Index Funds Drawing Scrutiny of Regulators
Federal regulators cracking down on the mutual fund business are now scrutinizing index funds, the core stock market investment of millions of Americans.
Some fund companies charge index fund fees that are as much as 10 times higher than those of their rivals. The probe by the Securities and Exchange Commission’s enforcement division involves about a dozen fund companies, said Stephen Cutler, the agency’s enforcement chief. He declined to identify them.
Fund companies and their directors have a legal obligation to act in the best interests of fund investors -- which includes ensuring that fees are reasonable.
Any fund company found to have improper fees could be fined, forced to disgorge ill-gotten gains and ordered to stop charging improper fees, effectively forcing fee rollbacks.
Index funds try to match the performance of stock benchmarks such as the Standard & Poor’s 500. Index fund managers generally do not pick the stocks that go into their funds and they don’t try to outperform the market. As a result, their funds are widely thought to be easier and cheaper to run than so-called actively managed funds.
“There is not a significant amount of portfolio management that goes into the management of index funds,” Cutler said. “You would not think there’d be a wide disparity in the fees charged by two similar index funds.”
The gap between the lowest and highest-priced index funds can be significant, according to data from Morningstar Inc., the fund-tracking firm.
On the low end, the benchmark fund is the $75-billion Vanguard 500 Index, which charges annual expenses of 0.18% of assets.
By contrast, the expense ratio for investors in the Morgan Stanley S&P; 500 Index fund can be as high as 1.5%, while the Scudder S&P; 500 Stock fund charges as much as 1.8%, according to Morningstar. (Costs vary within these funds depending, for example, on whether investors pay an up-front broker’s commission.)
Morgan Stanley declined to comment. Scudder did not return phone calls seeking comment.
The average fee for a large, S&P; 500-style index fund is 0.73%, according to Morningstar data.
Evergreen Investments has an expense ratio of as much as 1.32% for its Evergreen Equity Index. Evergreen spokesman Chad Peterson defended that ratio, saying the expenses were used in part to compensate the brokers and other middlemen who distribute the funds and provide ongoing advice to their clients.
A company such as Vanguard, which primarily sells its funds directly to the public, does not have that cost.
“We believe in the value of professional advice,” Peterson said. “Just as people pay doctors for quality healthcare, we feel it’s appropriate for investors to pay for financial advice.”
Even so, higher fees can significantly reduce an investor’s profits.
For example, a $10,000 investment in the Vanguard 500 fund seven years ago would be worth $16,604 today. The same investment in certain shares of the BlackRock Index Equity fund, which has a 1.53% expense ratio, would total only $14,967, according to Morningstar.
Some companies that sell their funds through brokerages defend themselves by saying their fees cover the advice investors receive from brokers. But critics say it takes little effort or know-how for brokers to stick clients in index funds.
The legal issue in the SEC probe hinges on whether high index fund fees are reasonable.
Under the Investment Company Act of 1940, fund directors have a fiduciary duty to shareholders, meaning that among other things, they must make sure management fees aren’t excessive.
According to Section 36(b) of the landmark act, “the investment advisor of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services.”
In other words, there should be some logic behind the fees charged by funds, said attorney Bob Friese, whose San Francisco firm, Shartsis, Friese & Ginsburg, represents fund companies and other financial services firms. “I don’t think anybody’s suggesting you have to match the least expensive fund.”
Friese called Vanguard Group’s fees “extraordinarily low ... even by pension fund standards.”
With hundreds of billions of dollars under management, indexing pioneer Vanguard has economies of scale that others don’t. Its costs are spread out over a much larger base of shareholders than almost all other index funds.
Still, Friese said, “There ought to be some reasonable relationship between what you’re charging and the services you’re providing.”
James Cox, a securities-law professor at Duke University says the SEC is correct to pursue an investigation: “Running an index fund is like running a water-works factory where the water is on the top of the hill and you have to get it down the hill.”
It’s unclear how high fees would have to be for regulators to consider them excessive. Friese said index funds are an obvious target for regulators because of their simplicity, and those funds with the steepest expenses are “the low-hanging fruit.” At the same time, he added, the fund industry might argue that because profit margins can fluctuate dramatically with the stock market, companies should be entitled to put something away for lean times.
The issue of fund fees has generated enormous attention -- and quite a bit of controversy -- amid the broader scandal sweeping the fund industry.
In a settlement last month with Alliance Capital Management, New York Atty. Gen. Eliot Spitzer forced the fund company to reduce its fees. The SEC made Alliance pay a large fine, but it did not require fee reductions.
SEC commissioners said that because Alliance was accused of improper fund-trading practices -- rather than excessive fees -- it was improper to require fee reduction in a settlement on an unrelated issue.
They also said it would be wrong for a government agency to set fund fees.
The SEC instead has pushed for greater disclosure, believing fees would be set according to what investors were willing to pay.
In the current index fund probe, SEC officials said the agency would be seeking to enforce existing securities laws rather than setting explicit fee levels.
Hamilton reported from New York and Friedman from Los Angeles.
