By Jason Zweig | Jan. 7, 2017 9:23 am ET
Image credit: Model 79, National Cash Register (ca. 1894), The National Museum of American History
My column in this weekend’s Wall Street Journal looks at why expenses on mutual funds have remained so rigid for so long. Here’s the first in-depth article I ever wrote on fees, back when I was the mutual-funds editor at Forbes magazine. It provoked dozens of angry letters and phone calls from top executives at fund companies complaining that we had distorted reality.
We probably had: With hindsight, it looks as if we understated how badly fund companies were overcharging investors and how intensely they were focused on confusing their clients rather than treating them fairly.
It might seem odd, from today’s viewpoint, that we said in this article that any fund charging more than 2% in annual fees was a ripoff. But that shows you just how expensive many funds were then — and how much praise asset managers deserve for reducing their fees. Not very much: Fund companies have gone from committing highway robbery to petit larceny.
As hundreds of billions of dollars continue to flee mutual funds, asset managers in search of the culprits shouldn’t be pointing fingers; they should be looking in the mirror.
Fee Madness
Jason Zweig and Mary Beth Grover
Forbes Magazine, Feb. 15, 1993
Do you really know how much you are paying in fees when you invest in a mutual fund? Here’s how to avoid getting nicked by fee-greedy fundsters.
It should be a buyer’s market out there for mutual funds. Everybody wants to get into this extremely lucrative business, and almost anybody can get in: There are already 4,000 funds clamoring for investors’ attention. New ones are rolling off the assembly line at the rate of one a day.
But all this creates a problem for even the most sophisticated investors. It is getting harder and harder to know how much you are paying for the fund manager’s services. The fact is that some fund managements are getting ever more imaginative in soaking the customer. They often do so by confusing investors with complexity.
By our count, there are now nine different ways to reach into the fund buyer’s pocket. We’d be surprised if the number didn’t increase before year’s end.
How do you, the investor, know whether you’re paying too much for the funs manager’s services? Here’s our definition of a bad buy: a fund that costs 2% a year for the time you hold it. Our definition of a really bad buy: a fund that eats away 3% of your money per year.
You can easily blunder into such a situation if you pay a load and leave quickly, or if you happen into a fund with an unusually high annual expense ratio.
Shearson’s Advisors Fund, for example, runs an annual expense ratio of 3.86%; on top of this drag on performance there is a one-time sales commission that goes as high as 5% (on an investment of $100,000 or less).
The Kaufmann Fund and the Prudent Speculator Leveraged Fund assess no sales loads but run annual expenses that are above 3%.
In the merely bad category are scores of funds with annual expenses over 2%.
What’s so bad about a 2% fee for professional money management in a market that seems to be shooting up 15% a year? Just the fact that you can’t count on that 15% for very long. Remember: You will still be nicked 2% if the fund loses money for you. With the market at an extremely high valuation by historical norms, it’s reasonable to assume that stocks are due to deliver real (after inflation) returns of only 6% a year — before expenses, that is. A bad-buy stock fund, then, is fixing to take a third of the real money you can expect to earn on your investment. Or to aggravate any losses the fund may incur in bad markets.
Bond funds are not immune to these hidden costs. Given current inflation and interest rates, the real return on medium-to-long-term U.S. Treasury bonds will be about 4%. Bad-buy Treasury funds are gobbling up half your prospective earnings.
For decades this magazine and others have been educating the investing public about the virtues of comparison shopping for funds. Unless you really need hand-holding by a stockbroker, we have said, buy a no-load. You can usually find one to suit any need.
That message has finally sunk in, but load fund groups, confronted with clients who are wary of upfront sales commissions, are firing back with a dizzying assortment of other fees that accomplish the same purpose. A fund might eliminate its upfront sales charge but then throw in a 12b-1 fee to finance marketing and distribution costs. Or maybe it offers you a deal: We’ll lower your annual 12b-1 fee by a quarter of a percentage point, but then we’ll tack on an identical amount for “servicing.”
The game board started getting really messy in 1988, when Merrill Lynch introduced dual-class shares in virtually all of its retail funds. The Class A shares carry a maximum 6.5% front-end load — every $1 you put in buys you 93.5 cents worth of fund shares, the rest going to the broker. The B shares carry, no front-end load — $1 buys you $1 — but the broker gets you on the way out. When you redeem a B share you could leave up to 4% with the broker. The idea of paying the load later seems to have big appeal. B shares are selling like hotcakes, and last year the Securities & Exchange Commission received 44 requests from fund companies to approve new multiclass shares.
In 1991 and 1992 PaineWebber thickened the alphabet soup with C and D shares. The C’s have no load and no 12b-1, while the D’s have no load but charge 1% in annual 12b-1 and “service” fees. The C’s, of course, would be the best deal. But you can’t buy them, unless you work for PaineWebber.
This labyrinthine game, so bewildering to the consumer, is a jackpot for fund companies and brokers. Last year, says Financial Research Corp. of Chicago, 60% of the multiclass funds sold by brokers — some $17.3 billion worth — went into these new classes of shares. “That’s a pretty compelling number when you consider that a lot of fund families just introduced them last year,” says financial services consultant John Keefe.
Broker-sponsored funds are not the only ones confusing investors. Last month Dreyfus Corp. got the SEC’s blessing to issue at least two classes of shares for all of its funds. Fidelity, which sells mostly low- and no-load funds over the phone, is trying to keep its distribution options wide open. The fund giant has obtained permission to issue “an unlimited number” of classes.
This business is getting so out of hand that newspapers around the country are asking the Associated Press, which collects daily fund data, to limit its listings. Says Jill Arabas, who helps oversee fund tables at the AP: “The papers are freaking out, saying, ‘Stop! We don’t have room!'”
Don’t look for any rescue from the folks who run the funds. Ostensibly, fund directors are there to represent your interests. They are, for example, supposed to approve 12b-1 assessments (named after an SEC regulation allowing them) only after determining that existing shareholders benefit when some of their money is spent to attract new customers.
With 12b-1 charges, funds can attract more customers and a greater pool of assets over which to spread fixed costs like legal and accounting fees — or so goes the logic behind the rule. Curious thing is that after years of ever more common 12b-1 plans, equity fund expense ratios refuse to come down.
Today 40% of equity funds carry 12b-1 fees. It’s big business. In the first three quarters of last year, Dean Witter, with $58 billion in fund assets under management, earned more from 12b-1s — $175 million — than it did from management fees.
Just how does the fund industry play Fee Madness? Let’s flip over some of the cards.
Buy now, pay later. Once called back-end loads, these shares, usually rechristened as Class B shares in multiclass funds, carry a higher 12b-1 fee than Class A. The typical Class B shareholder incurs a load only on selling the shares; this back-end load falls from 5% or 6% to zero within five to eight years. Many B shares convert to Class A at the end of this waiting period.
Brokers push these funds as quasi-no-loads. Yes, there’s a sales commission, but stick around long enough and you don’t have to pay it. That’s how most short-term global bond funds were flogged last year. When investors stampeded out after Europe’s currency upheaval last fall, they suddenly found themselves paying loads they had forgotten about. The loads accentuated their losses.
Among the big buyers of B shares are bank customers fleeing certificates of deposit. “It’s easier to sell them funds that have the appearance of no-loads,” says consultant Keefe. Last year, for example, 50% of Putnam’s B shares were sold to bank customers.
Do the buyers know what they have gotten into? Many do not. Warns Tom Decker Seip, mutual fund chief at Charles Schwab: “As surely as the sun rises tomorrow, you can bet that if interest rates go up and bond fund prices fall, people will be screaming that their salesman didn’t tell them about the back-end load.”
Even if the funds do well, people will be screaming about the paperwork. Take the befuddling bifurcation of Kemper Growth Portfolio, an equity fund that is split into “initial” and “premier” shares. The initial shares charge a 0.75% 12b-1 fee — that is, the investor is nicked 75 cents per year for every $100 invested in the fund. The premier shares do not pay this annual charge. Initials convert to premiers after six years. The two classes have separate daily net asset values and different returns.
And what if you buy a little of the fund every month? Each purchase is tracked separately, has one of three different back-end loads, depending on when you sell, and converts on a different date. Tell that to your accountant when you make a partial withdrawal from the account.
Buy now, pay forever. Welcome to the world of “level-load” shares. Getting into one of these funds is like getting trapped in a taxi with the meter running. Pioneered by Thomson and PaineWebber, this kind of fund is being considered by Alliance, Colonial, Putnam and others. Most level-load shares charge no front-end load but an annual 0.75% 12b-1 and a 0.25% service fee — forever. Both these charges are added to the regular management fee, which alone can easily top 1% a year.
Who sold you this thing? Then there are the ASO Outlook funds managed by AmSouth Bancorp. of Birmingham, Ala. According to a November SEC filing, these include: Class A, sold through AmSouth branches or outside brokers, carrying a front-end load yet to be determined and a maximum 0.40% 12b-1 fee; Class B, sold mainly to other financial institutions, charging no load but carrying a 0.25% 12b-1 fee; and Class C, sold through the bank’s trust department, charging no load and no 12b-1. Buy through a broker, buy through a bank or buy through the trust department: different fees each time.
Pay twice. Fund shareholders may find themselves paying for a broker’s “services” years after forking over a sales commission. In January Seligman piled on a maximum 0.25% annual service fee for the benefit of the chap who sold you the fund; this is on top of the maximum 4.75% front-end load shareholders had already paid.
Get a price cut, and still pay the same. Buy Eaton Vance’s new Greater China Growth Fund, and you pay a 0.50% 12b-1 fee in the first year. The second year, your 12b-1 fee drops to 0.25%, but a 0.25% “service fee” miraculously appears. Even if you fire the broker, you still pay the fee.
Pay to stay. Most fund operators are thrilled to have customers reinvest their dividends — it gives them more assets on which to assess management fees. Franklin Resources, though, charges investors in most of its bond funds a 4% commission to reinvest their income dividends. Of Franklin’s $331 million in fee revenue in fiscal 1992, close to $30 million came from dividend loads. A handful of other funds assess reinvestment loads.
Pay à la carte. Fidelity’s Spartan funds have low annual expenses (lower than other Fidelity funds, anyway) but charge customers with less than $50,000 a $5 fee for each withdrawal or transfer.
Pay a flat load. Is the Blanchard Short-Term Global Income Fund a no-load? Blanchard will sell you shares directly with no sales charge-but you will have to fork over a $75 “account opening fee.” On the minimum $3,000 investment, that’s the equivalent of a 2.5% load.
A sister to the flat load is the flat annual expense charge. Thus, the Vanguard Extended Market Portfolio boasts of its low 0.19% annual expense ratio but doesn’t include the flat $10-a-year account maintenance charge. On a $3,000 minimum investment, this $10 fee almost triples the published expense ratio, to 0.52%.
Pay a surprise increase. The Scudder Medium Term Tax Free Fund charges no annual expenses at all. What is this, a charity? No, just a come-on rate. Scudder is temporarily absorbing costs totaling 0.77% a year. The sale could end as soon as June 30 — or maybe not. Sponsors of at least 522 funds are absorbing expenses. They figure inertia will keep the customers even after the sale is over.
If all this sounds like nickeling-and-diming and not worth getting exercised about, consider this: The difference between 1% in fund expenses and 2% can make a mighty difference in your long-term return. Assuming stocks deliver their historical return of 10%, over ten years that extra charge will reduce your return by more than $2,250 on a $10,000 investment. The relative damage could be far greater if — as is not at all unlikely — the market hits some bad patches over the next few years.
So stick to funds with low overall costs. Keep a close eye on the annual expense figure. The tables that begin on page 166 should help you. In addition to performance ratings for bull and bear markets, the tables show a composite expense estimate for each fund. This figure combines the effect of an upfront sales load with five years of total annual expenses, assuming a $1,000 investment. The number is similar to, but a little lower than, the five-year expense projection published at the front of a fund prospectus.
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