Mutual Fund Costs Have Come Full Circle

Something for Nothing? Once upon a time, investment management was cheap, perhaps even free. Early in the 20th century, Charley Ellis writes, "Bank trust departments, often restricted to very low fees by state legislatures seeking to protect widows and orphans, traditionally changed little or nothing" to oversee a client's portfolio. "Fees of only 0.1% of assets were common."

Mutual funds charged more. Nonetheless, their fees were low. Jack Bogle notes that the oldest mutual fund, Massachusetts Investment Trust (now MFS Massachusetts Investors Trust) MITTX carried an expense ratio of 0.50% when it debuted in 1924. Forty years later, thanks to economies of scale from a growing asset base, MIT's annual expenses were but 0.19%.

Fee Inflation Then things changed. Fund companies realized that their customers, by and large, did not notice their funds' ongoing costs. Expenses were nigh-on invisible to shareholders, being accounting transactions between the fund and fund company. Fund owners made no overt fee payments to companies, nor did they receive receipts for their expenditures. Consequently, they were unlikely to fuss about fee hikes. So, why not charge them more? Running mutual funds was business, after all.

Expense ratios therefore rose. Not only did newly launched funds carry higher management fees than did their predecessors, but the SEC approved an abomination--er, I mean innovation--called the 12b-1 fee, which permitted funds to charge shareholders for marketing and distribution costs, up to 1.25% annually. By the 1990s, the typical equity fund's expense ratio was well north of 1%, and several prominent funds exceeded 2%. The mantra from fund marketers was, "You get what you pay for."

Eventually, the truth prevailed. The fund industry confounds the normal expectations that consumers have when making purchases, in that paying more leads to receiving less. Of course, this general rule has many exceptions, but the investment opportunities for expensive funds that perform well are far easier to spot when looking backwards, which generates no profits, than when looking ahead. Consequently, investors began to prize low cost above all.

The Bar Just Keeps Getting Lower That is where we find ourselves today. This week, as discussed in Ben Johnson's companion article, JPMorgan followed Fidelity's autumn 2018 announcement of its Zero series of index mutual funds (for example, Fidelity ZERO Total Market Index FZROX), which have expense ratios of yes, zero, by releasing the cheapest-yet ETF. JPMorgan BetaBuilders U.S. Equity ETF BBUS, which has an expense ratio of 2 basis points (0.02%). That is 1 basis point less than the previously cheapest exchange-traded funds. One would think there is no room for further price cuts.

But one would be wrong. The same day as JPMorgan's launch, BlackRock filed plans to issue a new share class of its S&P 500 mutual fund, with an expense ratio of 1.25 basis points. On a $100,000 investment, that amounts to $12.50 per year. Not that BlackRock is thinking in such modest terms. The minimum initial investment in that share class is … $2.5 billion. (That's a platform commitment, as opposed to being from an individual buyer, but even so, it's by far the highest investment minimum I have ever seen.)

Surely we can go no further. But immediately following the JPMorgan and BlackRock disclosures came the news from a startup provider, Salt Financial, that it will pay investors to own one of its funds. Salt Low truBeta U.S. Market Index LSLT (perhaps a worse name even than "BetaBuilders") will not only waive its official management fee until the fund reaches $100 million, but will also place its own money into the fund, at a rate of 5 basis points annually.

(To give the appropriate credit, information for these various fund launches came partly from trade-industry website Ignites. Morningstar also tracks such data, but I must confess that I encountered these items in Ignites first.)

Here to Stay While Salt's offer is temporary, the industry's giants will not be changing their prices anytime soon. They wish it could be otherwise. Except possibly in the case of Vanguard--and probably not even there, as Vanguard has been forced in recent years to respond to competitive pressures that previously had not existed--no fund company enjoys selling its funds so cheaply. The profit margins are bare, if they exist at all. But such are the current customer demands.

The 401(k) business inflicts similar price-war pressures. Not only are corporations, particularly the largest firms, well-informed about the importance of costs, but there are strong legal incentives for plan sponsors to own only the lowest-priced funds. Because 401(k) plans are governed by ERISA regulations rather than the SEC's rules, they are vulnerable to excessive-fee lawsuits. Fear of such actions continues to drive down the costs of 401(k) investments.

What's Old Is New In a sense, the mutual fund industry has come full circle. What was cheap became dear, and then became cheap again. Thanks to the invention of indexing and the huge scale of today's leading providers, there are far more low-cost funds now than at any time in the past. Many funds match Charley Ellis' figure of 0-10 basis points, albeit via passive strategies rather than active management.

However, something has been lost in process: simplicity. Although they rarely made the effort, mutual fund shareholders in the 1980s and 1990s who invested directly in funds, or through independent financial advisors (as opposed to those selling in-house products) could readily determine their all-in costs if they so desired. Multiply their account balances by their funds' expense ratios, consider any one-time load charges (if paid), and that would be their total bill.

These days, most leading fund providers run multiline businesses. They do much more than manage mutual funds. They have become conglomerates, offering brokerage services, security-lending businesses, custodial arrangements, and/or cash-management features. As such, these companies have many ways of generating revenue. Some of their funds are almost (or completely) free, but that doesn't mean their overall relationship comes at a low cost. When all is said and done, they might collect a pretty penny from the unwary.

Which returns us to the past. Banks in the 1920s could treat investment management as a giveaway because they made their money from clients elsewhere. That's now how mutual fund providers view the role of their index funds.

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.