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Fund Spy
Fund fees: Silver lining has a big dark cloud
Recent signs are encouraging, but the industry can do better.
By Russel Kinnel, Morningstar
Is there light at the end of the tunnel on fund fees? We're seeing some encouraging signs, but the hard data suggest we have a long way to go in delivering a better deal to the typical individual investor.
What are the encouraging signs? Well, Fidelity cut fees on its index funds. Other firms cut fees because New York Attorney General Eliot Spitzer made them. In fact, earlier this week The Wall Street Journal reported that the number of advisory fee cuts rose substantially from January 2004 through March 2005.
We did our own study and found that average investors paid a little less in 2004 in percentage terms than they did in 2003 or 15 years ago in 1989. Specifically, the dollar-weighted average expense ratio fell from 0.93% in 1989 to 0.89% in 2004.
Put in perspective, you can see that while the trend is encouraging, at this point it's only a drop in the ocean. In dollar terms, Americans paid about $55 billion in mutual fund expenses in 2004 compared with $5 billion in 1989. Assets grew at about the same pace meaning that almost none of the economies of scale from the industry's tremendous growth have made it to the fund investor. In fact, if you exclude institutional funds, the dollar-weighted average expense ratio has actually gone up from 0.94% to 0.96% over the past 15 years. In other words, typical individual investors haven't seen any benefit from the industry's tremendous growth even though they are the ones responsible for it.
Let's look at a couple of examples to illustrate this point. In 1989, American Century Ultra (TWCUX) had $345 million in assets and charged an expense ratio of 1.00%, which results in fees of $3.45 million. In 2004, assets were up to $22 billion, but the expense ratio was only down 1 basis point to 0.99%, meaning American Century collected about $218 million in fees -- an increase of $214 million.
At Templeton Growth A (TEPLX), assets have grown almost tenfold, yet the fund's expense ratio actually increased. In 1989, the fund charged 0.66% on assets of $2.4 billion, producing fees of $16 million. In 2004, the A shares charged 1.10% on assets of $19 billion -- producing fees of $204 million. I'm understating the fees in this case because the fund is also available in pricier share classes in addition to its A shares, where there's an additional $2 billion.
The role of the middleman
What happened to the economies of scale?
More on mutual funds
For the most part, the middlemen got them. Since 1989, the broker-sold side of the industry adopted B, C and D share structures. That means that rather than having an up-front sales charge, these share classes embed sales charges in their expense ratios. In addition, revenue sharing and other deals with brokerage firms have made it difficult for fund companies to lower expenses.
Mutual fund supermarkets have also had a role in keeping expenses high. Although they've flourished over the past decade by offering convenience and services you might not be able to get by investing directly, they typically charge funds 20 to 40 basis points to be included. That charge is generally passed along to fund investors -- even those who aren't investing through a supermarket.
In short, the middlemen have soaked up much of the economies of scale that would otherwise have been passed along to fund investors.
They're not the only ones, though. Fund companies have kept most of the rest for themselves. You can see this when we parse out the trends for A shares and no-load shares from the overall group. The average load fund investor (as measured by dollar-weighted figures) paid 0.80% in expenses in 1989, but today is paying 0.95% despite a vast increase in the amount under management. The trend is in the right direction for no-load funds, but it's still a pittance compared with the growth in assets. The dollar-weighted no-load average has fallen from 0.82% in 1989 to 0.79% in 2004.
How lucrative is asset management?
If you watched the NCAA men's basketball tournament on CBS, you probably have some sense that money management and brokerage are decent businesses to be in. It seemed like all the commercials were either for deodorant or mutual funds. Not only that, but the Final Four was played in the Edward D. Jones Dome -- the house that revenue sharing built. (If you missed Eric Jacobson's column about the lucrative business of revenue sharing, check it out here.)
Will fee cuts snowball?
My hope is that the latest wave of expense ratio cuts will build up momentum and fund directors will finally do a good job of providing economies of scale to the people they're supposed to serve. There's plenty of room for more cuts. We've made barely perceptible progress to this point, but that doesn't mean we can't see meaningful cuts over time.
However, to really get fund companies competing on costs, we need greater disclosure of how much middlemen are extracting from fund companies. We also need a ban on supermarket policies that expel fund companies that offer cheaper expense ratios for direct investors. (Schwab recently ejected Selected funds from its NTF platform for the sin of offering a cheaper share class.)
Alternatively, we could simply ban any payment from fund companies to brokerages or brokers. Let the middlemen charge what fees they deem appropriate but leave the fund company out of the mix. After all, stock brokers don't ask Pfizer (PFE, news, msgs) to pay a commission for people who buy its shares.
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