Thoughts and Quotes from the Supreme Court Case on Mutual Fund Fees; SCHW, MORN, BLK
| 03 November 2009
Things are bound to get a little messy when you start wading through the backwater sludge that is mutual fund industry fees. While we don't typically write about funds and we tend to shun them for obvious reasons, the current Supreme Court case is interesting to us on several levels. First, getting a glimpse into the underworld of mutual fund fees and the financial services industry in general is, well, just plain fascinating in a Desperate Housewives sort of way. And second, some of the assumptions most investors carry are being called into question -- and by investors I include the Chief Justice himself in that category.
The case kicked off Monday with oral arguments in the Supreme Court to determine whether the fees charged by mutual funds are too high. (No!) But the angle chosen by the plantiff is suspect. They've chosen to fight whether investors should be allowed to sue the boards that approved the fees. Oh well, I'm sure counsel thought long and hard about the best way to find a chink in the armor.
Things seemed to get off track right away when, on the issue of disclosure, Chief Justice Roberts seemed a little upset. "You can look it up on Morningstar," Roberts said. "It's right there. ... It takes 30 seconds."Oh, Chief Justice. Not everything. How about marketing fees, load fees, exit fees, tax liabilities and more?
But is the problem really disclosure? Perhaps. But perfect disclosure suggests that the free markets take over and investors aren't stupid. The fact is the free markets are already pushing the smart money out of funds. According to Morningstar, "those funds whose expenses were 20 percent or more below their category average have had $1.3 trillion in net inflows, while those whose expenses were 20 percent or more above category averages have had net outflows."
(By the way, a light bulb just went off in Chicago and Morningstar decided to roll out a new tool that lets you compare a fund's expense ratio with others in its category. Look for it next month.)
And what could be more free market than the sound of money moving? Well, how about the clunk of product development. We reported yesterday that Charles Schwab (SCHW) was releasing its own brand of ETFs with much lower fees (but wait, there's more!) and no commissions for Schwab account holders. No kidding. Here's the offer.
And what could be more free market than the swipe of a pen to acquire your rival? I think it's fair to say that BlackRock, Inc. (BLK) didn't snap up iShares from Barclays (BCS) because they thought indexed ETFs would flounder in the next decade.
So free market forces are already dismantling the industry, then what's the problem? There are several, actually. First, mutual fund companies seem to have a preferred pricing policy. They charge institutional shareholders one price and individuals another (usually higher) price. Despite the fact that you could argue the institutional clients require much more care and feeding.
The Court, it seems, has begun to understand this discrepancy and want to address possible solutions. As our friends at Morningstar heard it, "the plaintiffs state that it's fair game to compare mutual fund fees to the fees charged by the company's institutional accounts, and the defendants do not. But now they have each stated that officially."
Second, an issue that has not (yet) been addressed by the courts is the way in which mutual funds are often offered or sold. If the smart money is already moving out of the more expensive funds, this is where the dumb money sits and where smart fund companies siphon to their heart's content.
Funds are usually packaged in a 401(k) program where limited funds are available, based on behind-the-scenes negotiations with plan managers. Often it is even the expenses themselves that are negotiated. Then, by offering limited funds, they are sold and/or bought based on objectives, not costs. So if you want to buy a total market fund, an international fund and a muni fund, you're offered one, maybe two branded choices in each category and that's it.
The bottom line is that the courts, it seems, didn't give a hoot about the highness or lowness of the fees because that wasn't really the core of the case. At issue was how fund fees were decide and, well, just what is fair anyway. As reported by Morningstar, "Justice Scalia and Chief Justice Roberts are probably leaning towards upholding some type of Gartenberg standard, as it is known, which is really that the fees are going to be permissible if it's possible that they could have been arrived through an arm's-length transaction."
In other words, as long as the policy is clear and directors follow the policy, charge as much as you want. The free markets will take care of the rest. (We hope.)
For more interesting gavel to gavel coverage look no further than Morningstar (MORN). There you'll learn about everything from the cost of the storage lockers ($0.25) to "Greek-style pillars along each wall" to, yes, juicy quotes from the bench. (We are hoping they don't report on the bathroom breaks as well, but can't make any promises.)
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