Mutual Fund Fees, Expenses Under Increasing Scrutiny

By

Washington

Mutual fund fees and expenses are coming under increasing scrutiny both on Capitol Hill and at the Securities and Exchange Commission, as critics grapple with finding ways to improve disclosure to investors.

The SEC recently proposed a rule aimed at providing investors with a better way to compare fund expenses.

Under the proposal, funds would be required to include in shareholder reports the cost in dollars associated with an investment of $10,000 that earned the funds actual return over a specified period and incurred the funds actual expenses.

The SEC says this would permit investors to estimate their specific dollar costs.

In addition, SEC says, funds should disclose the cost in dollars, based on the funds actual expenses, associated with a $10,000 investment that earned a standardized return, such as 5%.

This, SEC says, would permit investors to compare the relative magnitudes of the ongoing costs of different funds.

SEC says the new disclosure is needed because despite existing disclosure requirements and educational efforts, the degree to which investors understand mutual fund fees and expenses remains a significant source of concern.

Indeed, SEC says, while transactional fees are relatively transparent, ongoing fees are less evident because they are deducted from fund assets and not separately stated.

One problem investors face in understanding mutual fund fees is a major disagreement within the industry itself over whether fees are increasing or decreasing.

The Investment Company Institute, Washington, says “total costs” of purchasing mutual fund shares have steadily declined over time.

In a recent statement before the House Financial Services Committee, Paul G. Haaga Jr., ICIs Chairman and Executive Vice President of Capital Research and Management Company, says that according to ICIs research, the total cost of bond funds decreased by 41% from 1980 to 2001, while the cost of money market funds decreased by 34%.

Haaga says the market structure of the mutual fund industry promotes active competition and that investors are benefiting from economies of scale.

Chris Wloszczyna, an ICI spokesman, adds that mutual funds provide the best and most complete disclosure of any financial instrument.

Looking at where investors actually put their dollars demonstrates that disclosure is working, he says. When looking at total sales of stock funds between 1997 and 2001, Wloszczyna says, 83% of investor dollars went into funds with below-average expense ratios.

In terms of stock fund accounts, he adds, 79% are have below-average expenses.

But John C. Bogle, president of Bogle Financial Markets Research Center, a division of Vanguard Group, questions ICIs conclusions, saying they are not supportable.

ICIs data, he says, captures not a long-term reduction in the costs charged by the industry, but investors increasing selection of lower cost funds. Price competition, however, is defined not by the action of consumers, but by the action of producers, Bogle says.

Moreover, he charges, the ICI analysis excludes many of the costs of fund ownership, including the substantial cost of portfolio turnover.

By not including these costs, Bogle says, the ICI understates fund costs by 50%. He insists that despite a 114-fold increase in assets from 197I to 2002, investors have not benefited from economies of scale.

“It is high time for an economic study of the mutual fund industry,” Bogle says.

But Haaga says Bogles criticism stems from a misconception, which is that economies of scale accrue to an industry. Rather, he says, economies of scale accrue to individual funds or fund families as they grow.

“In fact, evidence shows that mutual fund investors have benefited from economies of scale,” Haaga says. “Institute research shows that expense ratios of large equity funds were lower than those for smaller funds and that expense ratios declined as funds grew.”

Haaga says ICI supports the SEC proposed rule. “It should enhance investors awareness of the importance of fees by reminding them about the impact of expenses on their investment return and will also assist them in comparing the expenses of different funds,” he says.

The SEC proposal, he adds, would complement the extensive disclosure funds already provide.

But critics say more disclosure may be needed. Gary Gensler, former Treasury Department Under Secretary for Domestic Finance, looks at how mutual funds are sold.

Gensler, who authored a book entitled “The Great Mutual Fund Trap,” notes that the mutual fund industry relies heavily on brokers, insurance companies and financial advisors to sell its products.

Additionally, he says, funds actively compete to win defined contribution plans from large corporations and institutions.

In these transactions, he says, there are revenue-sharing agreements. Brokers, insurers and financial advisors, Gensler says, get paid handsomely for every new sale they make.

Large corporations and institutions receive part of the mutual fund fees, he adds.

It may be appropriate, he says, to consider greater disclosure of these revenue sharing arrangements.


Reproduced from National Underwriter Edition, March 31, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.