Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
On Wednesday, the Securities and Exchange Commission issued a proposal that could change the way fund investors pay for their mutual funds. Here to discuss the proposal and its possible implications for investors are Russ Kinnel, director of fund research for Morningstar, and Karen Dolan, director of fund analysis.
Guys thanks for being here.
Karen Dolan: Thank you.
Russel Kinnel: Thanks.
Benz: So there is a lot in the proposal. Russ, you've got it there, it's is hefty booklet.
Kinnel: 100 pages or so.
Benz: And we're still sifting through it, but the proposal really centers around Rule 12b-1, which is this opaque rule, and it has really shifted forms over the years. What is the SEC trying to accomplish with the proposal do you think?
Dolan: Well, we've been waiting a long time for it. This rule came into existence when the mutual fund industry was much, much smaller, and it offered funds a way to try to grow because funds have incredible economies of scale as they get larger.
And so, if they were able to spend some money of the fund assets to market and advertise and sell the funds, the thinking was those funds could grow, they could gain economies of scale and that actual expense ratios could come down as a result of that. So that's how the 12b-1 fee started, that was their original intent.
Benz: But it hasn't happened, right?
Dolan: Well, yeah. Russ had some great data on that actually.
Kinnel: Yes, so we looked at the numbers on expense ratios, and essentially the asset weighted number was 93 basis points in 1989. 20 years later in 2009, it had come down to 89 basis points. So we gained 4 basis points, and industry grew by trillions, about 10 or 11 fold. So, a gigantic growth. There are tremendous economies of scale in this business, but all of the economies of scale went somewhere other than to investors.
Dolan: And so the 12b-1 fee really what it became along the way was a way for paying for the intermediary, the financial advisor, paying for the fund supermarket, all of which do add value. But, however, it's just wasn't the original intent of the rule. So, a lot of what we are seeing here in this proposal is trying to bring the rule up-to-date with where the reality is.
Benz: Trying to clean it up a little bit and increase transparency. So it also would effectively cap what could fall under the 12b-1 umbrella at 25 basis points, and then anything beyond that would have to be considered a sales charge effectively?
Kinnel: That's right. And then essentially it says that a sales charge would be up to the broker, and therefore, you are essentially taking a fund company out of the business of collecting that sales charge, which is a great development, because you don't pay Microsoft to buy their shares, but what that potentially could mean is we could have an open architecture, depending on how it's interpreted, depending on how the brokers react, but you might be able to then buy American and Vanguard and Fidelity and Longleaf all together in the same basket and just pay the level of fees that you think are appropriate.
On the supermarket side, I've long been unhappy with the fact that you pay a Schwab or a Fidelity when you are a fund investor, you are paying their 40 basis point fee whether you buy from them or whether you buy from the fund company directly and the Schwabs and Fidelitys of the world prohibit the fund company from offering a lower cost fee, if you buy from them directly. So it really limits price competition.
Benz: So what you envision, Russ, would be a world or what this proposal might envision is a world where people actually pay for the service they receive. So if you want that flexibility that you get through a fund supermarket, you might pay a little extra for it, but if you're willing to go fund company by fund company and buy your funds directly, you maybe able to get around those extra layers of fees.
Kinnel: Yeah, you may have choice and price competition. In other words, capitalism could come to the fund industry.
Benz: Amazing! So one other thing I wanted to talk about, I know that you two think that fund fees could evolve even further, and it could be even clearer what investors are paying in various categories. Can you discuss the system that you think makes more sense and another direction that the SEC could possible consider?
Dolan: Well this does a big step in helping the 12b-1 or 12b-2 or now they are calling them service and marketing fees, a big step forward. But I'm really worried still that the other areas of the fees, the management fees, the administrative feels, when you bundle it all together into the expense ratio, there is still a lot of murkiness there.
Management fees aren't always being paid. What does it cost to have the portfolio manager or the analyst pay for the Bloomberg, pay for outside research. There are a lot of additional costs that are currently being put into the management fee that really are distributions, sales related, and so it's unclear to me whether this exact proposal is going to fix that.
And I think it goes a long way with fixing what's happening in that one bucket, but it would be nice to see a full wider-reaching proposal that makes it very clear exactly how all the buckets and make sure that it's all lined up with what the title is.
Because as investors, I want to know how much of my dollars at the end of the day are going to the management of the fund, how much of my dollars are going to the advisor I may have chosen, how much are going to market the fund and advertise to other shareholders, and how much is going into that overhead bucket, and so that's really what we are hoping.
Benz: So if you see two funds with equivalent expense ratios and you see that one has very high operating costs and the other has a lot of costs going to management and going to actually paying for research, you might want the one that that's paying more for management and less for the other stuff.
Kinnel: That's right, that's what the Oakmark/Harris case that went to Supreme Court illustrated was that management fee from a retail fund versus an institutional fund aren't comparable. And so it makes it harder for investors and even fund directors to accurately gauge what the management fees are--in the case of directors actually set them correctly.
Benz: Well, thank you both for sharing your insights. It will be interesting to see how this plays out, and I suspect that Morningstar will be weighing in with comments of its own. So, thank you.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.