That Nagging Question of Mutual Fund Fees
Paul Samuelson, the late Nobel laureate in economics, compared mutual funds to a saloon.
“I decided that there was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it,” he told Congress in 1967. It made sense to invest in mutual fund companies, Mr. Samuelson said, but not in mutual funds.
Then, as now, mutual fund management companies received handsome fees from people who often had no idea whether they were getting a good deal. For the most part, Mr. Samuelson suggested, they were not getting one.
Countless details have changed since Mr. Samuelson made those observations. For one, mutual funds have become far more popular. In 1965 in the United States, total fund assets were about $35 billion; in 2009 they exceeded $11 trillion, according to the Investment Company Institute, the mutual fund industry group.
And with the decline of traditional pensions, Americans are relying on mutual funds more than ever: 87 million people owned them last year. What’s more, many studies have shown that fund expenses predict performance better than any other indicator — low fees are generally linked to high returns — so fees have a direct bearing on the financial well-being of millions of people.
But the core of Mr. Samuelson’s critique is still on the mark for much of the industry, according to some critics, who say investors are paying far too much for mutual funds, especially those that are actively managed and run by publicly traded companies. A recent Supreme Court ruling may help matters a bit, said John C. Bogle, the Vanguard founder, but in his view the court did not go nearly far enough in setting guidelines for mutual fund fees.
“I suppose the decision is a help, but it’s not all that much of one,” said Mr. Bogle, creator of the first index mutual funds and perhaps the pre-eminent advocate of low-cost investing. “The court decision just isn’t very coherent.”
On the positive side, he said, the ruling on March 30 in Jones v. Harris gave the Supreme Court’s imprimatur to a benchmark for fees that has long been opposed by the mutual fund industry. In a unanimous decision written by Justice Samuel A. Alito Jr., the court said that when retail mutual fund directors bargained with advisers to set rates, they should make comparisons with “relevant” fees paid by “different types of clients” — including institutional investors like pension funds, as well as independent mutual funds.
Harris Associates, the Chicago investment adviser, was the defendant in the case, which has been sent back to lower courts for adjudication. Harris said that comparisons between pension funds and mutual funds were invalid. In a brief filed in support of Harris, Fidelity Management and Research derided attempts to make “apples-to-oranges comparisons between fees paid by mutual funds and those paid by institutional clients, such as pension funds.”
The I.C.I., representing the industry, has taken that position for many years, citing research supporting its position, but the court rejected it.
The plaintiffs — investors in Oakmark funds advised by Harris — pointed to research finding that pension funds typically pay about half the rate charged to retail mutual funds for equivalent services.
Even when mutual funds are much larger than individual pension funds and when portfolios set up for the two types of funds are “essentially the same,” economies of scale are not passed along sufficiently to the retail consumer, said Mr. Bogle, who filed a brief supporting the plaintiffs. The disparity between institutional and retail fees is even greater in sheer dollars than when measured by the expense ratios or basis points that the asset management business typically prefers.
One study, for example, compared public pension funds with mutual funds using similar investment strategies. The mutual funds had average assets of $1.3 billion, compared with $443 million for the pension funds, yet the mutual funds paid investment advisory fees of 0.56 percent, twice that of the pension funds. In raw dollars, the mutual funds paid six times as much, on average — $7.28 million compared with $1.2 million.
“We’re just talking about the investment advisory fees paid by the two types of funds, not about fees for mailings of brochures, or phone calls, or anything else, so they are directly comparable,” said John P. Freeman, professor emeritus at the University of South Carolina and a co-author of that study.
In its ruling, however, the Supreme Court did not acknowledge the significance of the total dollars paid to advisers. Furthermore, it upheld a series of principles enshrined more than 20 years ago that set a very high bar for investors.
Under those so-called Gartenberg principles, Justice Alito wrote, mutual fund directors have breached their “fiduciary duty” only when an adviser’s fee is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.”
Under this guideline, there hasn’t been a single trial verdict in investors’ favor. Several lawyers said that the court had made investors’ burden lighter but that it might still not be easy to prevail.
In a statement, Paul Schott, the president of the I.C.I., said that by embracing Gartenberg, the new ruling “brings stability and certainty” to mutual fund managers, directors and investors.
“This standard has well served the interests of funds and fund shareholders, who have seen their cost of investing fall by half in the last 20 years,” he said.
Of course, whether fees have fallen or risen depends on how you do the counting. By Mr. Bogle’s reckoning, fees have fallen sharply for investors who have put their money into index funds, but that’s about it.
The issue is complex and important, and I’ll be returning to it in future columns.