Fundholders Still Need Fee Clarity, Fierce Watchdogs

Did you hear that big sigh of relief? It came from the fund industry upon reading Tuesday's Supreme Court opinion in the Jones v. Harris fund-fee case. The justices unanimously upheld the pricing standard that's been used to establish mutual funds' expense ratios for decades.

Mutual funds' fees are set following a negotiation between a fund's board of directors and the fund's advisor, with the fund board representing fund shareholders' interests. In the Jones v. Harris case, some individual shareholders took issue with the fact that Harris, parent to the Oakmark funds, charged a higher fee to individual shareholders than it did to institutions, which typically make huge lump-sum investments in fund shares. The Supreme Court upheld this pricing standard, known among court-watchers as the Gartenberg standard, because the expense ratios are the product of an arms-length negotiation that wasn't hampered, for example, by information that was fraudulently withheld from the funds' directors.

You can't blame the Joneses for asking why they and other retail shareholders are charged more than institutions for a mutual fund share. Current mutual fund fee disclosure makes it easy to arrive at the overall expense ratio, but it's not clear exactly what services are covered by the management fee, administrative fee, or 12b-1 marketing fee. That makes comparing management fees between mutual funds and institutional accounts tough, too, because different services can be covered by a fee with the same name. If regulators were to mandate which expenses were covered by each fee, it would be much easier for all investors to understand how their dollars are being spent and determine for themselves whether that fee is reasonable.

This case also points to the need for staunchly independent mutual fund boards. Morningstar has long argued that fund boards led by independent chairmen avoid inherent conflicts of interest between the party governing the funds and the party getting paid to run the funds. Interested directors--those who work for or have worked for the fund's advisor--usually are present during the fee-negotiation process, and they also take part in key fund operational decisions. Each year, for example, the fund board must approve the funds' management contract, and it's highly unlikely that a fund board led by an executive of the fund company would ever move to replace a struggling in-house management team with a subadvisor. In fact, there's only one prominent example of a fund board firing the fund's advisor in the past decade. 

To be sure, the Supreme Court suggested in its opinion that fund directors need to scrutinize management fees for various types of investors as part of their review process. By asking more questions, fund boards could move fees lower, which would be a big win for individual shareholders. Morningstar's research has consistently shown that funds that are cheaper than their peers are much more likely to outperform over the long term. But the shareholder experience would be even more improved by clear fee disclosure and a team of watchdog fund directors who are willing to bear their teeth.