Are Fund Managers Carving Themselves Too Fat A Slice?
The $180 million Kaufmann Fund is one hot property. It had a nifty 79.4% total return last year, and investors are now shoveling in money at the rate of some $500,000 a day. They seem to pay no attention to Kaufmann's unusually high expense ratio of 3.50%. That's what investors pay annually out of the fund for portfolio management, marketing expenses, and overhead. It's more than twice that of the average equity fund. "It's on the high side," admits Lawrence Auriana, one of the portfolio managers. "But we think our shareholders get good value for their money."
Perhaps. But some analysts are wondering whether the fund industry--which experienced a tenfold increase in assets over the past decade--is giving shareholders a fair shake on fees. Says Don Phillips, publisher of Morningstar Mutual Funds: "The benefits of the tremendous economies of scale unleashed during the past decade were not shared with fund shareholders."
The numbers tell the story. The average expense ratio on equity funds is up from 1.19% in 1980 to 1.57% in 1991, according to Morningstar Inc. (chart). Although a 0.38% increase doesn't sound like much, it's $1.4 billion a year on equity-fund assets of $375 billion.
BANG-UP JOB. During the same period, bond-fund expenses climbed from 0.90% to 1.06%. And that's only the average. For example, 11 government bond funds and five municipal-bond funds have expense ratios of 2% or more. With interest rates on governments running below 8% and high-grade munis below 7%, a 2% expense ratio can eat up as much as one-third of the income that could flow to shareholders.
Mutual funds have done a bang-up job for investors, especially last year when they left the stock- and bond-market averages in the dust. And A. Michael Lipper of Lipper Analytical Services Inc. notes that funds provide money management at far less cost to consumers than such alternatives as individual money managers, banks, and insurance companies. Measured in constant dollars, the average equity-fund shareholders are paying about the same advisory or management fees as a decade ago, says Charles Dornbush, chief financial officer of the Fidelity Funds. Nonadvisory expenses are up about 18%, but, he adds, "10 years ago, you didn't have 24-hour account service, integrated financial statements, and other services."
True, there's no industrywide move to raise management fees--the money that goes to the portfolio manager and his research and support staff, which accounts for roughly half of total expenses. But despite sharp competition in the industry, these fees are not coming down as they are in the pension-fund business. "Perhaps that's because pension-plan sponsors pay attention to fees," notes Charles Trzcinka, a finance professor at the State University of New York at Buffalo.
Fund companies can't hike their management fees unilaterally. They need the approval of the funds' outside directors and shareholders, who have recently been generous. They have generally O. K.'d increases in management fees when requested by such companies as IDS, T. Rowe Price, Putnam, Smith Barney, and Templeton. Shareholders of Templeton Funds' four oldest and largest funds--Growth, World, Small Companies, and Foreign--voted to raise the base fee to 0.75% from 0.50%, the same as Templeton's newer funds. Says Daniel Calabria, president of Templeton Funds Management Inc.: "Those funds' fees have never been raised." Even with the hikes, he adds, the funds will still have below-average expense ratios.
HEAVY LOAD. The funds say fee changes are based on performance and industry norms. Gordon H. Silver, senior managing director at Putnam Cos., points to a consultant's study that looked at 29 Putnam funds and recommended hikes for 12, decreases for 9, and no change in 8. Fees on 5 Price funds were increased, and they were lowered on 4 funds.
But one component of the expense ratio was almost nonexistent 10 years ago and today comprises 15% of fund expenses, some $100 million. That's the "12(b)-1 fee," named for the Securities & Exchange Commission rule that enabled funds to levy it. About half of all funds use these plans, which let them tap assets to pay for marketing expenses--mainly brokers' commissions for selling the fund to individual investors.
In effect, this allows the fund to reduce the sales charge, or "load"--the broker's up-front payment. That appeals to investors who are increasingly wary of paying high loads. But an up-front load is a one-time charge, while the 12(b)-1 fee is an ongoing expense. The broker gets a commission as long as the client stays in the fund. Consider an investor in a fund that earns, say, 10% a year and charges an annual 12(b)-1 fee of 0.50%. After 10 years, those little fees add up to the equivalent of an 8.5% load.
Ironically, the idea behind the 12(b)-1 fee was that by spending fund assets on marketing, the funds could attract more money. With more assets under management, the funds would achieve economies and thus would lower shareholder expenses. The SEC staff has been studying the effects of the 12(b)-1 for five years but has not yet sent any proposed changes to the commission.
No one should rule out investing in a fund just because it has a high expense ratio. After all, a fund's performance is what counts. Last year was a phenomenal year, and expenses hardly dented investors' bottom lines. But 1992 is shaping up as a year of more modest returns, and high expenses could weigh more heavily on shareholder profits.