Are Mutual Fund Expenses Too High? A Commentary

he competitive market answer tomy question in the title is thatmutual fund prices are marketdetermined. In the case of funds,prices are the expenses, costs, and fees chargedshareholders for managing portfolios sold atmarket value. In a competitive market, giventhe large number of funds and the ease ofmarket entry, there should be pressure on fundsto properly measure and account for each ofthe various types of expenses (and costs andfees) and to provide transparent disclosure.But, most of all, there should be competitivepressure that forces fund expenses downward,especially as funds grow increasingly larger andtheir economies of scale greater.The facts are otherwise. The mutual fundindustry does not compete on price, its tradeassociation’s statements notwithstanding. TheSEC also contributed to non-price competi-tion years ago when it effectively eliminatedperformance-based management fees. As aresult, performance-driven funds joined otherfunds in adopting high asset-based manage-ment fees. Following are six pieces of evidencesupporting a finding of no price competition.First, the recent stock market boom—not to mention fund advertising—encour-aged shareholders to focus on performanceand only performance. It may well be arguedthat during this period shareholders in gen-eral simply ignored fund expenses. This is alsothe usual working assumption about the pricesensitivity of fund investors. One hopes thisunwise behavior will disappear with investorrealization that fund expenses are major pro-portions of normal fund returns and explainmost of the differences in fund returns.A greater sensitivity of investors toexpenses may be seen in the large movementof fund assets to low-cost index funds. Butnot all index funds are low-cost commodi-ties; some have high expenses and some also12b-1 fees. So what does their existence sayabout rational investors?Second, the external governance struc-ture of mutual funds provides an implicit pri-ority that does not favor fund shareholders.As separate entities, fund management com-panies give first priority to their own profitsand only secondarily to profits of fund share-holders. Fund managers are paid before share-holders receive a cent. This is not surprising. Why else wouldfund companies create funds to manage? Theanswer is also seen in the more than generousreturns that management companies earn bymanaging funds.The self-interested attitude of mutualfund managers is often implicitly supported