Why Should Current Fund Shareholders Pay to Get New Shareholders?

Acquisition Costs Friday's The Wall Street Journal carried an ominous headline: SEC Cranks Up Investigation Into Fund Firms' Fees. (The linked version reads "probe" rather than "investigation," but "investigation" it was this past Friday.) A potential mutual fund scandal! I expected follow-on stories from Internet sites to flood my email inbox.

Nope. Pretty darn sparse.

After reading the story, I understood why. The headline might be clear, but the subject is anything but. It's an important topic, though.

Let’s start at the beginning. Fund companies collect fees by transferring assets from a fund’s investment pool to a different account--one owned not by the fund but by the fund company. The amount of these transferred assets, summed over a fund’s fiscal year and expressed in percentage terms, is the expense ratio.

The expense ratio is an easily interpreted number. If Fund A reports an expense ratio of 1%, and Fund B one of 0.5%, we know that Fund A charges twice as much as Fund B. This makes price shopping for mutual funds simple. (Indeed, wondered Chief Justice John Roberts in 2009, why have mutual fund boards review fund expenses when investors could so readily compare prices on the Internet?)

Unfortunately, there are some additional wrinkles that affect comparability. One is that trading costs are not counted as official fund expenses, as they are regarded as arising from an investment activity, rather than from the fund company’s operations.* That makes sense from one perspective, as in theory the extra trading fees are offset by extra return, but for those who are less trusting of active management’s ability, it’s a drawback not to see all costs placed onto a single ledger.

* Yet curiously, the interest costs associated with short sales, which unquestionably arise from an investment activity, are put into the expense ratio. Strange, that.

Also, there is the issue of fund marketing. There’s no question that the fund, not the fund company, should pay for ongoing costs. Such items include, among other things, the monies owed to the custodian (that is, the entity that legally holds the fund’s assets and that follows the instructions of the fund company); the investment-management fee that is stipulated in the prospectus; and the cost of shareholder services, such as answering the telephone and mailing investor statements. Those items are straightforward. But what about the costs incurred not from serving existing shareholders but from trying to attract new ones?

Most fund companies pay a lot to get new assets. Schwab's Mutual Fund OneSource program might seem free to you, but it's assuredly not free to the fund companies that pay Schwab 0.40% per year of their OneSource assets to be on the platform. Full-service distributors also expect compensation. By this I mean not the payments that are linked to the sale of a particular fund by a particular advisor, as with the front-end load charge and with some portions of a 12b-1 fee, but rather unlinked payments that come from the fund and/or fund company to support a distributor's general business.

Which brings us to the Journal article. It reports that fund companies face increasing pressure from "Wall Street brokerages and insurance companies" to pony up more money. The distribution game without question is pay-to-play; that was already known. The Journal's article goes further in suggesting that fund companies that pay more than the required minimum to get onto the gaming floor get to play more, too.

That might seem neither here nor there from an investor's perspective. After all, if fund distribution is a sausage-making business, nobody is forcing us to watch the sausage being made. But--and here is the catch--not all of these distribution costs come from the fund company's pockets. A very large amount, up to 0.75% per year, is legally permitted to be taken from the fund itself, and thus from fund shareholders, through a 12b-1 fee. And now, according to the Journal article, some fund companies are paying even more than the permitted 0.75% through accounting gimmicks, such as designating payments as being for "record-keeping services."

So that, finally, is the upshot of the Journal article: Funds that already pay several times as much as a Vanguard fund's entire expense ratio solely for the distribution of their shares are allegedly finding that amount not to be sufficient and are supplementing those payments through additional means. These supplements are not hidden, in the sense that they do appear in a fund's expense ratio. But they are a sleight of hand, as they misrepresent the activity of acquiring new customers as being an activity of serving existing customers.

Thoughts? Here are mine.

I’m not pleased at the allegations. I don’t think mutual fund shareholders should be on the hook for distribution costs at all (except for front-end load charges, which are clean, transparent, one-time payments for services rendered). And I certainly don’t think accounting gimmicks should be used to con shareholders as to where their monies are going. If the cost is for acquiring new investors rather than for serving the current investors who are paying the bill, then don't pretend otherwise.

But I can't say that I am outraged. The potential damage caused by these allegations pales in comparison to the existing damage caused by the 35-year-old 12b-1 fee, which allows fund companies to extract up to 0.75% of assets per year from current shareholders in the attempt to acquire new shareholders. That is the real scandal. The latest allegations are but a minor smudge on a picture that's long been besmirched.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.