Wall St. And Business Wednesdays: July 16, 2003: E-Letter To The Baltimore Sun and Jay Hancock Re: Nathan Chapman's Mutual Fund Fees

I read your article "Chapman neglected to repay trust" with great interest, having followed the rise of Nathan Chapman for many years, as the head of one of Black America's few publicly-traded firms. Setting aside the more sordid details of the controversy surrounding Mr. Chapman's indictment, I just wanted to address a point and challenge an implication in your interesting piece.

The portion I am referring to is :

Chapman's mutual fund, the DEM Equity Fund, standing for domestic emerging markets, was seen as a way to steer capital to minority- and women-owned firms. Much of the money sunk into it by institutional and individual investors was propelled by social concerns as well as profit-seeking motives.

But much of the cash never made it into minority-owned stocks. The DEM Equity Fund came with sales commission -- often called a "load" -- of up to 4.75 percent, and it charged a fat 3 percent in annual expenses on top of that. Numerous mutual funds charge no load, and the average expense ratio for U.S. small-capitalization mutual funds, DEM Equity's category, is 1.72 percent, says Lipper Inc.

I think your depiction is misleading.

First, I think you might be comparing apples and oranges. Of the nine categories of growth mutual funds, that I am aware of, none are identical to the domestic emerging market of minority and women-owned firms. Companies with small market capitalization may be the same size as some Black, Latino and Women-owned companies but they certainly do not necessarily have the same experience as it relates to access to capital and servicing untapped consumer markets in the minority communities. This creates both greater risk and reward for say, Black-owned companies than for the average small-cap company. Naturally, a fund dedicated to investing in Black companies would probably be faced with a different risk-to-reward ratio than one investing in small caps.

A second significant difference that grows out of the first, that you are missing is that many Black-owned firms are not being covered by stock market analysts. This makes it harder for these firms to attract investment as there is a correlation between the proliferation of available research on a company and the liquidity for its shares. The less coverage, the less likely a company is to have investors beating a path to its doors. [To see this reality one only needs to look at the illiquid market, characterized by extremely low trading volume for several of Black America's publicly-traded firms, (and read this Business Week article to see how this problem affects even a high-profile small-cap company like World Wrestling Entertainment (WWE) Note the statement by the research director, "When you get down to zero or one [analyst], it's hard for portfolio managers to buy the stock."] That is just how Wall St. works. This is related to DEM's "high fees" because the adviser for a fund that is investing in Black or Latino-owned companies is more likely to be investing in companies that lack analyst coverage. As a result, he or she will have to proactively supplement analytical coverage by paying for premium research, sometimes, hiring individuals to cover the companies, just for them. Through soft dollar arrangements (as part of a brokerage commission) the fund adviser would pay for these research services and annual expenses would naturally be higher than would be the case for the average small-cap fund.

A third factor that you don't mention is that because the DEM Equity Fund represents investments that may be considered riskier than the average small-cap fund, DEM might have to pay more in 12b-1 fees which take care of fund marketing and distribution expenses. Since approximately 80 percent of mutual fund purchases are created through the efforts and channel of broker-dealers or financial professionals like pension plan administrators and financial planners; getting these intermediaries to push a fund is important. How much more difficult might it be for a pension plan or financial planner to advocate a mutual fund specializing in firms owned by Blacks, Latinos and women? Sure, you can answer that there is an "affirmative-action" appeal for some intermediaries but Wall St. isn't the government and performance rather than political-correctness rules at the end of the day. For a Black-oriented mutual fund to get prime placement by intermediaries, it might cost more. Especially when one considers the lack of analyst coverage associated with the companies that make up the fund. Thus, such a mutual fund would naturally have higher 12b-1 fees (which are included in the expense ratio) or loads (financial professionals that market and distribute mutual funds can be paid through the sales charges - "loads" - paid by investors).

In light of these three factors I think it can be easily argued that Nathan Chapman's DEM Equity Fund's 4.75 percent load and 3 per cent annual fee are not as expensive as your article implies.

Using the Security and Exchange Commission (SEC)'s mutual fund cost calculator I compared the returns of the DEM Equity Fund with its 4.75% load and 3% annual fee, with that of the average small capitalization fund (according to your reference of Lipper, Inc. - the mutual fund value experts owned by Reuters) that might have no load and an expense ratio (an expense ratio is just the percent of total fund assets eaten up by annual fees) of 1.72% . I found that if one hypothetically invested $10,000 for three years in the DEM Equity Fund and did the same in your "average" small-cap fund - with both the DEM and small-cap fund returning 10% - the small cap fund yields $12,634.95 while DEM yields $11,570.66. But if the small-cap fund returns 10% annually, while DEM returns 13% the gap narrows to less than $100 as the DEM fund would yield $12,543.41 at the end of the holding period.

Certainly, with the higher fees and greater risk the DEM fund is more expensive but with untapped markets in the Black and Latino communities the expected return, over time, should more than provide ample reward for the risk. At a 18% annual return, a $10,000 investment in the DEM Fund would equal $14,283.22.

From what you write, it would follow that you should be able to come to the same conclusion that I have, regarding the different risk-to-reward ratio between a minority-company centered mutual fund and one that focused on the average small-cap company. But you use the mutual fund fee comparison to make a case against Nathan Chapman rather than for him (perhaps you don't understand how mutual fund fees are calculated and what influences them. Or, you missed or forgot the instructive example of the junk-bond era that found Michael Milken raising millions upon millions of dollars for Black entrepreneurs at high interest rates because these companies were considered "riskier" than the rest of the market).

Even though the mutual-fund fee portion of your article doesn't reflect it, you clearly understand the unique and ground-breaking path that Nathan Chapman was blazing when you write:

Chapman, an African-American, promoted himself as the advocate of minority investors and entrepreneurs.

His "domestic emerging markets" mutual fund invested mainly in companies owned by African-Americans, Asians, Hispanics and women. He advertised heavily on black-oriented radio stations, and he urged African-Americans "to save money and build wealth."

There is nothing wrong with scouting one's social web for commercial possibilities. It's a networked world, and more than a few white guys on Wall Street would be unemployed if not for alumni directories and golf courses.

...Many shareholders in Chapman's publicly traded investment companies, eChapman Inc. and its predecessors and affiliates, were people of color inspired by the story of a black financier walking the same ground as Rothschild and Morgan.

They believed Chapman when he said he would build a "black Merrill Lynch,"...

Mr. Hancock, the first U.S. investment trust - the precursor of today's mutual fund - was put together by Robert Fleming in the 1800s, when he gathered money from investors in Scotland and invested it in emerging enterprises in the U.S., sharing the profits with the fund's investors.

Look how long it took for Nathan Chapman, who started the DEM Equity Fund in 1998 to follow, as a Black man, in Robert Fleming's steps. Certainly such a monumental undertaking was, and still is worth a 4.75% load and 3% annual fee. No?

Well, then what fee schedule do you propose to produce the "black financier walking the same ground as Rothschild and Morgan", as you put it?

Be careful that you aren't trying to have it both ways in condemning Nathan Chapman.


Cedric Muhammad

Cedric Muhammad

Wednesday, July 7, 2004