SEC May Put the Squeeze on Pricey Index Funds

A recent Los Angeles Times article reported that the SEC is investigating one of the mutual fund world's more vexing mysteries: Why do some index mutual funds cost so darn much? 

What's most remarkable about the SEC's heightened interest in this area is that it seems to signal a shift in the commission's rulemaking posture. Rewind two months to the Alliance Capital Management settlement--under which Alliance agreed to institute firmwide expense reductions at the behest of New York Attorney General Eliot Spitzer--and you find the commission singing a very different, free-market tune.

For example, consider the following statement--explaining the SEC's opposition to the fee-reduction provision of the Alliance settlement--which was included in the SEC press release announcing the settlement:

"[The commission] see[s] no legitimate basis . . . to act as a ‘rate-setter’ and determine how much mutual fund customers should pay for the services they receive in the future . . . This decision is better left to informed consumers, independent and vigorous mutual fund boards, and the free market."

In explaining their current interest in fees levied by index funds, SEC officials have reportedly said that their efforts are aimed at enforcing existing federal securities law rather than regulating expenses. Logic suggests that the federal laws in question are those governing a fund board's responsibility to negotiate fees with the advisor. If so, the SEC's heightened scrutiny of index funds could signal a reconsideration of whether fund boards have been sufficiently "vigorous" when negotiating fees on shareholders' behalf.

A Commodity Conundrum
Index funds are a logical starting point in that process given their commoditylike nature (which should, in theory at least, breed fierce price competition). Index funds that track the same benchmark, such as the S&P 500 Index, are virtually identical in terms of holdings. They also cost very little to operate since management merely entails purchasing the securities in the same proportion as the bogy and periodically rebalancing in response to asset flows or reconstitution of the benchmark. In other words, differentiation is nonexistent, barriers to entry are modest, and, it would seem, cost is king.

However, you wouldn't know it judging from the diversity of fees levied on index funds tracking the same benchmark. Take the current crop of S&P 500 Index funds, for instance. The asset-weighted average expense ratio of S&P 500 Index funds remains a pleasingly low 0.22% (though that figure jumps to 0.28% when  Vanguard 500 Index Fund (VFINX) is excluded). However, when one considers the arithmetic average (a far loftier 0.73%), median (0.60%), and range (from Vanguard 500 Index's 0.18% expense ratio to AAL Large Company Index's  1.94% price tag), it becomes obvious that not everyone has gotten the message that this is a quintessential commodity business.

12b-1 Blues
What's keeping expenses so stubbornly high in some cases? 12b-1 fees--which some funds levy to cover marketing, selling, and distribution expenses--seem to be the most common culprit. For example, the Invesco S&P 500 Index Fund --which closed its doors to new investors in March 2002--charges 0.65% annually, including a 25 basis point 12b-1 fee. Meanwhile, Merrill Lynch S&P 500 Index  costs 0.61% per annum, with 12b-1 fees accounting for 25 basis points of that tally. (This despite the fact that total assets nearly tripled between 1998 and 1999, and the fund currently stands as one of the largest offerings of its type.)

In aggregate, the impact of 12b-1 fees on retail S&P 500 Index fund expense ratios is stark: Offerings that levy a 12b-1 fee cost, on average, 57 basis points more than funds unburdened by such charges.

In other, more odious cases, good ol' fashioned avarice might be the best explanation for high fees. For example, the B share class of  Morgan Stanley S&P 500 Index  sports an absurd 1.50% expense ratio.

An Explosive Debate
While the SEC's case in pursuing firms that price-gouge index fund investors might seem open and shut given the economics concerned, the larger examination of fund costs is likely to be a long, tough slog.

Indeed, the stakes in the cost battle are enormous. While low costs greatly improve a fund's chance of outperforming peers while also moderating risk, the same high costs that have hampered fund performance have been an absolute boon to the fund industry. It's the collision of these opposing forces that has made the debate over fees so explosive. Thus, the SEC is likely to meet resistance as it investigates the issue.

But the SEC has an unprecedented opportunity to rise above that rancor by making boards more accountable for the fees they levy. We urge the commission to seize it.