Securities and Exchange Commission
last week released its long-awaited mutual fund fee study. In the same breath that it concluded that fees had
risen by nearly 20% over the past 20 years, the SEC acknowledged that a different set of assumptions could have resulted in a vastly different conclusion.
In fact, the fund industry's trade association, the
Investment Company Institute
, recently released its own study showing that from 1980 to 1998, fund fees
-- from 2.26% of assets to 1.35% for equity funds, and from 1.54% to 1.09% for bond funds.
The difference between the two studies has much to do with the ICI's questionable methodology. Unlike the SEC, the ICI weighted fees by fund sales, which reflect investor decisions to buy lower-cost funds -- not fee reductions by funds. Under this analysis, for example, the industry gets disproportionate credit for the success of
500 Index fund, which has attracted nearly $100 billion in assets with its rock-bottom 0.18% annual expense ratio.
Vanguard's Jack Bogle argues that this trumpets savings for which the industry deserves no credit.
There are other variables -- including different formulas for calculating the effect of
12b-1 marketing fees and sales commissions (also known as "
loads"), which make fund fee analysis more of an interpretive art than an exact science.
But one thing the SEC and the industry seem to agree upon is that the economies of scale created by the vast growth in mutual fund assets over the past two decades -- to $7 trillion currently from $134 billion -- often have not been passed on to shareholders.
It's All in the Numbers
These economies result from the fact that the larger a fund's asset base, the lower its operating costs. Where it might take two analysts to support a $10 million portfolio, it does not take 20 analysts to support a $100 million portfolio.
A key finding of the SEC study is that economies of scale often are not fairly reflected in the use of breakpoints. Breakpoints are the fund industry's version of volume discounts. When assets reach a certain level, the fee charged on assets above that level are reduced.
The SEC found that many large funds do not use breakpoints at all, or manage a substantial amount of their assets above the last breakpoint cutoff.
The SEC reviewed the management contracts of the 100 largest funds, representing about 45% of total industry assets. Surprisingly, 19 funds managing $376 billion charge a single fee -- in other words, they offer no breakpoints at all.
Fifty-five others managing $969 billion imposed breakpoints, but $359 billion of these assets are at levels that exceed the highest breakpoint. This means that fund managers are pocketing additional cost savings rather than offering a share of them to investors.
The industry's own analysis of economies of scale yielded similar results. In December 1999, the ICI studied the fees charged by 497 funds with assets in excess of $500 million. All of the funds had grown since their inception, and almost all had grown at least $500 million. The ICI found that
more than 100
of these funds had increased their fees, with 31 funds imposing increases in excess of 0.2%.
Additionally, a fund-fee study released last summer by the
General Accounting Office
, a federal agency, found that 25% of funds whose assets grew by 500% or more since 1990 had not reduced their expense ratios by at least 10% by 1998, and some had even raised their fees.
In sum, while you can debate the direction in which fund fees have been moving over the past couple of decades, the evidence that many funds are not sharing economies of scale with shareholders suggests strongly that fees are not as low as they should be.
Regulating Monopolistic Competition
Which raises the million-dollar question: Is more regulation of fund fees needed? Some argue that marketplace competition alone should set fund fees. They say that the fund industry is competitive, and indeed the growing market share of fund groups with the lowest fees (Vanguard,
) suggests that fund shareholders are cost-conscious consumers.
In contrast, the GAO found that, "The mutual fund industry generally does not attempt to compete on fees," but rather by differentiating the quality of services. The GAO concluded, "The mutual fund industry exhibits the characteristics of monopolistic competition."
Although most would agree that the marketplace, not regulators, should set mutual fund fees, it's unclear how this position precludes regulation. Without SEC-imposed disclosure requirements, funds wouldn't even have to reveal expense ratios, which enable investors to compare fund fees. Nor would investors have standardized performance results, comparisons to the performance of an index or data on portfolio turnover rates (the frequency with which funds buy and sell securities) to help them make informed decisions.
This information is available to the market only because SEC rules require that it be disclosed. Thus, the libertarian's motto, "Let the market decide," seems disingenuous when used to promote deregulation that would keep investors in the dark.
The GAO shares this view. Accordingly, last summer it recommended that the SEC require sending shareholders statements that show the actual dollar amount of fees they paid during the most recent quarter.
The SEC agreed that rules were needed to "encourage fund shareholders to pay more attention to fees and expenses." Its study recommended requiring funds to disclose the amount of fees that would have been paid each six-month period on a $10,000 account. (For more on this proposal, see my
Nov. 17, 2000, column.)
The SEC's approach essentially accomplishes the GAO's goal and has an extra advantage. As under the GAO approach, investors will be able to determine their approximate expenses by dividing their account balance by 10,000 and multiplying that number by the total fees. Thus, if the fee was $76 and you had a $12,000 balance during the period, you paid about $91.20 (12,000/10,000 x $76).
The advantage of the SEC's methodology is that it will provide a standardized fee amount that can be compared with other funds' fees. Individualized fees could not be compared from fund to fund unless the size and value of the investor's account in each fund was identical throughout the period.
But the SEC's recommendation fails in one significant respect. Its proposed placement of the fee amount in funds' semiannual reports will significantly undercut the usefulness of this disclosure. Investors simply don't read their semiannual reports, which typically go straight from their mailboxes to the recycling bin.
The fees should be disclosed, as suggested by the GAO, in shareholder account statements. If the SEC wants to draw shareholders' attention to fees, then the fee disclosure should be in the document to which shareholders pay attention.
In fact, the SEC should go further and consider requiring not only that account statements include the fee, but also do the math for shareholders by multiplying the fee by the shareholder's actual account balance.
This is not all that the SEC can do to ensure that markets operate efficiently in setting fund fees. The study also argued that fund governance reforms proposed by the commission would make fund directors more effective in negotiating fund fees. These reforms have since been adopted, and while not earth-shaking, they promise to give independent directors a stronger hand vis-a-vis the fund's investment adviser. (For more, see my
Jan. 17 column.)
And finally, the SEC should reaffirm its recommendation made to
more than 30 years ago simply to require that mutual fund fees be reasonable. Against stiff industry opposition, this common sense standard was shot down. But as I'll discuss in a column later this week, the legal standard for mutual fund fees may be due for a rehearing on Capitol Hill.
Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md. He wecomes your feedback at