It's Time for Funds to Cut Their Fees
04/16/2009 1:01 pm EST
Investors are pretty angry at a lot of people for their devastating losses in the market meltdown: Wall Street bankers, ratings agencies, regulators, reckless lenders and borrowers, and ineffectual politicians.
But nothing may stick in their craw more than the rotten performance of the equity mutual funds they own.
These funds, long touted as the best way for individuals to achieve financial security, had a dismal year in 2008—even worse than the wretched showing put in by the markets themselves.
Some legendary fund managers really took it on the chin. Bill Miller’s Legg Mason Value Trust (LMVTX) lost 55%, while Ken Heebner’s once-high-flying CGM Focus (CGMFX) was off 48%. David Dreman’s DWS High Return Equity (KDHAX) fell nearly 46%, and the fund’s owner, Deutsche Bank (NYSE: DB), recently gave the venerable investor the boot.
Six out of ten actively managed stock mutual funds underperformed their corresponding indexes in 2008, according to the Center for Institutional Investment Management at the University at Albany—SUNY. And the Center estimates that actively managed funds lost $42.7 billion in market value beyond the losses of the major indexes themselves.
Fees are the principal reason for this. But amazingly, expense ratios on actively managed funds are ready to rise, not fall.
Russel Kinnel, director of fund research at Morningstar, wrote recently that some major funds may boost their expense ratios by as many as 20 basis points—or 0.2%. That’s a huge jump when the average expense ratio of equity mutual funds is around 1%, according to the Investment Company Institute (ICI), the mutual fund industry’s trade association.
“Expenses are rising and they haven’t all been reported,” Kinnel told MoneyShow.com. “The officially stated expense ratios are stale right now.”
It’s just basic math, explains Brian Reid, the ICI’s chief economist. “All funds have certain costs that have to be covered,” he says. So, when values drop dramatically because of the market’s declines, fewer assets must cover the same fixed costs. Hence, a higher expense ratio.
That may reverse a trend toward lower expenses as assets grew in the 2003-2007 bull market. And indeed, the ICI’s data indicate a 50% decline in average fees and expenses over the last quarter-century.
But remember, that includes low-cost index funds, which charge as little as seven basis points and still represent only about 10% of the $5 trillion invested in stock mutual funds.
The real problem is the expenses in the 7,500 actively managed funds that hold $4.5 trillion of investors’ money, according to Morningstar. They’re still much too high, because expenses are the real killers of mutual fund returns.
An influential August 2000 study by Professor Russ Wermers of the University of Maryland, published in the Journal of Finance, found that many active fund managers actually were pretty good stock pickers, but high expenses undermined whatever advantage they achieved.
“Funds hold stocks that outperform the market by 1.3 percent per year, but their net returns underperform by one percent,” the study says. “Of [that difference,] 1.6 percent is due to expenses and transactions costs.”
In other words, the higher the expenses, the smaller the chance even the best managers can outperform a plain-vanilla index fund or ETF.
The problem is, fund companies and financial advisors are stuck in an archaic business model that rewards the insiders at the expense of the investors—a claim Vanguard founder John Bogle has made for decades.
That’s why investors still must pay 12b-1 fees and even sales loads on funds recommended by financial advisors.
The notorious 12b-1 fees range from 25 to 100 basis points, says the ICI’s Reid. They were actually instituted in the early 1980s to help defray funds’ costs of serving shareholders, executing trades, and running their operations—as well as marketing expenses, according to the ICI’s 2008 Investment Company Fact Book.
Nonetheless, “most of the 12b-1 fees collected by funds are used to compensate financial advisers and other financial intermediaries,” the book says.
And the 12b-1 was supposed to at least partially replace loads—percentage fees on either the purchase or sale of the fund—that went to advisers who recommended those funds.
But sales loads haven’t gone away, although they have fallen—from the 5.6% actually paid on average in 1980 to only 1.2% in 2007, according to the ICI. The same funds that you’d have to pay maybe 5% to buy from an adviser are often load-free in corporate retirement plans, and other share classes may be available at financial supermarkets like Fidelity and Schwab.
So, why have them at all?
“The equilibrium price for the services of a financial advisor is 100 to 150 basis points in fees,” claims Reid. And since 80% of investors surveyed use some sort of financial advisor (which I think is a good idea), somebody’s got to pay the freight.
But Professor David Smith of Albany responds that “the research is very clear: Load funds provide no advantage. In my opinion, given that loads do not provide an adequate [return] to investors, it is time to eliminate loads.”
In fact, after last year’s disaster, it’s time for the mutual fund and advisory industry to rethink its entire business model. Just as the incentive structure of Wall Street and the ratings agencies led to the credit disaster, the way advisers and mutual funds are paid has ultimately harmed investors, the people who keep these firms afloat.
“The industry has enjoyed tremendous economies of scale, and most of that has gone to them and not the fund shareholders,” claims Morningstar’s Kinnel.
That’s why I think fund companies should cut back 12b-1 fees to their bare minimum, get rid of loads entirely, and work out more uniform, transparent ways for compensating advisers. But guess what? The professionals are going to have to take a little less, so investors can keep a little more.
Meanwhile, the Supreme Court has agreed to hear a potential landmark case by investors suing mutual fund manager Harris Associates over what they claim is excessive fees. If the high court rules in their favor, it could give fund investors some much-needed relief.
Until then, the best thing you can do is to focus like a laser on low-cost funds or ETFs and if your adviser suggests otherwise, give him or her a polite but firm “no”—or go to someone else.
Ultimately your financial security is still in your hands.
Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of MoneyShow.