Bigger Doesn’t Mean Cheaper for Shareholders
The mutual-fund industry could use a refresher course in basic economics.
Remember what you learned in Econ 101 about economies of scale? It doesn’t apply in the mutual-fund business, at least not consistently.
In the past decade or so, the fund industry has grown astronomically. Hundreds of individual funds have each attracted millions of dollars.
Yet per-share operating expenses generally have not declined as funds have grown--if anything, they have risen. That’s bad news for shareholders who want to wring the best returns out of their investments.
Operating expenses include costs of portfolio management, legal and accounting work, shareholder record-keeping and so on. The costs are borne directly by shareholders in tiny increments deducted by the management company over the course of the year.
The easiest way to find out about these outlays is to check the “expense ratio” in the fund’s prospectus. Usually, numbers for several years are presented, so you can spot the trend at a glance.
Operating expenses don’t include the “load,” or commission, you might pay to buy certain funds. They do include “12b-1” fees, a sales charge approved by the Securities Exchange Commission in the early 1980s to allow funds a standard means of recouping operating costs.
Today, 58% of all funds have 12b-1 fees, says John Bogle, chairman of the Vanguard Group, and the proliferation of these charges helps explain why per-share expenses aren’t declining.
Rising expenses are a particular problem on stock funds, if only because bond and money-market portfolios typically return less and thus would have a tougher time justifying high costs.
According to Bogle, operating expenses on stock funds have increased markedly the past decade.
In 1981, he says, equity portfolios had $40 billion in combined assets and an average expense ratio of 1.04%, equivalent to a charge to shareholders of $10.40 annually on a $1,000 investment. By 1991, assets exceeded $300 billion, and the average expense ratio had risen to 1.45%.
There are also numerous cases of individual funds that have grown dramatically over the years yet couldn’t pass on meaningful economies of scale to investors.
One prominent example is Fidelity Magellan, the nation’s largest mutual fund. It has a higher expense ratio now than in 1983, even though assets have swelled from $1.6 billion to $19.5 billion since then.
Another example is the Berger 100 Fund, which appreciated a sizzling 89% in 1991 and boasts the seventh-best performance of all U.S. equity funds over the past five years.
This portfolio has an above-average expense ratio of 2.24%, anchored by a 1% yearly 12b-1 fee. Chairman William Berger considers these costs justified because of the fund’s superior long-term results.
“The public can differentiate between good and bad performance, and those performance numbers already reflect the impact of fees,” he says. “Funds with high fees that don’t perform will wither away.”
Berger believes that a 12b-1 fee is needed to help promote smaller funds, like his own, that don’t have the name recognition of a Fidelity Magellan.
Perhaps the only non-controversial thing you can say about mutual-fund expenses is that they aren’t the main factor investors examine. Glenn Woody, a financial consultant in Costa Mesa, examines the expense ratio when shopping for funds, but he regards it as a secondary consideration that pales beside superior, consistent performance.
While 12b-1 fees are largely responsible for rising expense ratios, many fund-management companies have also boosted their advisory income. “The trend is toward higher management fees,” says Don Phillips, publisher of Morningstar Mutual Funds in Chicago.
Management companies can’t raise their fees whenever they want because mutual funds are technically owned by the shareholders and overseen by an independent board of directors. Yet investor apathy and director indifference sometimes combine to give fund managers a de facto free hand, say critics such as Phillips and Bogle.
Ironically, even without fee increases, many medium and larger funds are still cash cows. Profit margins of 40% to 50% aren’t uncommon among management companies, Phillips says.
“The fees are charged as a percentage of assets, which means that the managers get a raise anyway when the fund gets a cash inflow from new investors or when the market rises,” he explains.
Shareholders who are unhappy with inflated expenses are always free to leave a fund, or they can vote down fee increases when management formally proposes them.
However, it’s unlikely that many investors are agitated by rising costs during a year like 1991, when the average equity fund rose 30.7%.
But tougher times are certainly ahead. When they arrive, every tenth of a percentage point will start to matter.
Fund Fees: Where They’re Headed
Mutual funds may charge any of several kinds of fees or expenses. Some of these charges have been trending downward in recent years, while others have been rising. Here’s a look at the main ones:
Operating expenses. These costs, common to all funds, are for portfolio management, shareholder representatives, record keeping and other services. Overall, operating expenses have been rising. Individual fund expenses range from 0.2% to 3% of assets annually.
12b-1 fees. This is a special type of ongoing charge, often used to pay for marketing expenses of a fund. These fees became widespread during the 1980s. The maximum allowable 12b-1 levy is 1.25% of fund assets each year.
Front-end loads. These are one-time, upfront charges used to compensate brokers who sell funds. Funds that deal directly with the public often don’t levy such fees. On load funds, charges of up to 8.5% of your investment are permitted, although the trend in recent years has been toward medium loads in the range of 4% to 6%.
Back-end loads. Also known as redemption fees, these loads (often 2% to 3%) are charged on your investment if you withdraw within a certain number of years. They are meant to encourage long-term investment. Funds with back-end loads often charge 12b-1 fees too.
