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Source: Investment Company Institute Similarly, an Institute study published earlier this year indicated that the market share of the top twenty mutual funds has fallen since 1984.6 Declines were also evident when the measurement was limited to the top five and top ten firms. The fund industry also passes the test used by the U.S. Department of Justice to make a determination of whether an industry might be excessively concentrated. The Department of Justice uses an index to measure market concentration by industry, with 1 being the least concentrated, 10,000 the most concentrated, and 1800 to indicate the possibility of excessive industry concentration. As of May 31, 1997, the mutual fund industry had an index number of 329.7 B. Most Shareholders Invest in Stock Funds That Cost Much Less than the Industry Average. But if you look at equity mutual fund fees from the perspective of where investors actually invest their money, a dramatically different picture emerges. As illustrated in Exhibit 1, the overwhelming majority of shareholders' equity fund accounts (77%) are found in mutual funds that charge annual fees below the simple average of 1.52 percent. Most Investors Own Lower Cost Stock Funds
Indeed, based on calculations made from data collected by Morningstar, a widely quoted fund research service, the average dollar invested in equity funds by investors accrues an annual fee at the rate of 0.97 percent.9 In other words, the average shareholder account is in a mutual fund whose annual fees are 36 percent lower than the simple industry average. When we look at how much shareholders have invested in these accounts, the preference for lower cost mutual funds becomes even more dramatic. Based again on calculations we performed using Morningstar data, and as illustrated in Exhibit 1-a, we estimate that 84.7 percent of all equity fund investments are in funds with an expense ratio below 1.52 percent. Most Stock Mutual Fund Assets Are In Lower Cost Funds
We believe it is extremely significant that so many equity fund investors pay far less than the average fund charges. In our judgment, this indicates that the market readily enables investors to own lower-cost mutual funds - and that most of them do. C. Why Most Shareholders Own Lower Cost Funds. 1. Information About Fees Is Widely Available. Shareholder research surveys conducted by the Institute confirm that fees are generally one of three items most likely to be considered before a shareholder invests in a new mutual fund (along with performance and risk).10 This research also found that a significant proportion of investors gather information on fund fees before investing. As will be described in Section V, information about fund fees is readily available, both in the SEC-mandated fee table at the front of the prospectus, and from extensive independent publications. Many of these publications stress the relevance of evaluating fees as part of the process of making an informed investment decision. Thus, it is not surprising that two prominent economists recently concluded that "[c]onsumers are fee-sensitive in that lower-fee funds, and funds that reduce fees, grew faster."11 Investors also appear to prefer lower costs in the case of loads (i.e., sales commissions). As is discussed further below, funds are permitted to charge loads of up to 8.5 percent of the purchase price. But very few funds have loads equal to the maximum. In fact, about one-third of all mutual funds don't charge loads or sales commissions of any kind. And even among firms that charge initial sales loads, the average charge is between 4 and 5% - only about half the legally permitted amount. 2. Performance Must Be Adjusted To Account For Fees. The star rating system employed by Morningstar that is frequently cited in the press and fund advertising also incorporates fund costs when assigning its "stars." The star rating system thus appears to favor funds with low expense ratios and either low or non-existent sales charges. Independent researchers have concluded that in recent years, up to 80 percent of all net new equity fund investments have been made in funds that were awarded one of Morningstar's two highest ratings.12 A result is that many investors are ending up in lower cost equity mutual fund investments. Finally, the economies of scale that have been realized among older funds that have experienced growth may have resulted in most investors owning lower cost funds. Economies of scale are discussed in more detail below. D. The Total Cost of Investing for Mutual Fund Shareholders is Declining. 1. The Two Key Elements of Total Cost: Sales Charges and Annual Fees. As in other industries, sales charges generally compensate the salesperson, but do not typically defray in any way the costs and expenses of the underlying product. Thus, there is a second category of mutual fund costs. This category includes annual fees paid by the fund (and thus indirectly by the investor). These fees compensate the various entities that manage the fund's investment portfolio and provide essential services to the fund and its shareholders. Among these services are some that are highly visible to shareholders (e.g., toll free 24 hour phone access, account statements, etc.) and some that are not (e.g., independent custodianship of the fund's securities). The total annual fees charged by the fund, expressed as a percentage of the fund's assets, are aggregated in a standard formula and reported as the fund's "expense ratio." Many investor and consumer advocates believe that if investors look at whether a fund charges a load and review its expense ratio, they will develop a reasonable understanding of the total cost of investing in mutual funds.15 As is discussed in Section V below, to facilitate the use and understanding of this information, the SEC requires that both of these figures be clearly disclosed in the fund's fee table, which must appear at the front of the prospectus. 2. How Competition Is Affecting Sales Loads. The sharp decline in up-front sales loads did not occur in isolation. This decline happened at least in part because of a trend toward new, more innovative methods of compensating the brokers who sell mutual funds. These new methods often involved combining a new type of annual fee with a reduced up-front sales load. Finally, although all mutual funds are permitted to charge loads, many funds choose not to do so, and are designed instead for individuals who do their own investing rather than relying on professional advisers. These funds are typically sold directly by fund companies to do-it-yourself investors, and are generally referred to as "no load" funds. Approximately 33 percent of all equity mutual funds do not charge loads. 3. How Competition Is Affecting Annual Fees. At the same time, however, there is substantial competitive pressure to provide enhanced and sometimes costly new services to shareholders. Many funds have capabilities that provide investors 24-hour access to account information by phone or over the Internet, as well as access to staff with detailed knowledge of all of the company's investment products. Increasingly, funds have upgraded their technologies to the point where investor transactions can be securely conducted via websites. Internet and toll free phone access are just one part of the growing menu of services fund companies provide. Others include an extraordinarily broad range of free educational materials about investing, about retirement planning and saving, and about the financial markets. To provide just one illustration, the Roth IRA recently enacted by Congress may provide an attractive investment opportunity for many individuals who qualify for it. But for some, the rules may seem quite complex. Many fund companies respond to this by providing planning kits and easy-to-use worksheets to help investors understand how this program works. In addition, any analyses of trends in mutual fund expense ratios must be adjusted to take into account shifts in investor preferences. For example, in 1997, equity fund investors showed much greater interest in higher-cost international funds than they had ten years earlier. International funds represented 8.8 percent of all equity fund assets in 1997, more than double the share they enjoyed in 1986.19 Several categories of equity funds with relatively lower costs declined in popularity over the same period. Changes in the way investment professionals are compensated also have influenced trends in fund expense ratios. Twenty years ago, most mutual funds were sold through a broker with an initial sales load. Other funds were sold directly by the fund company to investors without a load. That all changed in the mid-1980s. Initial sales loads declined in popularity in favor of a new type of sales commission and marketing fee that could be collected annually. Known as a 12b-1 fee (after the SEC rule that permits it), this charge in effect serves as a partial substitute or replacement for the traditional initial sales load by permitting investors to, in effect, pay the sales load gradually over time. Its introduction allowed significant innovations in how funds could be sold to investors. These plans give investors a range of choices about how to pay sales charges for their fund investments. They could continue to pay an initial load, they could pay a small part of the commission each year for several years, or they could pay the commission when they decided to redeem their shares. These options, which are described in greater detail in Appendix II, can result in investors choosing the alternative with the lowest overall costs, given their planned investment horizons. There are important differences between 12b-1 fees and the loads they often replaced. First, loads are not included as part of a fund's expense ratio. 12b-1 fees, however, are included in the expense ratio. Because 12b-1 plans have grown in popularity over the last fifteen years, a statistical analysis that attempts to compare expense ratios during different years in this period runs the risk of being highly distorted. If all other factors were held constant, the adoption of 12b-1 plans by funds would have the following two effects on statistics about costs. First, it would show a decline in initial sales loads. Second, it would show an increase in expense ratios. The SEC has noted on several occasions that some studies and reports fail to account for this major structural change when examining the total costs to shareholders of investing in mutual funds. For example, the SEC noted in a May 1997 submission to Congressman Edward Markey that "[w]e have reservations about certain of the data published to date on trends in fund fees. For example, some reports appear not to have taken into account changes in the load structure of mutual funds over time."20 Similarly, in 1992 correspondence to the Committee, the SEC staff expressed its view that "recent media coverage may not take into account a number of factors influencing fee levels," and that some media coverage "oversimplifies the analysis of mutual fund fees."21 To be credible, any study that looks at trends in mutual fund costs must address the changes produced by the shift from initial loads to 12b-1 plans. One way to address the effects of this shift is to examine changes in expense ratios in conjunction with changes in sales charges. An alternative would be to study the trend in expenses ratios while excluding the costs of 12b-1 plans. This would provide a more accurate picture of trends with respect to management and administrative fees, two key elements of the expense ratio. Different independent studies have employed different methods in evaluating costs. In each case, the results support the conclusion that the total costs of investing borne by shareholders are declining. In one of these studies, Professors Erik Sirri and Peter Tufano looked at a combination of sales loads and expense ratios. Their research found that the total costs of fund ownership declined between 1970 and 1989 because of sharp reductions in sales loads.22 A report by the independent consulting firm CDA-Weisenberger reached the same conclusion for a different time period. This report noted that although expense ratios increased between 1951 and 1991, the total costs to mutual fund shareholders with holding periods of 10 years or less actually fell. As with the previous study, they attributed this decline to dramatic reductions in sales loads.23 In another detailed study, Lipper Analytical Services examined trends in expense ratios after backing out 12b-1 fees. The Lipper study found that the median expense ratio for funds that began operations in 1986 or before has declined by 3% between 1986 and 1996.24 Finally, and most recently, Strategic Insight, another independent consultant, examined expense ratios while excluding any 12b-1 charges. Their study concluded that in 1997 expense ratios for equity funds had declined between 4 and 5 percent from the year before.25 4. Mutual Funds Cost Much Less than Similar Financial Products. a. Hedge funds - These are private investment pools, which have virtually no restrictions on the types of investments they can make or the investment strategies they can utilize. Because of their enormous potential risk, they can be legally offered only to wealthier, more financially sophisticated investors. Overall, hedge funds have vastly higher costs than mutual funds. The Lipper report found that hedge funds generally charge a minimum base annual fee of 1%, plus up to 20% of profits.26 b. Commodity Pools - These are pooled investments that consist of interests in various commodity contracts, such as precious metals or agricultural products. Based upon data provided by the Commodities Futures Trading Commission, the median expense ratio for commodity pools in 1995 was approximately 5.06 percent.27 This is five times higher than the expense ratio paid by a typical equity mutual fund investor. c. Wrap accounts - Wrap accounts are a service provided by some firms that offer to aggregate all of a client's investments into a single account. The annual fee to maintain and service this account is generally between 1% and 3%, according to the Lipper report, a much higher range than mutual funds.28 The wrap account fee is also charged in addition to any charges that may be associated with the underlying investments. While these examples are not exhaustive, they do highlight the fact that mutual fund investment costs are generally far lower than any of these other managed products. 5. American Mutual Funds Cost Much Less than Overseas Funds. We think it is also worth bearing in mind that foreign funds generally operate in a much less strict regulatory environment than exists in the U.S. For example, despite the possible conflicts of interest, many foreign jurisdictions do not restrict transactions between the fund and its affiliates to the same degree that the Investment Company Act does. Thus, in addition to the higher fees they collect, the advisers to funds in these jurisdictions have opportunities to profit from relationships with a fund that are generally prohibited in the U.S. E. Economies of Scale are Shared With Mutual Fund Investors. 1. The Use of Breakpoints in Mutual Fund Management Fees. "Over the past few years, fund companies have become much more proactive in controlling fees than they had been previously, instituting asset-based breakpoints in their funds' fee structures. Approximately 75% of all funds surveyed have a breakpoint in place, which will decrease a fund's management fee as its average assets increase in size."32 Thus, it is not surprising that a variety of independent studies have found that as individual funds grow, their expense ratios tend to fall33 and that mutual funds exhibit economies of scale.34 2. Common Misconceptions About "Economies of Scale." Imagine an industry with five mutual funds, each managing one million dollars. In one year, the industry doubles in size, growing from five million to ten million dollars. The question is then raised: are there economies of scale that reduce marginal costs and can be passed on to shareholders? The answer is that it depends on what caused the growth:
Operating a mutual fund is a vastly more complex enterprise than these simple illustrations might suggest. But the illustrations do point out that the intuitive expectation that some people have - that is, that rapid growth should by itself lead to an industry-wide reduction in fees - is mistaken. The recent study of fees conducted by Lipper Analytical Services emphasized this point. "The misunderstanding about the nature of economies of scale begins with the expectation that the tremendous growth in the asset size of the fund industry should translate into a reduction to the average industry expense ratio. This expectation presumes an industry economy of scale, which does not exist. The fund industry does not have any economies of scale, individual funds do."35 Lipper's observation has been confirmed repeatedly in practice: as individual funds grow, their expense ratios tend to fall. Many funds clearly share the benefits of lower operating expenses with their shareholders through breakpoints that automatically reduce certain key expenses as assets grow. V. Disclosure and Regulation Are Working
Institute President Matthew P. Fink discusses the standardized The principal source of information about mutual fund fees in the prospectus is the fee table. The fee table was first adopted by the SEC in 1988. Under recent changes to the rules governing mutual fund prospectuses (see Table 2), the fee table is now included as part of a "risk-return summary" that must appear in the front of every prospectus. The risk-return summary also describes the investment objectives, strategies, and risks and performance.36 The Fee Table Required by Federal Law
The fee table presents information about fees in a uniform format. It also discloses the fund's overall expense ratio. In addition, the fee table includes an example that illustrates the effect of fund expenses on a hypothetical investment over time. The example is designed to enable investors to readily compare two or more funds because it presents an "all-in" figure that takes into account both sales loads and annual fees and is expressed as a dollar amount. The SEC's recent changes to the mutual fund prospectus included revisions to the fee table, such as increasing the amount of the investment used in the hypothetical example from $1,000 to $10,000, which is more representative of a typical investment.37 At the same time it revised the mutual fund prospectus, the SEC adopted a rule authorizing optional use by mutual funds of a new disclosure document called the profile.38 A profile summarizes key information about the fund in a standardized format.39 The profile must include the risk-return summary section of a fund's prospectus, including the fee table. An investor who receives a profile will have the option of buying the fund shares before receiving a prospectus or requesting a copy of the full prospectus.40 An investor who purchases fund shares based on the profile must receive the fund's prospectus with the purchase confirmation.41 Earlier this year, the SEC also made another significant change to the mutual fund prospectus by adopting a new rule to require that the cover page, risk-return summary (including the fee table) and risk factor sections of a fund prospectus be written in plain English.42 The plain-English standard also applies to the entire profile. The plain-English requirements should help enhance investors' understanding of mutual fund fees and the impact of such fees on fund performance. In fact, the Director of the SEC's Division of Investment Management recently was quoted as saying that regulators have "been aggressive about tackling the fee issue with the SEC's most recent efforts focused on providing better disclosure through `plain-English' prospectuses, clearer fee tables and graphics."43 B. Formal Disclosure of Mutual Fund Fees Is Reinforced In Several Important Ways. Moreover, returns net of fees are a common means of reporting performance information about mutual funds. For example, Morningstar's "star rankings" utilize a risk-adjusted performance measure. The performance is net of all fees and expenses.44 Popular magazines, such as Barron's, Business Week, Money and Forbes, also report performance net of fees and expenses. 2. Advice and Guidance About Fund Fees Is Widely Available. For example, an investor can learn about fees charged by a particular fund by reviewing the mutual fund listings published daily in most newspapers. Several national and daily financial newspapers also include a listing of fund expense ratios on a weekly basis. A newspaper's listings offer information about a fund's fees by using a series of symbols next to the fund's name. In addition, many of these publications actively encourage investors to examine fee tables and to evaluate fees as an important part of making investment decisions.Indeed, as of September 25, 1998 more than 80% of on-line respondents to a Money Magazine website survey correctly answered a question about the impact of fees on mutual fund performance.46 Although this is obviously not a scientific survey, it does suggest that when investors make use of the many educational resources available about funds, they can develop a sound understanding of how fund fees can affect their investment. C. Mutual Fund Fees Are Strictly Regulated. 1. The NASD Limits Sales Charges and 12b-1 Fees. 2. Fund Directors Carefully Monitor Certain Key Fees. Section 36(b) of the Investment Company Act also provides that a fund's adviser has a fiduciary duty with respect to the receipt of compensation by the adviser.47 This statutory duty is not imposed on the managers of any other pooled vehicles. Section 36(b) creates a direct cause of action allowing the SEC and fund shareholders to bring suit against the adviser for breach of this duty.48 The explicit fiduciary duty in Section 36 empowers the SEC and fund shareholders to curb excessive fee levels, a powerful tool not available to investors in any other financial product. In carrying out their responsibilities under Section 15, and in accordance with standards developed under Section 36(b), mutual fund directors take into account a variety of factors in their review of advisory contracts and, in particular, the level of the advisory fee. These include the services provided by the fund's adviser; costs to the adviser; the extent to which the adviser realizes economies of scale; and any "fall out" benefits realized by the adviser, such as brokerage commissions. Courts have also considered, in the context of litigation under Section 36(b), the directors' expertise, their conscientiousness in performing their duties and the adequacy of the information made available to them, among other factors. In short, mutual fund regulation is unique in requiring that the most significant fee incurred in connection with investing in a fund be subject to independent, annual review in accordance with standards set forth in federal law and interpreted by federal courts. b. Distribution Expenses. Like the investment advisory contract, the fund's contract with its principal underwriter must be approved annually by a majority of the fund's directors, and a majority of its independent directors. In addition, any payments by a fund for distribution-related expenses (including payments to investment professionals and advertising and marketing expenses) must, pursuant to Investment Company Act Rule 12b-1, be in accordance with a written plan that must be approved annually by the fund's board of directors, including a majority of the independent directors. The fund's directors must review, at least quarterly, the amounts spent under a 12b-1 plan and the reasons for these expenditures. 3. Fees Can Be Increased Only If Investors Vote To Raise Them. D. Mutual Fund Disclosure and Regulation Is Unmatched By Other Investment Products. A good illustration of the disparity between mutual funds and other financial products occurs in the defined contribution plan area. These retirement plans are governed by the Employee Retirement Income Security Act of 1974 ("ERISA") and the Internal Revenue Code. Plan sponsors are not generally required under ERISA to provide plan participants with disclosure describing the fees that may be imposed by various investment options, except when the plan sponsor is relying on the 404(c) safe harbor.49 In this instance, participants receive complete information about a mutual fund's fees because they must receive the mutual fund's full prospectus. Mutual funds, however, constitute only about one-third of all defined contribution plan assets and approximately 42% of 401(k) plan assets. Other assets include bank and insurance company products and employer stock. Plan fiduciaries are required to deliver information about operating expenses of these investment vehicles only upon request by a participant. Because many participants are not aware they should ask for this information, many likely never receive it. The Department of Labor recently held hearings on 401(k) fees. A Department of Labor study released after the hearing noted that "it is clear from evidence in the literature that not all investment products disclose the fees and expenses charged to a 401(k) plan, nor are all of the fees and expenses charged by service providers disclosed."50 The Institute testified at the hearing and urged the adoption of regulations requiring that all participants in all 401(k) plans receive full fee information regarding all investment options.51 VI. Conclusion Mutual fund investors can readily obtain the information they need about fees. They can obtain this information directly from the standardized fee table that is required to appear in the front of every fund prospectus. And they can obtain the information through an exhaustive variety of fund company and independent sources. The mutual fund industry is ever mindful of Justice Brandeis' admonition that, "To be effective, knowledge of the facts must be actually brought home to the investor." Thus, we want to make sure that investors not only receive comprehensible information about mutual fund fees, but that they actually use it. We believe these are enduring responsibilities about which we can never be complacent. The mutual fund industry consistently has supported the SEC's efforts to improve fee disclosure, has called for disclosure in the 401(k) market, and taken the lead on many investor education efforts. We continue to explore ways to improve investor understanding about fees and stand ready to work with all to accomplish that goal. APPENDIX I: "The Organization and Operation of a Mutual Fund" APPENDIX II: ICI Investor Awareness Series: "Frequently Asked Questions About Mutual Fund Fees" ENDNOTES 1William J. Baumol, Steven M. Goldfeld, Julia Gordon, and Michael F. Koehn. The Economics of Mutual Fund Markets: Competition Versus Regulation. Boston, MA: Kluwer Academic Publishing 1990, p.5; Erik R. Sirri and Peter Tufano, "Competition and Change in the Mutual Fund Industry," in Financial Services: Perspectives and Challenges, edited by Samuel L. Hayes, III, Cambridge, MA, HBS Press, 1990, pp. 199-203. 2Estimates are based on companies reporting data to the Institute, as well as Institute membership data. 3Each new fund need only have $100,000 before distributing its shares to the public. This is a relatively small start-up cost, and is often provided by the adviser as an initial investment. 4Electronic Commerce: Investing On-Line, Hearing before the Subcommittee on Finance and Hazardous Materials of the House Committee on Commerce, 105th Congress, 2ndSession (June 18, 1998). 51998 Mutual Fund Fact Book, Investment Company Institute, p. 64. 6"Mutual Fund Developments in 1997," Perspective, Vol. 4, No. 1 (March 1998), pp. 11-12. See also, "Sustaining the Industry's Culture: Managing Expectations," Strategic Insight Overview, June 1998, p. iii ("[T]he dynamism of [the fund] industrys smaller companies, combined with a relentless bull market, has meant that the industrys top 20 managers at the beginning of each year in the past decade lost market share in aggregate") (emphasis omitted). 7This measuring technique is known as the Herfendahl Index. "Mutual Fund Developments in 1997," Perspective, at p. 11. 8Estimate is based on data from companies that report to the Institute, including member and non-member companies. This number of funds corresponds to an estimated 6,227 fund classes. 9The estimates of simple average and weighted average expense ratios are based on data obtained from Morningstar Principia for Mutual Funds software. Data are for the 4,786 equity funds (including fund classes) that reported both total assets and expense ratios, including 30 funds with zero assets, and were included in the June 30, 1998 release by Morningstar, Inc. This data is smaller than the universe of funds and fund classes reporting to the Institute, which is an estimated 6,227 fund classes. Estimates of the number of shareholder accounts for these funds and fund classes were based on data reported to the Investment Company Institute. 10Investment Company Institute, The Profile Prospectus: An Assessment by Mutual Fund Shareholders:Volume I, Washington, D.C., May 1996, p. 22. 11Erik R. Sirri and Peter Tufano, "Costly Search and Mutual Fund Flows," (working paper) (October 1997), p. 3. 12Putnam, Lovell & Thornton, The Investment Management Industry in the United States, July 11, 1997, p. 31. 13A more comprehensive description of the costs of investing in mutual funds is included as Appendix II. 14NASD Rule of Conduct 2830(d)(1)(A). 15See, e.g., James K. Glassman, "Funds Lofty Fees Add Insult to Injury," The Washington Post, September 13, 1998, at H1 (noting that information about fund fees "are reported by Morningstar and Value Line and in every mutual fund prospectus. Or just call your current or prospective fund and ask.") 16Letter from Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, to Rep Edward J. Markey, dated May 9, 1997. 17Lipper Analytical Services, Inc., "The Third White Paper: Are Mutual Fund Fees Reasonable?" September 1997, at p. 11; see also H. Sloane and S. Savage, "Some Perspective Amid the Debate Over Expenses," Financial Planning, p. 82 (Sept. 1992). 18Putnam, Lovell & Thornton, The Investment Management Industry in the United States, p. 31. 19Based upon data reported to the Institute. Mutual funds that invest in foreign stocks (and other securities) clearly require more intensive investment research, and can present much more complex legal and administrative issues than are present in a typical domestic stock fund. These and other issues are what can give rise to higher expense ratios relative to domestic mutual funds. 20Letter from Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, to Rep. Edward J. Markey, dated May 9, 1997. 21Letter from Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, to Rep. John D. Dingell, dated April 15, 1992. 22Erik R. Sirri and Peter Tufano, "Competition and Change in the Mutual Fund Industry," in Financial Services: Perspectives and Challenges, edited by Samuel L. Hayes, III, Cambridge, MA, HBS Press, 1993, pp. 199-202. 23See Steve S. Savage, "Perspective Amid the Debate Over Mutual Fund Expenses," AIA Investor News, published by the American Investors Alliance, February 1993, p. 5. 24Lipper Analytical Services, Inc., "The Third White Paper" at p. 12. 25"Advisory Fee Contracts," Strategic Insight Overview, May 1998, p. ii. 26Lipper Analytical Services, Inc., "The Third White Paper" at p. 5. Interestingly, the relatively high fees charged by hedge funds permit them to highly compensate their portfolio managers and other professionals sometimes with multi-million dollar contracts -- which in turn puts upward cost pressure on mutual funds. Many mutual funds compete with hedge funds to attract and retain talented investment managers. 27Investment Company Institute calculation based on data provided to the Institute by the Commodities Futures Trading Commission in response to a Freedom of Information Request dated December 6, 1996 (FOIA 96-0411). 28Lipper Analytical Services, Inc., "The Third White Paper" at p.5. 29Lipper reported that Canadian fund expense ratios averaged 2.4%, as compared to 1.2% for U.S. funds. Lipper Analytical Services, Inc., "The Third White Paper" at p. 5. Canadian Business magazine reported a somewhat smaller difference for long-term funds. It found that the average Canadian long-term fund had an expense ratio of 2.1%, as compared to 1.3% for U.S. funds. J. Harris, "Big Fees, Small Results," Canadian Business (Sept. 1997), p. 42. 30"Trends in the Offshore Mutual Fund Market," The Cerulli-Lipper Analytical Report, Cerulli Associates, Inc. and Lipper Analytical Services, Inc., 1996, p. 29. 31Lipper Analytical Services, Inc., "The Third White Paper" at p. 5. 32Financial Research Corporation, "Industry-Wide Expense Trends: Should Industry Asset Growth Necessarily Translate Into Lower Average Expense Ratios?" January 5, 1998. 33See "Advisory Fee Contracts: Recent Trends and Issues," Strategic Insight Overview, May 1998, pp. ii-v (using asset weighted averages, total expense ratios decline as assets grow). Similarly, the Lipper report states that management fees are declining for older, more successful funds, and notes that "[o]ne reason for this may be that these older funds have grown significantly in size." Lipper Analytical Services, Inc., "The Third White Paper" at p. 13. 34Various empirical studies have found that mutual funds exhibit economies of scale. See generally, William J. Baumol, Steven M. Goldfield, Lilli A. Gordon, and Michael F. Koehn, The Economies of Mutual Fund Markets: Competition versus Regulation, Boston: Kluwer Academic Publisher, 1990, pp. 192-94; Sean Collins and Phillip Mack, "The Optimal Amount of Assets Under Management in the Mutual Fund Industry," Financial Analysts Journal, 53:5 (October 1997), pp. 70-71. 35Lipper Analytical Services, Inc., "The Third White Paper" at p. 12. 36Investment Company Act Release No. 23064 (March 13, 1998). One of the most significant changes to the prospectus is the requirement to include in the risk/return summary a bar chart graphically illustrating the volatility of the funds total returns over the past ten years, a table comparing the funds return figures to those of an appropriate broad-based securities market index and the funds best and worst quarter performance over the last ten years. These requirements are designed to improve fund risk disclosure. 37Other changes include: (1) adding a new line item in the shareholder transaction section of the table describing account fees charged by the fund; (2) modifying the caption for sales charges (loads); and (3) adding a clear narrative explanation of the purpose of the hypothetical example. 38Investment Company Act Release No. 23065 (March 13, 1998). Mutual funds may file profiles with the SEC beginning on June 1, 1998 and may use the profile 30 days after it is filed. 39Specifically, profiles will summarize information about a funds investment objectives, strategies, risks, performance, fees, investment adviser and portfolio manager, purchase and redemption procedures, distribution and services available to fund investors. 40Both amended Form N-1A and the profile rule specifically permit funds to tailor their prospectus (or profile) for use in the defined contribution retirement plan market (e.g., by modifying purchase, redemption and taxation information). 41In addition to the prospectus, funds must send shareholders reports at least semi-annually that contain the funds financial statements, consisting of a balance sheet, an income statement, a portfolio schedule, a statement of operations and condensed financial information. The condensed financial information includes the funds expense ratios over time. 42Securities Act Release No. 7497 (January 28, 1998). 43SEC to Take 'Wait-and-See' Approach to Mutual Fund Fees, Dow Jones News Service, July 1, 1998. 44Morningstar Mutual Funds, How-to-Use Guide, p. 35; see alsoMarshall E. Blume, "An Anatomy of Morningstar Ratings," Financial Analysts Journal, Vol. 54, No. 2, March/April 1998. 45The Profile Prospectus: An Assessment by Mutual Fund Shareholders, Investment Company Institute, 1996, p. 23; see also "Financial Advisers Have Pull," Registered Representative, Sept. 30, 1998 survey of 2,000 mutual fund owners found that 41% said advisers were the most valuable source of information, compared with the funds prospectus (17%), press articles (12%), friends and relatives (7%), on-line services (4%) and fund advertisements (1%)). Nevertheless, it is likely that the SECs required disclosures are the source of much of the fee information available through these channels. Indeed, one reason why information about mutual funds is so readily available is that they are disclosed in so transparent a manner in fund prospectuses. 46"Mutual Fund IQ Test," http:~money.com>, at Q.14. "If two mutual funds hold the same securities, but one has higher operating expenses than the other, which of the following statements is true? The fund with the higher expenses will have a higher return. (Incorrect; chosen by 1.13% of on-line respondents). The fund with the lower expenses will have a higher return. (Correct; chosen by 80.63%). You cant say which fund would have a higher return, because expenses have no effect (Incorrect: chosen by 18.24%)." 47A mutual fund also enters into a number of contracts with other service providers, such as the funds principal underwriter, administrator, custodian and transfer agent. As part of its overall responsibilities, the board of directors oversees the performance of these service providers. If the service provider is the investment adviser or an affiliate of the adviser, the fund board must approve the contract with the service provider at the time the contract is entered into to ensure that any compensation paid thereunder meets the standards of Section 36(b). 48See, e.g.,Kalish v. Franklin Advisers, Inc., 928 F.2d 590 (2d Cir. 1991); Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982). 49Many plan sponsors choose to rely on the safe harbor established under Section 404(c) of ERISA, which relieves the sponsor from liability for a employees investment decisions. In order to be in compliance with the safe harbor, employees must be provided with, among other things, (1) a description of the available investment alternatives; (2) a description of any transaction fees and expenses (but not any plan administration fees) that affect the participants account balance in connection with purchases or sales (e.g., commissions, sales loads, deferred sales charges, redemption or exchange fees); and (3) in the case of an investment alternative subject to the Securities Act, a copy of the most recent prospectus. '50Study of 401(k) Plan Fees and Expenses, Pension and Welfare Benefits Administration, April 13, 1998, at Section 3.7. 51Statement of Matthew P. Fink, President, Investment Company Institute, on 401(k) Plan Expenses, before the Pension and Welfare Benefits Administration, Department of Labor (Nov. 12, 1997). |
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