Hidden Fees Spell Trouble for Funds Spitzer Underscores Disparity of Advisory Fees
February 2, 2004
WASHINGTON- Excessive fees and inadequate disclosure represent far more serious threats to mutual fund shareholders than the trading abuses uncovered in recent months and will require more stringent legislation to remedy them. And it's time to take the bull by the horns.
That was the message resonating from Capitol Hill last week as industry professionals, government regulators and whistleblowers delivered testimony before the Senate Subcommittee on Financial Management, the Budget and International Security.
Legislators believe late trading and market timing are abuses that could have been effectively curtailed through stricter enforcement and compliance, but addressing excessive fees and a lack of transparency is a much more daunting task.
Different Strokes for Different Folks
Responding to a wave of industry criticism for forcing funds to cut fees, New York Attorney General Eliot Spitzer fiercely defended his position that any settlement reached between a tainted fund shop and his office must contain some sort of advisory fee reduction.
"Requiring mutual funds to return to investors money that should never have been taken from them is not rate-setting," he told members of the subcommittee. "It is what regulators across the country do every day when they uncover evidence that consumers have been ripped off, and is what I will continue to do as I uncover more evidence that mutual fund investors have been cheated."
The unflinching attorney general illustrated his point by presenting data provided by two of the fund companies slapped with civil fraud charges. In 2002, Putnam Investments of Boston charged its mutual fund shareholders 40% more in advisory fees than its institutional clients. That represents an additional $290 million for individual investors.
Alliance Capital's mutual fund customers paid twice as much as their institutional counterparts, ponying up an additional $200 million. Spitzer's settlement with Alliance requires the firm to reimburse investors through a five-year, 20% reduction in advisory fees.
"There are two different fee structures being imposed, and we could demonstrate that in litigation," Spitzer testified.
The argument originated when the Investment Company Institute issued a report that aimed to refute evidence that mutual funds pay more than institutional clients. The trade group stipulates that investment advisory fees paid by pension plans are primarily for portfolio management, whereas management fees imposed on fund shareholders carry not only portfolio management expenses, but also a variety of administrative costs associated with running the fund.
Spitzer argued that the ICI study was "misleading and false" primarily because it was based exclusively on data concerning the fees that sub-advisors charge management companies. Sub-advised funds represent a narrow slice of the industry, comprising a mere 7% of the mutual fund universe, according to a recent Business Week poll.
And those funds often impose additional costs on top of the sub-advisory fees, which the ICI report does not include. Spitzer said that the ICI report does not take into account that fees charged by sub-advisors are not the typical way fees at most mutual funds are approved. Rather, they are the product of arm's length negotiation between two disinterested parties.
Paul Schott Stevens, an attorney representing the ICI, testified that retail mutual funds have thinner profit margins than public pension plans. The average profit margin for a retail mutual fund is roughly 23.1%, while the average institutional holding yields a 29% profit margin, he noted. Stevens dismissed the notion that fund companies charge significantly different prices for nearly identical services, calling it an "apples to oranges" comparison.
"Price gouging over advisory fees is rampant, and the industry is in denial," said John Freeman, a law professor at the University of South Carolina and author of an academic paper on fund fees. "Overcharging for portfolio management has been the industry's dirty secret for years."
Freeman cited an instance where Alliance was charging 93 basis points, or $162.7 million a year, for managing the $17.5 billion Alliance Premier Growth Fund. At the same time, the company was managing the Vanguard U.S. Growth Fund for only 11 basis points - less than 1/8 of what it was charging its own shareholders.
In addition to the advisory fee mess, Freeman spoke out against other shady practices including revenue sharing, soft dollars and directed brokerage arrangements. Broker/dealers have increasingly required mutual funds to make additional compensatory payments outside of sales loads and 12b-1 fees. These revenue sharing payments come straight from the adviser's bottom line and may supplement distribution costs from fund assets. Mutual funds pay brokers up to $2 billion annually in revenue sharing payments, according to the U.S. General Accounting Office.