Fund Fees at Online Brokers -- What's Too Much?

The topic of fees charged by online brokers on mutual fund sales has generated a feisty debate among readers of the What Works column.

The response followed a column about which of the big online brokers was best for mutual fund investors. E*Trade prevailed, though only relative to the others. No broker aced all criteria.

In addition to the fees subject, readers also wrote in about other fund investing features they care about, like minimum investments. And they suggested a look at fund programs of brokers not yet reviewed.

I will address these issues in three parts. Today's column is about fees for funds at online brokers. Friday's column will discuss additional features and services online mutual fund investors care about. And Monday's column will size up the fund offerings at several online brokers, including Vanguard, Web Street, Scottrade and others.

As always, let me know what you think with an email to [e-mail]. Please include your full name.

The What Works Approach

Before I get to fee nitty-gritty, readers' reaction to mutual fund fees provides a much-needed opportunity to explain how the What Works column works. When I research a topic, say online portfolio trackers, stock screeners, wireless trading services or mutual fund programs, I solicit reader input, do my own legwork and then offer my view on which service works best for online investors.

But "online investor" is a catchall phrase. Some folks are beginners, some advanced, some buy-and-holders, some in-and-outers. Different investing styles lead to different priorities in tools and services. So while you'll get my conclusions about "what's best," you'll also get the research behind those conclusions. This way you can weigh the conclusions against the factors that you care most about. When What Works works, you find the service that suits your needs.

An Example: The Fund Fees Debate

A perfect example is readers' reaction to the fees brokers charge for trading funds. I praised E*Trade for its competitive and simple fee structure for buying and selling funds, both long-term and for customers who move in and out of funds more quickly. E*Trade is more costly than brokers like Datek and Ameritrade but cheaper than Schwab and Fidelity.

The assessment got blasted on both sides. "Glad fees of $50 round-trip plus short-term trading costs of potentially another $25 don't bother you, they do me," wrote Datek fan Paul Sage. When "it costs the equivalent of dinner for two in New York to swap one mutual fund for another, it becomes a hindrance to good decision making."

Meanwhile, Schwab user George Johnson thought the column was too fee focused. "If you are going to put down a bet on someone else to manage your money or part of it, why not give him/her a chance? Even 30 days is not enough time, even in this market," wrote Johnson. "These fees are just noise! If you need to get out of the fund, get out!"

The lesson: Know thyself. If you want cheap fees, you'll see in the chart which broker's best for you. If you don't care, pay up and perhaps get better services for your money. That's why the column includes the research.

Fund Trading Fees

While ultimately the choice is yours, I don't abdicate judgment. I stand by my analysis, for example, that Schwab's policy on "short-term" fund trading is too draconian. Under Schwab's rules, if you purchase a fund that normally carries no transaction fee, and then sell it within 180 days, you have to pay $39 or 0.75% of principal up to $199 (for online trades), whichever is greater. E*Trade, in contrast, has a $24.95 fee on a 30-day period.

Schwab defends its stance. "In our point of view, funds are not designed as short-term speculative investments," says spokesman Morrison Shafroth. It's expensive for fund companies, and Schwab, to administer mutual fund trades, and these costs can get passed on to the shareholders who use funds for the so-called right reason -- buy and hold. Plus, shareholder sales can complicate managers' investing plans, pushing them to sell stock to come up with cash to meet shareholder redemptions. By imposing six-month holding periods and charging hefty fees when investors sell before then, Schwab says, it's discouraging frequent trading and placing the costs on those who incur them.

There's much sense to the anti-short-term case. But there's another side to it. First, let's not forget that the buy-and-hold mantra is a nice convenience for fund firms, which essentially are brokers' fund supermarket clients. The overwhelming majority of fund families get paid based on the assets they gather, rather than their performance. As long as you hold the fund, the firm makes money even if you don't. Second, fund managers are often the last folks actually practicing buy and hold. As many investors will see evidenced in their year-end tax statements, managers turn over stocks like crazy.

Finally, the argument is a bit paternalistic. In the past several years, individuals have gained access to an enormous amount of information on a daily or even intraday basis that can help them make decisions about their money (including fund selection). They won't always be right. But how many high-paid Wall Street analysts were right about the market last year?

All this is not meant as anti-fund. Having suffered horrible losses trading stocks, many investors these days are embracing diversified mutual funds for the long term. It's a fine choice, arguably a wise one. But it's best when it's a decision based on an investor's philosophy or experience, not brokers' rules.

So while fees on short-term trading serve a function, I can't sanction brokers taking it to the nth degree, like Schwab does. As 2000 showed, an awful lot can change in six months -- Schwab's time frame for the fee. Further, other full-service broker types, like CSFBdirect (formerly DLJdirect), charge a flat $35, and deeper discounters, like Scottrade, charge only $17 on sales within 90 days. "We're letting you see this fee as a reminder that it's a buy-and-hold type of product," says Casey Rozniak, mutual funds coordinator at Scottrade, commenting only on his firm's program. "It's a way to educate and not overly penalize."

What really matters is not whether I agree with Schwab, but whether you trade in and out of funds often enough that the short-term fund trading policy -- at any broker -- is going to apply to you. If it is, you probably don't want a broker like Schwab. And frankly, from their end, I'm sure the feeling is mutual.