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Friday, April 22, 2005

Why Are Fund Fees Not Falling?

by: Sean Hanna, Editor in Chief

BusinessWeek takes a stab at answering this question in this week's issue. While the magazine paints part of the picture, it still fails to fully show the costs faced by fund advisors, the role those costs play in holding up fees and, most importantly, the increased levels of service and access now taken for granted by investors.

The nation's leading business magazine points out that the average expense ratio for the fund industry has actually risen -- not fallen -- during the past 15 years despite an eleven fold increase in assets. Morningstar crunched the data and found that in 1989 that dollar-weighted expense ratio for the industry was 94 basis points, 2 bps below the 96 bps average at the end of 2004.

"In theory, as fund assets zoom up, the costs of running a portfolio shouldn't rise nearly as much, so fees should fall. But that just isn't happening consistently," reports BusinessWeek. The magazine does note the recent fee cuts at two fund giants -- American Funds and Vanguard Group -- but warns investors not to expect "markdowns in total expenses industry wide."

The problem, according to the magazine, is middlemen, namely brokers and fund supermarkets, that "sell the funds take a big chunk of the money" through 12(b)-1 fees. It also notes a shift by investors who are now making more purchases of international and small cap funds that are more costly to operate because of higher research-related costs.

Interestingly, BusinessWeek fails to point out that all of the major distributors have repeatedly raised the supermarket fees during the past 15 years or that fund supermarkets did not exist in 1989. Even brokerages at that time sold primarily their own product at not those of competitors.

Fifteen years ago, a fund investor wishing to diversify among a number fund families would have had to open a number of accounts and waded through multiple statements. To transfer funds that investor would have been out of the market for weeks, or more, as the U.S. Postal Service checks made their way across country.

Today, thanks to Fund/SERV and fund supermarkets such as Schwab and Fidelity, those shareholders can move assets across fund families with a simple mouse click.

Of course, those improvements to the product have come at an increasing cost. Since Schwab first rolled out its fund supermarket and no-transaction fee program, it has raised its charges to fund firms a number of times. Today, those charges are 35 basis points in most cases, or up to a third of the total expenses incurred by a fund. Broker sold funds face similar charges to gain shelf space on wire house platforms.

A look at those numbers shows that just to stay in place with the increased revenue sharing, fund advisors have had to cut their expenses by up to a third in the period examined by BusinessWeek.

In addition, a quarter or more of fund industry assets are held in 401(k) plans. In many of those cases a substantial portion of the fees collected by the fund and its advisor are used to support recordkeeping and administrative costs that mostly did not exist 15 years ago when the bulk of 401(k) assets were corralled in insurer's general accounts or the employers' own stock.

In short, it is a different world today than 15 years ago, but that is a story, it seems, that the industry has failed to explain adequately to both regulators and the media.  

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