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Archive for Sunday, December 28, 2003

Disclosure, competition may lower mutual fund fees

December 28, 2003

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No doubt about it: The average mutual fund's fees are outrageously high; investors would be well-served if fees were lower.

But is it right for regulators to take on the role of forcing fund companies to cut fees?

The idea leaves me uneasy.

The good news of the past week is that the fee debate has now taken center stage, thanks to this fall's late-trading and market-timing scandal. The debate should alert shareholders to fees' corrosive effect on their retirement and college investments, even though some of the contemplated regulatory approaches to fees are ill-conceived or inadequate.

Fees matter: An investor who saves just 1 percentage point a year by choosing low-fee funds could boost his or her nest egg by 20 percent during 30 years.

Settlement to set course

Alliance Capital recently agreed to settle the improper trading case brought by the Securities and Exchange Commission by paying a record $250 million fine, which will be turned over to investors who were cheated.

In addition, in settling a parallel case brought by New York Atty. Gen. Eliot Spitzer, Alliance agreed to cut its fund fees by 20 percent for five years -- saving its investors an estimated $350 million.

But as the settlements were announced, Spitzer and SEC officials traded barbs over the fee agreement.

The SEC said fees were not a factor in the Alliance case and shouldn't be regulated. Spitzer responded that he wasn't regulating them, just clamping down on a company that had fallen short on its fiduciary duty to investors.

Alliance deserves what it gets for allowing preferred investors to make quick in-and-out trades at the expense of ordinary shareholders, who weren't allowed to do the same. Spitzer's fee-cut serves nicely as an additional warning to other fund companies that might cheat their customers.

But Spitzer clearly has more on his mind than Alliance. Other funds, even if they have done nothing wrong, may have to cut their fees to compete with Alliance. So last week's agreement is regulatory fee-setting through the back door.

Spitzer is right about the problem. The average fund charges too much -- about 1.4 percent of investors' holdings a year for stock funds. That number has been rising, though technology and economies of scale should have driven it down.

On the other hand, investors have plenty of low-fee funds from which to choose. Many good index-style funds charge less than 0.20 percent.

Investors' involvement

The problem is that too many investors ignore fees or trust investment advisers who ignore them.

What's the best way to get funds to trim fees?

Instead of regulating fees, the SEC is looking at improving disclosure, so investors can better spot funds that charge too much.

Commissioners say that in January, they are likely to propose rules requiring funds to tell each investor, in dollars and cents, just how much he or she is paying in fees.

That would be a good start. But funds should have to break the fee charges down, so investors can see how much of the fee is really supporting the search for good investments and how much is spent on administrators and support personnel.

Such a breakdown might be modeled on the reports required of nonprofit organizations, meant to show how much of each dollar donated is drained away for administrative expenses.

Funds also should be required to show how their fees would chew into returns of a hypothetical $10,000 investment over 10, 20 and 30 years. And they should have to compare that to the effect of average fees charged by similar managed funds and low-fee indexers.

The SEC recently voted to request public comment on whether funds should be required to disclose transaction costs, such as the commissions paid when the fund buys and sells securities.

This is not currently included in the expense ratio data that funds do report, even though transaction costs can be enormous, given that the typical managed fund changes all its holdings every year. Investors should receive this information.

In yet another area, the SEC is expected to require that funds' boards of directors be chaired by outsiders. Currently, most are chaired by executives from the fund management companies the directors oversee. And the SEC is likely to require that three-quarters of the directors be outsiders, instead of the simple majority now required.

These, too, would be good changes -- but not good enough. Rules should be changed to make it easier for unhappy shareholders to nominate their own candidates for directorships. Currently, it's virtually impossible for a candidate not approved by the board to get on the ballot.

More reports

Finally, the SEC may require funds to report their holdings every three months instead of every six. Again, this doesn't go far enough, since it still allows "window dressing" at the end of each reporting period. That's when a fund manager loads up just before the reporting deadline on the stocks that have recently done well, hoping investors will think he'd had them all along.

Funds should have to disclose, after a reasonable wait, data on every trade. Astute investors -- and the people who write the fund guidebooks -- could then tell if the manager is racking up unnecessary commissions to make himself look like a better stock picker than he is.

Spitzer is right that high fees are bad, and there's nothing wrong with demanding lower fees of a fund company such as Alliance that breaks the rules.

But the long-term solution is to let competition drive down fees. That's more likely to happen if investors are told how much they are paying.

I don't believe funds with high fees will ever make much sense for most ordinary small investors. But there have been, and probably always will be, some high-fee funds that do provide stellar returns, and we can't predict what investment strategies will work best in the future. An investor who wants to bet on a high-fee strategy should have the right to.

Funds have every right to charge sky-high fees -- so long as they tell investors about every penny they're taking.

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