Are Fund Fees Excessive?

Plaintiffs' lawyers periodically charge that mutual funds impose excessive fees. But costs in the industry have been declining steadily. Expense ratios for equity funds dropped from 1.05 percent in 2003 to 0.90 percent in 2007, according to Strategic Insight, a fund researcher in New York. Front-end loads have also plummeted, dropping from an average charge to investors of 2.46 percent in 1995 to 1.15 percent in 2007, according to the Investment Company Institute, the mutual fund trade group.

Will costs keep dropping? Probably. Major trends in the fund industry seem likely to continue lowering expenses.

For starters, average front-end loads paid by investors should drop as more financial advisors shift to fee-based practices. “The traditional front-end load business is being marginalized,” says Avi Nachmany, research director of Strategic Insight.

To assess the state of loads, Strategic Insight surveyed major fund companies that sell through advisors, including American Funds, Franklin Templeton, MFS and Oppenheimer. These companies once depended on sales of front-end load shares. But in 2007, A shares with 4-percent-or-greater loads only accounted for 6 percent of the group's $750 billion in total sales; no-load funds accounted for 34 percent.

Not Dead Yet

To be sure, load shares remain a substantial business. Level load — or C class shares, which typically charge annual 12b-1 fees of 1 percent — accounted for 13 percent of mutual fund sales in 2007, according to Strategic Insight. What's more, sales of C shares enjoyed the strongest growth of any share class, rising 26 percent from the year before. Much of the C-share growth has come from advisors seeking to take limited steps toward a fee-based practice. By using C shares, an advisor can charge annual fees on a fund holding or two — and still use transaction fees on other assets.

Meanwhile, A shares are still alive and well, though the way they are being used is changing. Much of the activity comes from fee-based advisory programs. “We are seeing A shares being sold with the load waived at many advisory programs,” says Lindon Keyes, head of mutual fund products for Smith Barney.

Strategic Insight reckons that fee-based programs now account for 75 percent of sales for fund companies that depend on advisors. The fee-based business is growing steadily at major firms such as Smith Barney. Recently, traditional commission-based firms, such as Edward Jones, have shifted to selling some funds on fee-based platforms.

The move to fee-based investing is helping to lower fund expense ratios. Many fee-based wrap programs, and even 401(k) plans, now offer institutional class shares to retail investors at lower expense ratios than were available in the past.

As much as anything, the growth of the fund business has been putting downward pressure on fees. Total industry assets climbed from $6.3 trillion in 2002 to $12.0 trillion in 2007. Economies of scale have enabled funds to lower their expense ratios and offer breakpoints to investors as assets rise. Low-expense ratios provide major companies with an increasingly important competitive edge. Partly because of their low-expense ratios, major fund families like Dodge & Cox and American Funds have been delivering strong total returns. That attracts more assets, which leads to more economies of scale, and further reductions in fees.

The Low-Fee Advantage

Low fees have become an important advantage for funds that struggle to attract new assets. In recent years, financial advisors and retail investors have become savvier about the importance of fees. As a result, they have been avoiding the most expensive funds — regardless of returns. According to the Investment Company Institute, 91 percent of new fund flows in recent years have gone into funds with below-average expense ratios. For index funds, 99 percent of new flows have gone to the cheaper funds.

Fund industry critics have called for lowering fees further by reducing 12b-1 fees. The SEC is likely to propose new 12b-1 rules this year. While the shape of any proposal is still uncertain, Andrew J. Donohue, director of the SEC's Division of Investment Management, has talked about requiring that C shares convert to A shares after a set period, such as five years. Some financial advisors oppose changes, fearing that firms would have to spend more to track share classes and provide disclosures.

That might cause advisors to switch to no-load funds in fee-based accounts. “The industry has already been making a gradual transition to fee-based accounts,” says Nachmany. “That transition could accelerate, if some of the changes in 12b-1 rules are adopted.”

Nachmany says that eliminating C shares would not necessarily benefit shareholders. Instead of paying 1 percent in 12b-1 fees on C shares, shareholders could end up paying 1 percent in costs for fee-based accounts. Regulators who hope to lower costs may need to find a different strategy.