return of your investment.

All mutual funds include a management fee that is described as the “expense ratio.” This expense ratio must be clearly stated in the fund prospectus and fact sheet of every registered mutual fund. For example, the fact sheet of a popular mutual fund has an expense ratio of 0.29%. That’s 29 basis points and it represents what the mutual fund charges in order to manage the fund investments and operate the fund. At 0.29%, the fund receives a fee of $2.90 for each $1,000 of the net asset value of the fund.

Other fees common to mutual funds are sales charges (loads), redemption fees, broker fees and investment adviser fees. These fees are additive and it is common for them to accumulate to as much as 1.5% or more of the fund’s assets. (Remember 1.50% = 150 basis points). Still not impressed?

Let’s apply this to a real-life example. Assume that you invested $200,000 in each of two mutual fund portfolios. Both of them grow at an annual rate of 6% over a ten-year period.

Portfolio A has total expenses of 1.50% (150 basis points) and Portfolio B has total expenses of 2.0% (200 basis points). A difference in fees of only .50% (50 basis points) doesn’t sound like much, but the following results should get your attention as an investor. At the end of the decade, Portfolio A has a total value of $307,929 versus $292,651 for Portfolio B, for a difference of $15,278. The primary reason for this difference is that Portfolio B paid $11,710 more in fees. Viewed another way, Portfolio B had an effective annual return of 4.6% versus 5.4% for Portfolio A. As you can see, fees do matter, especially over the length of time an investment is held.

Let’s finish with an extreme but real example. At the end of September, the longstanding, well- respected manager of the PIMCO Total Return Bond Fund, Bill Gross, abruptly resigned his position as Fund Manager and Chief Investment Officer. This caused investors to redeem fund shares in September and October valued at $51 billion. The asset value of the PIMCO Total Return Fund valued at $293 billion as of April 2013 declined to $171 billion at the end of October 2014.

To stem the tide of redemptions, the new PIMCO managers are offering to reduce their fees for selected large accounts. In the case of the County Pension Trust for San Luis Obispo (SLOCPT), PIMCO has charged a fee of 50 basis points for the first $25 million, 37.5 basis points for the second $25 million, and 25 basis points thereafter. With total assets valued at $209 million, the annual fees amount to $616,250.

Under the new fee offering, a base fee of 5 basis points is charged for the total portfolio, plus a 15% (1500 basis points) participation fee for performance above the index for this fund. Deducting the base fee of $104,500 from the historic fee structure leaves a delta of $511,750. The “participation fee” is difficult to quantify, but it does represent significant risk for PIMCO and a huge benefit to Trust investors. For the year, PIMCO’s performance is below the index by -1.67% and is above the index by only +1.28% and +0.44% respectively for the past three- and five-year periods. This fee reduction creates a temptation for the pension trust adviser to stay with PIMCO and creates an extreme challenge for the new managers of the PIMCO Fund.

Point is: This article illustrates how important fund expenses really are, and in the case of PIMCO, that they are extremely significant!

by Kent Butcher, MBA
Kent is Vice President & C.O.O. at UPAL and is a Registered Investment Advisor Representative