Lawsuit Shines a Harsh Light on Subadvisory Fund Fees
Going to court to prove that a mutual fund charges small investors excessive fees is often an exercise in futility. For 30 years the courts have set the bar so high for plaintiffs in such cases that most suits are dismissed before they even get to trial.
According to a 1982 legal precedent known as the Gartenberg standard, the courts will deem a fund’s management fee excessive only if it is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” In part because it is often difficult to isolate the portion of management fees covering the crucial work of picking stocks and bonds from other more mundane administrative costs, proving that has been virtually impossible.
Until now. In December U.S. District Judge Renee Marie Bumb in Newark, New Jersey, allowed a case known as Kasilag et al. vs. Hartford Investment Financial Services to proceed, denying Hartford’s motion to dismiss. (Jennifer Kasilag is one of six plaintiffs who invested in Hartford funds.) The reason for the decision has everything to do with the type of mutual funds the plaintiffs chose to attack.
Level of transparency
Rather than go after, say, Fidelity, which manages funds in-house and bundles together most of its costs in its management fees, Kasilag’s lawyers targeted Hartford’s sub-advised funds, run primarily by Boston-based external manager Wellington. The fees Hartford pays Wellington specifically to pick stocks are spelled out in public documents and are separate from the fees Hartford charges for other services, so they provide a level of transparency that can better indicate whether the total management fee is excessive.
Part of the difficulty with previous shareholder suits is that plaintiffs would compare a mutual fund’s management fees to those of pension plans, arguing that the latter pay a fraction of the cost. Defendants would respond that it was an apples-to-oranges comparison because mutual funds have all sorts of additional administrative, advisory and legal costs baked into their management fees from handling multiple shareholder accounts.
“We can all intuitively agree that managing a mutual fund is more complicated than managing a single pension plan’s portfolio of $100 million, but the question is how much more complicated?” said Paul Ellenbogen, who as director of board consulting at Morningstar provides advice to fund directors about fees. “How do you quantify that?”
'Out of balance'
The breakout of Hartford’s sub-adviser fees provides an answer to that question. According to Kasilag’s complaint, in 2010 Hartford earned $157.6 million in investment management fees from six of its sub-advised funds and paid $57.6 million for subadvisory services to Wellington and Hartford Investment Management Company (HIMCO), a Hartford subsidiary hired as a sub-adviser. (More than 90 percent of the fees in dispute are for four Wellington sub-advised funds.)
“If a management fee is higher than the subadvisory fee and the sub-advisers are doing all of the work, you really have to ask yourself what the management company is doing for its fee,” said Niels C. Holch, executive director of the Coalition of Mutual Fund Investors, a shareholder advocacy group based in Washington. “It seems out of balance.”
Hartford executives declined multiple requests to be interviewed about the case. In an e-mailed statement spokesman Julia Zweig said, "We are confident in the reasonableness of our fee structure, and intend to defend vigorously."
Typically, there is one additional cost of having a sub-advised fund as opposed to an internally managed one: The adviser must monitor the sub-adviser to make sure its performance is adequate and that it is following its investment mandate. Is it worth paying Hartford $100 million a year to keep an eye on Wellington and HIMCO? Wellington, which has $748 billion in assets under management, is one of the largest, most well-respected money managers in the world.
As for administrative costs, many of these should be taken care of by an additional "Other Expense" fee Hartford and many funds charge shareholders. According to the Securities and Exchange Commission, the charge usually covers expenses for "payments to transfer agents, securities custodians, providers of shareholder accounting services, attorneys, auditors, and fund independent directors."
At the Hartford Healthcare Fund, one of the funds named in the suit, this “Other Expense” amounted to 0.34 percent of assets annually. That was in addition to the 0.90 percent management fee. Morningstar’s Ellenbogen did a screen of actively managed stock funds that disclose their administrative costs separately from their other fees and found the average cost to be 0.09 percent of assets.
The type of deal Hartford has with Wellington is commonplace in the industry. Most sub-advised funds have similar arrangements. For example, at a shop such as Aston Funds, which manages 23 sub-advised funds with $11.5 billion in assets, the typical arrangement is for Aston to collect half the management fee and the sub-adviser the other half. Aston, which is not involved in the Hartford case, declined to be interviewed.
It's also common for sub-advised mutual funds to have higher expenses than funds that are managed in-house. According to a 2011 study by fund tracker Lipper, the average sub-advised equity mutual fund charges 0.10 percentage point (10 basis points) more than the average internally managed one. For bond funds the difference was about 0.05 percentage point.
Even in cases where two funds are run by the same manager in very similar styles, the fees are higher for the sub-advised version of the funds. For example, retail shares of the Aston/Doubleline Core Plus Fixed Income Fund, sub-advised by DoubleLine Capital LP, have a 0.55 percent management fee and a total expense ratio of 0.96 percent. The DoubleLine Core Fixed Income Fund, meanwhile, has a management fee of 0.40 percent and a total expense ratio of 0.80 percent for retail shareholders.
In the same vein, administrative shares of the Harbor Bond Fund have a total expense ratio of 0.80 percent, while Pacific Investment Management Co.'s Total Return Fund has an expense ratio of 0.71 percent, even though the funds are run by the same manager in a very similar style. (DoubleLine, Harbor Funds and Pimco are not involved in the Kasilag lawsuit.)
A key argument plaintiffs put forth in the Hartford case is that competitor Vanguard offers similar funds run by Wellington for much less. Both the Vanguard Health Care and the Hartford Healthcare funds are run by Wellington. Vanguard has a total expense ratio of 0.35 percent, compared with the 1.49 percent charged by Hartford Healthcare’s A share class. That’s on top of the 5.5 percent front-end commission paid to brokers who sell it; Vanguard’s fund is no-load. Wellington declined to comment on the Hartford case.
Hartford "urges the Court to reject this comparison, arguing that Vanguard is a not-for-profit entity that specifically markets itself as a low-cost mutual fund provider,” according to Bumb's opinion.
Such a defense may not explain Hartford's fees on the subadvisory level. While Vanguard doesn’t seek a profit, Wellington does, whether it's working for Vanguard or Hartford. Vanguard pays Wellington 0.15 percent as manager of Vanguard Health Care while Hartford pays Wellington 0.40 percent to manage Hartford Healthcare, according to current SEC documents.
Economies of scale could partly explain the gap between the fees. Vanguard's huge size allows it to negotiate "a far better price when hiring money managers than anyone else," said T. Neil Bathon of Fuse Research Network. Kasilag’s lawyers argue that the fee disparity reveals that Hartford’s subadvisory fee wasn’t a product of successful “arm’s-length bargaining” with Wellington as the Gartenberg standard requires.
The argument that for-profit companies in the mutual fund business serve "two masters" -- the overarching management company's owners and the shareholders in the funds -- and fail as fiduciaries as a result is one Vanguard founder John Bogle has been making for decades. Vanguard is the only fund company run at cost.
Vanguard has been mum about the case. While Dan Newhall, a Vanguard principal who works on its deals with external advisers, declined to discuss Hartford specifically, he feels it’s unfair to compare any fund shop to Vanguard because of its unusual non-profit structure.
Instead of suing, Newhall thinks (unsurprisingly) that unhappy shareholders should simply move accounts to Vanguard. “There’s nothing to keep shareholders from moving from more expensive funds to less expensive funds,” he said.
Such a solution won’t help those Hartford shareholders who feel they paid excessive fees in 2010. They’ll have to wait for a settlement or for the trial to commence.
(Lewis Braham is a freelance writer based in Pittsburgh.)
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