A Better Way to Pay for Your Mutual Fund

Morningstar's Don Phillips says fund fees aren't the problem -- it's the lack of disclosure.
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When Don Phillips finished graduate school, he knew he wanted to be a mutual-fund analyst. The only problem, he says, was that the job didn't exist.

Fortunately, Joe Mansueto had founded

Morningstar

just two years earlier to provide individual investors with analysis and commentary on these pooled investment vehicles.

In 1986, Mansueto hired Phillips as the company's first mutual-fund analyst. Phillips subsequently became editor of the company's flagship publication,

Morningstar Mutual Funds

, and helped to develop the Morningstar Style Box, the Morningstar Rating, as well as other proprietary products that have since become standards for the mutual fund industry.

Phillips is currently one of the Chicago firm's managing directors and is responsible for corporate strategy, research, and corporate communications.

With the mutual-fund industry facing pressure from the

Securities and Exchange Commission

over its fee structure and increased competition for assets from exchange-traded funds,

TheStreet.com

decided to chat with the man who's been watching the industry for the past 21 years.

TheStreet.com: You participated in the SEC's roundtable about rule 12b-1 fees, which were created in 1980 to allow mutual funds to use a percentage of investor assets to offset distribution costs such as advertising and the printing and mailing of sales literature. They are now used to pay for all kinds of administrative expenses. What are your feelings about these fees?

Don Phillips: The problem ... is that you have the accounting on mutual funds determined by lawyers, not by accountants or business people. Who cares what section of the

Investment Company Act of 1940 allows this to be charged? Labeling them as 12b-1 fees doesn't tell the investor anything.

My biggest objection to the way 12b-1 fees were paid is they gave investors the impression you can have the services of an investment advisor for free. Instead of saying advisors have value, they allowed for the pretense that you don't have to pay that high service fee.

But even if the name and structure change, you believe investors should pay these costs?

Distribution, advertising and Web sites are all legitimate costs for a fund to bear. So, the investor should pay for distribution, since the investor benefits from it. But let's label it in a way that makes economic sense and shows where your money is going.

Every fund should have one total fee presented. But investors should have the ability to drill down deeper into greater detail. The expense ratio should be broken down in three parts: investment management; sales, marketing and distribution; and administration. That would give investors a better way to compare costs.

How would it help compare costs?

It would tell you where your money is going. Is the fund spending a lot on distribution to get on a platform and not investing in management, or does it have a better balance with these three areas?

Why is that important?

Well, compare it to two pharmaceutical companies: One spends more to motivate a big sales force to sell what you have today and the other is spending on research and development to build future drugs. So, if I'm buying a mutual fund, is it spending more to get on platform and paying a lot for sales people, or are they spending to get the best portfolio manager possible? At the end of the day, investors need to know where the money went.

The SEC tried to address 12b-1 fees before, and the fund industry essentially killed any changes. Do you think anything will happen this time?

I imagine that in the end the SEC will go through with something. I think

SEC Chairman Christopher Cox has the investor's best interests at heart. And I think you will see some tangible benefits for investors come out of these discussions.

If you believe these costs are necessary, getting rid of 12b-1 fees won't really lower an investor's expense, will it?

I think it's possible this might lower fees. Why does it cost you so much to do this, but your competitor charges less? I think the costs for record-keeping and administrative will surprise people when they see how high they are. But, any time you shine a light on fees there is a tendency for them to go down.

And that is why, even now, the fund fees in the U.S. are the lowest in the world -- we have the most disclosure.

In Europe, Asia and everywhere else in the world, fund costs are higher than here because investment managers have been recalcitrant to disclose what their costs are. And in some markets it's hard to even get an expense ratio on a fund. No where else do fund expense's have the transparency that they do in the U.S.

What are the other big issues facing the mutual fund industry?

The mutual fund industry has been on its best behavior recently. Two events at the start of decade profoundly affected the industry. They were the bear market and the market-timing scandal. In the 1980s, the industry's press was very favorable and funds were called the small investor's best friend. But in the bear market, funds were the way that people got overexposed to equities. Then the market-timing scandal led to

then state attorney general now New York Governor Eliot Spitzer calling the industry a "cesspool."

To go from wearing the white hat to being called the villain had a profound impact on the fund industry. A lot of people looked at the industry's practices and said "How do we get back into investors' good graces?"

So, what is the industry doing to get into investors' good graces?

It's different from the late 1990s, when you had not just Internet funds but b-to-b Internet funds. We've seen the industry pull back from specialized and tech-heavy funds for more diversified offerings. The main trend in the industry has been toward lifestyle and target-dated maturity funds where all the rough edges have been smoothed out.

Why is the trend moving to target-dated and lifestyle funds?

You limit the amount of damage that an investor might do to themselves and increase the odds the broker puts the investor into a suitable investment. So, from very narrowly defined products they've switched to more broadly diversified and balanced funds with a longer-term horizon.

The motto for the last five years has been "Do no harm. Don't buy something you will have to apologize for later."

The real model has become the

American Funds

. We asked brokers why they have such loyalty to American Funds and they said because they never had to apologize later for selling one to a client.

Have ETFs been eating into mutual funds assets?

It's silly to say ETFs haven't stolen some thunder from mutual funds. Clearly ETFs are taking some assets, especially considering the amount of media attention that had gone to funds is now going to ETFs. But the mutual fund industry lived through a period 25 years ago when people said no-load funds would rule the world and if you had a load fund you wouldn't get assets. All this talk about ETFs sounds very similar.

But the brokers haven't embraced ETFs. Mutual funds have a business model that is currently working. In that case, why change it?