Fee Waiver Practices Are Provoking Debate
March 6, 2000
Nearly half of the industry's mutual funds are on sale. Whether that represents a bargain or a potential headache for shareholders is the subject of disagreement within and outside the mutual fund industry.
A fund adviser's decision to gradually reduce its fee waiver is becoming a key part of the debate about the fairness of mutual fund fees. The flexibility of fee waivers - the practice of a fund adviser agreeing to limit or forego its fee as part of a cap on the expenses of a fund - effectively allows advisers to increase their fees without getting approval from fund shareholders, according to critics of the practice. That, the critics say, is unfair.
"It's just not the right thing to do," said Paul Haaga, Jr., executive vice president of Capital Research & Management of Los Angeles, adviser to the American Funds. "It's not straightforward. It's not honest."
Fee waivers are common in the mutual fund industry. Forty-five percent of funds had fee waivers in 1999, according to Lipper of Summit, N.J., the fund tracking and consulting firm.
Under federal securities laws, funds must ask shareholders to approve an increase in fund fees through a proxy vote. The outcome of proxy campaigns is uncertain and the campaigns themselves can be expensive to wage, fund lawyers said.
A fund adviser can avoid the proxy process by setting its initial fee and then agreeing to waive a portion of it. The adviser then can peel back the waiver over time without proxy votes, a move that increases the amount of fees that the fund adviser receives. In some instances, a fund adviser can reduce the fee waiver without the vote of the fund's board of directors.
Although there appears to be no industry-wide data on the issue, reductions in fee waivers outnumber proxy votes seeking fee increases, according to fund executives, lawyers and consultants. Reducing a fee waiver without a proxy vote is legal but is not consistent with the spirit of the federal securities laws, Haaga said.
"It's legal but it's not right," Haaga said.
Haaga is not alone on the issue. John Bogle, founder of the Vanguard Group of Malvern, Pa. has railed against the gradual lifting of fee waivers.
Low fees are not a problem but "what is objectionable is the practice whereby investors are subsequently saddled with onerous fees, without ever being informed of the change," Bogle wrote in his book Bogle on Mutual Funds. Bogle was not available for comment last week.
Bogle's views are shared outside the industry. Fee waivers are a sales technique used to attract assets, said Louis Stanasolovich, president of Legend Financial Advisors of Pittsburgh, an investment advisory firm that invests in mutual funds. When they buy a fund, investors usually do not understand that the adviser may gradually reduce the waiver, he said.
"I don't like that game," Stanasolovich said. "It certainly misleads people, I think."
Investors would be better served if they received a document when purchasing a mutual fund that explained in clear language the pros and cons of fee waivers, Stanasolovich said.
The debate over fee waivers comes as the fund industry is being scrutinized about the fees it charges. Both the General Accounting Office and the SEC are conducting studies of mutual fund fees. Both agencies are expected to issue their reports later this year.
Investors have access to abundant information about fees and fee waivers through fund SEC filings, fund company websites and independent data trackers such as Lipper and Morningstar of Chicago, fund executives and lawyers said. They deny that a reduction in a fee waiver is tantamount to circumventing a shareholder vote.
Setting a fund fee at a fair level and then deciding whether or not to reduce that fee affords investors the chance to get what amounts to a bargain, said David Sturms, a lawyer with Vedder, Price, Kaufman & Kammholz of Chicago.
"In fact, it is great for the investors that are getting that" deal, Sturms said.
Businesses of all sorts subsidize the cost of new ventures at the start, fund executives and consultants said. It is unreasonable to assume that advisers should offer to cut their fees indefinitely, fund lawyers said.
"People are not going to commit themselves to providing a below market advisory fee forever and ever," said Pamela Wilson, a lawyer with Hale & Dorr LLP of Boston.
Waivers have become a business necessity for new funds, executives, lawyers and consultants said. New funds must waive fees and cap expenses to insure that they can compete with their larger peers that have the benefit of lower expenses thanks to economies of scale, said Jeff Keil, a vice president at Lipper.
"You really necessarily have to waive to stay in the game," Keil said.
Indeed, fee waivers contribute to price competition in the fund industry, executives said. Fee waivers benefit fund investors by making it possible for new funds to be launched, said Thomas Sheehan, director and counsel for the Forum Financial Group of Portland, Maine, a mutual fund transfer agent, fund accounting and shareholder services firm. Without waivers, new, small funds would have high fees that would make them unable to compete effectively with larger, established funds, Sheehan said.
"Without the ability to waive fees, many currently successful funds never would have gotten off the ground and investors would see a significantly smaller universe of fund investment opportunities," Sheehan said.