How Much Do You Pay Each Year in Fund Fees?

The Bottom Line Curious minds recently surveyed fund investors, asking what the annual cost, expressed in dollars, would be for a $100,000 investment in an average-priced active stock fund. The correct answer, as most of this column's readers know, is something around $1,000--the $100,000 asset base multiplied by a 1.00% annual fee. However, only 11% of respondents answered that the cost would be above $750. Just over half estimated that the fee would be less than $500.

The SEC's Investor Advisory Committee--the source of those curious minds--hopes to improve those numbers. Created by the Dodd-Frank Act in 2010, the Committee was designed to address the "regulatory capture" that occurs when government officials hear far more frequently from the industries that they regulate than they do from consumers. The Committee counters the customary Wall Street lobbying by making periodic recommendations to the SEC, on behalf of Main Street.

The Committee's most-recent suggestion, released last week, is that funds be required to disclose their dollar costs to shareholders. By convention, funds cite their expenses in percentage terms, but--as Jack Bogle hastens to remind us--they spend dollars, not ratios. So, why not tell shareholders how many of those dollars were spent? If somebody had a fund account that averaged $47,312 over the calendar year, and that fund's expense ratio was 0.91%, then why not show $431 as that account's 2015 true cost?

That seems reasonable enough. Almost everything that we purchase comes with a receipt. Cars, college tuition, mortgage payments, doctors' fees, the electric bill, a burger and fries … all are priced in dollars and cents. In glossing over their charges by not sending a bill, or a receipt, or a confirmation of expenses paid, funds are very much an outlier.

Wishful Thinking? I suspect that the SEC probably will not approve the request. For one, the Investor Advisory Committee does not yet have a high hit rate. The cost-disclosure recommendation is the 13th that the Committee has sent to the Commission, and thus far, only one of those 13 has been enacted. Yes, Main Street does have a voice with the SEC--but it is one voice among many. And those other views, by and large, instinctively say "No."

For another, I know how the fund industry operates.

By nature, the mutual fund business is quite open. Morningstar in its early days received almost universal co-operation from fund companies for its requests, although Morningstar was nothing to nobody, and although some of the requests were fairly demanding--for example, historic performance data for funds or interviews with portfolio managers. Unlike the big brokerage firms, or insurers, the fund industry was used to being in the spotlight. It was a public industry.

However, that attitude changes when funneled into Washington's lobbying system. The math is inevitable. If a modest proposal is made to change an aspect of fund reporting, 90% of fund companies won't care. They will implement the change if it happens, or go on with their business if it doesn't. Matters not to them. The other 10% is against. Those companies contact the Investment Company Institute (ICI), the fund industry's trade organization. They urge opposition. The ICI hears murmurs from the silent majority, and shouts from the vocal minority. The shouts win.

Need-to-Know Basis That was how, in the early 1990s, the ICI found itself arguing that shareholders would be harmed by knowing the names of their funds' portfolio managers. At that time, fund companies were not legally required to state who ran their funds. Of course, the vast majority of companies did--the disclosure was good for business, by and large. But a few companies were unusually secretive, and a few others had so much personnel turnover that the truth would prove awkward. So those companies came out against the SEC's proposal to disclose--and the ICI promptly obliged.

Trust me, there's no good way to advocate that cause without looking foolish. Then as now, the ICI had some very bright, articulate people. But their job was hopeless. How to argue that fund owners should not know the names of the people who work for them? Such a task can be done, but never well. (The ICI's best attempt, such as it was, took the paternalistic angle that what shareholders did not know would not harm them, because if they learned that a portfolio manager left a fund, they might make a stupid, panicked trade.)

If the ICI could stand against that measure, then it surely can do so against this one. The cost-disclosure proposal has only recently been released, so the counterarguments have not yet appeared. But they surely will. When a similar idea was suggested 12 years ago--the fund industry sees little under the sun--the scheme was rejected, in part, for being too expensive. Per an estimate from the General Accounting Office, providing dollar fees would cost the fund industry $66 million per year.

I would have guessed something closer to $0.29. Once the technology is implemented, what on earth could be the ongoing costs? The ink for the extra characters in printing "2015 fees: $431?" If Morningstar spent $66 million on each 100 million calculations that it runs, we'd need Apple's revenue to survive. (An exaggeration, but you get the point.) Also, $66 million is one two-thousandth of 1% of fund-industry assets. It is $0.25 on a $50,000 account.

But perhaps the objection will be different this time around. We shall see.

Addendum: Lindsey emailed me this morning to say, "What about transaction costs?" I'm not sure whether Lindsey means a sales charge that is attached to a fund or a transaction fee levied by the brokerage firm. In either case, the convention when measuring fund costs is to assume that the investor holds the fund entering and exiting the time period, so neither the sale charge nor the transaction fee would apply. That convention makes sense to me, particularly when looking at a short, one-year time period.

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.