Mutual Funds
Earn Less, Pay More
Rising mutual fund fees make one thing certain: There's less left for you.
By Brian Knestout
From Kiplinger's Personal Finance magazine, September 2003
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What the mutual fund industry is doing to its customers isn't pretty. Before the recent rebound, stock funds in particular spent most of the previous three years losing heaps of their clients' cash. So why are fund fees rising? Something just doesn't compute.
Few people complained about rising fees during the high-flying 1990s. No one seemed to care if a fund company used profits to name a sports stadium after itself (Invesco Field at Mile High stadium, in Denver, reportedly cost Invesco $120 million over 20 years). And if a firm paid its chief executive a king's ransom (witness the 2002 compensation of Gabelli Asset Management boss Mario Gabelli, valued at $38 million), who complained?
But envision a worst-case future -- that stocks will return about 7% annually in the coming years. If your fund extracts 1% in expenses, you would relinquish 14% of your yearly gain to fees. With today's ultralow interest rates, a bond fund may earn 3% on its portfolio. Pay a 1% expense ratio and there goes one-third of your gain.
Yes, costs are rising. According to Lipper, annual expenses (outside of sales charges) for diversified domestic stock funds rose 29%, on average, over the past ten years. Costs at bond funds also rose over the decade, by 29%.
Pouring salt into an open wound, expenses even rose during the recent stock-market implosion. Annual fees for the A shares of AllianceBernstein Premier Growth fund rose from 1.4% in 2000, the year the bear market began, to 1.7% in 2002. USAA Aggressive Growth's fees went from 0.6% to 0.99%. Fees for the investor class of Invesco Growth jumped from 1% to 1.5%.
Expenses 101
A fund's expense ratio shows how much it extracts each year to pay the cost of doing business. The figure is expressed as a percentage of assets under management. If a fund has an expense ratio of 1%, you surrender $10 a year for every $1,000 you have invested. The ratio doesn't include sales charges or loads. Nor does it cover the costs of trading commissions and the spreads between bid and ask prices that funds encounter when buying and selling securities.
Of the three types of charges that are included in the expense ratio, the management fee is often the largest slice. It covers the manager's bill for picking securities.
Second is the 12b-1 fee, which some funds use to cover marketing costs, including commissions to brokers and other advisers who sell their products to investors. The maximum yearly 12b-1 fee for no-load funds -- those that sell directly to investors and don't levy sales charges -- is 0.25%. The top 12b-1 fee for load funds is 1% per year. Third are other costs. These include payments to the transfer agent (which keeps track of investor accounts), the custodian (which safeguards a fund's money) and the firms that provide legal, printing, accounting and other services.
Size matters
Bigger is better when it comes to fund costs. As a fund's size increases, relatively stable costs get spread over a larger asset base. Conversely, when assets shrink, expenses rise as a percentage of assets.
Consider Jacob Internet fund, whose assets plunged from $290 million at the peak in early 2000 to less than $10 million by September 2002. During that decline, the fund's expense ratio shot up from 2% to 4.6%. The biggest culprit was the transfer-agency fee, which manager Ryan Jacob says is based on the number of investor accounts. That number, he says, held fairly steady during the bear market even as assets dived. Fixed payments to lawyers and auditors also grew larger in comparison to assets.
The way management fees are structured also hurts when assets collapse. Many funds cut their management charges as assets grow. A fund may charge 1% for the first $1 billion in assets, then 0.9% for assets between $1 billion and $2 billion, 0.8% for assets between $2 billion and $3 billion, and so on.
What happened at AllianceBernstein Premier Growth shows how a tiered fee structure can hurt as assets fall. All of its share classes combined had about $20 billion in assets as the market peaked in 2000. That fiscal year (which ended November 30, 2000), the management fee claimed 0.9% of assets, or roughly $178 million. By the end of 2002, assets had fallen to $6 billion and management fees had ticked up to 1%. (For details on management fees, you may have to request a fund's Statement of Additional Information.)
Alphabet soup and Schwab
Fees were rising even before the bear market because of a change in the way full-service brokers are compensated for selling funds. Before the Securities and Exchange Commission approved rule 12b-1 in 1980, broker-sold funds only levied front-end commissions. But many investors are loath to pay those upfront charges -- they typically run 5.75% for stock funds -- and so load-fund families invented "B" shares and later "C" shares. These classes essentially transfer the commission from one upfront charge to ongoing charges in the form of higher 12b-1 fees of up to 1% per year. More than one-third of all new sales of broker-sold funds now go into B and C class shares, leading to higher annual fees.
The 12b-1 factor is also at work in raising the fees of no-load funds. A key reason is the success discount brokers have had selling no-load funds without additional brokerage fees, a concept pioneered by the Charles Schwab discount brokerage in the early 1990s.
The rub was that for a fund to participate in Schwab's no-transaction-fee program, it had to pay the discount broker a portion of its management fee. Originally, Schwab required sponsors to fork over 0.25% of assets for funds bought through its NTF program. Schwab's cut is now as high as 0.40%. Many other discount brokers play the same game.
Some fund companies split their management income with the discounters. Others, however, have added 12b-1 fees to help defray the costs. One of the most recent to do so is Harbor funds. Because of its low-fee structure, Harbor couldn't afford to join the NTF programs. So Harbor shut most of its lower-cost funds to new investors and created an "investor" class for newbies that adds additional 12b-1 fees of 0.25% per year. Although Harbor's fees remain below average, all new clients pay the higher charges, whether they buy through a broker or from Harbor.
Marketing madness
It's hard for existing funds to boost management fees because of the need to obtain shareholder approval. But when a company launches a new fund, it can set the fee at whatever the market will bear. Not surprisingly, new funds usually set higher management fees than older funds. AIM Charter fund, which began operating in 1968, charges a yearly management fee of 0.63% of assets. AIM Large Cap Growth fund, which started in 1999 and has a similar objective, charges 0.75%.
What accounts for the difference? Charter began when a fund with $150 million in assets was considered large. So it structured its management fee to drop to 0.63% when assets surpass $150 million (its various share classes contain $3.3 billion). But at AIM Large Cap Growth, which has less than $300 million in assets, it takes $2 billion to reach the 0.63% fee level. AIM says higher salaries for managers and shareholder demands for better services necessitate higher fees.
A proliferation of specialized funds, which sponsors say require greater expertise, also contributes to rising fees. For example, American Century Veedot uses a proprietary quantitative stock-picking strategy. The fund, launched in 1999, charges an all-inclusive annual fee of 1.5%, although nearly every other diversified U.S. stock fund offered by American Century charges 1% or less. Choice Long-Short fund, which owns some stocks and bets against others by selling them short, charges 2.7% per year for management (the total expense ratio for its C shares is an outrageous 5.03%).
Vanguard founder John Bogle, a noted scourge of high expenses, says funds have gone overboard. "We've crossed the line into creating new funds with higher fees, just because we think they will sell well," says Bogle.
Why it matters
Expenses demonstrably affect performance. Funds with higher expenses generally do worse than lower-cost funds. Standard & Poor's examined all diversified U.S. stock funds in nine different "style box" categories, dividing each style into funds with above-average costs and those with below-average costs. In eight out of nine categories, lower-cost funds beat higher-cost funds over one-year, three-year, five-year and ten-year periods. We found a similar pattern with bond funds.
Moreover, expenses are one of the few things in investing that you can predict with reasonable accuracy. So you can to a degree control your own fate by buying low-cost funds. It's no wonder that legions of investors flock to Vanguard 500 Index, which mimics Standard & Poor's 500-stock index. Only 25% of diversified U.S. stock funds have outpaced 500 Index over the past decade. Why? Because its expense ratio is just 0.18%, and the average expense ratio for diversified U.S. stock funds is 1.50%. That cost gap is too large a hurdle for most managers to overcome.
You can also send a message by favoring the small number of funds that tie fees to results. Among those that do are Fidelity, USAA and Vanguard among no-commission funds, and American Express among load funds. Sure, incentive-based fees will rise when a fund does well -- Fidelity Value's expense ratio rose from 0.48% in 2000 to a still-reasonable 0.95% in 2002 because it beat its bogey over the previous three years. But at least you'll have the comfort of knowing that Fidelity will share some of your pain when Value lags behind the market.
The inescapable conclusion of all this is that costs matter. Keeping costs low doesn't guarantee a winning fund, but it sure beats the alternative, which more often than not is a ticket to mediocrity.
Reporter: Alison Stevenson
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