Fund Fees on Trial
The most intriguing outcome would be a court ruling that puts downward pressure on fees.
When it comes to setting fees for mutual funds, sponsors have a fiduciary duty to act in the best interest of their customers. What that duty entails has long been the subject of debate. But sometime in the next few months the U.S. Supreme Court may clear up the matter once and for all.
The high court recently heard arguments in a lawsuit filed against Harris Associates, the Chicago money-management firm that runs the Oakmark funds. The case revolves around the discrepancy between what Harris charges for managing the funds and what it charges to run institutional accounts. The Seventh Circuit Court of Appeals ruled that courts needn’t get involved because the marketplace could handle the matter efficiently -- investors, for example, could vote with their feet by switching to lower-cost fund providers.
Easy standard. If upheld, the lower court’s ruling would essentially mean that fund companies have almost no fiduciary duty on behalf of shareholders when it comes to fees. That is much less rigorous than the already soft Gartenberg standard, a 1982 lower-court ruling that said that fees “should be within range of what would be produced by arm’s-length bargaining” between mutual fund sponsors and independent third parties. In practice, that’s proved to be such an easy standard to meet that no fund investor has ever won a lawsuit over fees.
I hope the Supreme Court comes up with a new, clear standard for fiduciary duty that disappoints the fund industry and trial attorneys alike. I don’t like the idea of giving fund companies a blank check. After all, a fund is owned by its shareholders, not the sponsor. But I would also hate to see fund companies hamstrung by scores of lawsuits that serve only to enrich lawyers rather than shareholders.
The oral arguments don’t give me much confidence, though, that the high court will decide wisely. My impression is that the justices wouldn’t know a mutual fund from an iguana. The plaintiff’s counsel mistakenly asserted that a fund board couldn’t fire the adviser and hire a new one, and the justices seemed to agree. In fact, a board can fire the adviser. It just doesn’t happen often.
Chief Justice John Roberts suggested that higher cost equals higher quality. In a way, it does, but only in terms of dollars spent on management, not in terms of fees as a percentage of assets, as he implied. For example, Pimco Total Return, run by the estimable Bill Gross, charges annual management fees of 0.25%. But because the fund, the nation’s largest, holds some $200 billion in assets, Pimco clears about $500 million a year.
Meanwhile, the middling Federated Bond charges a yearly management fee of 0.75%, which, on $1.1 billion in assets, generates fees of $8.3 million. So, does Federated charge triple Pimco’s management fee because its bond pickers are three times better than Pimco’s, or are the Federated folks less talented, as the huge gap between Pimco’s and Federated’s revenues implies? I’d say it’s the latter.
The fund industry says, rightly, that you can’t compare the fees of funds and separate institutional accounts because retail investors require more servicing. In many instances, however, a mutual fund’s management fee includes a kitchen sink’s worth of other charges, such as distribution costs, that aren’t used to pay investment professionals. Thus, investors and fund directors alike are in the dark when they compare fees, both between mutual funds and institutional accounts and among different mutual funds.
The most intriguing potential outcome of the Harris case would be a Supreme Court ruling that puts downward pressure on fees. For example, the court could rule that to meet their fiduciary duty, advisers must treat mutual funds and institutional accounts similarly. That would hardly be the worst thing in the world for fund investors.
Columnist Russel Kinnel is director of mutual fund research for Morningstar and editor of its monthly FundInvestor newsletter.