Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition
(Chapter Report, 06/07/2000, GAO/GGD-00-126).
Pursuant to a congressional request, GAO reviewed issues relating to
mutual fund fees, focusing on: (1) the trend in mutual fund advisers'
costs and profitability; (2) the trend in mutual fund fees; (3) how
mutual funds compete; (4) how fees are disclosed to fund investors and
how industry participants view these disclosures; and (5) what mutual
fund directors' responsibilities are regarding fees and how industry
participants view directors' activities.
GAO noted that: (1) GAO was unable to determine the extent to which the
growth of mutual fund assets during the 1990s provided the opportunity
for mutual fund advisers to reduce fees on the funds they operated; (2)
according to research, mutual fund advisers experience operational
efficiencies as their assets grow that could allow them to reduce their
funds' expense ratios; (3) because information on most fund advisers'
costs is not collected by regulators or otherwise publicly disclosed,
GAO was unable to determine if advisers' costs had increased more, or
less, rapidly than fund assets; (4) GAO determined that the 480 percent
growth in total fee revenues for advisers and other service providers
for stock and bond funds commensurate with the total 490 percent asset
growth in those funds during the period 1990 to 1998; (5) because of the
unavailability of comprehensive financial and cost information, GAO was
unable to determine overall industry profitability; (6) although unable
to measure the extent to which mutual fund advisers experienced
economies of scale, GAO's analysis indicated that mutual fund expense
ratios for stock funds had generally declined between 1990 and 1998; (7)
however, this decline did not occur consistently over this period, and
not all funds had reduced their expense ratios; (8) GAO found that not
all of the largest funds with the greatest asset growth had reduced
their fees; (9) while thousands of mutual funds compete actively for
investor dollars, competition in the mutual fund industry may not be
strongly influencing fee levels because fund advisers generally compete
on the basis of performance or services provided rather than on the
basis of the fees they charge; (10) requiring that investors be provided
information about the fees they pay on their mutual funds is another way
regulators seek to help investors evaluate fees charged by mutual funds;
(11) although most industry officials GAO interviewed considered mutual
fund disclosures to be extensive, others indicated that the information
currently provided does not sufficiently make investors aware of the
level of fees they pay; (12) under the law, mutual fund directors are
expected to review various data to ensure that the fees are not
excessive and that the fees are similar to those of comparable funds;
and (13) however, industry participants commented that directors'
activities may be keeping fees at higher levels because of the focus on
maintaining fees within range of other funds.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-00-126
TITLE: Mutual Fund Fees: Additional Disclosure Could Encourage
Price Competition
DATE: 06/07/2000
SUBJECT: Securities regulation
Brokerage industry
Information disclosure
Investments
Competition
Mutual funds
Fees
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United States General Accounting Office
GAO
Report to the Chairman, Subcommittee on Finance
and Hazardous Materials; and the Ranking Member,
Committee on Commerce, House of Representatives
June 2000
GAO/GGD-00-126
MUTUAL FUND FEES
Additional Disclosure Could Encourage Price
Competition
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Contents
Page 201 GAO/GGD-00-126 Mutual Fund Fees
Executive Summary 4
Chapter 1 24
Introduction
Background 24
Objectives, Scope, and Methodology 30
Chapter 2 33
Data Inadequate For
Determining How Asset
Growth Affected Adviser
Costs
Fund Asset Growth Expected to Produce 33
Economies of Scale
Cost Data Not Generally Available for 36
Mutual Fund Advisers' Overall
Operations
Fund and Other Industry Officials 37
Report that Mutual Fund Operating
Costs Have Risen
Asset Growth Has Varying Effects on 41
Fund Advisers' Costs
Fee Revenues Have Increased 42
Significantly
Data for Some Mutual Fund Advisers 44
Indicates Profitability Has Been
Increasing
Chapter 3 46
Mutual Fund Operating
Expense Ratios Generally
Declined
Studies Also Find Mixed Trend in Fees 46
Across Industry
Largest Mutual Funds Generally Grew 48
Faster Than Industry Average
Among Largest Funds, Average Expense 48
Ratios Declined for Stock Funds but
Less so for Bond Funds
Asset Growth Usually Resulted in Lower 50
Expense Ratios but Not All Funds Made
Reductions
Chapter 4 56
Competition in Mutual
Fund Industry Does Not
Focus on Fees
Mutual Fund Industry Exhibits 56
Characteristics of Monopolistic
Competition
Mutual Fund Industry Generally Does 62
Not Attempt to Compete On Basis of
Fees
Chapter 5 66
Mutual Funds Are Not
Required to Disclose
Actual Amounts Charged
to Individual Investors
Required Fee Disclosures Do Not 66
Provide Amounts Paid by Individual
Investors in Dollars
Charges for Other Financial Services 70
Typically Disclosed in Dollars
Mutual Fund Fees Are Not a Primary 72
Consideration for Investors
Opinions Varied on Adequacy of Current 76
Fee Disclosures
Chapter 6 82
Mutual Fund Directors
Required to Review Fees
Mutual Funds' Organizational Structure 82
Embodies Conflict of Interest Over
Fees
Mutual Fund Directors Have Specific 87
Responsibilities Regarding Fees
Opinions on Boards' Effectiveness in 92
Overseeing Fees Vary
Chapter 7 96
Conclusions and
Recommendations
Conclusions 96
Recommendations 97
Agency and Industry Comments and Our 98
Evaluation
Appendixes Appendix I: Comments From the 102
Securities and Exchange Commission
Appendix II: Comments From the 111
National Association of Securities
Dealers Regulation, Inc.
Appendix III: Comments From the 117
Investment Company Institute
Appendix IV: GAO Contacts and Staff 125
Acknowledgments
Tables Table 1: Total Assets for Stock and 9
Bond Mutual Fund as of 1998
Table 2: Estimated Mutual Fund 10
Adviser and Service Provider Revenues
From Operating Expense Fees 1990-1998
Table 3: Average Expense Ratio for 77 11
Largest Stock and Bond Funds From
1990 to 1998 in Dollars Per $100 of
Fund Assets
Table 4: Fee Reductions by Large Funds 12
Whose Asset Growth Exceeded 500
Percent From 1990 to 1998
Table 1.1: Growth in Mutual Fund 25
Assets, 1990-1998
Table 2.1: Source of Asset Growth for 35
All Stock and Bond Funds From 1990 to
1998
Table 2.2: Growth in Mutual Fund 42
Assets and Estimated Fund Adviser and
Other Service Provider Fee Revenues
1990-1998
Table 2.3: Assets and Fee Revenues for 43
77 Largest Mutual Funds for 1990-1998
Table 2.4: Average Fees Collected For 44
Stock and Bond Funds In Dollars Per
Account from 1990 to 1997
Table 2.5: Change in Revenue and 45
Expenses From Prior Year and
Resulting Operating Margin for Public
Asset Management Companies
Table 3.1: Average Size of Stock and 48
Bond Mutual Funds from 1990 to 1998
Table 3.2: Asset-Weighted Average 50
Operating Expense Ratios for 77
Largest Stock and Bond Funds From
1990 to 1998 in Dollars Per $100 of
Fund Assets
Table 3.3: Change in Operating Expense 50
Ratios Charged by 77 Largest Stock
and Bond Funds 1990-1998
Table 3.4: Relationship of Asset 52
Growth and Change in Operating
Expense Ratios for Largest Stock
Funds 1990-1998
Table 3.5: Relationship of Asset 52
Growth and Change in Operating
Expense Fees for Largest Bond Funds
1990-1998
Table 3.6: Change in Average Size in 55
Assets and Operating Expense Ratios
from 1990 to 1998 for Largest Funds
by Relative Fee in 1990
Table 5.1: Fee Disclosure Practices 71
for Selected Financial Services or
Products
Table 5.2: Sales of Mutual Funds for 75
Select Years 1984 to 1998 by Type of
Distribution Method
Figures Figure 3.1: Average Expense Ratios for 49
77 Largest Stock and Bond Mutual
Funds From 1990 to 1998
Figure 3.2: Average Operating Expense 54
Ratio From 1990 to 1998 for Funds
With Above and Below Average Fees in
1990
Figure 4.1: Number of Mutual Funds 58
from 1984 to 1998
Figure 4.2: Number of Mutual Fund 59
Famillies for Selected Years From
1984 Through 1998
Figure 5.1: Example of a Fee Table 68
Required as Part of Mutual Fund Fee
Disclosures
Figure 6.1: Comparison of 84
Organizational Structure of Typical
Corporation and Typical Mutual Fund
Figure 6.1: Continued 85
Abbreviations
ICI Investment Company Institute
NASD National Association of Securities
Dealers
NASDR NASD Regulation
NAV net asset value
SEC Securities and Exchange Commission
CDSL contingent deferred sales load
MUTUAL FUND FEES Additional Disclosure Could Encourage Price Competition GAO/GGD-00-126
B-281444
Page 2 GAO/GGD-00-126 Mutual Fund Fees
B-281444
June 5, 2000
The Honorable John D. Dingell
Ranking Minority Member
Committee on Commerce
House of Representatives
The Honorable Michael G. Oxley
Chairman, Subcommittee on
Finance and Hazardous Materials
Committee on Commerce
House of Representatives
This report presents the results of our review of issues
relating to mutual fund fees. Assets in mutual funds have
grown significantly during the 1990s. However, conflicting
views existed as to whether the fees that funds charge
investors had declined as would have been expected given the
operational efficiencies that mutual fund advisers likely
experience as their fund assets grow. As you requested, we
reviewed (1) the trend in mutual fund advisers' costs and
profitability, (2) the trend in mutual fund fees, (3) how
mutual funds compete, (4) how their fees are disclosed to
investors, and (5) the responsibilities that mutual fund
directors have regarding fees.
This report recommends that the Chairman of the Securities and
Exchange Commission (SEC) require that the quarterly account
statements that mutual fund investors receive include
information on the specific dollar amount of each investors'
share of the operating expenses that were deducted from the
value of the shares they own. Because these calculations could
be made various ways, SEC should also consider the costs and
burdens that various alternative means of making such
disclosures would place on either (1) the industry or (2)
investors as part of evaluating the most effective way of
implementing this recommendation. In addition, where the form
of these statements is governed by rules of the National
Association of Securities Dealers, SEC should ensure that this
organization requires mutual funds to make such disclosures.
As agreed with you, unless you publicly release its contents
earlier, we plan no further distribution of this report until
30 days from its issue date. At that time, we will provide
copies to interested Members of Congress, appropriate
congressional committees, SEC, the National Association of
Securities Dealers, the Office of the Comptroller of the
Currency, the Federal Deposit Insurance Corporation, and the
Board of Governors of the Federal Reserve System.
Key contributors to this report are listed in appendix IV. If
you have any questions, please call me at (202) 512-8678.
Thomas J. McCool
Director, Financial Institutions
and Market Issues
Executive Summary
Page 11 GAO/GGD-00-126 Mutual Fund Fees
Purpose
The U.S. mutual fund industry, which offers
investors an easy way to invest in diversified
portfolios of stocks, bonds, or other securities,
has grown dramatically, with assets rising from
$371 billion in 1984 to $5.5 trillion in 1998. As
of 1998, the proportion of U.S. households owning
mutual funds had risen to 44 percent; and the
returns on mutual funds, particularly those
invested in stocks, had also generally exceeded
those that could have been earned on savings
accounts or certificates of deposit. Because
mutual funds are expected to operate more
efficiently as their assets grow, the significant
asset growth in recent years has prompted concerns
about fund fee levels. Academics, industry
researchers, and others have also raised questions
about whether competition, fund disclosures, and
mutual fund directors are sufficiently affecting
the level of fees
In response to requests by the Chairman of the
Subcommittee on Finance and Hazardous Materials,
House Committee on Commerce, and the Ranking
Minority Member of the Committee on Commerce, GAO
conducted a review of the mutual fund industry to
determine (1) the trend in mutual fund advisers'
costs and profitability, (2) the trend in mutual
fund fees, (3) how mutual funds compete, (4) how
fees are disclosed to fund investors and how
industry participants view these disclosures, and
(5) what mutual fund directors' responsibilities
are regarding fees and how industry participants
view directors' activities.
Background
Mutual funds can be grouped into three basic types
by the securities in which they invest. These
include stock, (also called equity) funds, which
invest in the common and preferred stock issued by
public corporations; bond funds, which invest in
debt securities; and money market funds, which
generally invest in interest-bearing securities
maturing in a year or less. Funds that invest in a
combination of stocks, bonds, and other
securities, known as hybrid funds, are included in
this report under the category of stock funds.
Mutual funds are distinct legal entities owned by
the shareholders of the fund. Each fund contracts
separately with an investment adviser, who
provides portfolio selection and administrative
services to the fund. The fund's directors, 1 who
are responsible for reviewing fund operations,
oversee the interests of the shareholders and the
services provided by the adviser.
Mutual fund fees that investors pay include
operating expenses, which cover the day-to-day
costs of running a fund. These expenses are
accrued daily, and generally paid monthly, from
overall fund assets rather than from individual
investor accounts. The difference between the
value of the securities in a fund's portfolio and
its accrued liabilities represents the daily net
asset value, or NAV, of fund shares. Generally
shown as a percentage of the fund's average net
assets, the annual total operating fee amount is
referred to as the fund's operating expense ratio.
The largest portion of a fund's expense ratio is
generally the fund adviser's compensation, which
is used to cover its operating costs and earn
profits for its owners.
Mutual fund investors may also incur other
charges in addition to those included in the
operating expense ratio, depending on how they
purchase their funds. Mutual funds are sold
through a variety of distribution channels. For
instance, investors can buy them directly by
telephone or mail; or they can be sold by
dedicated sales forces or by third-party sales
forces, such as broker-dealer account
representatives. To compensate such sales
personnel, some mutual funds charge investors
sales charges (called loads), which can be paid at
the time of purchase, over a specified period, or
at time of redemption.
Although a mutual fund's expense ratio
appears to represent just a small percentage of
its total assets, the impact of these fees can be
significant. For example, increasing an expense
ratio from 1 percent to 2 percent on a $10,000
investment earning 8 percent annually can reduce
an investor's total return by about $7,000 over a
20-year period.
Neither federal statute nor Securities and
Exchange Commission (SEC) regulations, which
govern the mutual fund industry, expressly limit
the fees that mutual funds charge as part of their
expense ratios. Instead, mutual fund regulations
focus on ensuring that investors are provided
adequate disclosure of the risks and costs of
investing in mutual funds. The National
Association of Securities Dealers, Inc. (NASD),
whose rules govern the distribution of fund shares
by broker-dealers, has placed certain limits on
the sales charges and fees used to compensate
sales personnel.
Results in Brief
GAO was unable to determine the extent to
which the growth in mutual fund assets during the
1990s provided the opportunity for mutual fund
advisers to reduce fees on the funds they
operated. According to research conducted by
academics and others, as well as the industry
participants GAO interviewed, mutual fund advisers
experience operational efficiencies-or economies
of scale-as their assets grow that could allow
them to reduce their funds' expense ratios.2 Such
efficiencies arise when the fund assets increase
at a faster rate than do the costs of managing
those additional assets. Because information on
most fund advisers' costs is not collected by
regulators or otherwise publicly disclosed, GAO
was unable to determine if advisers' costs had
increased more, or less, rapidly than fund assets.
Industry officials reported that some costs of
operating mutual funds have been increasing, in
part, because funds have been expanding the level
of services they provide investors. Using data
provided by the mutual fund industry association,
GAO determined that the 480 percent growth in
total fee revenues for advisers and other service
providers for stock and bond funds3 was
commensurate with the total 490 percent asset
growth in those fundsduring the period 1990 to
1998. Because of the unavailability of
comprehensive financial and cost information,
however, GAO was unable to determine overall
industry profitability.
Although unable to measure the extent to
which mutual fund advisers experienced economies
of scale, GAO's analysis indicated that mutual
fund expense ratios for stock funds had generally
declined between 1990 and 1998. However, this
decline did not occur consistently over this
period, and not all funds had reduced their
expense ratios. Because concerns had been raised
over methodologies for existing mutual fund fee
studies, GAO conducted its own analysis. GAO's
analysis of data on the 77 largest mutual funds
indicated that the expense ratios of these funds
were generally lower in 1998 than they were in
1990, although average expense ratios for stock
funds rose in the early 1990s before declining.
The extent to which expense ratios declined also
varied across types of funds as the ratios for the
largest stock funds declined while those for bond
funds generally remained the same. Furthermore,
GAO found that not all of the largest funds with
the greatest asset growth had reduced their fees.
Among the 77 large funds analyzed, 51 of these
funds had experienced asset growth of at least 500
percent from 1990 to 1998. Of these 51 funds, 38
(or 74 percent) reduced their operating expense
ratios by at least 10 percent over the 9-year
period from 1990 to 1998. However, the remainder
had not reduced their expense ratios as much,
including six funds that either had not changed,
or had increased, their ratios.
As is customary for U.S. financial markets,
regulators rely on competition to be a primary
means of influencing the fees that mutual fund
advisers charge. In general, industries where many
firms compete for business generally have lower
prices than industries where fewer firms compete.
However, although thousands of mutual funds
compete actively for investor dollars, competition
in the mutual fund industry may not be strongly
influencing fee levels because fund advisers
generally compete on the basis of performance
(measured by returns net of fees) or services
provided rather than on the basis of the fees they
charge.
Requiring that investors be provided
information about the fees they pay on their
mutual funds is another way regulators seek to
help investors evaluate fees charged by mutual
funds. Mutual funds currently disclose information
on fund operating expense ratios and other charges
when investors make their initial purchases.
However, unlike other financial products, the
periodic disclosures to investors who continue to
hold their shares do not show, in dollars, each
investor's share of the operating expenses that
were deducted from the fund.4 Although most
industry officials GAO interviewed considered
mutual fund disclosures to be extensive, others,
including some private money managers and academic
researchers, indicated that the information
currently provided does not sufficiently make
investors aware of the level of fees they pay.
These critics have called for mutual funds to
disclose to each investor the actual dollar amount
of fees paid on their fund shares. Providing such
information could reinforce to investors the fact
that they pay fees on their mutual funds and
provide them information with which to evaluate
the services their funds provide. In addition,
having mutual funds regularly disclose the dollar
amounts of fees that investors pay may encourage
additional fee-based competition that could result
in further reductions in fund expense ratios. GAO
is recommending that this information be provided
to investors. Because producing such information
would entail systems changes and additional costs,
GAO is also recommending that cost-effectiveness
and investor burden be considered when alternative
means for disclosing the dollar amount of fees are
evaluated.
Regulators also look to a mutual fund's
directors to oversee the operating expense fees
their funds charge. The organizational structure
of the typical mutual fund embodies a conflict of
interest between the fund shareholders and the
fund's adviser that can influence the fees
charged. This conflict arises primarily because
the adviser has the incentive to maximize its own
revenues, but such action could come at the
expense of the fund's shareholders. Because of
this inherent conflict, mutual fund directors are
tasked under federal law with reviewing and
approving the fees charged by the fund adviser.
Under current law, mutual fund directors are
expected to review various data to ensure that the
fees are not excessive and that the fees are
similar to those of comparable funds. Mutual fund
adviser officials told GAO that the directors of
the funds they operate have been vigorous in
reviewing fees and seeking reductions. However,
others, including research organizations,
academics, and private money managers, commented
that the directors' activities may be keeping fees
at higher levels because of this focus on
maintaining fees within the range of other funds.
GAO received comments on a draft of this
report from SEC; NASD Regulation (NASDR), which is
the regulatory arm of NASD; and the mutual fund
industry association, the Investment Company
Institute. Overall, each of the commenting
organizations agreed that GAO's report raised
important issues and contributed to the public
dialogue on mutual fund fees. However, these
organizations also commented, among other things,
that mutual funds already make extensive
disclosures about fees and that competition on the
basis of performance does represent price
competition among mutual funds. GAO agrees that
mutual fund disclosures are extensive but also
believes that additional information on the
specific dollar amounts of fees for operating
expenses could be useful to investors and
encourage additional price competition among fund
advisers on the basis of fees directly.
Principal Findings
Principal Findings
Although Advisers Expected to Experience Cost
Efficiencies, Comprehensive Data on Their Costs
Were Not Available
Academic studies and other research find that as
mutual fund assets grow, mutual fund advisers
experience operational efficiencies or economies
of scale that would allow them to reduce their
funds' expense ratios. As shown in table 1 below,
data compiled by ICI indicate that mutual fund
assets have grown considerably during the 1990s,
with stock funds alone growing 1,081 percent as of
year-end 1998.
Table 1: Total Assets for Stock and Bond Mutual
Fund as of 1998
Dollars in billions
1990 1998 Percentage
change
Stock funds $283 $3,343 1,081%
Bond funds 284 831 193
Total 567 4,174 636
Source: GAO analysis of ICI data.
As the assets in a mutual fund grow,
economies of scale in a fund adviser's operations
would result in the adviser's costs increasing
more slowly than the rate at which its fund assets
and revenues are increasing. For example, if the
adviser of a fund employing 10 customer service
representatives experiences 100-percent growth in
its fund assets, this adviser may find that only
5, or 50 percent, more representatives would be
needed to address the workload arising from the
additional assets. In addition, GAO's analysis of
data from ICI also indicated that although
additional purchases by existing and new investors
account for some of the increase in the industry's
assets, as much as 64 percent of the mutual fund
asset growth has come from appreciation in the
value of the securities in these funds'
portfolios. Fund growth resulting from portfolio
appreciation would also provide additional
economies of scale because such growth is not
accompanied by many of the administrative costs
associated with inflows of money to new and
existing fund accounts.
However, GAO was unable to determine the
extent to which mutual fund advisers experienced
such economies of scale because comprehensive data
on the total costs incurred by mutual fund
advisers are not publicly available. Currently,
mutual funds disclose to regulators and to their
investors only those operating costs that have
been deducted from the assets of the fund, but not
the costs that the advisers incur to operate these
funds. Although total cost data were not
available, industry officials reported that fund
advisers' costs have been increasing. Industry
officials explained that these increased costs are
the result of new services for mutual fund
investors, increased distribution expenses, and
higher personnel compensation expenses.
GAO estimated the total revenue that fund
advisers and other service providers receive from
the funds they operate. 5 Largely as a result of
growth in mutual fund assets, mutual fund advisers
and service providers were collecting
significantly more revenues from fund operations
in 1998 than they did in 1990. As shown in table 2
below, the revenues stock funds produced for their
advisers and other providers had increased over
800 percent from 1990 to 1998.
Table 2: Estimated Mutual Fund Adviser and
Service Provider Revenues From Operating Expense
Fees 1990-1998
Dollars in millions
Estimated fee revenues
Fund type 1990 1998 Percent
age
change
Stock $2,544 $22,931 801%
Bond 2,408 5,933 146
Totals 4,952 28,864 483
Source: GAO analysis of data from ICI.
Fee revenues for the largest funds have
similarly increased. Using data on 77 of the
largest stock and bond funds,6 GAO found that the
advisers and service providers operating these
funds collected $7.4 billion in fee revenues in
1998. This was over $6 billion, or almost 560
percent, more than they collected in 1990. Over
this same period, the assets of these funds
increased by over 600 percent. Mutual fund
advisers and service providers were also
collecting more in fees on a per account basis.
For example, the total dollars collected annually
in fee revenues from stock funds rose 59 percent
from an average of $103 per account in 1990 to
$164 per account in 1997.
Although comprehensive cost data for most
fund advisers were not available, analyses of
information for 18 publicly traded mutual fund
advisers indicated that these firms' operating
profits as a percentage of their revenues have
been increasing for at least 5 years.
Average Mutual Fund Expense Ratios Have Generally
Declined, But Not All Funds Reduced Their Ratios
GAO identified various studies and analyses
of the trends in mutual fund fees. Some of these
analyses found that mutual fund expense ratios and
other charges had been declining, but other
analyses found that expense ratios had increased.
However, some industry participants criticized the
methodologies used by these studies. For example,
many of these studies failed to adjust for the
increase in newer funds, which generally charge
higher expense ratios than older funds.
Therefore, GAO conducted its own analysis of
the trend in expense ratios. Data on the 77
largest mutual funds indicated that that these
funds had grown faster since 1990 than the average
fund in the industry.7 Therefore, their advisers
were more likely to have experienced economies of
scale in their operations that would have allowed
them to reduce their expense ratios. Because the
sample consisted primarily of the largest and
fastest growing funds in the industry, it may not
reflect the characteristics and the trend in fees
charged by other funds.
To calculate the average expense ratios for
these funds, GAO weighted each fund's expense
ratio by its total assets. The resulting average
expense ratios represent the fees charged on the
average dollar invested in these funds during this
period. As shown in table 3, the average expense
ratio declined by 12 percent for the largest stock
funds and by 6 percent for the largest bond funds
from 1990 to 1998, although this decline did not
occur steadily over the period.
Table 3: Average Expense Ratio for 77 Largest
Stock and Bond Funds From 1990 to 1998 in Dollars
Per $100 of Fund Assets
Type of Number 1990 1991 1992 1993 1994 1995 1996 1997 1998 Percent
fund of age
funds change
Stock 46 $.74 $.78 $.78 $.80 $.81 $.79 $.75 $.68 $.65 -12%
Bond 31 .62 .61 .61 .60 .61 .63 .61 .60 .58 -6
Source: GAO analysis of data from Morningstar,
Inc. and Barron's Lipper Mutual Funds Quarterly.
Although the average expense ratio for these
funds generally declined during the 1990s, not all
of them reduced their fees. Overall, 23 of the 77
funds reported higher expense ratios in 1998 than
in 1990. Table 4 shows the changes in expense
ratios for the 51 funds among the 77 largest funds
that experienced asset growth of at least 500
percent from 1990 to 1998. Of these funds, 38 (74
percent) had reduced their expense ratios by at
least 10 percent during this 9-year period. Of the
remaining 13 funds, 7 (14 percent) reduced their
expense ratios by less than 10 percent, and 6 (12
percent) had either not changed their fees or had
increased them.
Table 4: Fee Reductions by Large Funds Whose Asset
Growth Exceeded 500 Percent From 1990 to 1998
Total change in fee from 1990 to 1998 Number of Percentage
funds
Reduction over 30 percent 17 33%
Reduction of 10 to 30 percent 21 41
Subtotala 38 74
Reduction under 10 percent 7 14
No change 3 6
Increase under 10 percent 2 4
Increase of 10 to 30 percent 0 0
Increase over 30 percent 1 2
Subtotal 13 26
Total 51 100
aMay not total due to rounding.
Source: GAO analysis of Morningstar and Barrons
Lipper Mutual Funds Quarterly data.
Competition Does Not Focus on Price of Service
Active competition among firms within a given
industry is generally expected to result in lower
prices than in those industries in which few firms
compete. Although hundreds of fund advisers
offering thousands of mutual funds compete
actively for investor dollars, their competition
is not primarily focused on the fees funds charge.
Instead, mutual fund advisers generally seek to
differentiate themselves by promoting their funds'
performance returns8 and services provided.9
Marketing their performance and service as
different from those offered by others allows fund
advisers to avoid competing primarily on the basis
of price, as represented by the expense ratios
they charge mutual funds investors. This applies
particularly to actively managed funds investing
in stocks. Advisers for money market funds; index
funds;10 and to some degree, bond funds are
generally less able to differentiate their funds
from others because these types of funds invest in
a more limited range of securities than stock
funds do. As a result, the returns and fees of
such funds generally tend to be more similar, and
the fees are generally lower than the fees charged
on most stock funds.
Fee Disclosures Do Not Provide Investors With
Specific Dollar Amounts
The disclosures mutual funds are legally
required to make are, among other things, intended
to assist investors with evaluating the fees
charged by the funds they are considering for
investment. As required by SEC rules, mutual funds
are required to provide potential investors with
disclosures that present operating expense fees as
a percentage of a fund's average net assets. In
addition, these disclosures provide a hypothetical
example of the amount of fees likely to be charged
on an investment over various holding periods.
However, after they have invested, fund
shareholders are not provided the specific dollar
cost of the mutual fund investments they have
made. For example, mutual fund investors generally
receive quarterly statements detailing their
mutual fund accounts. 11 These statements usually
indicate the beginning and ending number of shares
and the total dollar value of shares in each
mutual fund owned. They do not show the dollar
amount of operating expense fees that were
deducted from the value of these shares during the
previous quarter.12 This contrasts with most other
financial products or services, such as bank
accounts or brokerage services, for which customer
fees are generally disclosed in specific dollar
amounts.
Surveys conducted by industry research
organizations, fund advisers, and regulators
indicate that investors generally focus on funds'
performance (net of fees), service levels, and
other factors before separately considering fee
levels. In contrast, investors appeared more
concerned over the level of mutual fund sales
charges, and industry participants acknowledged
that as a result, the loads charged on funds have
been reduced since the 1980s.
The mutual fund and regulatory officials GAO
contacted generally considered mutual fund
disclosures to be extensive and adequate for
informing prospective investors of the fees they
would likely incur on their mutual fund
investments. However, some private money managers,
industry researchers, and legal experts indicated
that the current fee disclosures are not making
investors sufficiently aware of the fees they pay.
One suggestion for increasing investor awareness
was that mutual funds should disclose to each
investor the actual dollar amount of the portion
of the funds' fees they paid. Some of the
officials GAO contacted indicated that having the
specific dollar amount of fees disclosed to
investors would spur additional fee-based
competition among fund advisers. For example, a
legal expert GAO contacted noted that having such
information appear in investors' mutual fund
account statements might also encourage some fund
advisers to reduce their fees in order to be more
competitive. Requiring that such information be
provided to mutual fund investors would also make
such disclosures more comparable to fee
disclosures for other financial services, such as
stock brokerage or checking accounts. Compared to
mutual funds, the markets for these services
appear to exhibit greater direct price
competition.
Fund adviser officials GAO interviewed
indicated that calculating such amounts exactly
would entail systems changes and additional costs,
but they also acknowledged that less costly means
of calculating such amounts may exist. For
example, instead of calculating the exact amount
of fees charged to each account daily, a fund
adviser could provide an estimate of the fees an
investor paid by multiplying the average number of
shares the investor held during the quarter by the
fund's expense ratio for the quarter. Another
alternative would be to provide the dollar amount
of fees paid for preset investment amounts, such
as $1,000, which investors could use to estimate
the amount they paid on their own accounts. In
determining how such disclosures could be
implemented, regulators will have to weigh the
costs that the industry may incur to calculate
fees for each investor against the burden and
effectiveness of providing investors with the
requisite information and having them be
responsible for making such calculations on their
own.
Mutual Fund Directors Tasked With Reviewing Fees,
But Opinions on Their Effectiveness Were Mixed
The structure of most mutual funds embodies a
potential conflict of interest between the fund
shareholders and the adviser. This conflict arises
because the fees the fund charges the shareholders
represent revenue to the adviser. For this reason,
mutual funds have directors who are tasked with
overseeing the adviser's activities. Under the
Investment Company Act of 1940, fund directors are
required to review and approve the compensation
paid to the fund's adviser.
In 1970, this act was amended after concerns were
raised over the level of fees being charged by
mutual funds. The amendments imposed a fiduciary
duty on fund advisers and tasked fund directors
with additional responsibilities regarding fees.
These amendments to the act also granted investors
the right to bring claims against the adviser for
breaching this duty by charging excessive fees.
Various court cases subsequently have interpreted
this duty, and the decisions rendered have shaped
the specific expectations currently placed on fund
directors regarding fees. As a result, directors
are expected to review, among other things, the
adviser's costs, whether fees have been reduced as
fund assets grow, and the fees charged by other
advisers for similar services to similar funds.
The officials at the 15 mutual fund advisers13
GAO contacted said that their boards have been
vigorous in reviewing fees and have frequently
sought reductions in the fees received by the
adviser. However, some private money managers,
industry researchers, and others have stated that
the activities undertaken by directors may be
serving, instead, to keep fees at higher levels
than necessary, because the directors are just
expected to keep their funds' fees within a range
of similar funds instead of actively attempting to
lower them.
Recommendations
To heighten investors' awareness and understanding
of the fees they pay on mutual funds, GAO
recommends that the Chairman, SEC, require that
the periodic account statements already provided
to mutual fund investors include the dollar amount
of each investor's share of the operating expense
fees deducted from their funds. This disclosure
would be in addition to presently required fee
disclosures. Because these calculations could be
made in various ways, SEC should also consider the
cost and burden that various alternative means of
making such disclosures would impose on (1) the
industry and (2) investors as part of evaluating
the most effective way of implementing this
requirement. Where the form of these statements is
governed by NASD rules, SEC should require NASD to
require the firms it oversees to provide such
disclosures.
Agency Comments and GAO's Evaluation
GAO obtained comments on a draft of this report
from the heads, or their designees, of SEC, NASDR,
and ICI. These comments are summarized and
evaluated in chapter 7, with specific comments
made by each organization addressed in appendixes
I through III.
Overall, each of the commenting organizations
agreed that GAO's report raised important issues
and contributed to the public dialogue on mutual
fund fees. In his letter, the director of SEC's
Division of Investment Management indicated that
SEC staff agreed that investors need to be aware
of and understand the fees that mutual funds
charge. The letter also indicated that the SEC
staff welcomed the report's recommendation and
intended to consider it carefully. The vice
president of NASDR's Investment
Companies/Corporate Financing Department agreed in
his letter that investors should consider fees,
expenses, and other issues in addition to
performance in making investment decisions.
However, the letters from the SEC, NASDR and ICI
officials also raised several issues about GAO's
report. All three organizations commented that
mutual funds currently make extensive disclosures
about their fees to investors at the time of
purchase and in semiannual reports thereafter. For
example, ICI's letter noted that promoting
investor awareness of the importance of fund fees
is a priority for ICI and its members. However,
ICI expressed reservations about GAO's
recommendation that investors periodically receive
information on the specific dollar amounts of the
operating expense fees deducted from their mutual
fund accounts. Their concern is that this
requirement could erode the value of the fee
information currently provided in the prospectus
and thus impede informed assessments of fee levels
at competing funds, which could paradoxically
diminish rather than enhance investors' overall
understanding of fund fees.
GAO agrees with ICI and the other commenters that
the current disclosures made by mutual funds,
which provide fund expense ratios expressed as a
percentage of fund assets and include an example
of the likely amount of expenses to be incurred
over various holding periods for a hypothetical
$10,000 account, are useful for investors in
comparing among funds prior to investing. The
additional disclosure GAO recommends is intended
to supplement, not replace, the existing
disclosures. It should also serve to reinforce to
investors that they do pay for the services they
receive from their mutual funds as well as
indicate to them specifically how much they pay
for these services.
SEC, NASDR, and ICI also commented on GAO's
observation that other financial products and
services disclose specific dollar amounts for the
fees charged to their users, but mutual funds do
not. In their comments, these organizations
generally indicated that not all charges are
disclosed for other financial products and
services and; thus, the disclosures for mutual
funds are not that dissimilar. For example, SEC
noted that funds disclose to investors specific
dollar charges subtracted from their accounts,
such as for sales loads or account fees, but do
not disclose the specific charges that are levied
outside the account. SEC stated that this is
similar to banks not disclosing the spread between
the gross amount earned by the financial service
provider on customer monies and the net amount
paid to the customer.
GAO does not agree with the commenting
organizations that mutual funds' lack of
disclosure of the specific operating expenses to
individual investor accounts is comparable to the
practices of banks or other businesses that do not
disclose the difference between their investment
or operating earnings and the amounts they pay to
the individuals who provided those operating or
investment funds. Investors in mutual funds have
in essence hired the adviser to perform the
service of managing their investment dollars for
them. The fees that the advisor and the other
service providers deduct from the fund's assets
represent the price of the services they perform.
Although such fees are deducted from the fund
overall, each individual investor's account is
ultimately reduced in value by their individual
share of these deductions. However, the specific
amount of these deductions is not disclosed in
dollar terms to each investor. In contrast,
customers and users of other financial services,
such as private money managers, banks, and
brokerage firms, are told of the specific dollar
amounts subtracted from their individual assets or
accounts.
All three commenting organizations also generally
questioned this report's finding that mutual funds
do not compete primarily on the price of their
services. SEC noted that although an argument
could be made that more price competition should
occur in the mutual fund industry, it is not
completely absent. ICI emphasized that because
funds report performance on an after fees and
expenses basis, mutual funds do compete on the
basis of their fees. NASDR stated that the draft
report did not address the fact that mutual funds
present performance net of expenses.
GAO's report notes that mutual funds' performance
returns, which are the primary basis upon which
funds compete, are required to be disclosed net of
fees and expenses. However, competition on the
basis of net returns may or may not be the same as
competition on the basis of price. Separating the
fee from the return would remind investors that a
fee is embedded in their net returns. In addition,
GAO also notes that when customers are told the
specific dollar amounts of the fees or charges,
such as they are for stock brokerage transactions
or bank checking accounts, firms in those
industries appear to more frequently choose to
compete directly on that basis and, in some cases,
the charges for such services have been greatly
reduced. Implementing GAO's recommendation to have
such information provided to mutual fund investors
could provide similar incentive for them to
evaluate the services they receive in exchange for
the fees they pay. Disclosing such information
regularly could also encourage more firms to
compete directly on the basis of the price at
which they are willing to provide mutual fund
investment services.
SEC and ICI also questioned the legal accuracy of
some of the statements made by individuals GAO
interviewed regarding the role of mutual fund
directors in overseeing fees. Although the
individuals quoted in this report were critical of
mutual fund directors setting their funds' fees
only in relation to the fees charged by other
funds, both SEC and ICI indicated that fund
directors, by law, are required to review a wide
range of information when assessing the fees
charged by their fund advisor and other service
providers.
In response to these comments, text has been
added to the report to indicate that comparing one
fund's fees to those charged by other funds is not
the only factor that directors are required to
consider when evaluating fees. However, in the
opinion of the individuals whose comments are
presented in the report, directors are primarily
emphasizing such comparisons over the other
factors they are also are required to consider as
part of their fee reviews. As a result, these
individuals see directors as maintaining fee
levels, or at least allowing fees to be lowered
only to the extent that other funds are taking
similar actions.
_______________________________
1 Although the Investment Company Act of 1940,
which governs mutual fund operations, does not
dictate a specific form of organization for mutual
funds, most funds are organized either as
corporations governed by a board of directors or
as business trusts governed by trustees. When
establishing requirements relating to the
officials governing a fund, the act uses the term
"directors" to refer to such persons, and this
report will also follow that convention.
2 As discussed in chapter 1 of this report, the
operating expense ratio for a mutual fund is the
cumulative total of various fees and expenses
charged to the fund during a particular period
shown as a percentage of the fund's average net
assets. The expense ratio includes a management
fee that compensates the adviser for selecting and
managing the fund's portfolio, distribution fees,
and any other expenses associated with
administering the fund that have been deducted
from the fund's assets.
3 Data on stock funds presented in this report
also include information on hybrid funds. The
report focuses primarily on stock and bond funds
because money market funds generally have not been
the subject of the recent concerns over fees.
4 Mutual fund shareholder account statements do
include the specific dollar amounts of certain
fees or charges, such as for wire transfers,
maintenance fees, or sales loads.
5 Fund adviser and service provider revenues were
estimated by multiplying fund assets by operating
expense ratios.
6 These 77 funds included all of the largest stock
and bond funds in existence from 1990 to 1998.
These 77 funds comprised 46 stock funds, including
all stock funds with assets over $8 billion; and
31 bond funds, including all those with assets
over $3 billion. The data for the stock funds
include five hybrid funds that also invest in
bonds or other debt securities.
7 The sample focused on the time period since 1990
because it represented the most current and
consistent period of mutual fund industry history
and market conditions.
8 SEC requires funds to report their performance
returns net of the fees deducted from fund assets.
9 As discussed in chapter 4 of this report, the
type of competition prevailing in the mutual
industry appears to resemble "monopolistic
competition," which is one of the primary
competitive market types described by economists.
Markets with monopolistic competition
characteristically include large numbers of
competing firms, ease of entry, and products
differentiated on the basis of quality, features,
or services included.
10 Index funds invest in the securities represented
in a broad-based index, such as the Standard &
Poor's 500 Index.
11 A requirement for quarterly statements arises
under NASD rules, which govern the actions of the
securities broker-dealers that act as the
distributors of most mutual fund shares.
12 Sales charges, redemption fees, and other
transactional fees are disclosed in dollar amounts
in either account statements or confirmation
statements.
13 These firms included the advisers for 13 of the
77 largest funds and 2 smaller fund advisers.
Chapter 1
Introduction
Page 27 GAO/GGD-00-126 Mutual Fund Fees
Mutual funds offer investors a means of investing
in a diversified pool of stocks, bonds, and other
securities. As of 1998, 44 percent of U.S.
households owned mutual funds, and the returns,
particularly for stock funds, had generally
exceeded returns that could have been earned on
savings accounts or certificates of deposit. Since
1984, assets in U.S. mutual funds increased about
14-fold, growing from $371 billion in 1984 to $5.5
trillion in 1998. Because costs of providing
mutual fund services are generally expected to
rise less rapidly as fund assets increase, the
significant growth in recent years has prompted
some concerns by some industry participants and
the news media over the level of fees funds
charge.
This report responds to requests by the Chairman,
Subcommittee on Finance and Hazardous Materials;
and the Ranking Minority Member of the House
Committee on Commerce.
Background
A mutual fund is an investment company that pools
the money of many investors-individuals or
institutions-that it invests in a diversified
portfolio of securities. Mutual funds provide
investors the opportunity to own diversified
securities portfolios and to access professional
money managers, whose services they might
otherwise be unable to obtain or afford.
A mutual fund is owned by its investors, or
shareholders. Fund share prices are based on the
market value of the assets in the fund's
portfolio, after subtracting the fund's expenses
and liabilities, and then dividing by the number
of shares outstanding. This is the fund's net
asset value (NAV). Per share values change as the
value of assets in the fund's portfolio changes.
Investors can sell their shares back to the fund
at the current NAV,1 and funds must calculate the
shareholders' share prices on the day a purchase
or redemption request is made. Many newspapers
publish daily purchase and redemption prices for
mutual funds.
Various types of funds are offered to investors.
Three basic types of mutual funds include stock
(also called equity), bond, and money market
funds. Some funds that invest in a combination of
stocks, bonds, and other securities are known as
hybrid funds and are discussed in this report as
part of the information presented for stock funds.
Money market funds are referred to as short-term
funds because they invest in securities that
generally mature in about 1 year or less; stock,
bond, and hybrid funds are known as long-term
funds. The firms that operate mutual funds
frequently offer investors a family of funds that
includes at least one each of the three basic fund
types, although some firms may offer only one fund
while others specialize in funds of a particular
type, such as stock or bond funds. Of the total
$5.5 trillion invested in mutual funds at the end
of 1998, $2.98 trillion was invested in stock
funds, $1.35 trillion was in money market funds,
$831 billion was in bond funds, and $365 billion
was in hybrid funds. This report will focus
primarily on stock and bond funds because money
market funds generally have not been the focus of
recent concerns regarding fees.
Mutual Fund Assets Increased Dramatically in the
1990s
As shown in table 1.1, mutual fund assets grew
dramatically in the 1990s, with stock funds
growing 1,082 percent in the 1990-1998 period.
Table 1.1: Growth in Mutual Fund Assets, 1990-1998
Fund type Total assets Percenta
(dollars in ge
millions) growth
1990 1998
Stock fundsa $ $ 1,082%
282,800 3,342,900
Bond funds 284,300 830,600 192
Money Market funds 498,300 1,351,700 171
Total 1,065,50 5,525,200 419
0
a This category combines equity and hybrid fund
data.
Source: GAO analysis of Investment Company
Institute data.
Mutual Funds Contract with Investment Advisers to
Conduct Their Operations
Although it is typically organized as a
corporation, a mutual fund's structure and
operation differ from that of a traditional
corporation. In a typical corporation, the firm's
employees operate and manage the firm; and the
corporation's board of directors, elected by the
corporation's stockholders, oversees its
operations. Mutual funds also have a board of
directors that is responsible for overseeing the
activities of the fund and negotiating and
approving contracts with an adviser and other
service providers for necessary services.2
However, mutual funds differ from other
corporations in several ways. A typical mutual
fund has no employees; it is created and operated
by another party, the adviser, which contracts
with the fund, for a fee, to administer fund
operations. The adviser is an investment
adviser/management company that manages the fund's
portfolio according to the objectives and policies
described in the fund's prospectus.3 Advisers may
also perform various administrative services for
the funds they operate, although they also
frequently subcontract with other firms to provide
these services. Functions that a fund adviser or
other firms may perform for a fund include the
following:
� Custodian: A custodian holds the fund assets,
maintaining them separately to protect shareholder
interests.
� Transfer agent: A transfer agent processes
orders to buy and redeem fund shares.
� Distributor: A distributor sells fund shares
through a variety of distribution channels, such
as directly through advertising or telephone or
mail solicitations handled by dedicated sale
forces, or by third-party sales forces. Funds that
are marketed primarily through third parties are
usually available through a variety of channels,
including brokers, financial planners, banks, and
insurance agents.
Distinct from the fund itself, the fund's adviser
is generally owned by another entity with its own
group of directors. (Ch. 6 of this report
discusses in more detail the relationship between
funds and their advisers and the specific legal
duties placed on mutual fund directors.)
Mutual Fund Fees Include Operating Expenses and
Sales Charges
Various fees are associated with mutual fund
ownership. All mutual funds incur ongoing
operating expenses for which they pay the adviser
and other providers who operate and service the
funds. AnThT annual total of these operating
expenses, commonly known as the fund's operating
expense ratio, is expressed as a percentage of the
fund's average net assets in a fund's prospectus
and other reports. Fund operating expenses can
vary in accordance with the work required by fund
managers; the complexity of the fund's
investments; or the extent of shareholder services
provided, such as toll-free telephone numbers,
Internet access, check writing, and automatic
investment plans. The largest component of a
fund's total expense ratio usually is the
management fee, which is the ongoing charge paid
to the investment adviser for managing the fund's
assets and selecting its portfolio of securities.
The management fee is customarily calculated as a
percentage of the fund's average net assets.4
Included as part of the operating expenses that
are directly deducted from some funds' assets are
fees that go to compensate sales professionals and
others for selling the fund's shares as well as
for advertising and promoting them. These fees,
known as "12b-1 fees," are named after the
Securities and Exchange Commission (SEC) rules
authorizing mutual funds to pay for marketing and
distribution expenses directly from fund assets.
The National Association of Securities Dealer,
Inc. (NASD), whose rules govern the distribution
of fund shares by broker dealers, limits 12b-1
fees used for these purposes to no more than 0.75
percent of a fund's average net assets per year.
Funds are allowed to include an additional service
fee of up to 0.25 percent of average net assets
each year to compensate sales professionals for
providing ongoing services to investors or for
maintaining their accounts. Therefore, any 12b-1
fees included in a fund's total expense ratio are
limited to a maximum of 1 percent per year.
In addition to the fees in the expense ratio, some
mutual funds include a sales charge known as a
"load." Loads usually compensate a sales
representative or investment professional for
advice they provide investors in selecting a fund.
Loads can be applied at the time of purchase (a
"front-end load") or at redemption (a "back-end
load").5 NASD rules limit the load that can be
charged as part of purchasing fund shares to no
more than 8.5 percent6 of the initial investment.
Some mutual funds, known as "no-load" funds, do
not have sales charges7. Other fees that may be
charged directly to investors for specific
transactions include exchange fees (for
transferring money from one fund to another within
the same fund family) and account maintenance
fees.
Mutual Fund Investors' Total Costs Vary Depending
on How Shares are Purchased
The total charges for investing in a mutual fund
can vary according to how the investor purchases
shares. In some cases, investors may purchase
mutual fund shares on the advice of an investment
professional, including sales representatives
employed by securities broker-dealers or banks or
independent financial planners. When recommending
mutual funds, these individuals may also be
entitled to receive the sales loads charged by the
funds as well as to charge the investors for
providing investment services.
Many mutual funds can be purchased without
professional assistance. To purchase the shares of
these funds, investors contact the mutual fund
companies directly, by visiting fund offices, or
by telephone, mail, or Internet. Funds sold
directly to investors in this way are known as
"direct market" funds. In addition, investors can
purchase direct market mutual funds through
accounts they hold with broker-dealers. Investors
may also use retirement benefit plans, such as
401(k) plans, to invest in any mutual funds.
Long-Term Impact of Annual Fees on Mutual Fund
Investment Returns Can Be Significant
The annual fees that investors pay can
significantly affect investment returns over the
long term. For example, over a 20-year period a
$10,000 investment in a fund earning 8 percent
annually, and with a 1-percent expense ratio,
would be worth $38,122; but with a 2-percent
expense ratio it would be worth $31,117.
Various studies have also documented the impact of
fees on investors' returns by finding that funds
with lower fees tended to be among the better
performing funds. A March 1998 analysis by an
industry research organization examined stock
funds across six different investment objectives
over a 5-year period and found that lower fee
funds outperformed higher fee funds over 1-, 3-,
and 5-year periods through November 1997.8 For
example, of the large funds that invest in
undervalued securities, the funds in the quartile
with the lowest fees, which averaged 78 cents per
$100 of assets, had the highest average
performance--returning 138 percent over 5 years.
Conversely, the funds in the quartile with the
highest fees-averaging $2.26 per $100 of
assets-had the lowest performance return over the
period, averaging 112 percent.
Various Federal Statutes Apply to Mutual Fund
Activities
SEC oversees the regulation of mutual funds under
the Investment Company Act of 1940. Among the
act's objectives is to ensure that investors
receive adequate, accurate information about the
mutual funds in which they invest. Other
securities laws also apply to mutual funds. Under
the Securities Exchange Act of 1934, persons
distributing mutual fund shares or executing
purchase or sale transactions in mutual fund
shares are to be registered with SEC as securities
broker-dealers. Broker-dealers who sell mutual
funds are regulated and examined by both SEC and
by the regulatory arm of NASD, called NASD
Regulation, Inc. (NASDR). NASD, which is subject
to SEC's oversight, acts a self-regulatory
organization for brokerage firms, including those
firms that engage in mutual fund distribution.
Neither federal statute nor SEC regulations, which
govern the mutual fund industry, expressly limit
the fees that mutual funds charge as part of their
expense ratios. Instead, mutual fund regulations
focus on ensuring that investors are provided
adequate disclosure of the risks and costs of
investing in mutual funds. As noted previously,
NASD rules have placed certain limits on the sales
charges and fees used to compensate sales
personnel.
Although most mutual fund activities are subject
to SEC and NASD requirements, the mutual fund
activities conducted by some banks are overseen by
the various bank regulatory agencies. 9 Because
banks are exempt from the Securities Exchange Act
of 1934, they are allowed to offer mutual funds
and other securities to their customers without
registering with SEC as broker-dealers. However,
most banks have chosen to conduct their securities
activities, including mutual funds, in
subsidiaries or affiliates that are subject to SEC
oversight. A small number of banks conduct
securities activities either from within the bank
or in other affiliates that are not subject to SEC
oversight.10 Depending on how such a bank is
chartered, its mutual fund activities would be
overseen by the Federal Reserve System, the
Federal Deposit Insurance Corporation, or the
Office of the Comptroller of the Currency.11
Objectives, Scope, and Methodology
The objectives of this report were to review the
mutual fund industry to determine (1) the trend in
mutual fund advisers' costs and profitability, (2)
the trend in fees, (3) how mutual funds compete,
(4) the requirements for fee disclosures to fund
investors and how industry participants view these
disclosures, and (5) the responsibilities of
mutual fund directors regarding fees and how
industry participants view directors' activities.
As part of analyzing the trend in mutual fund
advisers' costs and profitability, we interviewed
various industry officials. These officials
included representatives of 15 mutual fund
advisers, including 13 large firms and 2 smaller
firms. These firms included some of the largest
mutual fund families, one firm affiliated with a
bank, and several firms known for charging lower
fees. We also interviewed officials from 10
industry research organizations that compile
information, conduct analyses, or perform
consulting services relating to the mutual fund
industry. These firms included the major providers
of data and analysis on the mutual fund industry.
We also interviewed three officials from money
management or financial planning firms and two
former senior regulatory officials. In addition,
we interviewed officials from two financial
industry associations, including the Investment
Company Institute (ICI), which is the national
association of the U.S. mutual fund industry; and
the American Association of Individual Investors.
We also interviewed, and obtained information
from, SEC and NASDR officials who oversee mutual
fund activities.
We also obtained and analyzed data from ICI
on the number of funds and total assets invested
in mutual funds. ICI officials indicated that
these data included information representing over
90 percent of the funds and the assets invested in
mutual funds in the United States. We reviewed
studies and analyses of the trend in mutual fund
fees by academic organizations, industry
associations, and regulators.
To identify what costs funds are required to
disclose, we reviewed SEC regulations. We also
reviewed the annual reports for a random selection
of 35 funds, including at least 1 of the funds
whose officials we interviewed, to identify the
types of cost information these funds disclosed.
We also discussed the trends in costs associated
with operating mutual funds with industry
officials at the organizations identified above.
We also reviewed various academic research papers
and analyses by industry research organizations
and others. To identify the trends in average
account size, we obtained and analyzed data from
ICI. We also analyzed cost, revenue, and
profitability data compiled by an industry
research organization on 18 public mutual fund
advisers, which represent all of the public
companies whose primary business activity involves
operating mutual funds as an adviser.
To determine the trend in mutual fund fees,
we interviewed industry participants and reviewed
studies, analyses, and academic research regarding
mutual fund fees. To conduct our own analysis of
the trend in fees, we collected and analyzed data
on the largest mutual funds. These included the 77
largest mutual funds in existence for the entire
1990-1998 period based on asset size as of
February, 28, 1999, as reported in the Lipper
Mutual Funds Quarterly section in the April 5,
1999, issue of Barron's. We focused on the time
period since 1990 because it represented the most
current and consistent period of mutual fund
industry history and market conditions. The 77
largest funds consisted of 41 stock funds and 5
hybrid funds, each with assets over $8 billion;
and 31 bond funds, each with assets over $3
billion. We excluded 10 other stock, hybrid, and
bond funds that were above the asset minimums but
came into existence after 1990. We obtained annual
expense, sales load, and asset data for each of
the 77 funds for each year from 1990 to 1998 from
Morningstar, Forbes Magazine, and Standard &
Poor's; and from annual reports, prospectuses, and
registration statements filed by the mutual funds
with SEC or available at mutual fund internet
sites.
To determine the nature and structure of
competition in the mutual fund industry, we
reviewed academic research papers, economic
literature, speeches, testimonies, and other
documents discussing mutual fund competition. We
collected data on numbers of funds, fund
complexes, and advisers. We also discussed the
extent of competition with the funds with industry
officials at the organizations identified above.
To identify what factors funds emphasized in their
advertisements, we collected and analyzed the
content of selected business, news, and personal
finance magazines.
To determine how mutual funds disclose their fees,
we reviewed the relevant laws, rules, and
regulations governing mutual fund fee disclosure
and interviewed officials from SEC, NASDR, the
Office of the Comptroller of the Currency, the
Federal Deposit Insurance Corporation, and the
Board of Governors of the Federal Reserve System.
To compare mutual fund disclosures to those for
other financial products and services, we reviewed
the relevant regulations for those products and
consulted with regulatory and industry association
officials. To determine how investors use the
information on fees, we reviewed studies and
surveys done by industry research organizations.
We also interviewed industry participants to
obtain their opinions regarding the effectiveness
of existing fee disclosures and suggestions for
additional disclosures. A broker dealer also
provided us summary information from a customer
survey that included questions about the utility
and desirability of current and proposed fee
disclosures.
To determine the responsibilities of mutual
fund directors regarding fees, we reviewed the
relevant laws, rules, and regulations governing
mutual fund organizational structure and
directors' responsibilities. We also interviewed
officials from SEC and NASDR. In addition, we
discussed the effectiveness of fund directors with
industry participants. From legal databases, we
also obtained and reviewed decisions and other
documents pertaining to various court cases
involving mutual fund fees.
We conducted our work in Washington, DC;
Chicago, IL; New York, NY; Boston, MA; San
Francisco, CA; and Los Angeles, CA, between
November 1998 and April 2000, in accordance with
generally accepted government auditing standards.
We requested comments on a draft of this report
from the heads, or their designees, of SEC and
NASDR. In addition, we requested comments from the
mutual fund industry association, ICI. Each of
these organizations provided us with written
comments, which appear along with our responses to
individual comments in appendixes I through III.
Additional technical comments received from SEC
were incorporated into this report as appropriate.
_______________________________
1 Shareholders of open-end mutual funds, which
continuously issue and redeem shares, have a right
to redeem shares at the current NAV. Closed-end
funds, in which the number of shares is fixed,
trade at market prices that are frequently above,
or below, the actual NAV of the assets held by the
fund.
2 Although the Investment Company Act of 1940 does
not dictate a specific form of organization for
mutual funds, most funds are organized either as
corporations governed by a board of directors or
as business trusts governed by trustees. When
establishing requirements relating to the
officials governing a fund, the act uses the term
"directors" to refer to such persons, and this
report also follows that convention.
3 In some cases, the adviser may contract with
other firms to provide investment advice, becoming
a subadviser to those funds.
4 The fees investors pay to the fund adviser
constitute some of the adviser's revenue from
operating the fund. For this reason, there is a
potential conflict between the interests of the
fund shareholders who pay the fund expenses and
those of the adviser, which seeks to maximize its
own revenues and profits. Chapter 6 of this report
discusses how the laws that govern mutual funds
have attempted to address this conflict of
interest.
5 A common type of back-end load, called a
contingent deferred sales charge, typically is
calculated as a percentage of the net asset value
or offering price at the time of purchase and is
payable upon redemption. However, such charges
generally decrease incrementally on an annual
basis and would not be applied to redemptions
after a certain number of years.
6 The maximum permissible front-end and deferred
sales load varies depending on factors, such as
whether the fund offers certain rights or imposes
an asset-based sales charge or service fee.
7 NASD rules prohibit members from describing a
mutual fund as "no load" if the fund has a front-
end or deferred sales charge, or if the fund's
total asset-based sales charges and service fees
exceed ..25 percent of average net assets per
year.
8 Correlating Total Expenses to the Performance of
Four and Five Star Equity Funds, Financial
Research Corporation and Wechsler Ross & Partners
(Mar. 2, 1998).
9 Additional information on the mutual fund
activities of banks is contained in Bank Mutual
Funds: Sales Practices and Regulatory Issues
(GAO/GGD-95-210, Sep. 27, 1995).
10 However, the Gramm-Leach-Bliley Act passed in
1999 will require any banks conducting more than
500 securities transactions per year to move such
activities into a securities broker-dealer after
May 12, 2001.
11 The Office of the Comptroller of the Currency
oversees banks with national charters. The Federal
Reserve System oversees bank holding companies
and, in conjunction with state banking
authorities, also oversees any state-chartered
banks that are Federal Reserve members. The
Federal Deposit Insurance Corporation oversees
state-chartered banks that are federally insured
but not members of the Federal Reserve. Any mutual
fund activities conducted by thrifts would be
subject to SEC's oversight because thrifts are not
exempted from the definition of "broker" and
"dealer" under the Securities Exchange Act of
1934.
Chapter 2
Data Inadequate For Determining How Asset Growth
Affected Adviser Costs
Page 45 GAO/GGD-00-126 Mutual Fund Fees
Academic studies and other research suggest
that as mutual fund assets grow, mutual fund
advisers should experience operational
efficiencies-or economies of scale-that could
allow them to reduce their funds' operating
expense ratios.1 However, we were unable to
determine the extent to which mutual fund advisers
experienced these economies of scale because
information on the costs and profitability of most
fund advisers was not generally publicly
available. Industry officials reported that the
costs of operating and providing mutual fund
services have been increasing. Although
comprehensive cost data were not available, we
were able to determine that mutual fund advisers
and other mutual fund service providers were
earning significantly more in fee revenues in 1998
from the funds they operated than they had in
1990. In addition, analyses by industry research
organizations of 17 public mutual fund management
firms indicated that such firms were generally
profitable and that their profitability had been
increasing.
Fund Asset Growth Expected to Produce Economies of
Scale
As fund assets grow, advisers usually
experience increases in both their revenues and
their costs. However, the research we reviewed and
the officials we interviewed agreed that fund
advisers experience operational efficiencies that
result in their costs growing less rapidly than
the assets of the funds they manage. Academic
researchers and industry officials acknowledged
that mutual fund advisers' operations likely
experienced economies of scale as fund assets
grew. Fund advisers also likely experienced
economies of scale in their operations because the
majority of fund asset growth has come from
increases in the value of the securities in funds'
portfolios, which is a less costly source of
growth than additional share purchases by new or
existing investors.
Many Agree that Mutual Fund Advisers Experience
Economies of Scale
As fund assets grow, the adviser earns
additional revenue because its fee is a percentage
of the fund's average net assets. However, in
performing the various services necessary to
operate the fund, the adviser incurs various costs
for services, such as researching selections for
the portfolio and managing the investments to
maximize returns. Fund advisers also incur costs
to administer accounts, process account
transactions, and promote their funds to attract
new shareholders and additional investor inflows.
The difference between the adviser's costs and the
amount of revenue it collects is its operating
profit from the fund. If the adviser's revenues
are increasing faster than its costs, then the
adviser is experiencing operational efficiencies,
or economies of scale.
Academics, industry research organizations,
regulators, and fund advisers we consulted
generally agreed that mutual fund operations are
subject to economies of scale as their assets
grow. Most studies we reviewed found that as fund
size increased, average operating expense fees
decreased. A December 1999 ICI study reported that
stock funds with assets of $250 million or less
had an average expense ratio of $1.39 per $100 of
assets, and funds with assets of over $5 billion
had an average expense ratio of 70 cents per $100
of assets.2 The ICI study also reported that funds
with significant asset growth tended to reduce
their expense ratios as they grew, suggesting the
presence of economies of scale.
In this study, ICI states that the operating
efficiencies that mutual fund advisers experience
arise, not from spreading fixed costs across a
growing asset base, but from needing
proportionally fewer additional resources as
assets grew. The study found that fund advisers
typically expend additional resources for
portfolio management, investment research, and
fund administration as fund assets grow. For
example, an adviser of a fund experiencing 100-
percent growth in fund assets may need to add only
5 new hires to a staff of 10 customer service
representatives, rather than doubling the staff to
address the workload arising from the additional
assets. Therefore, customer service personnel
costs would be proportionally less for twice the
assets.
Industry officials we interviewed also
generally agreed that mutual fund operations
experience economies of scale. An official at a
money management firm whose customers invest in
mutual funds told us that mutual fund advisers'
operations are subject to large economies of
scale, and additional investor inflows result in
little additional cost. Officials of the fund
advisers we interviewed also agreed that their
operations experienced economies of scale.
Some of the studies and industry officials noted
that economies of scale should not be assumed to
exist on an industrywide level. For example, a
study by one industry research organization,
Lipper Analytical Services, Inc., stated that the
mutual fund industry as a whole does not
experience economies of scale, but individual
funds do.3 In his testimony before Congress, the
ICI president offered various explanations as to
why asset growth for the industry has not
translated into economies of scale for all funds.
For example, asset growth arising from the
creation of new funds would not likely result in
economies of scale because new funds usually incur
high costs in their initial periods of operation.
In addition, asset growth by certain funds could
produce operating efficiencies for those funds but
not for others that had not grown.
Substantial Asset Growth From Portfolio
Appreciation Should Also Result in Economies of
Scale
An additional factor that should contribute
to economies of scale among mutual fund advisers
was the extent to which their assets grew due to
portfolio appreciation. Such growth results as the
securities that have been selected and purchased
for the fund's portfolio increase in value. As the
value of the fund assets increase, the adviser's
revenues also increase because it deducts its fee
as a percentage of all of the assets in the fund.
However, these additional assets would not be
accompanied by the additional account processing
costs that result from asset growth arising from
additional share purchases by new or existing
shareholders.
Mutual fund advisers likely experienced such
economies of scale because most of the industry's
growth in the 1990s resulted from portfolio
appreciation. We analyzed industrywide data from
ICI on the growth in mutual funds to determine the
extent to which funds' asset growth resulted from
either additional share purchases by existing and
new investors or from appreciation of the
securities within fund portfolios. As shown in
table 2.1, portfolio appreciation accounted for
about 56 percent of the mutual fund asset growth
for all stock and bond funds. In contrast, growth
resulting from additional investor share purchases
accounted for about 44 percent these funds'
growth.
Table 2.1: Source of Asset Growth for All Stock
and Bond Funds From 1990 to 1998
Fund type Portfolio Investor share Totals
appreciation purchases
Stock 56.5% 43.5% 100%
funds
Bond 54.2% 45.8% 100%
funds
Totals 56.1% 43.9% 100%
Source: GAO analysis of ICI data.
Cost Data Not Generally Available for Mutual Fund
Advisers' Overall Operations
Determining the extent to which mutual fund
advisers experienced economies of scale was not
possible because comprehensive data on advisers'
costs are not publicly available. Mutual funds are
required to disclose certain fees and costs paid
by investors that are deducted from fund assets,
but these disclosures do not specify the costs
that the adviser incurs in providing services to
the fund.
Under the requirements of the securities
laws, a fund is required to periodically disclose
to fund shareholders the costs attributable to
individual funds. Among these costs is the fee
that the adviser to the fund charges for managing
the fund and selecting the investments to be
included in its portfolio. In addition, these
costs include those resulting from various
administrative functions performed as part of
operating a fund, such as those for legal services
or the printing of required reports.
Under the laws governing mutual fund
activities, mutual funds must make publicly
available certain financial information applicable
to the fund when initially offering shares to the
public and on a semiannual basis thereafter. This
information includes a balance sheet, which lists
the fund's assets and liabilities; and a statement
of operations. The statement of operations
presents the income and expenses incurred by the
fund. A fund's income is generally the dividends
and interest earned on the securities in its
portfolio. For expenses, the disclosure
requirements for the statement of operations are
relatively brief and require separate reporting of
� investment advisory, management, and service
fees in connection with expenses associated with
the research, selection, supervision, and custody
of investments;
� amounts paid as part of a 12b-1 plan; and
� any other expense items that exceed 5 percent
of the total expenses.
In addition, funds are required to disclose in
footnotes to this statement how the management and
service fees were calculated. Funds are also
required to provide information on the net change
in the assets of the fund resulting from
operations, which includes any realized and
unrealized gains or losses .
Review of the financial statements issued for
35 funds4 indicated the information disclosed for
these funds was generally similar. The total
amounts expended for the management or advisory
fee and for expenses relating to the directors
were disclosed for every one of the funds we
reviewed. The amounts expended for audit services
and shareholder reporting were also shown in the
reports of a majority of the 35 funds.
Although funds provide some information on the
operating costs of individual mutual funds, the
trend in the costs and profitability of advisers
that manage mutual funds cannot be identified from
the required reporting for individual funds. The
information disclosed by funds pertains to the
funds' associated income and expenses, but the
advisers that operate these funds are separate
legal entities with their own revenues and costs.
Some of the revenue earned by fund advisers can be
determined from the amount of management/advisory
fees shown in fund disclosures. . However, the
reporting does not include disclosure of the
specific costs that advisers incur to operate a
fund. Nor does the material that mutual fund
advisers file with SEC include such information.
For example, the salaries of portfolio managers or
other executives an adviser employs or the
research expenses it incurs are not required to be
disclosed. Without knowing the specific costs the
adviser incurred to operate the funds it offers,
the profitability of most mutual fund advisers
cannot be determined. Some of the advisers that
manage mutual funds are publicly owned companies
and thus are required under other SEC regulations
to periodically disclose the financial results of
their operations. However, the majority of
advisers are privately held and thus not subject
to these requirements.
Fund and Other Industry Officials Report that
Mutual Fund Operating Costs Have Risen
Only limited public data existed on the
individual costs incurred by mutual fund advisers,
but this information and industry officials'
statements indicated that costs have been rising.
Some of the increase in overall operating costs
stemmed from the costs of the new services that
advisers have added to those they already perform
for investors or for the firms that market mutual
funds. In addition, overall operating costs have
risen due to increases in other areas, including
the costs of distribution, advertising, and
personnel .
New Services Increase Operating Costs
Mutual fund officials cited new services as
an important reason for the increasing costs of
operating mutual funds. Testifying before
Congress, the president of ICI stated that mutual
fund advisers are under substantial competitive
pressure to provide enhanced and sometimes costly
services. Officials at the industry research
organizations and at the mutual fund advisers we
contacted also indicated that new and expanded
services have raised costs. Among the new services
that these firms are adding were new
telecommunication services. These included such
services as 24-hour telephone centers and voice-
recognition systems to provide investors with
information and more convenient access to their
accounts. Mutual fund advisers are also
increasingly providing information and account
access services over the Internet.
Distribution Costs Also Increasing
Mutual fund advisers have also apparently
experienced increased costs incurred as part of
having their funds distributed. Some broker-
dealers whose sales representatives market mutual
funds have narrowed their offerings of funds or
have created preferred lists of funds, which then
become the funds that receive the most emphasis in
the marketing efforts made by broker-dealer sales
representatives. When a fund is selected as one of
the preferred fund families on these lists, the
mutual fund adviser is required to compensate the
broker-dealer firms. According to one research
organization official, there are significantly
fewer distributing firms than there are mutual
fund advisers. As a result, the mutual fund
distributors have the clout to require the
advisers to pay more to have their funds sold by
the distributing firms' staff. For example,
distributors sometimes require fund advisers to
share their profits and pay for expenses incurred
by the distributing firms, such as requiring an
adviser to pay for advertising or for marketing
materials that are used by the distributing firms.5
Mutual fund advisers' distribution costs are
also increased when they offer their funds through
mutual fund supermarkets. Various broker-dealers,
including those affiliated with a mutual fund
adviser, allow their customers to purchase through
their brokerage accounts the shares of funds
operated by a wide range of fund advisers.
Although these fund supermarkets provide the
advisers of participating funds with an additional
means of acquiring investor dollars, the firms
that provide such supermarkets generally require
fund advisers to pay a certain percentage on the
dollars attracted from purchases by customers of
the firm's supermarket. For example, advisers for
the funds participating in the Charles Schwab One
Source supermarket pay that broker-dealer firm up
to 0.35 percent of the amount invested by that
firm's customers .
Fund Advertising Costs Also Increasing
Another area in which mutual fund advisers
were reportedly experiencing higher costs was in
advertising expenditures. According to data
compiled by one industry research organization,6
consumer investment advertising by financial
services companies has grown at an annual rate of
33 percent from 1995 to 1998, with nearly $1
billion spent in 1998.
Industry officials offered various reasons
for increased advertising expenditures. As
discussed in chapter 4 of this report, mutual fund
advisers attempt to compete primarily by
differentiating their firms' fund offerings from
those of other firms. For example, one industry
research organization official indicated that
competition among so many funds requires advisers
to increasingly promote their particular funds.
Mutual fund supermarkets may also increase fund
advisers' advertising expenses. Advisers selling
through fund supermarkets may find that they avoid
the costs associated with a salesforce or certain
other expenses. However, increasing the likelihood
that investors will select their funds out of all
those offered through such supermarkets usually
requires that advisers must spend on advertising
to increase investor awareness of their funds.
Personnel Costs Also Increasing
Although already paying among the highest
levels of compensation, mutual fund advisers
apparently have to pay increasing amounts to
attract and retain personnel. Mutual fund
personnel are among the best-compensated staff
among various financial organizations. In 1999, an
association for the investment management
profession and an executive recruiting firm
sponsored a study of compensation for 19 different
positions among 7 types of financial industries.7
Along with mutual funds, the other industries were
(1) banking; (2) insurance; (3) investment
counseling; (4) pension consulting; (5) plan
sponsors, endowments, and foundations; and (6)
securities broker-dealers. The study obtained data
by survey for staff employed in these industries
in various positions; including chief executives,
chief investment officers, research directors,
securities analysts, and portfolio managers for
four different investment types. According to our
analysis of the information presented in this
study, the industry median compensation for mutual
fund industry overall was the highest among the
seven industries. Across the various positions,
the compensation for mutual fund industry
personnel was ranked as the highest or second
highest in 13 of the 19 positions surveyed.
Specifically, mutual fund industry personnel had
the highest compensation in six of the positions,
including having the highest median compensation
for chief executive officers and for each of the
four portfolio manager positions.
Personnel costs are also reportedly rising
for mutual fund advisers. Officials with three of
the industry research organizations we contacted
cited expenses for personnel as an area in which
fund advisers have experienced increased costs. An
official at one such organization told us that
with the low unemployment rate, fund advisers must
pay personnel more to avoid losing them and having
to replace them with new and untrained personnel.
Officials at the mutual fund advisers we
contacted also cited personnel as an area in which
their costs were increasing. Many officials noted
that mutual fund industry personnel costs are
being driven higher due to competition for quality
personnel from hedge funds.8 An official with one
large fund adviser told us that increasing the
size of compensation packages for portfolio
managers was necessary to keep them from leaving
to join hedge funds. He likened the market for
such staff to that for sports stars.
Information Technology Expenditures Also Increase
But May Eventually Reduce Adviser Costs
Fund adviser and other officials also cited
the need to make continued investments in their
overall information technology resources as a
source of increased costs to their operations. For
example, officials at one mutual fund adviser told
us the staffing of their information technology
department has risen from 1 person to over 700
over a 26-year period. Mutual fund adviser and
industry research officials also described other
information technology expenditures that firms are
making; including implementing automated telephone
voice processing systems and creating Internet Web
sites.
Although mutual fund advisers are reportedly
experiencing increased costs resulting from the
increased investments they are making in
technology and service enhancements, some of these
investments may result in reduced operating costs
in the future. According to officials at two
industry research organizations, the investments
that fund advisers make in technologies such as
the Internet and voice-processing systems will
eventually allow them to reduce service costs.
According to an article prepared by one of these
research organizations,9 companies that deploy Web-
based customer services can cut their costs by
close to half, if not more. For example, the
article cites research by one organization that
indicated that typical customer service
transactions cost $5 if responded to by a live
agent, 50 cents if by a voice response system, and
a few cents if done on the Web.
Asset Growth Has Varying Effects on Fund Advisers'
Costs
Fund asset growth can affect advisers' costs
in varying ways. Although mutual fund advisers'
costs were reportedly rising, industry officials
explained that these costs do not generally rise
smoothly as assets increase. Officials also
indicated that advisers' costs rise more when
their asset growth comes from new accounts rather
than from existing shareholders.
Adviser Costs Do Not Rise Smoothly
According to industry officials, the costs of
providing mutual fund services may not rise in a
smooth, continuous way. Officials at the mutual
fund advisers we contacted told us that some of
their operating costs increase in a staggered
fashion as their assets grow. For example,
officials at one adviser said that as their assets
grow, they find that the number of staff
performing certain functions, such as answering
customer inquiries, can stay the same for some
time. However, when assets reach a certain level,
they find that they must add additional staff to
address the additional workload. Therefore,
although assets may be growing steadily, many of
their costs remain temporarily fixed until certain
asset levels are reached; then their costs rise to
a new, higher fixed level. Officials at another
fund adviser explained that other costs are more
fixed; thus, as assets grow, these costs go down
on a per-share basis. Such costs would include the
cost of maintaining custody10 over the securities
invested in by their funds.
New Accounts Also Increase Adviser Costs
Fund adviser officials also explained that if
their asset growth comes from new accounts, then
their costs correspondingly increase more than if
the additional dollars came instead from existing
shareholders. Officials at one mutual fund adviser
told us much of the industry's asset growth has
come from new, smaller accounts. They said that
such accounts are more expensive to service than
larger accounts on a per dollar basis, because
each account requires a minimum level of service
regardless of size.
However, we analyzed data on shareholder
accounts compiled by ICI. Although the number of
shareholder accounts for stock funds has grown by
over 430 percent, from 22 million in 1990 to about
120 million in 1998, this was less than the growth
in the assets of these funds, which grew by over
1,100 percent during that same time frame.
Changes in the average account size at
individual mutual fund advisers can affect these
firms' costs. For example, officials at one mutual
fund adviser reported to us that their average
account size had fallen from $12,000 to $9,000,
with its median size being $1,500. According to
this firm's officials, having more, smaller
accounts increases their overall servicing costs.
Although some firms may experience a decline in
their average account size that results in an
increased cost per account, industrywide data
indicated that this is not affecting all firms.
According to our analysis of ICI data, the average
account size for all stock funds in the industry
has risen by 127 percent, from just under $11,000
in 1990 to almost $25,000 in 1998. The average
account size in 1998 for bond funds has increased
similarly since 1990 as well.
Fee Revenues Have Increased Significantly
Although comprehensive data on the costs fund
advisers incurred was not available, the revenue
fund advisers and other service providers collect
as fees from the mutual funds they operate appears
to have increased significantly. The fee revenues
earned by the advisers and service providers of
the largest mutual funds have also risen
significantly during the 1990s.11 The amount of
fees collected on a per account basis has also
risen .
As mutual fund assets have grown, the
revenues that fund advisers and other service
providers collect through the fees they deduct
from these funds have also risen. ICI provided us
with data on the assets and operating expense fee
revenues for 4,868 stock and bond funds, which
their officials indicated represented over 90
percent of the total industry assets for these
fund types.12 As shown in table 2.2, our analysis
of this data indicated that asset growth has led
to comparable growth in the fee revenues earned by
mutual fund advisers and other service providers.
Table 2.2: Growth in Mutual Fund Assets and
Estimated Fund Adviser and Other Service Provider
Fee Revenues 1990-1998
Dollars in millions
Fund Total assets Estimated fund
type adviser and provider
fee revenuesa
1990 1998 Percent 1990 1998 Percent
age age
change change
Stock $256,7 $2,396, 833% $2,544 $22,931 801%
66 410
Bond 268,52 160 2,408 5,933 146
9 698,365
Totals 525,29 3,094,7 489 4,952 28,864 483
5 75
Source: GAO analysis of data from ICI.
The largest funds have also produced more
revenue for their advisers and other service
providers during the 1990s. Using 1998 data, we
identified the 77 largest stock and bond funds
that had been in existence since 1990.13 For these
funds, we found that the advisers and service
providers operating these funds collected $7.4
billion in revenues from the fees deducted from
these funds' assets in 1998. As shown in table
2.3, this was over $6 billion, or almost 560
percent more than they earned in 1990.
Table 2.3: Assets and Fee Revenues for 77 Largest
Mutual Funds for 1990-1998
Dollars in millions
1990 1991 1992 1993 1994 1995 1996 1997 1998 Percent
age
change
1990-
1998
Total $164,4 $232,9 $303,3 $409,7 $432,2 $595,8 $745,8 $954,7 $1,157 604%
assets 25 85 39 55 41 57 89 25 ,219
Total fee $1,128 $1,640 $2,157 $2,986 $3,255 $4,488 $5,387 $6,347 $7,428 559
revenue
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
Some of the largest funds experienced
significant increases in their fee revenues from
1990 to 1998. For example, the assets of the
largest stock fund grew 580 percent from $12.3
billion in 1990 to $83.6 billion in 1998. The
revenues of the adviser and other service
providers for this fund grew 308 percent,
increasing from about $127 million to over $518
million during the same period. As the assets of
another stock fund grew 825 percent from $5.6
billion in 1990 to $51.8 billion in 1998, its
adviser's adviser and other service providers'
revenue increased 729 percent, growing from $38.7
million to $321 million during the same period.
On an industrywide basis, the average amount
of total revenues fund advisers and other service
providers earned per investor account has also
risen. According to data compiled by ICI, the
increase in fee revenues on a per account basis
has been less dramatic than the increases in total
fee revenues shown above. As shown in table 2.4,
the average fees collected by fund advisers and
other service providers per account rose 61
percent for stock funds and 37 percent for bond
funds from 1990 to 1997.14
Table 2.4: Average Fees Collected For Stock and
Bond Funds In Dollars Per Account from 1990 to
1997
Type of 1990 1991 1992 1993 1994 1995 1996 1997 Percent
fund age
change
Stock $102 $106 $122 $136 $138 $135 $150 $164 61%
Bond 184 180 210 230 237 223 235 251 37
Source: GAO analysis of data from ICI.
Data for Some Mutual Fund Advisers Indicates
Profitability Has Been Increasing
Recent data on the profitability of mutual
fund advisers were generally limited to a few
studies done by industry research organizations.15
As noted previously, financial statements are not
available for most mutual fund adviser firms.
Although hundreds of mutual fund advisers exist,
information was available for only a small subset
of firms that have issued securities to the
public, which requires them to file publicly
available financial statements with SEC. The
financial results of these public mutual fund
adviser firms may not be representative of the
industry as a whole because the public firms tend
to be among the largest firms. However, analysis
of information for some of these firms indicated
that they were generally profitable and that their
profitability had been increasing.
An analysis by 1 industry research
organization of 18 mutual fund advisers indicated
that these firms' revenues were generally growing
faster than their expenses. This organization,
Strategic Insight, LLC., annually reports on
trends in mutual fund adviser costs and profits by
using data for those advisers that have issued
securities to the public and thus are required to
make their financial statements publicly
available. For its analysis, Strategic Insight
reviewed the financial results from 1994 to 1998
for 18 public companies16 that manage mutual funds
and other private account assets. According to its
report, these 18 firms managed about $1.1 trillion
in mutual fund assets and accounted for about 20
percent of total industry assets in 1998. As shown
in table 2.5, the operating expenses for the 18
companies have been rising since 1995, but their
data indicated that the rate of increase has been
slowing each year.
Table 2.5: Change in Revenue and Expenses From
Prior Year and Resulting Operating Margin for
Public Asset Management Companies
1995 1996 1997 1998
Fee revenue growth 43% 36% 34% 28%
Operating expense growth 48 34 31 27
Operating profit margina 33 34 35 36
a Operating margin is the percentage that
operating profit (revenue minus expenses)
represents of total revenue before taxes.
Source: Strategic Insight, LLC., analysis of 18
public companies
Although the Strategic Insight data shows
that expenses have been increasing for these
companies, it also showed that their revenues
were, on average, increasing at a higher rate than
their expenses between 1996 to 1998.
As table 2.5 also shows, Strategic Insight
found that as measured by profit margins, the
profitability of these mutual fund management
companies has been increasing. In 1998, Strategic
Insight's calculations indicated that these 18
companies' pretax operating profits, calculated by
subtracting total expenses from total revenues
before subtracting taxes, averaged about 36
percent of their revenues.
These mutual fund advisers also appear
generally profitable compared to firms in other
industries. A commonly used measure of
profitability is return on equity, which is the
ratio of profits to the amount of equity invested
in the business by the firm's owners, which is
derived by subtracting the firm's liabilities from
its assets.
The Strategic Insight data lacked complete
information on all 18 publicly traded mutual fund
advisers, but we were able to assess the rates of
return on equity of 9 of the advisers as far back
as 1995. From 1995 to 1998, the returns on equity
for these nine firms were generally consistent and
ranged, on average, between 23 and 26 percent
during these years, with the 26 percent occurring
in 1998. This was comparable to the 500 U.S.
companies in the Standard & Poor's 500 index,
whose return on equity had averaged 22 percent
from 1995 to 1999.
_______________________________
1 As discussed in chapter 1 of this report, the
operating expense ratio for a mutual fund is the
total of various fees and expenses charged to the
fund during a particular period shown as a
percentage of the fund's total assets. The expense
ratio includes a management fee that compensates
the adviser for selecting and managing the fund's
portfolio, 12b-1 fees used for expenses associated
with distributing fund shares, and any other
expenses associated with administering the fund
that have been deducted from its assets.
2 Investment Company Institute Perpective:
Operating Expense Ratios, Assets, and Economies of
Scale in Equity Mutual Funds, John D. Rea, Brian
K. Reid, and Kimberlee W. Millar, (Washington,
D.C.: Dec. 1999).
3 The Third White Paper: Are Mutual Fund Fees
Reasonable? (September 1998 Update), Lipper
Analytical Services, Inc. (Sep. 1998).
4 Included among these 35 funds were at least 1 of
the funds offered by the 15 advisers that we
contacted and a random selection of others that we
obtained from public filings made to SEC.
5 Amounts paid to fund distributors deducted from
fund assets must be paid pursuant to a 12b-1 plan.
Other amounts paid to distributors would come out
of adviser profits.
6 "Fund Advertising: Evolving Trends Among
Television, Internet, and Print Media," Mutual
Fund Caf�: Blue Plate Special, Financial Research
Corporation (Jan. 18, 1999).
7 1999 Investment Management Compensation Survey,
Association for Investment Management and Research
and Russell Reynolds Associates (Jul. 20, 1999).
8 Hedge funds are private investment partnerships
or offshore investment corporations that include a
general partner, which manages the fund, and a
limited number of other investors that usually
must meet high minimum investment requirements.
9 "How Fund Companies Are Using the Internet to
Strengthen Customer Relationships and Cut Costs,"
Mutual Fund Caf�: Inside Scoop, DeRemer &
Associates and Wechsler Ross & Partners (Aug.
1998)
10 Mutual funds pay such costs to entities known as
custodians, which provide for the safekeeping of
stock certificates and other assets owned by the
funds.
11 Fund adviser and service provider revenues were
estimated by multiplying fund assets by operating
expense ratios.
12 The total asset amounts differ from those
presented elsewhere in this report because the
data ICI provided for this revenue analysis did
not include any funds sold as part of variable
annuity products.
13 Using data as of February 24, 1998, we
identified these funds as being the largest funds
that had been in existence since at least 1990.
These 77 funds included 46 stock funds (including
5 hybrid funds that invested in both stocks and
bonds), each with assets over $8 billion; each of
the 31 bond funds had assets of $3 billion.
Collectively, these 77 funds had combined assets
of $1,157 billion in 1998 and represented nearly
28 percent of the $4,174 billion in total industry
assets invested in these types of funds. As of
that date, 10 other funds had similar levels of
assets as the funds in our analysis; we did not
include them in our analysis because they had been
created after 1990.
14 ICI did not provide data on the number of
accounts for 1998.
15 The studies we identified that addressed mutual
fund adviser costs or profitability included Money
Management Financial Comparisons 1998, Strategic
Insight, LLC. (New York, NY: Apr. 1999); The Third
White Paper: Are Mutual Fund Fees Reasonable?
(September 1998 Update), Lipper Analytical
Services, Inc. (Sep. 1998); and Price Valuation
and Performance Analytics, Putnam Lovell Thornton
& LaGuardia (Apr. 1999).
16 The companies include AMVESCAP PLC, Affiliated
Managers Group, Alliance Capital L.P., Eaton
Vance, Franklin Resources, Federated Investment,
Gabelli Asset Management, Kansas City Southern
(financial group only), Liberty Financial, PIMCO
Advisors L.P., Phoenix Investment Partners,
Pioneer Group, Pilgrim America, The John Nuveen
Company, Nvest L.P., T. Rowe Price, United Asset
Management, and Waddell & Reed.
Chapter 3
Mutual Fund Operating Expense Ratios Generally
Declined
Page 51 GAO/GGD-00-126 Mutual Fund Fees
Previously completed studies of trends in the
operating expense ratios charged by mutual funds
produced varying conclusions as to whether such
fees were declining or increasing and faced
criticism over the methodologies they used. Our
own analysis indicated that the expense ratios
charged by the largest funds were generally lower
in 1998 than their 1990 levels, but this decline
did not occur consistently over this period. The
expense ratios for the largest stock funds, which
experienced the greatest asset growth during the
1990s, declined more than had the largest bond
funds, whose expense ratios had generally remained
flat. Finally, not all funds have reduced their
fees despite experiencing growth in their assets.
Our analysis of the largest funds indicated that
25 percent of the funds whose assets grew by 500
percent or more since 1990 had not reduced their
expense ratios by at least 10 percent by 1998,
including some funds that raised their fees.
Studies Also Find Mixed Trend in Fees Across
Industry
Studies and analyses that looked at the trend
in operating expense ratios and other charges to
mutual fund investors had generally mixed
findings, with some finding fees have risenand
others finding them to have declined. Questions
were raised about the conclusions of some of these
studies because of the methodologies they used.
Some Studies Find Declines in Mutual Fund Fee
Charges
Some of the studies we reviewed that had
looked at the overall trend in mutual fund fees
since 1990 found that the operating expense ratios
and other charges were declining. Among these were
a series of studies conducted by ICI, which looked
at the trend in mutual fund fees charged by stock
and bond funds .1 In these studies, ICI combined
funds' annual operating expense ratios with an
amortized portion of any sales loads charged.2 To
calculate the average total annual costs for all
funds, ICI multiplied each fund's total cost by
the proportion that its sales represented of all
fund sales that year. ICI stated that this
methodology was intended to incorporate all of the
costs that an investor would expect to incur in
purchasing and holding mutual fund shares.
Weighting these costs by fund sales was intended
to reflect the costs of funds actually being
chosen by investors each year.
Using this methodology, ICI found that the
total costs investors incurred as part of
purchasing mutual funds declined 40 percent
between 1980 and 1998 for stock funds and 25
percent between 1980 and 1997 for bond funds. The
studies also reported that a significant factor in
the declining investor costs was the shifting by
investors to lower cost funds. This shift by
investors was also reflected in data showing
faster growth in no-load funds than load funds.
The ICI studies reported that a general decline in
distribution costs (sales loads and 12b-1 fees)
also contributed to the overall decline in
investor costs.
Other Studies Found Fees Rising
In contrast, some studies or analyses that
looked at the trend in mutual fund fees found that
fees had been rising. These included analyses by
academic researchers, industry research
organizations, and regulators. For example, an
analysis by an academic researcher indicated that
the median asset-weighted average operating
expense ratio of funds in the industry had
increased by 7 percent from 1987 to 1998. An
internal study by SEC staff found that median
expense ratios had increased by 11 basis points
from 1979 to 1992.
Criticisms Raised Regarding the Methodologies Used
by Some Fee Studies
The conclusions reached by some of the mutual
fund fee studies have been criticized because of
the methodologies used. Some industry participants
were critical of the conclusions reached in the
ICI studies because it calculated average annual
shareholders' costs by weighting them by each
fund's sales volume. For example, analysts at one
industry research organization acknowledged that
the ICI data may indicate that the total cost of
investing in mutual funds has declined. However,
they said that because ICI weighted the fund fees
and other charges by sale volumes, the decline ICI
reports results mostly from actions taken by
investors rather than advisers of mutual funds.3
These research organization officials noted that
ICI acknowledged in its study that about half of
the decline in fund costs resulted from investors
increasingly purchasing shares in no-load funds.
Criticisms were also made of some studies or
data that reported that the mutual funds fees had
been rising. Such studies usually did not focus on
a fixed number of funds over time but instead
averaged the fees of all funds in existence each
year. Critics noted that the averages calculated
by these studies would be biased upwards by the
increasing number of new funds, which tend to have
high initial expenses until certain asset levels
are reached. Such averages would also be
influenced upwards by the increasing prevalence of
funds with more specialized investment objectives,
such as international funds, which usually have
higher research costs and thus tend to have higher
expense ratios overall than other funds.
Largest Mutual Funds Generally Grew Faster Than
Industry Average
Our analysis indicated that the largest funds
grew more than other funds in the industry. As
shown in table 3.1, the average size of the 46
largest stock funds increased by about 1,100
percent from 1990 to 1998; the average size of all
other stock funds increased by about 300 percent.
Combined, the average size of the largest stock
and bond funds grew by about 600 percent during
this period as compared to the approximately 200-
percent increase in the size of all other stock
and bond funds.
Table 3.1: Average Size of Stock and Bond Mutual
Funds from 1990 to 1998
Dollars in millions
Largest Funds Average size of fund
1990 1998 Percentage
change
46 stock funds $1,828 $21,459 1,074%
31 bond funds 2,551 5,828 128
Total for largest 2,135 15,029 604
funds
All other funds in
industry
Stock funds 159 602 279
Bond funds 206 291 41
Total for all other 178 484 172
funds
Source: GAO analysis of data from ICI;
Morningstar, Inc.; and Barron's Lipper Mutual
Funds Quarterly.
Among Largest Funds, Average Expense Ratios
Declined for Stock Funds but Less so for Bond
Funds
Because they grew more than other funds, the
largest funds would likely have been subject to
the greatest economies of scale, which could have
allowed their advisers to reduce the fees they
charge investors. In general, the expense ratios
on large mutual funds investing in stocks have
been reduced since 1990, but the ratios of funds
investing primarily in bonds have declined only
slightly since then. In addition, these declines
did not occur consistently over the period from
1990 to 1998.
According to our own analyses and those performed
by others, larger mutual funds have generally
reduced their operating expense ratios during the
1990s. Using the data we collected on the 46
largest stock and 31 largest bond funds in
existence from 1990 to 1998, we calculated a
simple average of their operating expense ratios.
The simple average represents the fee an investor
would expect to pay by choosing among the funds at
random. As shown in figure 3.1, the average
expense ratio per $100 of assets for largest stock
funds declined from 89 cents in 1990 to 71 cents
in 1998, which was a decline of 20 percent. The
expense ratio for the largest bond funds was 66
cents in 1990 and 64 cents in 1998, a decline of 3
percent.
Figure 3.1: Average Expense Ratios for 77 Largest
Stock and Bond Mutual Funds From 1990 to 1998
Source: GAO analysis of data from from ICI;
Morningstar, Inc.; and Barron's Lipper Mutual
Funds Quarterly.
Analysis by the mutual fund industry association,
ICI, also found that the advisers of large stock
funds had generally reduced their funds' operating
expense ratios. In its November 1998 study, ICI
presented its analysis of data on the 100 largest
stock funds established before 1980. It reported
that the simple average of the operating expense
ratios for these funds had declined from 82 cents
in 1980 to 70 cents in 1997, representing a
decline of about 15 percent.
The decline in the fees charged by the
largest stock and bond funds did not occur
consistently over the period from 1990 to 1998.
For both the stock funds and the bond funds in our
analysis, we calculated the percentage that
operating expense revenues represented of these 77
funds' total assets during 1990 to 1998. This
represents what the average dollar invested in
these funds was charged in fees during this
period. As shown in table 3.2, the fees paid by
the average dollar invested in the largest stock
funds rose in the first years of this period
before declining in the last several years. As
table 3.2 also shows, the fees paid by the average
dollar invested in the largest bond funds remained
relatively constant during this period but also
declined in the most recent years.
Table 3.2: Asset-Weighted Average Operating
Expense Ratios for 77 Largest Stock and Bond Funds
From 1990 to 1998 in Dollars Per $100 of Fund
Assets
Type of Number 1990 1991 1992 1993 1994 1995 1996 1997 1998 Percentage
fund of change 1990-
funds 1998
Stock 46 $.74 $.78 $.78 $.80 $.81 $.79 $.75 $.68 $.65 -12%
Bond 31 .62 .61 .61 .60 .61 .63 .61 .60 .58 -6
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
Asset Growth Usually Resulted in Lower Expense
Ratios but Not All Funds Made Reductions
Although mutual funds in general appear to have
reduced their operating expense ratios, our
analysis and those by others indicated that not
all funds had. The more funds' assets had grown,
the more likely the fund adviser was to have
reduced the expense ratios of those funds. Even
among funds that grew significantly, however, not
all had reduced their ratios by more than 10
percent.
Most Large Funds Had Reduced Expense Ratios
Our analysis and those by others indicated that
the advisers for most large funds had reduced
their funds' expense ratios. Of the 77 large funds
for which we collected data, 54 funds, or 70
percent, had lower operating expense ratios in
1998 than they had in 1990 (see table 3.3). As can
also be seen, the largest bond funds were less
likely to be charging lower fees than were stock
funds; 48 percent of the bond funds had lower
expense ratios compared to 85 percent of the stock
funds.
Table 3.3: Change in Operating Expense Ratios
Charged by 77 Largest Stock and Bond Funds 1990-
1998
Type of Funds that reduced Funds with no Funds that Total
fund fees change in fees raised fees number of
funds
Number Percentag Number Percentag Number Percentag
e e e
Stock 39 85% 2 4% 5 11% 46
Bond 15 48 2 6 14 45 31
Total 54 70 4 5 19 25 77
Note: percentages do not total to 100 percent due
to rounding.
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
ICI also found that the expense ratios of
large funds had declined over time. In its
December 1999 study that discussed economies of
scale for mutual funds, ICI provided data on the
trend in operating expense ratios for 497 stock
funds in existence as of 1998. ICI selected these
funds because they all had assets of at least $500
million and thus had experienced significant asset
growth and likely reached sufficient size to
realize economies of scale. ICI reported that 368,
or 74 percent, of these 497 funds had lower
operating expense ratios as of 1998 than they had
charged in their first full year of operation.
Conversely, the expense ratios of the other 129,
or 26 percent, of the funds ICI reviewed had
either not reduced their ratios or had raised them
since their first full year of operation.
The data on the largest funds cannot be used
to ascertain what the trend in operating expense
ratios has been for the industry as a whole. As
noted, our sample consisted of the 77 largest
funds in existence since 1990. ICI's study
reviewed 497 funds with assets of over $500
million. In both analyses, the percentage of
funds that had reduced their expense ratios was
about the same. SEC officials that reviewed our
analysis noted that reviewing data for only the
largest funds would bias the results towards those
funds most likely to have reduced their expense
ratios. As a result, a review of funds outside
the largest funds could find that a smaller
percentage of funds had reduced their expense
ratios to any significant degree.
Funds With More Asset Growth More Likely to Reduce
Expense Ratios, But Not all Funds Made Significant
Reductions
In analyzing the largest mutual funds, we found
that the largest reductions in expense ratios
generally involved funds with the greatest growth
in assets. Conversely, increases in expense ratios
tended to involve funds with more modest asset
growth and a few funds with asset reductions.
However, our analysis also showed that not all
funds that experienced significant asset growth
had reduced their operating expense fees by at
least 10 percent over the period from 1990 to
1998.4
The more a fund's assets grew, the more likely its
adviser was to have reduced the expense ratio. As
shown in table 3.4, the more the assets of the 46
largest stock funds had increased since 1990, the
more likely they were to have lower operating
expense ratios in 1998. However, not all funds had
lower expense ratios even when they experienced
significant asset growth. As can be determined
from table 3.4, the assets of 40 of the large
stock funds grew 500 percent or more from 1990 to
1998. Of these 40 funds, 10 funds, or 25 percent,
had not reduced their operating expense ratios by
at least 10 percent in the 9 years since 1990; and
2 of the funds were charging higher ratios in 1998
than they had in 1990.
Table 3.4: Relationship of Asset Growth and Change
in Operating Expense Ratios for Largest Stock
Funds 1990-1998
Change in operating Percentage change in assets Total
expenses
+1,000 +500 to +200 to +200 to Decline in
1,000 500 0 assets
Reduction over 30 percent 14 2 16
Reduction between 10 and 7 7 1 15
30 percent
Reduction under 10 4 2 2 8
percent
No change 1 1 2
Increase under 10 percent 1 1
Increase between 10 and 1 1
30 percent
Increase over 30 percent 1 1 1 3
Total 28 12 3 3 0 46
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
Although bond funds had generally experienced less
growth than had stock funds, a similar
relationship between asset growth and operating
expense reductions also existed for the largest
bond funds that we analyzed. As table 3.5
indicates, bond funds whose assets had grown since
1990 were more likely to be charging lower
operating expense ratios in 1998. However, similar
to the stock funds, not all of the advisers for
bond funds with significant asset growth had
reduced their funds' fees. As can be determined
from table 3.5, the assets of 11 of the large bond
funds grew 500 percent or more from 1990 to 1998.
Of these 11 funds, 3 funds, or 27 percent, had not
reduced their expense ratios by at least 10
percent in the 9 years since 1990.
Table 3.5: Relationship of Asset Growth and Change
in Operating Expense Fees for Largest Bond Funds
1990-1998
Change in Percentage change in assets Total
operating expenses
+1,000 +500 to +200 to +200 to Decline in
1,000 500 0 assets
Reduction over 30 1 1
percent
Reduction between 4 3 2 1 10
10 and 30 percent
Reduction under 10 1 2 1 4
percent
No change 1 1 2
Increase under 10 1 2 3
percent
Increase between 2 5 1 8
10 and 30 percent
Increase over 30 2 1 3
percent
Total 6 5 6 10 4 31
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
The December 1999 ICI study also reported that
advisers for funds with greater asset growth had
generally reduced their funds' operating expense
fees by the largest amounts. Among the 497 funds,
ICI determined that the funds in the top 20
percent of asset growth had reduced their
operating expense ratios on average by 51 cents
per $100 of assets. In contrast, the decrease in
the expense ratio for the funds in the bottom 20
percent of asset growth averaged only 5 cents per
$100 of assets
Funds with Higher Operating Expense Ratios Made
Greater Reductions Than Funds With Lower Ratios
The extent to which advisers reduced a fund's
expense ratio appears to depend on the initial
level of the ratio. In its December 1999 study,
ICI found that changes in operating expense ratios
among the 497 stock funds they analyzed were
related to the level of the fees the funds charged
when they first began operations. To conduct its
analysis, ICI divided the 497 stock funds into 5
equal groups (quintiles) after ranking them by the
expense ratios they charged during their first
full year of operations. ICI reported that the
funds in the quintile with the lowest ratios
initially were charging an average of about 50
cents per $100 of assets. By 1998, the average
expense ratio charged by these funds had increased
by 7 cents. In contrast, the funds in the quintile
with the highest fees had an average operating
expense ratio in the initial period of $1.86, and
by 1998 they had reduced their ratios by an
average of 76 cents.
Our own analysis of the largest mutual funds
confirmed this relationship between relative fee
levels and subsequent operating expense ratio
changes. To perform this analysis, we separated
the 77 largest stock and bond funds into 2 groups
based on whether their operating expense ratios
were higher or lower than the combined average for
each type of fund5 in 1990. This resulted in 29
funds whose 1990 expense ratios were higher than
the average charged by funds of their type in 1990
and 48 funds whose ratios were lower. As shown in
figure 3.2, the average ratio for the 29 high-fee
funds declined from $1.22 to 92 cents; the average
ratio charged by 48 low-fee funds remained
relatively flat at about 54 cents.
Figure 3.2: Average Operating Expense Ratio From
1990 to 1998 for Funds With Above and Below
Average Fees in 1990
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
The relative asset growth of these funds also may
help to explain the changes in their operating
expense ratios. Our analysis of these large funds
indicated that the 29 higher fee funds had
experienced a larger increase in assets than the
48 lower fee funds. As shown in table 3.6, the 29
funds grew 901 percent in average fund size during
1990-98, almost twice the 496-percent growth in
average fund size of the other 48 funds. These
results are consistent with our previously
discussed findings discussed previously that
greater asset growth is generally associated with
greater reductions in expense ratios.
Table 3.6: Change in Average Size in Assets and
Operating Expense Ratios from 1990 to 1998 for
Largest Funds by Relative Fee in 1990
Type of fund N Asset size of average fund Operating expense ratio (in
u (dollars in millions) dollars per $100 of assets)
m
b
e
r
o
f
f
u
n
d
s
1990 1998 Percentage 1990 1998 Percentage
change change
High fee 3 $1,515 $15,162 901% $1.22 $.92 -25%
funds 0
Low fee 4 2,510 14,948 496 .54 .54 0
funds 7
Total 7 2,135 15,029 604 80 68 -15%
7
Source: GAO analysis of data from Morningstar,
Inc., and Barron's Lipper Mutual Funds Quarterly.
_______________________________
1 The three ICI studies were: Trends in the
Ownership Cost of Equity Mutual Funds, November
1998; Total Shareholder Cost of Bond and Money
Market Mutual Funds, (Washington, D.C.: Mar.
1999); and Mutual Funds Costs, 1980-1998,
(Washington, D.C.: Sep. 1999). ICI also issued a
related study of economies of scale that also
included fee trend information: Investment Company
Institute Perspective: Operating Expense Ratios,
Assets, and Economies of Scale in Equity Mutual
Funds, John D. Rea, Brian K. Reid, and Kimberlee
W. Millar, (Washington, D.C.: Dec. 1999).
2 To account for any sales loads charged, the ICI
researchers spread (or amortized) the load charges
over numerous years according to estimates of the
average period over which investors hold their
funds. Thus, the total costs to fund shareholders
each year was calculated as the annual operating
expenses plus that year's proportionate share of
any applicable sales load.
3 Morningstar.Net Commentary: Revisiting Fund
Costs: Up or Down?, Scott Cooley, Morningstar,
Inc. (Feb. 19, 1999).
4 We used 10 percent as the threshold for
identifying a significant reduction because 10
percent is a traditional accounting measure of
materiality, and it appeared to be a reasonable
amount given the level of asset growth that
occurred during this 9-year period.
5We computed separate averages for each fund type.
This resulted in the 46 stock funds being
separated into 19 funds with fees higher than the
stock fund average fee and 27 funds below the
average. The 31 bond funds included 10 high-fee
funds and 21 low-fee funds.
Chapter 4
Competition in Mutual Fund Industry Does Not Focus
on Fees
Page 64 GAO/GGD-00-126 Mutual Fund Fees
The structure and nature of competition in the
mutual fund industry appear to resemble the type
of market referred to by economists as
"monopolistic competition."1 In industries with
this type of competition, entry is easy and many
firms are present. Also, products differ from one
another, which lessens direct competition on the
basis of price. Our review found that the mutual
fund industry has characteristics of a
monopolistically competitive market. Although
thousands of mutual funds appear to compete
actively for investor dollars, this competition
has not focused primarily on the price of the
service-i.e., fees charged to shareholders.
Instead, mutual funds compete primarily on
performance returns, which implicitly consider
fees, services, and other fund characteristics.
Mutual Fund Industry Exhibits Characteristics of
Monopolistic Competition
In general, the mutual fund industry exhibits the
characteristics of monopolistic competition. As
stated above, markets or industries where
monopolistic competition prevails typically have
large numbers of firms and easy entry into the
market/industry. Such industries also offer
products that differ from one another in terms of
quality, features, or services included. Our
review, and the analyses of others, found that the
mutual fund industry, with its numerous
participants, easy entry, and many different
products, has the traits of a monopolistically
competitive market.
Characteristics of a Monopolistically Competitive
Market
Economists often classify industries by the
prevailing type of competition for products in
those markets. For instance, perfectly competitive
markets have large numbers of competing firms,
easy entry into the industry, and standardized
products. Such markets have commodity-like
products; all units offered are basically the
same, such as agricultural products. In such
markets, the products of one firm are often very
close or perfect substitutes for those offered by
other firms. Firms in markets with perfect
competition are unable to charge a price different
from that set by the market.
Industries where monopolistic competition prevails
usually have large numbers of firms and andanan
easy industry entry, but products are
differentiated by characteristics, such as quality
or service. Because their products differ, firms
can charge different prices from other firms in
the industry. This ability to distinguish one
firm's product from that of others, results in
somewhat higher pricing levels than would result
from a perfectly competitive market. In such
markets or industries products are promoted by
brand, rather than price. Various features, such
as quality, service, or other characteristics,
differentiate products from one another,
accordingly, prices differ.
The markets for various retail products and
personal services are among those generally
characterized by monopolistic competition. For
example, one market that could be considered to
have such competition could be medical services,
such as doctors or dentists. These professionals
generally do not compete primarily on the basis of
the price of their services but instead rely on
their reputations for quality and their physical
location to attract customers. Other product
markets that could be characterized as
monopolistically competitive could include those
for snack foods. Although a grocery would likely
offer the widest selection and the lowest prices
for snack foods, such products are also available
at convenience stores, gas stations, and vending
machines. These other retail outlets generally
charge more for similar items but attract
customers by offering more convenient locations
and a reduced effort on the part of customers to
make a purchase.
Large Numbers of Competing Funds and Fund
Complexes Exist
The mutual fund industry is characterized by a
large and growing number of funds. As shown in
figure 4.1, the number of individual mutual funds
in the industry has grown significantly since the
early 1980s.
Figure 4.1: Number of Mutual Funds from 1984 to
1998
Source: GAO analysis of data from ICI.
Figure 4.1 shows that from 1984 to 1998, the
total number of funds grew almost 500 percent,
from over 1,200 to about 7,300. The number of
stock funds increased 650 percent during this 15-
year span to about 3,500, and the number of bond
funds grew by 730 percent to about 2,300. The
number of funds increased most dramatically during
the 1990s, as over 4,200 new funds were created
between 1990 and 1998. Stock funds represented
more than half of the 1990s growth, increasing in
number by over 2,300 funds.
The number of fund families also rose
significantly during the same period. As shown in
figure 4.2, the number of families grew from 193
in 1984 to 418 in 1998, a 117-percent increase
over the 15-year period. Growth during the 1990s
was more modest than in the 1980s, as the number
of fund families increased by 94 from 1990 to 1998
compared to an increase of 201 from 1984 to 1990.
Figure 4.2: Number of Mutual Fund Famillies for
Selected Years From 1984 Through 1998
Source: ICI.
Concentration of assets under management in
the mutual fund industry has changed little since
1984. Data compiled by an industry research
organization showed that the 20 largest fund
families accounted for about 65 percent of the
total assets as of November 1998, compared to
about 67 percent in March 1984. A statistical
measure of industry concentration known as the
Herfindahl-Hirshman Index,2 which is used by the
Department of Justice in assessing antitrust
cases, also shows that the mutual fund industry is
not concentrated. On a scale with a maximum value
of 10,000, the mutual fund industry scored 329 as
of May 1997, slightly lower than its score of 350
in 1984.
Although Some Barriers Exist, Most Saw Relative
Ease of Entry into Industry
Most of the officials we contacted, and
documents we reviewed, indicated that entry into
the mutual fund industry has been relatively easy.
As previously discussed, ease of entry is a
characteristic of monopolistic competition. In
1998 testimony before Congress,3 the ICI president
indicated that barriers to entry were low, as
start-up costs were not high and firms did not
have to register in each state. Some officials
explained that entry into the industry was also
easy because new mutual fund advisers can quickly
be operational by contracting with one or more of
the various organizations that specialize in
providing many, if not all, of the administrative
services and functions required to operate a
mutual fund.
Another factor officials cited that likely
increases funds' ability to compete is the advent
of fund "supermarkets." In recent years, various
mutual fund or broker dealer firms have created
fund supermarkets, through which they provide
their customers the opportunity to invest in a
wide range of funds offered by different mutual
fund families. Industry officials said that such
supermarkets provide small or new fund advisers
access to investors.
Not all of the officials we contacted agreed
that barriers to entry are low in the mutual fund
industry. For example, an official of an
organization that researches the mutual fund
industry told us that start-up costs for new funds
are high because a fund typically needs to attract
at least $100 million in assets before it
adequately covers its costs. Another industry
research organization official said that one
significant barrier to entry is that new entrants
lack a long enough performance history to be rated
by the major mutual fund rating services. Many
officials remarked that these ratings greatly
influence investors' fund choices. Thus, new funds
without such ratings would have much more
difficulty attracting investors. Another barrier
to entry faced by new fund advisers is obtaining
adequate distribution of their funds. Recently,
fund distributors, such as broker-dealer firms,
have been reducing the number of funds and fund
families they are willing to promote and
increasing charges for their services, further
escalating start-up costs.
Alternative Financial Products Also Represent
Competition to Mutual Funds
In addition to the large numbers of competing
firms in the mutual fund industry, other similar
financial products also likely create competition
for mutual funds. Currently investors seeking to
invest in portfolios of securities, which is the
type of investment that mutual funds offer, can
also choose to purchase other products whose
values are derived from the prices of various
underlying securities. For example, World Equity
Benchmark Shares (WEBS), which are traded on the
American Stock Exchange, allow investors to
purchase shares whose values are intended to track
the prices of a selection of foreign stocks from
various countries. Other firms have begun offering
investors the opportunity to invest in custom-
designed baskets of securities. With the dramatic
decrease in the commissions charged to conduct
individual securities transactions and the ability
of investors to conduct their own transactions
through on-line brokerage accounts, investors
could also create their own portfolio of
securities without having to invest in mutual
funds.
Mutual Funds Offer Differentiated Products
Another characteristic of the mutual fund
industry consistent with monopolistic competition
is that it offers differentiated products.
Although all mutual funds basically offer
investors a standardized means for investing in a
pool of diversified securities, firms offering
mutual funds compete by attempting to
differentiate their products from others. Mutual
funds invest in a variety of securities that can
be grouped primarily into three categories:
stocks, bonds, and money market instruments.
However, within these categories, funds can
further differentiate the nature and/or mix of
securities or bonds in the fund's portfolio, such
as by investing in
� stocks of large, mid-size, or small
companies;
� bonds of corporations or government entities;
� bonds with different maturities; or
� stocks or bonds of domestic or foreign
companies or governments.
A fund's portfolio manager can be another
differentiating factor. Funds commonly have
specific portfolio managers who make investment
decisions for the fund. At times, the popularity
of a particular fund portfolio manager can be such
that investors view that manager's fund as unique
even though many other funds may exist that invest
in similar types of securities.
Yet other differentiating factors would be the
number and quality of services provided to
shareholders. Among other services, the fund
officials we met with spoke of providing 24-hour
telephone service, allowing investors to access
their accounts over the Internet, and providing
well-trained customer service staff.
Mutual Fund Industry Generally Does Not Attempt to
Compete On Basis of Fees
The competitive conduct of firms within the mutual
fund industry does not generally emphasize the
fees investors pay for the service. Instead,
mutual fund advisers seek to differentiate their
offerings primarily by promoting their funds'
returns and their fund families' services.
However, the potential for differentiation varies
among the three primary fund categories. Because
equity funds generally have the greatest variety
of investment alternatives and styles, they have
the greatest potential for differentiation.
Because money market funds are the most
standardized, they have the least potential for
differentiation. Bond funds tend to be somewhere
between the other two, although more like money
market funds. Most officials saw these differences
as leading to greater variation in the level of
fees charged by stock funds than for bond and
money market funds.
In general, firms offering mutual funds attempt to
compete by emphasizing factors other than the
operating expense fees they charge for their
services. Although markets with commoditylike
products usually compete primarily on the basis of
price, when products can be differentiated, price
competition tends to be less important than other
factors. One academic analysis4 characterizes a
monopolistically competitive industry as offering
products that are near, but imperfect,
substitutes. According to this study, to avoid
competing on price, firms will strive to
differentiate their products from those of their
rivals, allowing them to set prices within a
market niche. The authors describe various other
factors, besides price, through which mutual funds
can seek to differentiate themselves. These
factors include funds' investment selections,
trading and execution abilities, customer
recordkeeping and reporting, and investor
liquidity services. For example, funds can
emphasize investor liquidity services by allowing
investors to switch from one fund to other funds
in the fund family by telephone .
In the academic papers and speeches we reviewed
and the interviews we conducted, observers agreed
that although the importance of fees to
competition varies by fund type, mutual funds do
not compete primarily on the basis of their
operating expense fees . Observers noted that
because the range of securities in which money
market funds and bond funds can invest is
generally more restricted than for other funds,
they are not as differentiated and are more
commoditylike. Therefore, fees for these funds can
have a greater effect on their performance
relative to other money market and bond funds and,
thus, on their ability to compete. According to
one industry research organization's analysis,
fees can dictate whether bond funds succeed or
fail. This analysis indicated that for one type of
fund-municipal bond funds-just a few basis points
difference in operating expense fees can be
critical to the overall performance of the fund
because the returns on these funds vary so little
from those of their peers.5
The greater importance of operating expense fee
levels to money market and bond funds influences
the fees that fund companies set for these types
of funds. For example, firms offering money market
funds, for competitive reasons, often waive
portions of asset fees as a means of attracting
additional assets to their funds. Industry
officials also said that the less diverse nature
of money market and bond funds contributes to
their having lower fees than most stock funds.
For stock funds, industry officials explained that
the large variety of investment objectives could
lead to a wider range of investment returns and
thus greater possibilities for differentiation
among funds. An industry research organization
official explained that because investment returns
can vary much more from one stock fund to another,
the fee levels of stock funds may be much less
relevant to their relative performance. For this
reason, officials generally acknowledged that
firms offering stock funds did not attempt to
compete primarily on the basis of operating
expense fees charged by the fund. The chairman of
one mutual fund firm stated that although price
competition exists among money market and bond
funds, for which the impact of operating expense
fees was more obvious, stock funds were not
subject to nearly as much price competition. In
addition, an official of an industry research
organization told us that because the range of
returns for stock funds can be wider, the
investment manager can add more value; thus, the
operating expense fees on such funds are higher
than those for money market and bond funds.
Instead of competing on the basis of the
price of providing mutual fund services, fund
advisers generally emphasize the performance of
their funds when attempting to differentiate their
funds from those of their competitors. Mutual fund
firm officials and others in the industry
acknowledged that funds compete primarily on the
basis of their performance. However, mutual fund
adviser and other industry officials also observed
that because funds are required to report
performance figures net of expenses, operating
expense fees are indirectly taken into account in
their competition.
To document factors mutual fund companies
emphasize in their promotions, we analyzed a
selection of mutual fund print advertisements for
content. We evaluated 43 mutual fund
advertisements for 28 different mutual fund
families, which appeared in 5 randomly selected
issues of popular business, news, or personal
finance magazines and 1 business newspaper between
July and November 1999. In 27 of the 43
advertisements, performance was the primary
emphasis; and attributes of the fund adviser, such
as its experience or strategy, were primarily
emphasized in another 11. Fees and other charges
were the primary emphasis in 2 of the 43
advertisements, both of which were from the same
fund family. However, 16 of the 43 advertisements
included statements that the funds described did
not charge sales loads.
Opinions Were Mixed on the Effect of Competition
on Fees
Opinions were mixed as to whether the large
number of competing funds and fund complexes
provided effective fee competition. Officials from
mutual fund advisers, industry associations, and
research organizations we contacted generally
agreed that the large number of funds and fund
complexes in the industry leads to active
competition, which affects fees. An official of a
bank-affiliated fund adviser told us that the
industry is extremely competitive because the
competition among so many different companies and
funds highlights and maintains downward pressure
on fees. Ease of entry to the industry could also
exert downward pressure on fees. One mutual fund
adviser official remarked that in an environment
of easy entry where fees were too high, other
firms would enter the industry and charge lower
fees.
However, other officials, including financial
planning firm representatives and academic
researchers, disagreed with the contention that
competition among the many mutual fund firms in
the industry serves to effectively lower fees. An
academic researcher testified before Congress on
mutual fund issues that although the industry
competes vigorously against other financial
services industries, fee competition within the
industry is not as effective, noting that most
economists view competition in the mutual fund
industry as imperfect. A senior official at one
mutual fund firm said in a speech6 that about 50
fund advisers actually attempt to compete across
all types of funds. He asserted that in other
industries, this number would be enough to produce
fierce price competition, but he found price
competition conspicuously absent among mutual fund
advisers.
Competition on the Basis of Price Not Completely
Absent
Despite the fact that competition in the
mutual fund industry does not focus primarily on
the price of mutual fund services, some evidence
of competition on the basis of fees did exist. For
example, the two largest fund groups are among the
industry's low-cost providers, with one group
actively promoting its low fees and expenses as a
means of attracting customers. Regulatory
officials told us that the increased popularity of
low-cost index funds, whose share of total stock
fund assets increased from less than 2 percent in
1990 to 7 percent in 1999, was evidence that
competition on the basis of fees occurs and that
some investors are mindful of it.
_______________________________
1 In addition to monopolistic competition,
economists also classify the nature of competition
prevailing in markets into at least three other
types that include perfect competition, oligopoly,
and monopoly. The distinguishing features of each
type vary across various characteristics,
including the number of firms, ease of entry,
degree of product differentiation, and competitive
strategies used.
2 The index determines a score of industry
concentration based on the percentage market share
of each firm in the industry. An index score of
close to 0 would indicate perfect competition --
where all firms have equal market shares--but a
score of 10,000 would indicate a monopoly--where
one firm has the entire market to itself.
Therefore, the lower the index score, the higher
the level of competition in the industry;
conversely, the higher the score, the lower the
level of competition.
3 "Improving Price Competition for Mutual Funds
and Bonds," before the Subcommittee on Finance and
Hazardous Materials, House Commerce Committee,
September 29, 1998.
4 "Competition and Change in the Mutual Fund
Industry," Financial Services: Perspectives and
Challenges, Erik R. Sirri and Peter Tufano, HBS
Press (Boston, MA.: 1993).
5 Industry-Wide Expense Trends: Should Industry
Growth Necessarily Translate into Lower Average
Expense Ratios?, Blue Plate Special, Mutual Fund
Caf�, Financial Research Corporation (Jan. 5,
1998;
http://www.mcafe.com/pantry/bps_010598.html).
.6 Remarks on Receiving the Special Achievement
Award of the National Association of Personal
Financial Advisors, John C. Bogle, Senior
Chairman, The Vanguard Group (Washington, D.C.:
Jun. 4, 1999).
Chapter 5
Mutual Funds Are Not Required to Disclose Actual
Amounts Charged to Individual Investors
Page 81 GAO/GGD-00-126 Mutual Fund Fees
Under existing law, mutual funds are required
to inform investors of sales charges and ongoing
operating expenses for the funds in which they
invest. However, funds are not required to provide
information on the actual dollar amount of each
investor's share of the operating expenses that
were deducted from the fund. This contrasts with
most other financial products and services for
which specific dollar charges are generally
required to be disclosed. Studies and data that
others, and we, collected indicate that mutual
fund investors have focused more on fund
performance and other factors than on fee levels.
In contrast to the consideration they give fees,
investors appeared more concerned over the level
of mutual fund sales charges (loads). Industry
participants acknowledged that such concerns have
resulted in fund advisers lowering the loads
charged on mutual funds since the 1980s.
Opinions varied on the usefulness to
investors of the required fee disclosures. The
mutual fund and regulatory officials we contacted
generally considered mutual fund disclosures to be
extensive and adequate for informing prospective
investors of the fees they would likely incur on
their mutual fund investments. However, some
private money managers, industry researchers, and
legal experts indicated that the current fee
disclosures do not make investors sufficiently
aware of the fees they pay. Having mutual funds
disclose to each investor the actual dollar amount
of fees he or she paid was one way suggested to
increase investor awareness and to potentially
stimulate fee-based competition among fund
advisers. Although exact fee computations would
require fund advisers and others to make systems
changes and incur additional costs, alternative,
less costly ways may exist for computing the fee.
Required Fee Disclosures Do Not Provide Amounts
Paid by Individual Investors in Dollars
Neither federal statute nor SEC regulations
expressly limit the fees that mutual funds deduct
for operating expenses. Instead, mutual fund
regulations focus on ensuring that investors are
provided with adequate disclosure of the risks and
costs of investing in mutual funds. At the time of
purchase, mutual funds are required by law to
provide certain information to potential fund
investors about the funds, including information
about the fees they will pay. This fee information
is governed by certain provisions of the
Investment Company Act of 1940 and various SEC
rules and regulations that require fee disclosures
so that investors can make more informed
investment decisions.
Presently, all funds must provide investors
with disclosures about the fund in a written
prospectus. SEC rules require that the prospectus
include a fee table containing certain specific
information about the sales charges, operating
expenses, and other fees that an investor will pay
as part of investing in the fund.
Figure 5.1 shows an example of a fee table
for a typical mutual fund. As shown in the figure,
the fee table required for mutual funds primarily
consists of three sections. The first section
presents information on shareholder transaction
expenses, which investors pay out of the amount
they invest. These include any sales charges or
loads that will apply to the purchase of the fund
shares, which are shown as a percentage of the
amount to be invested. Investors are also to be
informed of the percentage charges that may be
assessed at redemption1 or that apply to
reinvested dividends or other distributions.2 In
addition, some funds charge redemption or exchange
fees. Redemption fees are expressed as a
percentage of the amount redeemed and are paid at
the time the investor sells fund shares. Exchange
fees can be assessed when investors exchange
shares of one fund for shares of another fund in
the same family. The fund depicted in figure 5.1
charges its investors a 5.75-percent load but does
not levy any other sales charges.
Figure 5.1: Example of a Fee Table Required as
Part of Mutual Fund Fee Disclosures
Source: GAO example based on fee table in actual
mutual fund prospectus.
The middle section of the fee table shown in
figure 5.1 presents the fund's total operating
expenses incurred over the previous year. Funds
are required to provide information on the
management fee, distribution and/or service fees
(referred to as 12b-1 fees), and any other
expenses that are deducted from the fund's assets
or charged to all shareholder accounts. Other
expenses deducted from fund assets would include
amounts the fund paid for transfer agent services,
as well as record-keeping, printing, mailing, or
other services. These fees and expenses are
deducted from the fund's assets on an ongoing
basis and presented in the fee table, in
aggregate, as a percentage of the fund's average
net assets for the prior year. In the fee table
shown in figure 5.1, the total expenses deducted
from the fund's assets over the course of the
prior year represented 0.70 percent of its average
net assets for that period.
In the last section of the fee table, mutual
funds are required to present a hypothetical
example of the total charges an investor is likely
to incur on a fund investment. This portion of the
fee table must show costs the investor will likely
incur over 1-, 3-, 5-, and 10-year periods,
assuming a $10,000 investment in the fund, a 5-
percent return each year, and fund operating
expenses that remain constant throughout each
period. SEC requires that the fee table include a
statement that information in the example is
intended to allow investors to compare the cost of
investing in the fund with that of investing in
other mutual funds.3
In addition to the disclosures required when
investors initially purchase shares, mutual funds
are required to provide shareholders of their
funds, at least semiannually, reports that also
include certain fee and expense information. In
these reports, funds are to include a statement of
operations that shows the total dollar amount of
the various expenses the fund incurred over the
prior period. Funds must also indicate the
percentage of average net fund assets that these
total expenses represent.4 Also, shareholders who
purchase additional shares during the year must be
provided an updated prospectus document, at least
annually, which would include the fee table with
the latest year's expense information. In
practice, many mutual funds send an updated
prospectus to all of their shareholders annually.
However, mutual funds are not required to provide
investors with information showing the specific
dollar amount of operating expenses that they paid
as part of holding their mutual fund shares.
Mutual fund shareholders generally receive a
quarterly statement of account5 that denotes any
money balances or account activity during the
quarter. These quarterly statements generally
indicate the number of shares held by the
investor, the NAV of those shares as of the
statement date, and the corresponding total value
of the shares. These statements do not show, in
either dollars or as a percentage of assets,6 the
shareholder's portion of the operating expenses
that were deducted from the fund's assets.
Charges for Other Financial Services Typically
Disclosed in Dollars
Although mutual funds do not provide individual
shareholders information on the specific dollar
amounts of all fees paid, most other financial
services or products are generally required to
make such disclosures.
To compare the information investors receive on
mutual funds, we collected information on the
extent to which the users of certain other
financial products or services are informed of
specific dollar charges for such products or
services. We collected this comparative
information on products and services that we
believed mutual fund investors would be likely to
use, such as bank deposit accounts or stock or
bond transactions through a securities broker-
dealer. Our information sources for determining
disclosure requirements for these other products
included applicable federal statutes or
regulations; in some cases, we summarized common
industry practices regarding fee disclosure
information. As shown in table 5.3, investors in
other financial products or users of other
financial services generally receive information
that discloses the specific dollar amounts for
fees or other charges they pay.
Table 5.1: Fee Disclosure Practices for Selected
Financial Services or Products
Type of product Disclosure requirement
or service
Deposit Depository institutions are
accounts required to disclose itemized fees,
in dollar amounts, on periodic
statements.
Bank trust Although covered by varying state
services laws, regulatory and association
officials for banks indicated that
trust service charges are generally
shown as specific dollar amounts.
Investment When the adviser has the right to
services deduct fees and other charges
provided by directly from the investor's
individual account, the dollar amounts of such
investment charges are required to be
advisers disclosed to the investor.
Wrap accountsa Provider is required to disclose
dollar amount of fees on investors'
statements.
Stock, bond, or Broker-dealers are required to
other report specific dollar amounts
securities charged as commissions to
purchases investors.
Real estate Brokerage commissions generally are
property specified as a percentage of
purchases property value but disclosed as a
specific dollar amount on purchase
documents.
a In a wrap account, a customer receives
investment advisory and brokerage execution
services from a broker-dealer or other financial
intermediary for a "wrapped" fee that is not based
on transactions in the customer's account.
Source: Applicable disclosure regulations and/or
rules, and/or industry practice.
The information in the table illustrates that in
contrast to mutual funds, the providers of the
featured services and products usually disclose
the specific dollar amount of the charges their
users incur. We believe that such disclosures may
be one reason for the apparently vigorous price
competition among firms offering these services
and products. For example, securities commissions
were formerly fixed by law, with transactions
commonly costing hundreds of dollars. In 1975, SEC
invalidated fixed commission rates as being in
violation of the antitrust laws. Subsequently,
certain securities firms began competing for
customers primarily by promoting their lower
charges for conducting transactions. Competition
among these firms, commonly known as discount
brokers, has been heightened by their increasing
use of the Internet, with their commissions for
buying or selling securities now less than $10 or
$20 at some firms. Banks also frequently compete
for customers on the basis of the fees they charge
on checking accounts, and advertisements for "no-
fee checking" have become common.
However, the fee disclosures provided by mutual
funds may exceed those of certain other investment
products, although such products may not be
completely analogous to mutual funds. For example,
fixed-rate annuities or deposit accounts that
provide investors a guaranteed return on their
principal at a fixed rate do not charge the
purchasers of these products any operating expense
fees. The financial institutions offering these
products generate their profits on these products
by attempting to invest their customers' funds in
other investment vehicles earning higher rates of
return than they are obligated to pay to the
purchasers of the annuities. However, the returns
they earn on customer funds and the costs they
incur to generate those returns are not disclosed
as operating expenses to their customers.
Mutual funds differ from such products in that
they do not guarantee their investors a specific
return, and their fund fees are directly deducted
from fund assets for specific expenses associated
with operating the funds, including adviser
compensation for its investment management
services. Thus, investors placing money in mutual
funds are essentially hiring the fund adviser to
provide money management services rather than
purchasing an investment product with a stated
return as they do with annuities and other fixed-
rate investment products. As a result, disclosure
of the dollar amounts of mutual fund fees would be
akin to the dollar amount disclosures that
customers receive for brokerage services or
checking account services. In contrast, customers
purchasing or placing money in fixed-rate
investments, such as certificates of deposit or
annuities, are not told the amount that the
financial institution earns on the customer's
capital. In these cases, the customer is
purchasing a product with specific features,
including its promised return, rather than
obtaining a service from the provider as they are
with mutual funds.
Mutual Fund Fees Are Not a Primary Consideration
for Investors
According to surveys and other information,
investors tend to consider other factors before
considering fees charged by mutual funds. On the
other hand, investors appear to be more sensitive
to mutual fund loads, and these charges have
declined over time.
Various Other Factors Get Greater Consideration
Than Fees
Investors themselves have indicated that
other factors take precedence over fees when they
evaluate mutual funds. To assess the extent to
which investors consider fee information when
selecting and evaluating mutual funds, we
consulted a wide variety of sources, including
academic literature, industry research firms and
other industry experts, mutual fund advisers,
industry associations, and regulators. Our review
of this information revealed that when evaluating
funds, investors generally gave greater
consideration to several other factors before
considering fund fees. The primary factor
investors used in selecting mutual funds was
generally the fund's performance. Other factors
also given greater consideration than fees
included fund manager or company characteristics,
the investments made by funds, or fund risk
levels. For example, a 1995 random survey
conducted on ICI's behalf of individuals who had
recently made stock or bond fund purchases7 asked
what information they had considered beforehand.
Cited by 75 percent of the 653 respondents, fund
performance was most frequently considered,
followed by fund risk (69 percent), investment
goals (49 percent), and portfolio securities (46
percent). Cited by only 43 percent of the
respondents, fees and expenses ranked fifth.
Even after purchasing shares, investors
apparently continue to consider other factors
ahead of fund fees when reviewing their mutual
funds. A 1997 ICI report8 relating the results of
interviews with over 1,000 recent mutual fund
purchasers, selected at random,stat stated that 76
percent of those surveyed had considered fees and
expenses before making their purchases. However,
respondents cited five other factors, including
account value and rate of return, as information
they monitored more frequently than fees and
expenses after they had made their purchases.
The apparent lack of investors' attention to fees
by investors has been a source of concern for
regulators. During testimony before the House
Subcommittee on Finance and Hazardous Materials of
the Committee on Commerce,9 SEC's Chairman stated:
"The Commission is very concerned. that many fund
investors are not paying attention to the
available information about fees." He further
stated that the agency's research showed that
fewer than one in six fund investors understood
that higher expenses can lead to lower returns,
and fewer than one in five could give any estimate
of expenses for their largest mutual fund. He
cited other research that found that about 40
percent of fund investors surveyed believed
incorrectly that a fund's annual operating
expenses have no effect on its gains.
Both critics and industry participants told
us that the unprecedented bull market of the last
10 years has allowed investors to ignore the
impact of fees. In a January 1998 study10 that
looked at the trend in mutual fund fees, one
research organization noted that fees are not a
primary consideration for investors and that as
long as stock prices are rising, investors would
accept even the highest of fees. Some industry
participants stated that when market returns
eventually revert to lower levels, investors might
then take more interest in the fees they pay on
their mutual funds.
Some research indicated that the majority of
mutual fund investors are likely to be less
sensitive to the fees their funds charge because
they rely on the advice of investment
professionals when selecting funds. According to
research by ICI and others, the majority of mutual
fund investors make their purchases on the basis
of advice from an investment professional, such as
a broker-dealer representative or private money
manager. For example, ICI's 1997 report on the
1995 survey of over 1,000 investors who had
recently purchased mutual funds stated that about
60 percent had consulted with investment advisors
to assist with their decisions. Some industry
participants said that investors who rely on
investment advisors are not likely to exert much
pressure for lowering fees.
Investors Appear More Aware of Sales Loads than
Operating Expense Fees
Although investors do not appear to give
primary consideration to the fees funds charge as
a percentage of fund assets, they are aware of
loads. Many officials we interviewed attributed
load declines to investor awareness.
Various studies have documented the fact that
the share of funds charging front-end loads has
been declining over time. For example, one
industry research organization reported that the
share of front-end load fund sales had gone from
90 percent of sales by third-party sales forces
(such as broker-dealers) in 1990 to about 38
percent by 1998.11
In addition to the declining sales of front-
end load funds, sales of no-load funds have risen.
Table 5.2 shows the relative share of mutual funds
purchased by investors using two of the primary
distribution methods used by fund advisers: (1)
sales by proprietary or third-party sales forces,
such as the sales representatives of a broker-
dealer, who are generally compensated by a sales
load; and (2) sales directly to investors by the
fund through its own mutual fund distributor,
which is the customary method for no-load funds.
As shown in table 5.2, new sales of funds sold
directly to investors rose from about a third, to
almost 40 percent of the dollar volume of all new
mutual funds sold in 1998.
Table 5.2: Sales of Mutual Funds for Select Years
1984 to 1998 by Type of Distribution Method
Dollars in millions
Year Distribution method
Sales by third-party sales Direct sales by advisers to investors
forces
Sales Market share Dollar volume Market share
1984 $26,893 67% $13,522 33%
1991 124,522 62% 74,806 38%
1998 542,600 61% 348,210 39%
Source: GAO analysis of ICI data.
The level of loads charged by mutual funds
has also declined since the 1980s. The customary
percentage charged as a front-end load in 1980 or
earlier was 8.5 percent. This amount has declined
to the 5-percent range, according to officials
from the fund advisers, industry research, and
other organizations we contacted. Our analysis of
the 77 largest stock, bond, and hybrid mutual
funds in existence from 1990 to 1998 also
illustrated this trend. In 1990, 43 of these funds
charged investors loads. Using data from 1984,
which was the earliest period we reviewed, we
found that 16 of these funds had loads of more
than 6 percent, including 14 that charged at least
8 percent. However, by 1998, 5 funds had
eliminated their loads; of the remaining 38 load
funds, none charged a load greater than 6 percent,
with the average load being 4.62 percent. During
this same period, some of these funds were raising
their loads. The loads charged by six funds
increased from 4.00 to 4.25 percent, and one fund
raised its load from 4.00 to 4.75 percent.
Investor awareness was the reason industry
participants cited for investor resistance to
paying loads and the overall decline in loads.
According to some industry participants, investors
had become increasingly resistant to paying the
higher front-end loads. An industry expert told us
that investors are generally more concerned about
the concept of a front-end load because they "see
it occur" when the amount is deducted from their
initial investments on their account statements.
Operating expense fees, on the other hand, are
deducted from fund assets rather than from the
individual investor's account. Research findings
indicate that investors continue to resist load
charges. For example, officials from one industry
research organization told us their research found
that up to a third of mutual fund investors would
never be willing to pay a load or commission when
buying a fund. In another research organization's
survey, only 4 percent of over 4,000 investors and
potential investors queried cited mutual fund
loads as their preferred means of paying for
investment advice.12
Opinions Varied on Adequacy of Current Fee
Disclosures
Industry participants' opinions varied on the
adequacy of mutual fund fee disclosures to
investors. Many, including fund adviser officials
and researchers, indicated that current
disclosures adequately highlight the fees that
investors can expect to pay on their mutual fund
investments. However, others, including academic
researchers and private money managers we
contacted, raised concerns about the adequacy of
the disclosures. Some officials suggested that
additional information, such as dollar amounts or
comparative data on other funds' charges, would be
useful.
Most Officials Found Disclosures Adequate
Most of the officials from the mutual fund
advisers, research organizations, regulators, and
other organizations we contacted said that mutual
fund fee disclosures made under the current
requirements provided adequate and important
information to investors. Several officials noted
that investors can use the standardized
information found in the fee table of the
prospectus to compare costs easily between funds.
For example, one mutual fund adviser official
likened the percentage fee information in the fee
table to unit pricing that allows consumers to
compare the cost per ounce of various products in
grocery stores. Several officials also said that
mutual funds make more extensive disclosures than
those made byother financial services and
products, and two noted that U.S. mutual fund
disclosures are more detailed than those of other
countries.
Some Expressed Concerns Regarding the Adequacy of
Mutual Fund Fee Disclosures
Although most opinions were positive about
the fee information that mutual funds are
currently required to disclose, some industry
observers raised concerns about the adequacy of
these disclosures. Several, including academic
researchers, investment advisers and regulatory
representatives, saw problems with the fee
disclosures. AAAa private money manager we
interviewed questioned the usefulness of
hypothetical fee disclosures in prospectuses,
citing the fact that investors have not exited
from high-cost funds to any large degree. In his
opinion, these disclosures are too simplistic, and
they fail to include benchmarks or indicate the
impact of fees on returns. He commented that "No
one sends the investor a bill, and the fund simply
quietly and continually deducts its fees. The
result is that the information is ignored." Two
researchers and a mutual fund representative also
stated that investors ignore fee disclosures.
Some mutual fund adviser officials told us
that current disclosures may actually provide
investors too much information. Given the
prominence of fee information in required
disclosures, some fund adviser officials expressed
concern that disclosures could emphasize cost over
performance or other factors important to
investors. Another criticized the fee table as
being too complex, and possibly confusing, for
investors.
As mentioned earlier, the SEC Chairman has
stated that investors are not paying attention to
the available fee information. He voiced concern
that the fee structures of some mutual funds are
too complex, making it more difficult for
investors to evaluate overall costs and services.
In a 1998 speech to an ICI gathering, the chairman
asked "Do you really expect investors to
understand alphabet soup of A, B, C, D, I, Y, and
Z shares? To figure what combination of front-end
loads, CDSLs,13 12b-1 charges, commissions and who
knows what else they are paying?" He also has
urged the mutual fund industry to place less
emphasis on fund performance and more emphasis on
clearly detailing fund risks and expenses, or
fees, as the industry markets its products. He
warned the industry that by focusing fund selling
strategy on the bull market to the exclusion of
other key variables, such as risk and expense, the
industry is setting itself up to disappoint
millions of investors.
To address this issue, SEC has taken steps of
its own to encourage investors' use of
disclosures. In April 1999, the agency began
offering a computer program, publicly accessible
over the Internet, which lets investors compare
the cost of owning a particular fund with the
costs of similar funds. To use this program, an
investor enters information from a fund
prospectus, and the program calculates the effect
of fees and other charges on the investment in the
fund over time.14
Disclosing to Investors Actual Dollars Paid in
Fees Was One Suggested Improvement
To improve fee disclosure to mutual fund
investors, some officials favored providing
investors with a personalized fee statement that
would show the specific amount of fees paid by the
investor on his or her holdings. In his September
1998 testimony, the SEC Chairman indicated that
the information from such statements might help
investors understand the relationship between fees
and returns on their mutual fund investments.
Others who advocated requiring mutual funds to
provide investors with the dollar amount of fees
they paid indicated that such disclosure would
increase investors' awareness of the fees they are
charged. We interviewed representatives of
industry research firms, industry experts, and
private money managers, who supported personalized
expense statements for investors. Generally, they
told us that such personalized expense statements
would be useful to investors, and they would be
more likely to focus shareholders' attention on
costs than the fee table in the prospectus
currently does. Representatives of some mutual
fund advisers also acknowledged that such
statements could serve to focus investors'
attention on the fees they pay on their mutual
funds.
Some officials indicated that such disclosures may
also increase competition among fund advisers on
the basis of fees. An attorney specializing in
mutual fund law told us that requiring funds to
disclose the dollar amount of fees in investor
account statements would likely encourage fund
advisers to compete on the basis of fees. He
believed that this could spur new entrants to the
mutual fund industry that would promote their
funds on the basis of their low costs, in much the
same way that low-cost discount broker-dealers
entered the securities industry. A market
participant told us that having dollar amounts
disclosed on investors' periodic statements could
also lead to increased fee-based competition among
mutual fund advisers. His expectation is that
after such information begins to appear in
investor statements, fees will probably be more
frequently mentioned in fund advertisements.
Information from a survey of investors generally
indicated that they supported getting dollar
amount disclosures of the mutual fund fees they
paid but would be unwilling to pay for this
disclosure. We obtained information from a large
securities broker-dealer that had recently
included a number of mutual fund fee questions in
a November 1999 survey as part of a series of
periodic customer surveys it conducts. Of more
than 500 responses to the question "If mutual fund
companies were to provide the specific dollar
amount of fees paid on your investment per
quarter, how useful would it be to you?" about 89
percent indicated that the information would be
useful or very useful. However, of over 500
responses to a question asking if respondents
would be willing to pay for this information,
about 54 percent indicated "very unlikely," versus
about 14 percent who checked "very likely" or
"somewhat likely," although no estimates of the
cost were provided.
Industry Representatives Raised Concerns Over the
Effort to Produce, and the Usefulness of, Such
Statements
We also solicited the views of industry
representatives on the feasibility of providing
personalized fee statements for their
shareholders. Representatives of several mutual
fund advisers and broker-dealer firms that market
mutual funds to their customers responded that
changing their accounting systems to accommodate
such statements would be costly and would be of
limited benefit to individual investors. They
stated that providing accurate fee information
specific to each investor would require keeping
detailed records on fund expenses incurred each
day and apportioning them daily among investor
holdings.
Another complication mutual fund adviser
officials cited was that in some cases, broker-
dealers, rather than the advisers, maintain a
significant portion of mutual fund investors'
records. As a result, these broker-dealers, too,
would have to change their accounting and
information management systems. A fund adviser
maintains a single account for each broker, called
an omnibus account, which includes all shares held
by that broker-dealer's customers. Because the
fund adviser has no record of the individual
customers included in each omnibus account, broker-
dealers would have to set up their own systems to
apportion fee information among their customers'
accounts. This would require broker-dealers to
revise their accounting and information management
systems to receive the cost data from each fund
adviser and then apportion this information among
customer accounts holding that adviser's funds.
One broker-dealer with about 6.5 million
customer accounts estimated that developing the
systems necessary to produce such statements might
cost as much as $4 million, with additional annual
costs of $5 million. At our request,
representatives of a prominent industry research
firm estimated the likely costs to funds for
providing quarterly personalized expense
statements. They responded that programming to get
the necessary information would require some up-
front fixed costs, but they would probably amount
to less than a penny per shareholder. Besides
these up-front costs, fund adviser representatives
had indicated to us that there would also be
annual costs to provide the statements. Using the
estimates of the broker-dealer mentioned
previously, we calculated that its costs to
provide such statements would be less than $1 per
customer per year.
Mutual fund adviser officials and others also
questioned whether the information provided by
these personalized fee statements would be
meaningful. One objection they raised was that
unlike the standardized percentage fee information
in the fee table, individual investors' fee
information would not be directly comparable to
the fees they incur on other funds because of
differences in the number of shares held or the
investment objectives of the funds. Some officials
said that investors might make inappropriate
investment decisions solely on the basis of the
dollar amounts of fees they paid. Some said, for
example, that investors might choose to exchange
their stock fund shares for those of money market
funds, which typically have lower fees than stock
funds, even though it may not be appropriate in
light of their investment and financial goals.
Industry representatives also pointed out that
because fee disclosure is intended to help
investors make investment decisions, the
information on periodic statements would come too
late, after an investor has already made his or
her investment decision.
We agree with industry representatives that the
operating expenses, currently shown in the
required fee table disclosures as a percentage of
fund assets, are more appropriate for comparing
fee levels across funds when investors are
initially choosing between funds. However, the
purpose of the dollar amount disclosures would be
to further highlight for investors the costs of
the mutual funds in which they have invested and
to supplement the disclosures they already
receive. Concerns that investors might make
inappropriate investment decisions based solely on
the dollar costs of their mutual funds could be
addressed by advising investors to consider such
specific fee information in conjunction with their
own investment goals and other factors, rather
than isolated from other considerations.
Less Costly Means of Calculating the Individual
Dollar Costs of Fees Might Be Considered
Providing investors with information on the dollar
amounts they pay in mutual fund fees likely could
be accomplished in various ways. As noted above,
some industry participants provided estimates of
their costs to calculate exact dollar amounts of
fees each investor paid during a statement period.
However, less costly alternatives may exist. For
example, one fund adviser representative suggested
that an alternative means of calculating the fee
would be to multiply the average number of shares
in each account during the statement period by the
fund's expense ratio for that period. He stated
that the figure derived in this way would be a
reasonable approximation of the dollar amount of
fees the investor paid. He added that it also
would be less costly and burdensome than computing
an exact amount, because it would not entail
maintaining daily expense and share records for
each investor.
Another way of disclosing the dollar amount of
investor fees would be to use preset investment
amounts. For example, each investor's statement
could include the dollar amount of fees paid on
$1,000 invested in the fund. Investors could then
use this dollar amount to determine how much in
fees they paid based on the value of their own
particular accounts. One market participant we
spoke with offered a similar example of a
disclosure involving preset investment amounts.
Although he would prefer that periodic statements
disclose the specific dollar amount that was
deducted for fees from each investor's account
during that period, he believes an acceptable
alternative would be for statements to include a
table showing fees for the reporting period on
accounts of various sizes, such as $1,000, $5,000,
$10,000, and others.
Another Option Was to Provide Comparative Fee
Information
We also sought opinions on whether mutual
funds should be required to provide investors with
comparative information on fees charged by both
their own, and comparable, funds. Such disclosures
would be similar to requirements for automakers or
major appliance producers to provide data on gas
mileage or efficiency ratings to prospective
purchasers of those items.
Survey information indicated that investors
would support receiving such information but not
if it was costly to prepare. In the previously
mentioned survey conducted by a large broker-
dealer, about 97 percent of the over 500
respondents indicated that such data would be very
useful or somewhat useful. However, about 54
percent indicated that they would be "very
unlikely" to pay, compared to about 14 percent who
checked "very likely" or "somewhat likely,"
although no estimates of the cost were provided.
Industry participants also raised various concerns
over requiring funds to provide comparative
information on fees. Most industry participants
told us that this requirement would be difficult
to implement while providing little, if any,
benefit to investors. One concern was that
determining the appropriate fund groupings for
comparison purposes would be problematic. Another
was that lack of comparability could result if
fund advisers were left to identify the peers for
their own funds. In addition, one industry
research organization official questioned why
mutual funds should be subjected to such a
requirement when other financial products are not
similarly required to provide such comparative
information.
_______________________________
1 Funds must disclose the maximum of any deferred
sales charges, which include sales charges that
apply to the purchase of fund shares payable
either upon redemption, in installments, or both
expressed as a percentage of the offering price at
the time of purchase or the NAV at time of
purchase. These charges typically decline over a
period of years such that if an investor holds the
shares for the specified time, the charge will be
waived.
2 Funds must disclose the sales charges imposed on
reinvested dividends and other distributions, such
as returns of capital, as a percentage of the
amount to be invested or distributed.
3 The disclosure requirements described here have
been the result of various changes over time. The
fee table was first required to be provided as the
result of rule amendments in 1988. In 1998, the
hypothetical investment amount illustrated in the
fee table example was also increased from $1,000
to $10,000 to reflect the size of the more typical
fund investment. Most recently, in March 2000, SEC
proposed that mutual funds be required to report
investment returns on an after-tax basis in
prospectuses and shareholder reports because of
the significant impact that taxes can have on an
investor's return.
4 Specifically, the statement of operations must
list the amounts paid by a fund for all services
and other expenses in dollar amounts. These may
include amounts paid for investment advisory
services, management and administrative services,
marketing and distribution, taxes, custodian fees,
auditing fees, shareholder reports, and annual
meeting and proxy costs.
5 Mutual fund shares distributed by broker-dealers
are subject to SEC and NASD rules, including NASD
rule 2340 that requires that quarterly account
statements be provided to investors. Some banks
also sell mutual funds but most use securities
broker-dealers to conduct such activities. In a
limited number of transactions, bank personnel
sell mutual funds to investors and will either
issue periodic statements similar to those issued
by broker-dealers themselves, or such periodic
statements will be issued by the broker-dealer who
distributed the shares to the bank. Furthermore,
Title II of the Gramm-Leach-Bliley Act passed in
1999 will require that banks conducting more than
500 securities transactions per year move such
activities into a securities broker-dealer after
May 12, 2001.
6 Funds sometimes charge investors other fees,
such as for account maintenance or wire transfers,
that are set dollar amounts that may be deducted
from an investor's account and shown on subsequent
statements.
7 Shareholder Assessment of Risk Disclosure
Methods, ICI (Washington, DC: Spr. 1996).
8 Understanding Shareholders' Use of Information
and Advisers, ICI (Washington, DC: Spr. 1997).
9 "Improving Price Competition for Mutual Funds
and Bonds," before the Subcommittee on Finance and
Hazardous Materials, House Commerce Committee,
Sept. 29, 1998.
10 "Industry-wide Expense Trends", Mutual Fund
Caf�: Blue Plate Special , Financial Research
Corporation, (Boston, MA: Jan. 5, 1998).
11 "Pricing Structure Trends: Prime Destination for
Net Flows is Back-End Loaded Shares," Mutual Fund
Caf�: Blue Plate Special, Financial Research
Corporation (Boston, MA: Feb. 1, 1999).
12 1996 Series on Personal Financial Advice:
Payment Practices Preferred by Customers (Report 5
of 9), Dalbar, Inc. (Boston, MA: Nov. 1996).
13 CDSL is an acronym that stands for "contingent
deferred sales load," a charge, or load, imposed
at the time of redemption. This is an alternative
to front-end loads to compensate financial
professionals for their services, and it typically
applies only for the first few years of share
ownership.
14 Information about the mutual fund cost
calculator is available on the Internet at
www.sec.gov/news/press/99-36.txt.
Chapter 6
Mutual Fund Directors Required to Review Fees
Page 83 GAO/GGD-00-126 Mutual Fund Fees
The organizational structure of most mutual funds
embodies a conflict between the interests of the
fund shareholders and those of the adviser that
can influence the fees a fund charges. This
conflict arises primarily because part of the fees
charged by the fund, which reduce investors'
returns, are the adviser's revenue and a source of
profit to the adviser's owners. As one safeguard
against this potential conflict, the Investment
Company Act of 1940 requires the presence of
independent directors on a mutual fund's board of
directors, who review and approve the fees their
fund charges. Congress passed amendments to the
act in 1970 that imposed a fiduciary duty on fund
advisers, tasked fund directors with additional
responsibilities regarding fees, and gave
investors the right to bring legal action against
fund advisers charging excessive fees. A series of
court cases interpreting this duty has served to
clarify the information that fund directors must
review to determine if fees are excessive. As a
result, mutual fund directors are expected to
review, among other things, the adviser's costs,
whether fees are reduced as fund assets grow, and
the fees charged by other advisers for similar
services to similar funds. Although mutual fund
adviser representatives indicated that their
boards are vigorous in reviewing fees and seeking
reductions, some other industry participants were
critical of mutual fund directors' fee oversight,
stating that the current practices serve to keep
fees at higher levels than necessary. SEC has
recently proposed changes regarding the
requirements applicable to fund directors, but
these are not specifically fee-related, and their
impact on the level of fees is uncertain.
Mutual Funds' Organizational Structure Embodies
Conflict of Interest Over Fees
Although most mutual funds are organized as
corporations, their structure and operation differ
from a typical corporation because of the
relationship between the fund and its adviser.
Typically, the adviser, who is a legal entity
separate from the fund, conducts the fund's
operations, and the advisory fees it charges to
the fund represent revenue to the adviser,
creating a possible conflict of interest. However,
at least one mutual fund family's organizational
structure appeared to reduce this conflict between
the interests of its shareholders and the adviser
by operating similarly to a credit union, wherein
the shareholders of its funds own the entity that
operate the funds.
Mutual Funds Organization Includes Two Primary
Legal Entities
The mutual fund structure and operation differ
from those of a traditional corporation. In a
typical corporation, the firm's employees operate
and manage the firm; and the corporation's board
of directors, elected by the corporation's
stockholders, oversees its operations. After
subtracting its expenses from its revenues, a
corporation can use the resulting profits to
conduct further operations; or its board of
directors can vote to distribute a portion of
these profits to the stockholders as dividends.
Although generally organized as a corporation, a
mutual fund differs from other corporations in
several ways. A typical mutual fund has no
employees but is created by and operated by
another party, the adviser, who contracts with the
fund, for a fee, to administer fund operations. A
primary service the adviser typically provides is
to select and manage the fund's investment
portfolio.1 Advisers can provide additional
services but frequently subcontract with other
organizations, such as transfer agents, for
services such as maintaining shareholder records.
Advisers are legal entities separate from the
mutual funds they manage, and any profits they get
from operating the fund accrue to the owners of
the adviser. The fund shareholders are entitled to
the income from, and gains or losses in the value
of, securities in the fund's portfolio but are not
entitled to profits from the adviser's operations.
In addition, the relationship between a fund and
its adviser is rarely severed.2 Figure 6.1
illustrates the contrast between the structure of
a traditional corporation and that of most mutual
funds.
Figure 6.1: Comparison of Organizational Structure
of Typical Corporation and Typical Mutual Fund
Figure 6.1: Continued
Source: GAO analysis of corporate and mutual fund
structures.
As shown in figure 6.1, the mutual fund's expenses
are collected by its adviser and other service
providers as revenue. In most cases, some of the
expenses deducted from a fund's assets are paid by
the fund to other entities, such as transfer
agents or custodians, but some advisers may also
perform such services for a fund. An adviser's
profits are derived after subtracting any payments
to third parties and its own operating expenses,
separate from those of the fund, from the revenue
it collects from the fund. In addition, an adviser
may have other revenues and expenses from other
lines of business in which it engages.
Regulators and Congress have recognized that the
interrelationship between the mutual fund and its
adviser creates a potential for conflict between
the adviser's duties to the fund shareholders and
the adviser's duties to provide profits to its
owners. In describing this conflict, SEC recently
noted that fund shareholders would generally
prefer lower fees (to achieve greater returns),
but the stockholders or owners of the adviser
would prefer to maximize profits through higher
fees.3
Congress also acknowledged this potential
conflict; in the Investment Company Act of 1940,
it established certain safeguards designed to
protect the interests of fund shareholders. The
primary safeguard was to have mutual fund
directors4 oversee certain of the adviser's
activities. Although representatives of the
adviser generally participate as fund directors,
the act requires that at least 40 percent of the
directors be individuals without any significant
relationship with the fund's adviser. Congress
intended that the unrelated directors, known as
the independent directors,5 serve as an
independent check on the adviser. The board's
remaining directors, which are typically employees
of the fund's investment adviser, are known as
"interested" directors. An additional safeguard
provided by the act is the requirement that fund
shareholders approve the advisory contract.
The Organizational Structure of One Mutual Fund
Family Appears to Minimize the Potential Conflict
of Interest
Although most mutual funds are organized as
described above, one mutual fund
family-Vanguard-has a unique organizational
structure that its officials credit for allowing
it to have among the lowest fees in the industry.
As of November 1998, Vanguard was the second
largest fund family in the industry, operating
more than 100 different funds with over $367
billion in total mutual fund assets. Most other
mutual funds are operated by advisers owned
separately by a third party; however, the Vanguard
Group, Inc.-which operates the Vanguard funds6-is
jointly owned by the funds themselves and,
therefore, by the funds' shareholders. The company
required specific permission from SEC to deviate
from the standard structure envisioned by the
Investment Company Act of 1940 in order to
organize itself in this way.
According to documents obtained from Vanguard,
this structure allows the Vanguard Group to
provide the funds' services on an at-cost basis.
As a result, the profits from operating the funds
are returned to the fund shareholders through
lower operating expenses rather than going to the
owners/stockholders of a separate adviser, as is
the case for most other mutual funds. According to
materials provided by Vanguard, the Vanguard
family's operating expense ratios averaged 0.28
percent, which it stated were the lowest in the
industry. In 1998, the average fund fee was 1.25
percent. Vanguard's average expense ratio is also
lower because it operates several index funds,7
which have among the lowest ratios of all fund
types.
Although this structure appears to minimize the
conflict of interest between the typical mutual
fund and its adviser, it is not a structure that
has been widely replicated within the industry.
According to SEC officials, one other fund company
had an organizational structure similar to that of
Vanguard's but later changed its structure to
resemble the third-party ownership structure used
by most firms in the industry. The third-party
structure that is most prevalent does allow the
firm that initially provides its own capital to
create a mutual fund to earn a return on the
investment it put at risk. In addition, it can use
that capital to subsidize the fund in the event
that the fund needs an influx of capital, as
occurred for several money market funds that
incurred losses on structured notes investments in
1994. In contrast, having the fund adviser owned
by the fund shareholders, as is the case for
Vanguard, is more analogous to the structure of a
credit union, whose depositors and borrowers are
the owners of the institution. However, credit
unions may be more prevalent because the services
they provide are more generically required by the
public and the affiliated groups that tend to
create such institutions than are mutual fund
services.
Mutual Fund Directors Have Specific
Responsibilities Regarding Fees
Because of the conflict of interest inherent in
the organizational structure of a typical mutual
fund, fund directors have been tasked by law to
oversee fees charged to shareholders. These
responsibilities regarding fees are derived from
both state and federal law. The primary federal
statute governing mutual fund activities, the
Investment Company Act of 1940, tasks fund
directors with specific duties to review and
approve the fees their funds charge. Concerns over
the level of fees led to amendments of the act in
1970 that imposed additional responsibilities on
fund directors, placed a fiduciary duty on fund
advisers, and granted investors the right to sue
advisers for charging excessive fees. A series of
court cases interpreting this duty has served to
clarify the information that fund directors review
to determine if fees are excessive.
Federal and State Laws Provide Responsibilities
for Mutual Fund Directors
Because mutual funds are typically organized as
corporations, the laws of the states where the
funds are incorporated also place various general
duties on fund directors. These duties generally
require them to act in the best interests of the
shareholders they represent.8
In addition to the general duties imposed by state
law, federal law provides specific
responsibilities relating to the composition and
duties of a fund's board of directors. The
Investment Company Act of 1940 is the primary
federal statute governing mutual fund operations,
and it establishes various requirements and duties
for mutual fund directors.9
Under the act, a mutual fund's board of directors
is generally entrusted with protecting the fund
shareholders' interests and policing conflicts of
interest that might arise in connection with
payment for services to the fund. Under section
15(c) of the act, the terms of any advisory
contract and its renewal must be approved, in
person, by a vote of a majority of the independent
directors. The section also specifies that fund
directors are to obtain and consider any
information necessary to evaluate the terms of
both advisory and underwriting contracts and that
fund management must furnish this information to
the directors. The requirement that directors
obtain and review such information was added as a
result of amendments in 1970 to the Investment
Company Act of 1940.
In addition to the requirement that they approve
the overall advisory contract and its fees, a
mutual fund's directors are also required to
review distribution fees. A fund is prohibited
from using fund assets to pay for the sale and
distribution of its shares unless it adopts a plan
of distribution approved by the directors-known as
a rule 12b-1 plan. Such plans must be approved by
a majority of both (1) all of a fund's directors
(both the interested and independent directors)
and (2) the independent directors separately.
Fund Adviser Responsibilities Increased After
Concerns Over Fees
Congress also tasked mutual fund advisers with
additional fee-related responsibilities in 1970.
The impetus for the 1970 amendments to the
Investment Company Act arose primarily from
findings of two studies of mutual fund operations
done in the 1960s. One of the studies was by the
Wharton School of Finance in 1962,10 and SEC
prepared the other in 1966.11 The Wharton study
found that mutual fund shareholders lacked
bargaining power relative to the adviser, which
resulted in higher fees.
In its study, SEC found that litigation by fund
shareholders had been ineffective as a check on
fund advisers because of the difficulty in proving
that the adviser was charging excessive fees. The
standard being used by most courts at the time was
whether the fees charged by advisers represented a
flagrant misuse of fund resources. Because of the
difficulty of proving that fees charged met such a
standard, SEC recommended that the Investment
Company Act be amended to impose a reasonableness
standard on fund advisers regarding the fees they
charge. SEC noted that such a standard would
clarify that advisers would charge no more than
what would be charged if fees were negotiated on
an "arm's-length" basis (i.e., as if between
unrelated parties).12
However, the amendments to the Investment Company
Act of 1940 did not contain SEC's reasonableness
standard after objections to it were raised by
industry participants, who feared that courts
would substitute their judgment over that of fund
directors. As a compromise, the legislation
instead placed a fiduciary duty on the fund
adviser regarding the fees it receives.
Specifically, section 36(b) of the act13 imposes on
the adviser a fiduciary duty with respect to
compensation or material payments the adviser or
its affiliates receive from the fund. The statute
does not further define the fiduciary duty
imposed. Typically, under state common law, a
fiduciary must act with the same degree of care
and skill that a reasonably prudent person would
use in connection with his or her own affairs.
Section 36(b) also granted investors and SEC the
right to bring claims in federal court against the
adviser, the directors, officers, and certain
other persons14 for breach of fiduciary duty
regarding the compensation or payment they receive
from the fund. Investors have a 1-year period in
which to bring suit, and damages are limited to
fees received by the advisers within the prior
year. 15 In reviewing such cases, section 36(b)
directs the courts to give consideration as is
deemed appropriate under all circumstances to
board approval and shareholder ratification of the
compensation or advisory contract.
Court Decisions Have Shaped Directors
Responsibilities
Court decisions have played an important role in
shaping the role of mutual fund directors
regarding fees. Since 1970, various cases were
filed under section 36(b), and the resulting
decisions have served to provide specific
guidelines for fund directors. These guidelines
arise primarily from a Second Circuit Court of
Appeals case decided in 1982.16
After the Investment Company Act was amended to
give investors the right to sue advisers for
charging excessive fees, a series of cases was
brought under this new section of the act.
However, section 36(b) of the act, which provides
investors with the right to sue a fund adviser for
breach of fiduciary duty regarding fees, does not
contain specific standards for determining when
such a breach has occurred. Instead, the federal
courts adjudicating the claims brought by
investors under 36(b) have developed standards for
making such determinations. These standards focus
on assessing whether a payment is excessive.
The key case that established the standard for
determining whether a fund's fee is excessive was
Gartenberg v. Merrill Lynch Asset Management Inc
(Gartenberg). The shareholders in Gartenberg sued
the investment adviser for breach of fiduciary
duty with respect to its compensation. The
shareholders of this money market fund claimed
that given the fund's size and growth, the
adviser's profits were excessive due to its
disproportional fee. In Gartenberg the fee
schedule called for payment of 0.50 percent (1/2
of 1 percent) of the fund's average daily value of
net assets under $500 million and for various
intermediate percentages as the value of the net
assets increased down to 0.275 percent for assets
in excess of 2.5 billion. 17 In dismissing the
investors' claim of excessive profits, the
district court emphasized that the principal
factor in determining whether the adviser breached
its fiduciary duty to the fund with regard to fees
is to compare a fund's fees to the fees charged by
other funds in the industry.
In upholding the district court's decision, the
Second Circuit Court stated that to be guilty of a
violation under section 36(b), the fee must be "so
disproportionately large that it bears no
reasonable relationship to the services rendered
and could not have been the product of arm's-
length bargaining." The Second Circuit Court
disagreed with the district court's suggestion
that the principal factor to be considered in
evaluating a fee's fairness is the price charged
by other similar advisers to funds they managed.
The court stated that "the existence in most cases
of an unseverable relationship between the adviser-
manager and the fund it services tends to weaken
the weight to be given to rates charged by
advisers of other similar funds." The court
further stated that since a fund cannot move
easily from one adviser to another, advisers
rarely compete with each other on the basis of
fees and advisory contracts.
The court thus reasoned that although fund
directors may consider the fees charged by similar
funds, it indicated that other factors may be more
important in determining whether a fee is so
excessive that it constitutes a breach of
fiduciary duty. These include
� the nature and quality of the adviser's
services,
� the adviser's costs to provide those
services,
� the extent to which the adviser realizes and
shares with the fund economies of scale as the
fund grows,
� the volume of orders that the manager must
process,
� indirect benefits to the adviser as the
result of operating the fund, and
� the independence and conscientiousness of the
directors.
Since Gartenberg, additional cases have been
decided that continue to apply the standards
established by the Gartenberg court.18 The court
decisions in Gartenberg and the cases that
followed it, therefore, have served to establish
the current expectations for fund directors
regarding fees. As a result, regulators expect
mutual fund directors to review the types of
information the courts identified as important
when assessing whether the fees their fund pays to
its adviser are excessive. As noted above, among
the information to be considered by directors is
how their fund's fee structure compares to those
of similar funds. Under such standards,
independent directors are not required to seek the
lowest fee. For example, SEC's chairman
characterized these duties by stating that
"[d]irectors don't have to guarantee that a fund
pays the lowest rates. But they do have to make
sure that the fees fall within a reasonable band"
of other funds' fees.19
Standards Criticized as Lacking Specific Guidance
For Assessing Fees
Opinions on Boards' Effectiveness in Overseeing
Fees Vary
Opinions on mutual fund boards' effectiveness in
overseeing fees varied. Some fund adviser
officials depicted directors as assertive in
reviewing fees, even seeking reductions and
resisting fee increases. However, other industry
participants expressed various criticisms of
directors' effectiveness in overseeing the fees
mutual funds charge, including that directors lack
sufficient independence and that legal standards
governing their actions are flawed. To address
concerns over a potential lack of independence
among mutual fund boards, SEC and others have
various initiatives under way, but they are not
likely to have a significant impact on fees
because most funds already have them in place.
Fund Officials Say Boards Are Effective in
Lowering Fees
Mutual fund adviser officials indicated that their
boards of directors follow rigorous review
processes when reviewing their funds' fees.
Officials at several of the 15 mutual fund
advisers we contacted described a rigorous process
of review that their independent directors use to
evaluate the investment management contract and to
review fees. For example, officials at one fund
adviser said that their board members are
successful businessmen and women who are very
knowledgeable about how the funds operate. The
officials said that these directors obtain expert
advice, when needed, with which to make their fee-
related decisions.
Adviser officials told us that their fund
directors often obtain data from independent
sources, such as the industry research
organizations Lipper and Morningstar, Inc. They
told us that their directors also actively seek
out other materials they need to help them do a
thorough job of reviewing fund costs. Several
indicated instances where fees were lowered or fee
raises were denied at the board's insistence.
Adviser officials we contacted indicated that
their fund directors meet several times a year,
and a committee of independent directors typically
meets at least annually to discuss the investment
adviser's contract and related fees. They said
that they provide directors large amounts of
information relevant to the investment management
contract and fee schedule, and they include
comparative fees paid by similar funds for these
services. According to the adviser officials,
independent directors typically review and
deliberate on the information provided by the
adviser before meeting with fund officials,
consult with independent counsel on the terms of
the proposed contract, and compare the fees they
are being asked to approve with those of peer
groups of funds. Adviser representatives depicted
their funds' independent directors as tough
negotiators who scrupulously review available
information and then lower fees or refuse fee
hikes when they feel such actions are warranted.
SEC examinations we reviewed cited few
deficiencies relating to directors' role in
evaluating fees. According to an SEC official, SEC
examines all mutual fund families within a 5-year
cycle. In our review of SEC examinations of 16
fund advisers conducted between 1995 and 1999, we
found 3 instances citing deficiencies related to
the directors' role in reviewing fees. Two stated
that minutes of board meetings failed to indicate
that certain factors had been reviewed or
discussed, and one found that the directors for
two funds in a particular family had not received
information on certain expense information when
they approved their investment advisory
agreements.
Some Officials Criticized Directors' Effectiveness
in Overseeing Fees
Various industry participants criticized mutual
fund directors' effectiveness in overseeing fees
charged for operating their funds. A primary
criticism of mutual fund directors is that they
lack sufficient independence and knowledge to
effectively oversee the fund adviser's activities
and fees. Such allegations have appeared in
various press and magazine accounts. In addition,
some of the industry participants we contacted
raised similar criticisms. A private money manager
told us that because a fund's investment adviser
or an affiliate usually manages the fund, its
independent directors cannot be truly autonomous
in negotiating adviser fees and contracts.
According to an industry analyst, a general lack
of experience with mutual fund operations prevents
independent directors from being as effective as
they could be in keeping fees down. Because of
their inexperience, the independent directors will
often defer to the opinions of the interested
directors, who are also employees of the adviser,
during the deliberations of the board.
Critics have also indicated that the legal
standards applicable to directors' oversight of
fees are flawed. One factor that directors
consider is how their fund's fee compares to those
charged by other similar funds. However, a private
money manager stated that directors have no basis,
therefore, for seeking a lower fee if their fund
is charging fees similar to those of other funds.
An industry analyst indicated that basing a fund's
fees on those charged by similar funds results in
fees being higher than necessary. He stated that
although it is a safe way to set fees, in light of
the Gartenberg standards, such practices do not
contribute to lower fees.
SEC and ICI Proposed Reforms to Increase Director
Independence and Knowledge
In response to criticism that independent
directors on mutual fund boards may not be
sufficiently independent of the adviser, SEC and
ICI took steps to examine ways in which
independent directors might be more autonomous.20
In February 1999, SEC conducted 2 days of public
discussions, with various industry participants
and critics evaluating independent directors'
responsibilities and ways in which they could more
effectively carry them out. Shortly thereafter,
ICI assembled an advisory group to identify and
recommend best practices for fund boards to
consider adopting.21 In addition, in response to
the SEC chairman's call for improved fund
governance, a Mutual Fund Director's Education
Council, chaired by a former SEC chairman and
administered by Northwestern University, has been
formed. The Council intends to foster the
development of programs to promote independence
and accountability in fund boardrooms.
In October 1999, SEC promulgated proposed rules to
enhance the independence of certain mutual fund
boards. SEC noted in its introduction to the
proposed rules that in order to truly enhance the
effectiveness and independence of all fund
directors, the Investment Company Act would need
to be amended, but SEC's recent attempts to
achieve such changes by legislation were never
enacted. As a result, SEC's proposal applies to
funds that rely on exemptions granted by SEC of
certain statutory conflict of interest
prohibitions.22 According to SEC officials, almost
all funds rely on one or more of these rule
exemptions, and thus the proposal would apply to
virtually all funds.
Under SEC's proposal, funds relying on any of
these exemptions would be required to have
independent directors who constitute either a
majority or a super-majority (two-thirds) of their
boards and who select and nominate other
independent directors. In addition, if the
independent directors use legal counsel, such
counsel would be required to be separate from that
used by the fund's adviser.
SEC's proposed rule amendments also would
require funds to provide additional information to
investors about fund directors. Under the
proposal, funds would be required to provide
investors with basic information about the
identity and business experience of the directors,
the extent to which the directors own shares of
funds within the fund family, and any potential
conflicts of interest.
These proposed rule amendments may not
significantly affect the level of fees in the
mutual fund industry. First, the rule proposals
focused on enhancing director effectiveness and do
not specifically address fees. SEC officials
acknowledged that most funds already have a
majority of independent directors on their boards.
Officials at the 15 fund advisers we contacted
also told us that the requirements they place on
their boards already meet SEC's proposed changes.
Most of them indicated that a majority of their
boards are independent directors, they set their
own compensation, and they nominate and select new
independent members. In addition, they have
separate outside counsel and advisors to help them
evaluate the fees and contracts they are
responsible for negotiating in the shareholders'
best interests.
Others argue that even though many funds have
these requirements in place, they should be
required for all funds so that all investors have
consistent protections. Some commenters to the
proposed rule amendments stated that the proposed
changes are burdensome and that SEC is attempting
to do by regulation what it has been unable to
achieve through legislation. Others claim that the
proposal is a necessary measure to provide
investors consistent protection. As of May 16,
2000, the amendments in the proposal had not yet
been adopted.
_______________________________
1 In some cases, the adviser may contract with
other firms to provide investment advice, which
then act as subadvisers to the fund.
2 Investment Company Amendments Act of 1970, S.
Rep. No. 91-184, 91st Cong., 2d Sess. (1970),
reprinted in [1970] U. S. Code Cong. & Ad. News
4897, 4901 (1970).
3 Proposed Rule: Role of Independent Directors of
Investment Companies, Rel. Nos. 33-7754; 34-42007;
IC-24082, 64 Fed. Reg. 59825 (Oct. 15, 1999) (to
be codified 17 C.F.R. parts 239; 240; 270 & 274).
4 Although the Investment Company Act of 1940 does
not dictate a specific form of organization for
mutual funds, most funds are organized either as
corporations governed by a board of directors or
as business trusts governed by trustees. When
establishing requirements relating to the
officials governing a fund, the act uses the term
"directors" to refer to such persons, and this
report also follows that convention.
5 Independent fund directors cannot be affiliates
of a fund's investment adviser, be immediate
family members of an affiliated person of an
adviser, have beneficial interests in securities
issued by the adviser or the principal underwriter
or any of their controlling persons, be registered
broker-dealers or affiliated with broker-dealers,
or be affiliated with any recent legal counsel to
the funds.
6 About 30 of the 100 Vanguard funds use the
services of independent investment managers, which
provide portfolio selection and advice services
for these funds. These firms receive a subadvisory
fee paid out of fund assets. However, the Vanguard
Group, Inc., and not the investment manager,
provides all other administrative services for
these funds.
7 Index funds invest in the securities represented
in a broad-based index such as the Standard &
Poor's Index.
8 Under state law, directors are typically bound
by duties of care and loyalty to the shareholders
they represent. The duty of care requires
directors to carry out their responsibilities in
good faith and to exercise the degree of skill,
diligence, and care that a reasonably prudent
person would exercise in the same circumstances in
the management of his or her own affairs. The duty
of loyalty prohibits directors from benefiting
personally from opportunities rightfully belonging
to the company. This requires the directors to
place the interests of the corporation above their
own individual interests. State common law
provides the "business judgement rule." This rule
provides that directors will not be found liable
for their actions, provided that they act
reasonably and in good faith for the best
interests of the corporation, even if their
decisions turn out to be wrong.
9 This discussion focuses on mutual fund
directors' specific responsibilities regarding the
fees their funds charge. The law also places
various other responsibilities on fund directors
that exceed those of the directors of a typical
corporation. These additional responsibilities
include approving the contracts between the fund
and the adviser and the other service providers,
approving trading practices, and monitoring
investments in derivatives as well as other
duties.
10 A Study of Mutual Funds: Prepared for the
Securities and Exchange Commission, Wharton School
of Finance and Commerce, University of
Pennsylvania (Philadelphia, PA: 1962).
11 Public Policy Implications of Investment Company
Growth, SEC (Washington, DC: 1966).
12 SEC also recommended that application of the
reasonableness standard not be affected by
shareholder or director approval of the advisory
fee and that recoveries be limited to excessive
compensation paid in the 2 years prior to
commencement of an action.
13 15 U.S.C. 80a-35(b).
14 Section 36(b) authorizes excessive fee claims
against officers, directors, members of an
advisory board, investment advisers, depositors,
and principal underwriters if such persons
received compensation from the fund.
15 Courts have held that section 36(b) is an
equitable claim; therefore, plaintiffs do not have
the right to a jury trial.
16 Gartenberg v. Merrill Lynch Asset Management,
Inc., 694 F.2d 923 (2d Cir. 1982), cert. denied,
461 U.S. 906 (1983).
17 Gartenberg v. Merrill Lynch Asset Management
Inc., 528 F. Supp. 1038 (S.D.N.Y. 1981), aff'd ,
694 F. 2d 923 (2d Cir. 1982), cert. denied, 461
U.S. 906(1983).
18 Schuyt v. Rowe Price Prime Reserve Fund, 663 F.
Supp. 962 (S.D.N.Y.), aff'd, 835 F.2d 45 (2d Cir.
1987), cert. denied, 485 U.S. 1034(1988); Krinsk
v. Fund Asset Management, 715 F. Supp. 472
(S.D.N.Y. 1988), aff'd, 875 F. 2d 404 (2d Cir. ),
cert. denied, 493 U.S. 919 (1989); Kalish v.
Franklin Advisers, 742 F. Supp. 1222 (S.D.N.Y.
1990), aff'd , 928 F. 2d 590 (2d Cir.), cert.
denied, 502 U.S. 818 (1991).
19 May 15, 1998 remarks before the Investment
Company Institute, Washington, DC. See also Krinsk
v. Fund Asset Management, 715 F. Supp. at 502-03 .
20 In 1992, SEC staff conducted a study of the
regulation of investment companies to determine
whether existing regulations imposed unnecessary
constraints on funds and whether there were gaps
in investor protection. As a result of this study,
the staff recommended that the act be amended to
require that the minimum proportion of independent
directors be increased from 40 percent to a
majority, that independent director vacancies be
filled by the remaining independent directors, and
that independent directors be given the authority
to terminate advisory contracts. Notwithstanding
the SEC staff recommendations, the legislation was
never enacted.
21 Enhancing a Culture of Independence and
Effectiveness, ICI (Washington, DC: Jun. 24, 1999.
22 Examples of these exemptive rules include Rule
12b-1, which permits the use of fund assets to pay
distribution expenses; Rule 17a-8, which permits
mergers between certain affiliated funds); and
Rule 18f-3, which permits funds to issue multiple
classes of voting stock.
Chapter 7
Conclusions and Recommendations
Page 99 GAO/GGD-00-126 Mutual Fund Fees
Conclusions
Because of the unavailability of
comprehensive data on costs advisers incurred
operating mutual funds, we were unable to
determine to what extent the growth in mutual fund
assets during the 1990s provided advisers the
opportunity to reduce fund expense ratios. We
found that many large funds had reduced their
operating expense ratios between 1990 and 1998,
with the average fee among the largest stock funds
declining by 20 percent. However, not all funds
reduced their fees, including some that had grown
by more than 500 percent during that period.
These results also reflect the largest funds,
whose advisers were most likely to have
experienced economies of scale that would have
allowed them to reduce these funds' expense
ratios. In addition, our sample consisted
primarily of the largest and fastest growing funds
in the industry and thus may not reflect the
characteristics and the trend in fees charged by
other funds.
We also found certain limitations in the
mechanisms that regulators currently rely on to
influence fee levels. As with other financial
products, regulators rely on competition as means
of setting prices for products and services.
However, competition in the mutual fund industry
is not generally price-based and thus may not be
strongly influencing fee levels.
Regulators also rely on fee disclosures to inform
investors of the fees that funds charge. The
information that is disclosed in mutual fund
prospectuses and annual reports allows investors
to compare the relative fees and expenses charged
by differing funds. However, while mutual fund
statements show the dollar amounts of any
transaction fees deducted from shareholder
accounts, they do not disclose the actual dollar
amounts of each investor's share of the fund's
operating expenses. Some officials we interviewed
acknowledged that such information would reinforce
the fact that investors are paying for mutual fund
advisers' services. Including the dollar amount
paid in fees along with each investor's account
value would also put mutual fund statements on
comparable footing with that of other financial
services whose specific charges also routinely
appear in confirmation and account statements.
Fees stated in dollar terms, considered in
conjunction with other relevant information such
as investment goals, could spur investors to
evaluate the services they receive from their
funds in exchange for the fees being charged and
to compare their funds' services and fees with
those of other funds with similar investment
objectives. Prominently and regularly disclosing
to investors the specific dollar amount of
operating expense fees each investor pays could
also encourage more fee-based competition among
fund advisers, as has occurred with brokerage
commissions and other financial services.
To produce such information, fund advisers may
have to make changes in their account management
systems to collect and calculate information that
is not currently maintained. Advisers and certain
broker-dealers whose customers invest in mutual
funds would also incur both one-time and ongoing
costs. However, estimates for these costs did not
appear to be inordinately high-with some estimates
generally indicating that such costs might be a
few dollars or less per investor. In addition,
industry participants have already identified
alternative, less costly, ways of calculating the
dollar amount of fees paid by individual fund
investors, such as by multiplying a fund's share
value by its expense ratio and an average of the
number of shares held by an investor during the
prior period rather than by maintaining
information on each investors actual daily share
of expenses.
Another alternative means of disclosing dollar
amounts of operating expense fees paid on
individual investor statements would be to provide
the dollar amount of fees paid for preset
investment amounts, such as $1,000, which
investors could use to estimate the amount they
paid on their own accounts. In determining how
such disclosures could be implemented, regulators
will have to weigh the costs that the industry may
incur to calculate fees for each investor against
the burden and effectiveness of providing
investors with the requisite information and
having them be responsible for making such
calculations on their own.
Regulators also rely on mutual fund boards of
directors to serve as a check on the fees charged
by the funds they oversee. Currently, fund
directors annually review the fees of the funds
they direct and, among other things, generally
maintain their funds' fees within a reasonable
range of fees charged by other funds. Opinions
about fund directors' effectiveness varied, and
regulators are taking steps to increase directors'
independence from their funds' advisers. However,
these steps are not likely to have a significant
impact on fees because most funds already have
many of the proposed reforms in place and their
purpose is to generally enhance director
effectiveness and did not specifically address
fees. Our analysis of the largest funds' fees,
which showed higher fee funds migrating to lower
fee levels while lower fee funds generally
retained their levels, is consistent with
assertions that mutual fund directors are choosing
to keep fees at a level comparable to those of
other funds. Whether this level is appropriate for
the industry is not known.
Recommendations
To heighten investors' awareness and understanding
of the fees they pay on mutual funds, we recommend
that the Chairman, SEC, require that the periodic
account statements already provided to mutual fund
investors include the dollar amount of each
investor's share of the operating expense fees
deducted from their funds. This disclosure would
be in addition to presently required fee
disclosures. Because these calculations could be
made in various ways, SEC should also consider the
cost and burden that various alternative means of
making such disclosures would impose on (1) the
industry and (2) investors as part of evaluating
the most effective way of implementing this
requirement. Where the form of these statements is
governed by NASD rules, SEC should require NASD to
require the firms it oversees to provide such
disclosures.
Agency and Industry Comments and Our Evaluation
We requested comments on a draft of this report
from the heads, or their designees, of SEC and
NASDR. In addition, we requested comments from the
mutual fund industry association, ICI. Each of
these organizations provided us with written
comments, which appear along with our responses to
individual comments in appendixes I through III.
Additional technical comments from SEC were
incorporated into this report as appropriate.
Overall, each of the commenting organizations
agreed that our report raised important issues and
contributed to the public dialogue on mutual fund
fees. In his letter, the director of SEC's
Division of Investment Management indicated that
SEC staff agreed that investors need to be aware
of and understand the fees that mutual funds
charge. The letter also indicated that the SEC
staff welcomed the report's recommendation and
intended to consider it carefully. The vice
president of NASDR's Investment
Companies/Corporate Financing Department agreed in
his letter that investors should consider fees,
expenses, and other issues in addition to
performance in making investment decisions.
However, the letters from the SEC, NASDR and ICI
officials raised several issues about our report.
ICI's letter notes that although promoting
investor awareness of the importance of fund fees
is a priority for ICI and its members, ICI
officials had reservations about the account
statement recommendation that investors
periodically receive information on the specific
dollar amounts of the fees deducted from their
mutual fund accounts. Their concern was that this
requirement could erode the value of the fee
information currently provided in the prospectus
and thus impede informed assessments of fee levels
at competing funds, which could paradoxically
diminish rather than enhance investors' overall
understanding of fund fees.
We agree with ICI and the other commenters that
the current disclosures made by mutual funds,
which provide fund expense ratios expressed as a
percentage of fund assets and include an example
of the likely amount of expenses to be incurred
over various holding periods for a hypothetical
$10,000 account, are useful for investors in
comparing between funds prior to investing. The
additional disclosure we recommend is intended to
supplement, not replace, the existing disclosures,
and should serve to reinforce to investors that
they do pay for the services they receive from
their mutual funds as well as indicate to them
specifically how much they pay for these services.
SEC, NASDR, and ICI also commented on our
observation that other financial products and
services disclose specific dollar amounts for the
fees charged to their users, but mutual funds do
not. In their comments, these organizations
generally indicated that not all charges are
disclosed for other financial products and
services; thus, the disclosures for mutual funds
are not that dissimilar. For example, SEC noted
that funds disclose to investors specific dollar
charges subtracted from their accounts, such as
for sales loads or account fees, but do not
disclose the specific charges that are levied
outside the account. SEC stated that this is
similar to banks not disclosing the spread between
the gross amount earned by the financial service
provider on customer monies and the net amount
paid to the customer.
We do not agree with the commenting
organizations that mutual funds' lack of
disclosure of the specific operating expenses to
individual investor accounts is comparable to the
practices of banks or other businesses that do not
disclose the difference between their investment
or operating earnings and the amounts they pay to
the individuals who provided those operating or
investment funds. Investors in mutual funds have
in essence hired the adviser to perform the
service of managing their investment dollars for
them. The fees that the advisor and the other
service providers deduct from the fund's assets
represent the price of the services they perform.
Although such fees are deducted from the fund
overall, each individual investor's account is
ultimately reduced in value by their individual
share of these deductions. However, the specific
amount of these deductions is not disclosed in
dollar terms to each investor. In contrast,
customers and users of other financial services,
such as private money managers, banks, and
brokerage firms, are told of the specific dollar
amounts subtracted from their individual assets or
accounts.
Customers who place money in savings
accounts, bank certificates of deposit, or bonds
are not purchasing investment management or
financial transaction services as are mutual fund
investors. Thus, customers placing money in those
other investment or savings products are generally
told what the nominal returns will be, regardless
of how the firm providing the product will use the
customer's capital to conduct investment or
operating activities intended to produce
sufficient income to provide the promised rate of
return to the customer. In such cases, customers
are not entitled to the residual returns earned by
their capital but instead are promised and paid a
fixed return.
Furthermore, the fact that not all financial
products provide information on all their charges
to account holders does not reduce the likely
usefulness of such information to the millions of
mutual fund investors. Instead, independent
evaluations of the usefulness of providing such
information for those other products would be
necessary to determine if similar disclosures
would also benefit the users of those other
products.
All three commenting organizations also generally
questioned our finding that mutual funds do not
compete primarily on the price of their services.
SEC noted that although an argument could be made
that more price competition should occur in the
mutual fund industry, it is not completely absent.
ICI emphasized that because funds report
performance on an after fees and expenses basis,
mutual funds do compete on the basis of their
fees. NASDR stated that our draft report did not
address the fact that mutual funds present
performance net of expenses.
Our report notes that a mutual fund is required to
disclose its performance net of fees and expenses;
its performance is the primary basis upon which
funds compete. However, competition on the basis
of net returns may or may not be the same as
competition on the basis of price. Separating the
fee from the return would remind investors that a
fee is embedded in their net returns. In addition,
our report also notes that when customers are told
the specific dollar amounts of the fees or
charges, such as they are for stock brokerage
transactions or bank checking accounts, firms in
those industries appear to more frequently choose
to compete directly on that basis, resulting in
greatly reduced charges for such services.
Implementing our recommendation to have such
information provided to mutual fund investors
could provide similar incentive for them to
evaluate the services they receive in exchange for
the fees they pay. Disclosing such information
regularly could also encourage more firms to
compete directly on the basis of the price at
which they are willing to provide mutual fund
investment services.
SEC and ICI also questioned the legal accuracy of
some of the statements made by individuals we
interviewed regarding the role of mutual fund
directors in overseeing fees. The individuals we
quoted were critical of the director practice of
setting their funds' fees only in relation to the
fees charged by other funds; however, both SEC and
ICI indicated that fund directors, by law, are
required to review a wide range of information
when assessing the fees charged by their fund
advisor and other service providers.
We have added text to the report to indicate
that comparing one fund's fees to those charged by
other funds is not the only factor that directors
are required to consider when evaluating fees.
However, in the opinion of the individuals whose
comments we cited, directors are primarily
emphasizing such comparisons over the other
factors they are also required to consider as part
of their fee reviews. As a result, these
individuals see directors as maintaining fee
levels, or at least allowing fees to be lowered
only to the extent that other funds are taking
similar actions.
Furthermore, we recognize that a firm's
comparison of the prices it charges with those its
competitors charge is a legitimate and perfectly
acceptable means for firms to evaluate their own
business strategies. However, in the mutual fund
industry, which competes indirectly on the basis
of such charges, such comparisons may serve to
maintain fees at a consistent level or allow them
to be reduced only by amounts similar to those of
other funds' reductions, as the individuals we
interviewed stated. Although we did find that fees
for many mutual funds have declined, we also noted
in chapter 2 of our report that we were unable to
determine if the growth in fund assets would have
provided advisers the opportunity to reduce fees
by even more.
Appendix I
Comments From the Securities and Exchange
Commission
Page 110 GAO/GGD-00-126 Mutual Fund Fees
Note: GAO comments supplementing those in the
report text appear at the end of this appendix.
See comment 1.
See comment 2.
The following are GAO's comments on the Securities
and Exchange Commission's May 10, 2000, letter.
GAO's Comments
1. The Securities and Exchange Commission (SEC)
described various changes since the 1980s to the
fee disclosures that mutual funds are required to
make. To acknowledge this, we have added a
footnote to our discussion of the currently
required disclosures that describes some of the
changes made to these disclosure requirements over
time.
2. SEC stated that our report should note that the
current disclosure does provide investors with
access to information on an annual basis that
enables them to assess and understand the fees
they bear and to effectively compare fees. We
agree that disclosure of such information is
currently required, and we have added additional
language to our report to clarify that these
disclosures are made annually. However, these
disclosures present fund expense ratios as a
percentage of fund assets and include an example
of the likely amount of expenses to be incurred
over various holding periods for a hypothetical
$10,000 account. Furthermore, these reports are
provided to investors only semiannually. Although
investors can use this information to compare
among funds, the additional disclosure we
recommend is intended to supplement, not replace,
the existing disclosures, and should serve to
reinforce to investors the fact that they do pay
for the services they receive from their mutual
funds. The specific dollar amounts we recommend
that funds disclose should also have the added
immediacy of being unique to each investor and his
or her account. By disclosing these additional
dollar amounts on investors' quarterly account
statements, funds will provide fee disclosures to
investors more frequently than they currently do.
Appendix II
Comments From the National Association of
Securities Dealers Regulation, Inc.
Page 115 GAO/GGD-00-126 Mutual Fund Fees
Note: GAO comments supplementing those in the
report text appear at the end of this appendix.
Now on p. 97.
Now on p. 96.
Now on p. 27; see comment 4.
See comment 3.
See comment 2.
See comment 1.
Now on p. 74; see comment 7.
Now on p. 42; see comment 6.
Now on p. 29; see comment 5.
See comment 4.
The following are GAO's comments on the National
Association of Securities Dealers Regulation's May
8, 2000, letter.
GAO's Comments
1. The National Association of Securities Dealers
Regulation, Inc. (NASDR) commented that our draft
report assumed that mutual funds impose ongoing
fund operating expenses, such as Rule 12b-1 fees
and advisory fees, at the account level. NASDR
stated that, instead, funds impose these expenses
at the entity level. In addition, it noted that
NASD member broker/dealers are generally required
to send all customers, at least quarterly, account
statements that detail, among other things, all
charges and debits imposed at the account level.
We have added language to both the Executive
Summary and chapter 5 that clarifies that
shareholder account statements do show amounts
deducted directly from shareholder accounts, such
as transaction charges and sales loads. However,
the statements do not show in dollars each
investor's share of the operating expenses that
were deducted from the fund. In chapter 5 we
mention that NASDR rules require quarterly
statements.
2. NASDR stated that our recommendation may be
difficult, if not impossible, to implement. It
stated that mutual funds do not perform the
shareholder-level accounting envisioned by the
proposal and that many broker/dealers would not
have access to the information about the mutual
fund's expenses necessary to comply with these
rules.
From discussions with operational staff at various
mutual fund advisers and broker dealers, we
learned that although such information is not
currently calculated, compiling and making the
calculations necessary to report to individual
investors is feasible. As we discussed on page 79
of chapter 5, producing such information will
require some additional programming and will
entail some development and ongoing costs to fund
advisers and broker dealers, but the estimated
costs did not appear to not be prohibitive. On the
basis of these discussions, we believe that SEC
and NASDR can determine a cost-effective way for
funds and others who maintain shareholder accounts
to provide this information to shareholders.
3. NASDR commented that if our recommendation
results in investors focusing solely on
identifying funds with low expenses, such
investors may sacrifice the performance that they
might obtain if they were to consider other
factors, such as a fund's investment objectives
and the quality of the fund adviser's investment
management.
As we stated in the conclusions to this report,
investors should evaluate a fund's expenses in
conjunction with their own investment goals and
objectives. A reasonable approach may be for
investors to first determine what types of funds
they wish to invest in on the basis of the their
tolerance for risk and the types of markets or
securities invested in by the fund. After
determining a desired fund category type, the
investors could then evaluate the relative fees,
expenses, and services provided by funds within
each investment category.
Adequate disclosure is one of the primary goals of
the securities laws. Withholding such specific
information from investors because it could
potentially be used inappropriately would not be
consistent with the spirit of these laws. We would
anticipate that funds would likely include
explanatory materials with the disclosures we
recommend to better ensure that investors evaluate
the specific operating expense fee dollar amounts
in context with their investment objectives and
other information relevant to the fund.
4. We have changed the language noted in chapter 1
to clarify that NASDR regulates broker-dealers and
not the funds. We also added footnotes stating
that maximum permissible sales loads vary
depending on certain factors, such as whether the
fund imposes an asset-based sales charge or
service fee; and stating the required conditions
for a no load mutual fund.
5. We corrected the effective date of the
applicable Gramm-Leach-Bliley Act provisions to
May 12, 2001.
6. We calculated our estimates of fund adviser and
service provider revenue by multiplying fund
expense ratios by fund assets. These estimates
used the net expense ratios reported by the funds
in our sample, which exclude the amounts of any
fund operating expenses that may be waived by the
fund adviser.
7. In chapter 5, we corrected the table number to
table 5.2 and changed wording in the sentence to
reflect that direct sales are made by a fund,
either through an internal or external sales
force, and not the fund adviser.
Appendix III
Comments From the Investment Company Institute
Page 121 GAO/GGD-00-126 Mutual Fund Fees
Note: GAO comments supplementing those in the
report text appear at the end of this appendix.
See comment 1.
See comment 3.
See comment 2.
See comment 4.
The following are GAO's comments on the Investment
Company Institute's May 3, 2000, letter.
GAO Comments
1. The Investment Company Institute (ICI) notes
that our report indicates that mutual funds
compete primarily on the basis of investment
performance but gives less prominent attention to
the fact that mutual funds disclose their
performance after fees and expenses have been
deducted. ICI states that as a result, investors
who consider performance are indirectly taking
into account the impact of fees on returns. ICI
also states that this indirect consideration
appears to be highly relevant to shareholder
investment decisions because, as of year-end 1999,
more than 78 percent of shareholder accounts and
86 percent of shareholder assets were invested in
equity mutual funds that charged less than the
industry average. Finally, ICI states that by
competing on the basis of net performance, funds
have an incentive to keep fee levels as a low as
possible because small differences in performance
can affect a fund's competitive standing.
At the beginning of each discussion of how funds
compete, our report notes that funds are required
to disclose performance net of fees. However,
competition on the basis of net returns may or may
not be the same as competition on the basis of
price, and such indirect competition may not
result in the same level of fees as could likely
result from more direct fee-based competition. As
we noted in chapter 5 of the report, the charges
associated with other financial services, such as
bank checking accounts and stock brokerage, which
are generally disclosed in dollar terms to the
users of these services, have been subject to
vigorous competition directly on the basis of
these costs, which has resulted in lower charges
for many consumers. In addition, we noted that
loads, which are disclosed in investor statements,
have also declined over time. In addition, because
past performance is not an indication of future
returns, relying on such disclosures alone would
not be sufficient for ensuring that adequate
competition is occurring on that basis.
The statistics that ICI cites in its letter
regarding the majority of mutual fund shareholders
invested in funds charging fees lower than the
industry average is based on a calculation of the
simple average fees charged by funds in the
industry. As we note in chapter 3 of our report,
calculations using simple averages of mutual fund
fees are biased upwards by the growing proportion
of new funds, funds investing in foreign
securities, and other funds that tend to have
higher expense ratios than older funds investing
in domestic securities. Therefore, finding that
most investors are invested in funds charging less
than such an average is not sufficient evidence to
indicated that fund investors overall are highly
fee-conscious, particularly in light of surveys we
reviewed that indicated that investors generally
considered fees to be less important than other
factors in making their investment decisions. In
addition, although ICI's studies reported that
some investors are increasingly investing in lower
fee funds does not obviate the need for more
explicit disclosure of fees and the increased
competition that could result.
2. ICI noted that our draft report assumed that
total fee revenues were the same as the revenues
of fund investment advisers. ICI states that the
expense ratios deducted from fund assets include
amounts that are used to compensate not only the
fund adviser but also other entities for
shareholder servicing, marketing (12b-1 fees), and
other services. ICI's letter also notes that
adviser fees now typically account for 50 to 60
percent of fund expense ratios. It further states
that the report suggests that the growth rates of
fund assets and adviser revenues have been similar
in the 1990s. ICI indicates that a more accurate
finding would be that advisers' revenues have
grown more slowly than both overall fund expenses
and assets.
Although our report previously acknowledged
that the expense ratio includes fees charged for
various purposes, we have added additional text
where appropriate to indicate that the fees
deducted from fund assets represent revenue to
more entities than just the fund advisor. However,
all fees, regardless of which entities receive
them as revenue, are deducted from investor
assets; thus, our overall conclusion that such
fees and assets grew at comparable rates remains
accurate.
3. ICI commented that the duties that mutual
fund directors have regarding the fees funds
charge exceed those of typical corporate
directors. ICI emphasized that these duties are
unique and were specifically designed to provide
safeguards for fund shareholders. ICI notes that
one of the individuals with whom we spoke about
mutual fund directors appears to have suggested
that mutual fund directors' activities may be
serving to increase fees by evaluating a fund's
fees in light of those charged by other funds. ICI
states that directors, as fiduciaries, are legally
required to act on shareholders' behalf and to
consider a broad range of specific factors when
reviewing fees. ICI indicates that the
individual's claim is also contradicted by various
studies, including our own, that found fees have
declined.
ICI has identified various duties placed on
mutual fund directors that exceed those of the
directors of a typical corporation, and we have
added a footnote in chapter 6 to acknowledge these
additional responsibilities. However, as our
report points out, these additional duties,
particularly those related to the approval of the
advisor's contract and its fees, arise because of
the potential conflicts of interest between fund
shareholders and the adviser. As a result, the
independent directors are required to review and
approve the fund's contract and fee arrangement
with the adviser.
Congress intended that the independent
directors of mutual funds serve as a check on the
adviser because of the conflicts between the
interests of the adviser and fund shareholders.
However, the critics of fund directors whose
comments we cited are of the opinion that
directors are placing primary emphasis on
comparing their funds' fees to those of other
funds rather than the other factors that directors
are required to consider as part of their fee
reviews. Therefore, these individuals see
directors as maintaining fee levels, or at least
allowing fees to be lowered only to the extent
that other funds are taking similar actions.
Although we did find that fees for many mutual
funds have declined, we also noted in chapter 2 of
our report that we were unable to determine if the
growth in fund assets would have provided advisers
with the opportunity to reduce fees by even more
than they had. Furthermore, a firm comparing the
prices it charges its customers to those charged
by competitors is a legitimate and perfectly
acceptable means for such firms to evaluate their
own business strategies. However, in an industry
that only indirectly competes on the basis of such
charges, such an activity may serve to maintain
fees at a consistent level or allow them to be
reduced only to the extent that other funds reduce
theirs, as the individuals we interviewed stated.
4. ICI commented that the assertion in our
report that unlike mutual funds, most other
financial services disclose the specific dollar
amounts of all fees paid is unsupportable. As an
example, ICI states that no bank it is aware of
discloses to depositors the amount of the spread
that the bank earns on a depositor's balances in
checking or savings accounts. ICI states that the
fee disclosures required of mutual funds are the
most comprehensive and understandable in the
financial services world. It also notes that these
disclosures have been recently made simpler by the
Securities and Exchange Commission.
We agree with ICI that the currently required
disclosures are comprehensive and reasonably
understandable. In response to this comment by ICI
and others on the draft report, we have added a
footnote that discusses some of the recent changes
to the disclosures we describe in our report.
Although the disclosures that mutual funds
make are comprehensive and useful for investors in
comparing the relative fees charged by different
funds, the information in them discloses fees in
percentage terms and uses hypothetical examples,
which are less direct indications of the specific
prices charged to any one investor. In our report,
we cite five examples of other common financial
services or transactions with which most mutual
fund investors are also likely to be familiar,
such as checking accounts, stock brokerage, or
bank trust services. These services disclose in
periodic statements the specific fees in dollars
charged to customers. As we point out, mutual
funds do not similarly provide specific dollar
amounts of charges on the periodic statements they
provide to individual investors.
Appendix IV
GAO Contacts and Staff Acknowledgments
Page 125 GAO/GGD-00-126 Mutual Fund Fees
GAO Contacts
Thomas J. McCool, (202) 512-8676
Cody J. Goebel, (202) 512-7329
Acknowledgments
In addition to those named above, Michael
Burnett, Suzie Bright, Melvin Thomas, Darlene
Wall, and Desiree Whipple made key contributions
to this report.
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