Taking Sides: Day of reckoning is nigh for funds

The bull market drew tens of millions of new investors into the stock market, thanks largely to the rise of individual retirement accounts, 401(k)s and other self-directed savings plans.

By far, the mutual fund industry has been the biggest beneficiary of this trend. Today, around 77 million Americans, by some estimates, hold investments in one or more of 10,000 funds.

It should come as no surprise that the fund industry has profited handsomely. But the sharp market downturn and innovative investment products are ending that gravy train, and the industry – which has always operated on equal parts hubris and indifference – could be facing a day of reckoning.

imperious attitude

The purveyor of this message is none other than John C. Bogle, the founder and retired chairman of the Vanguard Group in Malvern, Pa. For years, Mr. Bogle has been a thorn in the industry’s side. He has railed incessantly against the high costs of owning mutual funds.

No matter how well taken his points are – and they are right on target – the industry has largely shrugged off his concerns. And why not? If it ain’t broke, don’t fix it, right?

Maybe so, but the industry has been able to get away with its imperious attitude only because the seemingly unremitting bull market generated stellar returns for so long.

Realistically, who wants to take the time to figure out costs when the average fund returns more than 15% a year, as has been the case over the past 20 years? Not that funds make cost comparisons simple. On the contrary, they border on obfuscation.

Investors are also lulled into complacency by the often fractional variations in fees. After all, how much difference on a fund’s return can a 1.5% annual expense ratio have compared with 1%? As it turns out, a lot over time. On a $10,000 investment earning an average of 8% a year over 20 years, the difference is about $3,000.

Investors who want to figure out fund costs should be prepared to wade deep into prospectuses. Then they’ll still need a calculator to figure out the effect of 12b-1 fees, deferred sales loads, contingent fees, redemption fees, management fees and exchange fees, not to mention embedded capital gains taxes.

The process is so complicated that the Securities and Exchange Commission was compelled to develop an Internet-based calculator to help out.

In a recent speech before the National Press Club in Washington (InvestmentNews, April 2), Mr. Bogle estimated that fees and operating expenses now average 1.6% a year. Taxes, he noted, subtract an additional 1.5%. In the end, costs can rob an investor of nearly half a 10% return.

Mutual funds, of course, compete on performance, not cost. And that’s a source of yet another problem, according to Mr. Bogle. Mutual funds are chasing performance by turning over stocks more often, holding them an average of 11 months, compared with the more traditional average of six years. That drives up transaction costs and increases the tax burden.

“Simply put, there are too many croupiers in the mutual fund casino,” he told the group. “Their rakes sweep too wide a swath from financial market returns.”

The problem gets serious for the industry because the heady days of double-digit returns are over. If, as Mr. Bogle projects, the market gains an average of 5% annually over the next decade, investors could end up netting a scant 1% return on their mutual funds after fees and taxes.

And the industry is facing stiff new competition from exchange-traded funds. It’s easy to see why. They are tax efficient, easy to trade and cheaper than mutual funds.

The industry, of course, points out that costs have declined. And they have. But change has come begrudgingly. For example, why do many mutual funds still pay high commissions on trades at a time when costs have plummeted for individual investors? It’s taking an SEC investigation to find out. The SEC also had to force the industry’s hand on embedded taxes. A new SEC rule, effective April 15, will require mutual funds to calculate and report how taxes from capital gains affect returns.

Financial advisers, meanwhile, owe it to their clients to see that they get the best deal possible. In the current climate, it may be harder and harder for them to recommend mutual funds – unless, of course, the industry decides to wake up.