Updated from 1:26 p.m. EST

The lobbying arm of the mutual fund industry has fired another salvo in the fight over how retail mutual fund fees compare with fees assessed by funds in pension plans. The battle, though, is far from over.

The Investment Company Institute released Tuesday a study it says refutes a case made in a law-journal article that has been cited by New York State Attorney General Eliot Spitzer in his probe of the fund industry.

The study published by the ICI posits that portfolio management fee levels at mutual funds and pensions are actually quite similar -- findings that are in direct contrast to an article first published in an Iowa law journal, which states that the fees mutual fund companies charge retail fund investors are far higher than those for individuals investing through pension plans. The ICI's analysis -- designed to revive the debate -- essentially repackages the results of a study it did a few months ago.

Spitzer, though, quickly issued a statement indicating he was unimpressed with the ICI's report. "The report released today by the Investment Company Institute is fundamentally flawed," he said. "A fair reading of the ICI report ... supports my office's conclusion that the advisory fees charged to mutual fund investors are too high. It also supports the conclusion that we need to fix the governance and structural imbalances that favor management at the expense of investors and that lead to the fee overcharges."

At issue is the nature of the fees being compared. ICI argues that because mutual funds have costs that far exceed the costs associated with pension funds, management fees are higher -- and it's therefore specious to compare a mutual fund's expense ratio with the expenses attached to a pension fund.

"Mutual fund fees are for a whole package of services," said ICI President Matthew Fink on a conference call for reporters Tuesday morning. Aside from the basic asset allocation and portfolio management costs, Fink says, mutual fund fees also cover the record-keeping costs associated with tracking capital-gains distributions, preparing account statements for individual shareholders, issuing proxy statements and shareholder reports, as well as the various compliance costs that "go well beyond the costs associated with pension funds."

In addition, mutual funds have costs associated with liquidity issues (pension plan participants are generally not able to withdraw money from funds with the same spontaneity as retail investors). Pension plans also manage far fewer accounts than mutual funds, which means that they have higher average account balances, which, in turn, provide economies of scale that lead to reduced fees. And those pension funds have a greater portion of their assets in fixed-income securities, which also contributes to lower fees.

Just to be clear -- when both studies refer to funds held in pension accounts, it's only traditional defined-benefit accounts, not defined-contribution plans, such as 401(k)s.

Fee Frenzy

To make what Fink repeatedly insisted was an "apples to apples" comparison, the ICI study looked solely at the fees subadvisers charge for their outsourced portfolio management, rather than overall fund expenses. (Many fund companies -- such as Vanguard, AIM and American Express ( AXP) -- opt to hire outside advisers to actively manage specific funds, rather than hiring their own in-house portfolio managers.) By comparing the costs associated specifically with subadvising (essentially, what the fund company pays its subadvisers) with the pension fund expenses, ICI says, investors will be looking purely at portfolio management costs, and not costs distorted by ancillary management and administrative fees that are in excess of what pension funds incur.

The ICI study found that, when comparing portfolio management fees, mutual fund investors and pension fund participants paid roughly the same amount.

The most egregious difference, according to the ICI study, is in comparing large funds. Large pension funds assess an average portfolio management fee of 28 basis points, whereas large subadvised mutual funds charge 31 basis points for the portfolio management. That's a negligible difference of 0.03%.

In its analysis, ICI economist Sean Collins used the universe of subadvised funds, excepting only Vanguard. Because of Vanguard's low-cost structure, Collins said, including it in the study would have unnaturally depressed the average fund costs. In other words, including Vanguard's subadvised funds would have made the fund industry's numbers even lower -- which would have been misleading.

Some $700 billion -- or 20% -- of mutual fund assets are in subadvised funds, Fink said.

The ICI study used the figures for pension funds from the August 2001 article "Mutual Fund Advisory Fees: The Costs of Conflicts of Interest," published in the University of Iowa Journal of Corporation Law, authored by Stewart Brown and John Freeman.

Both Brown and Freeman were on the ICI conference call and were disconnected after taking too much time arguing the merits of their study vs. the ICI report. Brown and Freeman found that asset management firms on average charge mutual funds 67 cents per $100 invested, vs. 28 cents for pension funds, representing a 140% premium.

Them's Fighting Words

To be sure, the ICI makes a valid argument -- there are legitimate reasons for fund companies to charge retail fund investors higher management fees (beyond straight portfolio management) that just aren't applicable to funds offered in pension plans.

But that's exactly why Brown and Freeman took that fact into account when doing their study.

"We stripped out every disclosed cost -- legal, administrative, accounting, prospectus printing; we noted and eliminated everything," Freeman said in a separate interview. "And funds that didn't disclose their administrative costs weren't included in the study." The Brown/Freeman study was based on a sample of 1,343 actively managed equity funds; all fund data were collected from Morningstar.

Both Spitzer and Freeman take issue with the ICI's focus on subadvised funds. There are two reasons for this: First, subadvised funds represent a small portion of the fund universe. Second, their beef is that fund fees in general are too high -- and the additional fees heaped on top of subadvised funds are just as egregious.

When a fund's directors shop around for a subadviser, they're able to find highly competitive pricing, as various investment management companies vie for the business. If it's more cost effective to manage a fund in-house, the fund company will usually choose that option.

Clearly, it's in the fund's best interest to choose the cheapest option. But just like Nike can opt to manufacture shoes on the cheap in Indonesia but charge $150 for them stateside, that doesn't mean the fund company passes the savings on to investors.

Unlike sneaker shopping, though, mutual fund investors are at a disadvantage when assessing the true cost and value of the fees they pay on their investments. Even if a fund hires a subadviser to manage the portfolio for, say, 30 basis points, it can still charge another 40 basis points for "overseeing" that subadviser -- grossly inflating the cost to investors. (A tactic that would not have been picked up in the ICI study, either.)

"The fund industry is really good at exploiting investor ignorance," Freeman says. "The bottom line is that when fund directors negotiate management contracts, they should be at arm's length from the fund's management . Otherwise, it's a conflict of interest."

Spitzer has stated several times that a fund's directors should negotiate management contracts at arm's length, and that should be the fee that gets passed on to retail investors. In the case of Alliance Capital ( AC), which last month agreed in a settlement with Spitzer's office to cut its fees 20%, the firm had been charging 10 to 20 basis points (0.1% to 0.2%) for subadvising funds in a slew of state pension plans. Retail investors buying Alliance funds, though, were paying on average an expense ratio of 1.85%. By the ICI's logic, that means retail investors were paying some 1.65% for costs not associated with portfolio management. That figure alone is higher than the average 1.5% expense ratio for domestic stock funds.

Clearly, though, the cost of actually managing a portfolio is far less than what most retail investors get charged. And while the ICI's position is correct in that there are reasons fees attached to a retail fund would be higher than in a pension account, those reasons do not account for such a gross disparity. Meanwhile, the average expense ratio has been steadily increasing, as fund firms have been training investors to compare fund fees to other fund fees -- rather than the actual cost of managing a fund.

"The result is that the managers have once again pocketed a savings that truly belongs to the investors," Spitzer said in Tuesday's statement. "An unbiased study would have used the net cost to investors in subadvised funds. The failure to do so is another example of the ICI's ignoring the interests of mutual funds investors in favor of an industry that has cheated them."