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Rekenthaler Report

Will the Fund Industry Ever Come Clean?

If so, they will need to overcome investor preferences.

The Invisible Hand
Ask somebody which is better: open fees where the buyer readily understands all costs, or hidden fees that can’t be seen (and often aren’t known)? You know what the response will be. That answer, however, is incomplete. We may fervently believe that transparency is best, but that doesn’t mean that we invest that way. We sin, again and again.

For starters, the mutual fund was founded on opacity. The first mutual fund could have charged for its services in various ways. It could have charged a fixed fee for its services, as a barber does. Pay the fund $50, and in return it will manage your assets for the next 12 months. (Fifty bucks was real money in 1924.) Or, it could have charged a floating fee, adjusted for the size of the customer’s account, to be collected in arrears. The fund took neither approach. It spared the buyer from making any explicit payment, and instead extracted its fee from the portfolio.

People liked that. Fifty dollars gradually removed from a pile, bit by bit, felt better than plunking down a bag of gold coins. It’s fair to say that without this psychological shell game, the mutual fund would not have succeeded. Asking investors to repay each year means regularly revisiting their purchase decisions. Few funds perform so well, so regularly, as to survive that scrutiny. In contrast, by collecting their revenue invisibly, funds postponed such analysis—and sometimes avoided it altogether.

The Great Eighties
To give credit where it is due, the original mutual funds were more transparent than what followed. Aside from the process of gathering revenue, what investors saw is what they got. That began to change in the 1980s, as fund companies realized that shareholders not only preferred their ongoing expenses hidden, but also their initial sales charge. Traditional front-end load funds, with straightforward initial sales charges, faced competition from alphabet-soup share classes that hid their costs. Now it was possible to buy a fund from a financial advisor, without paying a fee!

(Of course, that was not so; the conspicuous front-end load had been replaced by inconspicuous 12b-1 fees. But the belief was prevalent. In my early days at Morningstar, I talked with many investors who believed that they owned “no-load” B shares, which in reality charged them 100 basis points per year in sales and marketing fees. They had no idea.)

In the same decade came 401(k) plans. The firms that kept records for such plans realized quickly that 401(k) plan sponsors disliked paying record-keeping fees. So, too, did employees, if they were notified that their accounts had paid for such services. The solution was obvious: Stop notifying the employees. Instead, use higher-expense funds when creating 401(k) lineups, and then have those funds rebate some of their revenue to the record-keeper. Voila, happy employees!

Updated Flavors
The 1990s brought no-transaction-fee fund platforms. By now, you know the refrain. Don’t bill the customer directly; in fact, don’t bill the customer at all. It will only distress him. Instead, have the platform receive its revenue from the participating mutual funds. If you bring them the business, funds will pay an annual 0.25% of their platform assets—a rate that has subsequently been raised to as high as 0.40%. Such was the thinking, and it was correct. Most fund companies (more on that subject in a bit) were delighted to make that exchange.

So were investors. NTF platforms became a smash hit, attracting hundreds of billions in assets. They generated high revenue from their larger investors. At the initial 0.25% rate, for example, a $500,000 account brought the platform $1250 per year. Would that investor pay $1250 for the NTF platform’s services, if billed for them directly? No, she wouldn’t. Would that same investor turn down those services, if they felt as if they were free? Oh yes, most happily.

Yet another example of hidden costs comes through money market sweeps. Your columnist knows from first-hand experience. He trades very infrequently, holds either stocks or very cheap mutual funds, and prides himself on having minimal portfolio costs that he fully understands. There are the fund expense ratios, and then the occasional commission that comes from trading stocks or exchange-traded funds, which are tiny in the grand scheme of things.

That guy is fooling himself. Every year, he forfeits $2000 (calculating very roughly) in extra interest that he would collect on his portfolio cash, if he were to move those assets from that brokerage firm’s money market fund—which deliberately offers a low rate, in the hopes of profiting from dopes like your columnist—into a competitive fund. He does not move those assets. Even though he effectively is being charged $2000 as a brokerage-account fee, he feels no pain. If, on the other hand, the brokerage firm were to levy a $2000 annual “account maintenance charge,” he would withdraw his account in a huff.

(This is all true, even to the part of recognizing the mistake and not getting around to fixing it.)

The most-recent development in hidden fees came last month, and it made a splash. TD Ameritrade created a ruckus among financial advisors by dropping several dozen ETFs, including all its Vanguard offerings, from its commission-free platform. Although Ameritrade didn’t present the issue that way, it made those moves because of revenue-sharing. Ameritrade requested that ETFs pay for the privilege of being on its commission-free platform. Those funds that did not, were made unwelcome.

Not an Acquired Taste
Which brings me, at long last, to the somewhat rhetorical question that began this column. Will the fund industry ever come clean? That is, will all charges from fund companies, distributors, record-keepers, and any other parties that serve shareholders eventually become explicit and transparent? (For that question, I will set aside how fund expenses are collected, because while I believe that they fail the transparency test, that process realistically will not be changed.)

The industry’s largest company, Vanguard, would seem to provide the answer. Vanguard has thrived by unbundling its compensation. (Even with Vanguard, though, the lines get blurry … when Vanguard bills clients 0.30% per year for its “robo-advisor” Personal Advisor Services, does that fee stand alone, or it is to some extent subsidized by the management fees that the company receives from the underlying Vanguard funds that are used by the service?) Typically, an industry’s smaller players follow the steps of the leader.

This industry, however, is built differently than most. Its biggest player rose to the top by being the exception, not the rule. Vanguard is the choice for those who reject the industry standards. It exists to stand in opposition to the norm.

On this topic, I expect that Vanguard will remain in opposition. Many have predicted that the fund industry (and related parties) will gradually unbundle their services, so that they are clearly priced. What investors see is what they will get. Such predictions appear to be reasonable. Certainly, they are what we believe should happen. “Clean” and “transparent” sound appealing; “dirty” and “opaque” do not. Ultimately, however, the customer will make the decision, by voting with his wallet. That wallet will continue to reward many firms that obscure their fees. Opacity might not be good for our financial health, but it sure does taste sweet. Sugar is not an acquired taste.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.