Another Year of Mesmerizing Returns
Washington Post Staff Writer
Sunday, January 10, 1999; Page H01
Dazzled by performance, indifferent to cost -- that's the description that mutual fund regulators, managers and analysts say fits most fund investors.
"Our own research
Costs, typically a yearly charge of 1 percent to 3 percent of an investment but sometimes more, can eat up tens of thousands of dollars in 20 years on a $10,000 investment. Yet people who wouldn't buy a car or dishwasher without comparison shopping readily plunk their life savings into mutual funds without knowing how much they are being charged, experts say.
The trend is especially troubling at a time when individuals are increasingly shouldering the burden of saving for retirement through 401(k) or other investment plans, and when pundits are warning that the market's 10-year run of double-digit returns could end soon.
Fund costs overall -- which include operating expenses and sales fees -- have fallen in the past several years, but at rates that lag grossly behind the explosion in fund investing. For example, costs to invest in funds that focus on stocks -- equity funds -- fell by an average of 33 percent from 1980 to 1997, to $1.49 from $2.25 for every $100 invested, according to a study by the Investment Company Institute, the fund industry's lobbying group. Over the same time, investments in those funds grew more than 5,000 percent, to $2.37 trillion from $44.4 billion.
The lag has prompted concern that the industry isn't sufficiently passing on to investors cost savings gained through economies of scale. Experts largely blame consumers, who they say haven't held the industry accountable, either because they don't know how to find the cost information that is available, or, if they do, find it confusing or don't understand its importance. How to change that behavior has become a hot topic of debate among regulators, lawmakers, consumers and industry officials.
"People have been mesmerized by high returns," said John Bogle, founder of the Vanguard Group, a fund company that has specialized in offering index funds -- low-cost funds that try to match rather than outperform a market index such as the Standard & Poor's 500. "Investors should make a New Year's resolution to look at cost first when buying a mutual fund. The record is crystal clear: The shortest and surest route to the top performance category is to be in the bottom cost category."
Steven E. Norwitz of T. Rowe Price Investment Services Inc. in Baltimore agrees: "The problem is that when investors get 20 percent-plus returns in the stock market, they're not as concerned about paying 1 to 2 percent for expenses. If we get into a tougher market, and you start getting minus 5 percent and you're paying 2 percent, you're going to notice. But you ought to notice all the time."
Consider this example from a consumer guide to fees published by the fund industry a few months ago: A $10,000 investment in a fund with an annual return of 10 percent and annual expenses of $1.10 for every $100 invested would grow to $302,771 in 40 years.
But if annual expenses are increased by less than one percentage point, to $1.74 for every $100 invested, the same investment for the same time period would grow to only $239,177, with the additional expenses taking $63,594 from the consumer's return.
Testifying to the House Commerce subcommittee on finance and hazardous materials, which oversees mutual funds, Levitt emphasized the dramatic effect fees can have on an investor's return by pointing out that a "1 percent annual fee . . . will reduce an ending account balance by 17 percent on an investment held for 20 years."
Everyone understands that fees are necessary. Mutual funds incur expenses buying and selling securities, advertising and marketing for new customers and providing expert investment advice. And almost everyone agrees that fees have come down. The question, experts say, is whether funds are overcharging.
"It's legitimate to say costs have come down per $1 invested," said John Rekenthaler, director of research for Morningstar Inc. of Chicago, which tracks mutual fund performance. "But it's also fair to ask, 'Have they come down as much as they should have?' "
Vanguard's Bogle said the answer is clearly no. "Profit margins are excessive in the mutual fund industry," he said.
Performance hasn't justified such excess, he and others said. That fact has become a central part of Vanguard's marketing pitch for its index funds, such as the one that tracks the S&P 500.
In 1998, the average return for S&P index funds was 27.98 percent -- very close, not surprisingly -- to the S&P 500's gain of 28.58 percent, according to Morningstar.
By contrast, the 3,024 actively managed diversified equity mutual funds in the United States had an average gain last year of only 13.84 percent, and only 504 of these funds, or 16 percent of them, beat the S&P 500.
So why would anyone invest in a high-cost fund, especially one that delivers below-market returns?
Eager to answer is Heiko Thieme, manager of the American Heritage Fund, which has an outsized expense ratio of 5.85 percent -- $5.85 for every $100 invested -- and annualized losses of 10.32 percent for the three years ended Nov. 30.
His explanation is that his is a high-risk strategy that isn't for the faint of heart. When the fund does well, as it did in 1997, when it had a return of 75 percent, investors are happy, Thieme said. "And when we are down, we look ugly," he allowed.
The high expense ratio he explained as a simple function of his fund's comparatively small size, having only $6 million in assets. The largest funds have tens of billions in assets, he pointed out.
But costs, such as rent, lawyers, telephones and salaries, are fixed, and vary little for a fund that manages $10 million or one that manages $100 million, he said. But the average cost for every $100 goes down as the size grows.
"The real question," he said, "is whether there's any validity or logic to having a small fund." Only investors can answer that, he said.
Debate on mutual fund fees has been around for decades, said Barry Barbash, who was director of the SEC division that oversees the mutual fund industry until October, when he left to practice law in the Washington office of Shearman & Sterling.
Since 1988, the SEC has required funds to place in the front of their prospectuses a chart that lists shareholder fees such as sales commissions and operating expenses such as marketing costs (known as 12b-1 fees) and management fees. By comparing the prospectuses of several funds, an investor can compare expense ratios, which represent many of the costs a fund incurs for each dollar invested in it.
A company also must provide, near that chart, an example showing how much money in fees an investor would pay on a typical investment in its fund over several years. Until now, the example has used an investment of $1,000. Under new SEC rules adopted last year, the example will use $10,000, an amount closer to the $18,000 median investment that households have in funds.
Investors can also request a document called a statement of information that breaks down into more detail many of the expenses lumped together in the prospectus.
This information is a good start, experts say, but more needs to be done.
Expense ratios don't include sales commissions, called loads, which can be charged at specific times, such as the initial investment or the cashing-out, or in a variety of other ways. Trying to compare costs for a fund with no load but a high expense ratio with a fund that has a big load but a low expense ratio can be tricky for someone without a strong math background and a good calculator or computer program, experts say.
Another source of confusion is that in recent years funds are selling different classes of shares in the same fund. The shares offer consumers different expenses and timing limits, such as when they can pull out of a fund without paying a fee.
"I know people who are quite brilliant who don't have a clue about this," said Miles Livingston, a professor of finance at the University of Florida who has co-authored several studies of mutual fund fees. "They don't have time to figure it all out."
Bogle said that every prospectus, in addition to the chart and example, should carry a sentence stating clearly that costs "that seem minor when taken as percentage of total investment can consume a much higher percentage of returns over time."
He and others also favor requiring each prospectus to carry an average expense ratio for funds in similar categories so consumers could see whether the ones they are investing in fall above or below that mark.
John Markese, president of the American Association of Individual Investors, would like the SEC to require each fund to include "on every statement it sends to each customer what that customer paid in expenses and sales commissions for the quarter and for the year to date."
The SEC is considering many of these suggestions. In addition, last spring the agency launched a study that is expected to be concluded this summer on fees, including whether economies of scale are passed on to consumers.
And it is looking at how independent directors on fund boards perform their task of making sure fees are reasonable. It's an issue that has been raised in several recent lawsuits, including one by two Maryland investors against T. Rowe Price. Many independent directors serve on the board of several funds owned by the same company. Plaintiffs argue that such directors, who are paid for each board they sit on, aren't truly independent and therefore can't act impartially on investors' behalf.
Henry Hopkins, general counsel of T. Rowe Price, said the company has done nothing wrong. "Our fees were very reasonable," he said, ticking off the many services the company offers by computer and telephone, services that require sizable investments in technology. "The level and quality of services we produce today is so much greater than 20 years ago, and certainly our fees have stayed in the ballpark."
Investment Company Institute officials say evidence suggests that consumers do indeed gravitate to better-priced products. About 77 percent of the 150 million mutual fund accounts are in funds with below-average costs, said ICI spokesman John Collins.
And ICI economist John Rea said bigger funds do have lower expense ratios. His claim is supported by Morningstar research, which shows that the 10 largest diversified equity funds have an average expense ratio of 0.66, which means they have 66 cents in expenses for every $100 invested, while the average expense of 20 funds in the same category but of medium size is 1.46, meaning they have $1.46 in expenses for every $100 invested.
But no studies have been done to show whether people flocked to lower prices or whether lower prices occurred because they flocked to those funds. And still unanswered is whether the lower costs of big funds are sufficiently low given the industry's growth.
Many industry experts believe these questions need to be addressed not just for the good of consumers but also for the good of the industry.
"Someday markets will come down," Barbash said. "And consumers are going to turn around and say, 'Hey, we've been paying all this money and we're not getting much for it.' If people believe they are paying for something that isn't a worthwhile service, and are paying too much for it, that they are getting gypped, they will end up leaving. That could hurt the markets and the industry."
The bottom line will rest with consumers. Whether they will make better use of additional information than they have with what's currently available is anyone's guess. "People scream about paying $1 in an ATM fee, but many people pay many times more than that in mutual fund fees, in unnecessary fund fees," said Morningstar's Rekenthaler.
"The mystery remains: Why don't people care enough to become experts in fees?" said ICI's general counsel, Craig Tyle. "It puzzles many people."
Here are some of the top U.S. diversified equity funds , ranked by five-year return. The last two columns show what a $10,000 investment would have grown to over five years -- excluding fees and accounting for them.
*Click for additional data
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