Spitzer overboard

Posted: Dec 11, 2003 12:00 AM

While watching the news on a trip to New York City, I happened upon State Attorney General Elliot Spitzer being interviewed by NBC's Gabe Pressman. Spitzer was tossed a softball about his next crusade against Wall Street, as though no month should ever again go by without more financial firms being accused of something or other. Spitzer then began to rant on cue about mutual fund fees being exorbitant, unfair and biased against the little guy.

Always one to overreach, Spitzer has clearly gone overboard this time. As UCLA law professor Steven Bainbridge points out, "N.Y. Attorney General Elliot Spitzer has no power -- none, nada, zilch -- to regulate mutual funds fees." To be more precise, he has "no constitutional right, statutory authorization or common law power" to tinker with such fees.

What Spitzer might be able to do, though, is to persuade Congress or the SEC to adopt his ill-considered solutions to this ill-defined problem. In testimony before the Senate banking committee a few weeks ago, Spitzer proposed that mutual funds be required to disclose "the precise dollar amount of fees charged to each investor ... (for) advisory, management, marketing and other administrative costs. Armed with this knowledge, investors can begin to engage in true comparison shopping among funds."

The idea is chimerical. Investors could not possibly compare "precise dollar amounts of fees" because only their own fund would provide such figures. Investors can't compare dollars, but they can easily compare percentages. Morningstar explains that all these fees "are included in the expense ratio, which is the most commonly used measure of a fund's overall expenses and a figure that is frequently used to compare mutual fund costs."

Many newspapers and magazines publish quarterly comparisons of mutual funds that include each fund's ratio of expenses to investments. Nobody but Spitzer cares how these expenses are split between marketing and advice. We care only about total expenses and only to the extent they affect total returns. This information is readily available in many published sources, and in every mutual fund prospectus. It's a lot easier than comparing lawyers' fees.

Nearly every newspaper also publishes daily figure on how each mutual fund is doing so far this year, and those results always subtract fees. If fees result in subpar returns, investors will switch to other funds that perform better with or without lower fees. If any fund's blend of returns and risk continues to attract investors, that means its fees are acceptable to its investors. The mutual fund business is extremely competitive and transparent.

Funds that merely match the stocks held in the S&P 500 stock index should have low fees because there is no research and little work involved. In this case, comparing fees is uniquely relevant because one index fund is like another.

Yet nearly all the largest mutual funds beat the S&P 500 handily over the past five years, and some routinely beat the S&P 500 for 10 years or more, including Legg Mason Value Trust, Meridian Value and Fidelity Contrafund. Fees for such well-managed funds are necessarily higher than for index funds, but returns have nonetheless been significantly better.

Sector funds, like Vanguard's health fund, also require a lot of research and expertise, so fees are bit higher. Fidelity Select electronics had impressive gains before and after the tech crash, even though that fund charges a sales load (which isn't usually subtracted from returns). Funds specializing in international stocks or small companies have their work cut out for them, so their fees are usually high. But that doesn't mean investors should never invest in managed or specialized funds simply because simpler funds have lower fees. Investors understand the dollars involved in a fee of, say, 1.2 percent and can decide for themselves whether or not that fund is worth its fees, even though Spitzer might prefer to ban that choice.

Aside from his Quixotic idea of requiring fund expenses to be broken down by purpose and reported in dollars, Spitzer also gets agitated about the fact that Putnam charged a higher "advisory fee" to its mutual fund customers than to giant pension funds. Complaining about discounted services for institutional investors makes no more sense than complaining that car rental companies get a better deal than retail car buyers. Folks with a 401k fund should be glad if their fund managers negotiate low fees. Any Spitzerian scheme to ban such volume discounts would be more likely to raise fees for our pension funds than lower them for our taxable accounts.

If Congress or the SEC could be persuaded to tinker with mutual fund fees in some way that accomplished what Spitzer promises -- to limit fees -- the "law of unintended consequences" would come into play with a vengeance. Small investors would soon be foreclosed from the best mutual funds.

Administrative costs are much higher for funds with many tiny accounts than for funds with fewer but bigger accounts. The Vanguard health fund thus keeps fees down by refusing accounts smaller than $25,000. Some outstanding funds have minimums much higher than that. The first consequence of any effort to cap mutual fund fees would be that most if not all funds would adopt a similar requirement, and thus be closed to those with little to invest.

Another handy way to cut costs, and thus comply with any new rules to limit fees, is to charge an annual "maintenance fee" on accounts smaller than, say, $10,000 (as Vanguard index funds do). If fees were arbitrarily constrained, we should expect such maintenance fees on small accounts to grow larger and more prevalent, if small accounts are permitted at all.

Limits on fees would probably also result in fewer no-load funds and more funds charging a sales commission (load) when the fund is purchased or cashed out. Fees charged by no-load funds are largely for marketing expenses. But commissions to brokers could replace advertising and other marketing expenses if fees were constrained by law or regulation, thus leaving a larger portion of the fee for other expenses.

Spitzer's latest crusade over mutual fund fees is literally none of his business. If he nonetheless got what he claims to want, the predictable result would be to keep small investors out of the best vehicles now available to them, thanks to increased minimum investment requirements and maintenance fees.

Endless and often baseless gripes from the Spitzer camp are pleasing the press but spooking many unsophisticated Americans who most need to be saving and investing for the future. Despite his pretentious ritual incantations of intent to "restore investor confidence," Spitzer's unfounded claims that the entire mutual fund industry is untrustworthy and overpriced can only have the opposite effect.