MUTUAL FUND

FEES

Additional Disclosure

Could Encourage

Price Competition

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

United States General Accounting Office General Government Division

Washington, D.C. 20548

Page 1 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.
B-281444

Page 2 GAO/GGD-00-126 Mutual Fund Fees

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
Page 3 GAO/GGD-00-126 Mutual Fund Fees
Executive Summary

Page 4 GAO/GGD-00-126 Mutual Fund Fees

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.

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,

 

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.

Purpose

Background
Executive Summary

Page 5 GAO/GGD-00-126 Mutual Fund Fees

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.

GAO was unable to determine the extent to which the growth in mutual Results in Brief fund assets during the 1990s provided the opportunity for mutual fund
Executive Summary

Page 6 GAO/GGD-00-126 Mutual Fund Fees

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

 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.
Executive Summary

Page 7 GAO/GGD-00-126 Mutual Fund Fees

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.

 

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.
Executive Summary

Page 8 GAO/GGD-00-126 Mutual Fund Fees

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.
Executive Summary

Page 9 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Principal Findings

Principal Findings Although Advisers

Expected to Experience

Cost Efficiencies,

Comprehensive Data on

Their Costs Were Not

Available

Table 1: Total Assets for Stock and

Bond Mutual Fund as of 1998
Executive Summary

Page 10 GAO/GGD-00-126 Mutual Fund Fees

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.

Dollars in millions

Estimated fee revenues

Fund type 1990 1998

Percentage

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

 

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.

Table 2: Estimated Mutual Fund Adviser

and Service Provider Revenues From

Operating Expense Fees 1990-1998
Executive Summary

Page 11 GAO/GGD-00-126 Mutual Fund Fees

advisers indicated that these firms’ operating profits as a percentage of

their revenues have been increasing for at least 5 years.

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.

Type of fund

Number

of funds 1990 1991 1992 1993 1994 1995 1996 1997 1998

Percentage

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

 

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.

Average Mutual Fund

Expense Ratios Have

Generally Declined, But Not

All Funds Reduced Their

Ratios

Table 3: Average Expense Ratio for 77 Largest Stock and Bond Funds From 1990 to 1998 in Dollars Per $100 of Fund Assets
Executive Summary

Page 12 GAO/GGD-00-126 Mutual Fund Fees

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.

Total change in fee from 1990 to 1998 Number of funds Percentage

Reduction over 30 percent 17 33%

Reduction of 10 to 30 percent 21 41

Subtotala38 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

a

May not total due to rounding.

Source: GAO analysis of Morningstar and Barrons Lipper Mutual Funds Quarterly data.

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

 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.

Table 4: Fee Reductions by Large Funds

Whose Asset Growth Exceeded 500

Percent From 1990 to 1998

Competition Does Not

Focus on Price of Service
Executive Summary

Page 13 GAO/GGD-00-126 Mutual Fund Fees

more similar, and the fees are generally lower than the fees charged on

most stock funds.

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

 

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.

Fee Disclosures Do Not

Provide Investors With

Specific Dollar Amounts
Executive Summary

Page 14 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Mutual Fund Directors

Tasked With Reviewing

Fees, But Opinions on Their

Effectiveness Were Mixed
Executive Summary

Page 15 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

 

13 These firms included the advisers for 13 of the 77 largest funds and 2 smaller fund advisers.

Recommendations

Agency Comments and

GAO’s Evaluation
Executive Summary

Page 16 GAO/GGD-00-126 Mutual Fund Fees

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.
Executive Summary

Page 17 GAO/GGD-00-126 Mutual Fund Fees

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.
Executive Summary

Page 18 GAO/GGD-00-126 Mutual Fund Fees

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.
Page 19 GAO/GGD-00-126 Mutual Fund Fees
Page 20 GAO/GGD-00-126 Mutual Fund Fees

Contents

Executive Summary 4

24

Background 24

Objectives, Scope, and Methodology 30

Chapter 1

Introduction

33

Fund Asset Growth Expected to Produce Economies of

Scale

33

Cost Data Not Generally Available for Mutual Fund

Advisers’ Overall Operations

36

Fund and Other Industry Officials Report that Mutual

Fund Operating Costs Have Risen

37

Asset Growth Has Varying Effects on Fund Advisers’

Costs

41

Fee Revenues Have Increased Significantly 42

Data for Some Mutual Fund Advisers Indicates

Profitability Has Been Increasing

44

Chapter 2

Data Inadequate For

Determining How

Asset Growth Affected

Adviser Costs

46

Studies Also Find Mixed Trend in Fees Across Industry 46

Largest Mutual Funds Generally Grew Faster Than

Industry Average

48

Among Largest Funds, Average Expense Ratios Declined

for Stock Funds but Less so for Bond Funds

48

Asset Growth Usually Resulted in Lower Expense Ratios

but Not All Funds Made Reductions

50

Chapter 3

Mutual Fund Operating

Expense Ratios

Generally Declined

56

Mutual Fund Industry Exhibits Characteristics of

Monopolistic Competition

56

Mutual Fund Industry Generally Does Not Attempt to

Compete On Basis of Fees

62

Chapter 4

Competition in Mutual

Fund Industry Does

Not Focus on Fees
Contents

Page 21 GAO/GGD-00-126 Mutual Fund Fees

66

Required Fee Disclosures Do Not Provide Amounts Paid

by Individual Investors in Dollars

66

Charges for Other Financial Services Typically Disclosed

in Dollars

70

Mutual Fund Fees Are Not a Primary Consideration for

Investors

72

Opinions Varied on Adequacy of Current Fee Disclosures 76

Chapter 5

Mutual Funds Are Not

Required to Disclose

Actual Amounts

Charged to Individual

Investors

82

Mutual Funds’ Organizational Structure Embodies

Conflict of Interest Over Fees

82

Mutual Fund Directors Have Specific Responsibilities

Regarding Fees

87

Opinions on Boards’ Effectiveness in Overseeing Fees

Vary

92

Chapter 6

Mutual Fund Directors

Required to Review

Fees

96

Conclusions 96

Recommendations 97

Agency and Industry Comments and Our Evaluation 98

Chapter 7

Conclusions and

Recommendations

Appendix I: Comments From the Securities and

Exchange Commission

102

Appendix II: Comments From the National Association of

Securities Dealers Regulation, Inc.

111

Appendix III: Comments From the Investment Company

Institute

117

Appendix IV: GAO Contacts and Staff Acknowledgments 125

Appendixes

Table 1: Total Assets for Stock and Bond Mutual Fund as

of 1998

9

Table 2: Estimated Mutual Fund Adviser and Service

Provider Revenues From Operating Expense Fees

1990-1998

10

Table 3: Average Expense Ratio for 77 Largest Stock and

Bond Funds From 1990 to 1998 in Dollars Per $100 of

Fund Assets

11

Table 4: Fee Reductions by Large Funds Whose Asset

Growth Exceeded 500 Percent From 1990 to 1998

12

Tables

Table 1.1: Growth in Mutual Fund Assets, 1990-1998 25
Contents

Page 22 GAO/GGD-00-126 Mutual Fund Fees

Table 2.1: Source of Asset Growth for All Stock and Bond

Funds From 1990 to 1998

35

Table 2.2: Growth in Mutual Fund Assets and Estimated

Fund Adviser and Other Service Provider Fee

Revenues 1990-1998

42

Table 2.3: Assets and Fee Revenues for 77 Largest Mutual

Funds for 1990-1998

43

Table 2.4: Average Fees Collected For Stock and Bond

Funds In Dollars Per Account from 1990 to 1997

44

Table 2.5: Change in Revenue and Expenses From Prior

Year and Resulting Operating Margin for Public Asset

Management Companies

45

Table 3.1: Average Size of Stock and Bond Mutual Funds

from 1990 to 1998

48

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

50

Table 3.3: Change in Operating Expense Ratios Charged

by 77 Largest Stock and Bond Funds 1990-1998

50

Table 3.4: Relationship of Asset Growth and Change in

Operating Expense Ratios for Largest Stock Funds

1990-1998

52

Table 3.5: Relationship of Asset Growth and Change in

Operating Expense Fees for Largest Bond Funds 1990-

1998

52

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

55

Table 5.1: Fee Disclosure Practices for Selected Financial

Services or Products

71

Table 5.2: Sales of Mutual Funds for Select Years 1984 to

1998 by Type of Distribution Method

75

Figure 3.1: Average Expense Ratios for 77 Largest Stock

and Bond Mutual Funds From 1990 to 1998

49

Figure 3.2: Average Operating Expense Ratio From 1990

to 1998 for Funds With Above and Below Average Fees

in 1990

54

Figure 4.1: Number of Mutual Funds from 1984 to 1998 58

Figure 4.2: Number of Mutual Fund Famillies for Selected

Years From 1984 Through 1998

59

Figures

Figure 5.1: Example of a Fee Table Required as Part of

Mutual Fund Fee Disclosures

68
Contents

Page 23 GAO/GGD-00-126 Mutual Fund Fees

Figure 6.1: Comparison of Organizational Structure of

Typical Corporation and Typical Mutual Fund

84

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
Chapter 1

Introduction

Page 24 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.

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

 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.

Background
Chapter 1

Introduction

Page 25 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

Fund type

Total assets

(dollars in millions)

Percentage

growth

1990 1998

Stock fundsa $ 282,800 $ 3,342,900 1,082%

Bond funds 284,300 830,600 192

Money Market funds 498,300 1,351,700 171

Total 1,065,500 5,525,200 419

a This category combines equity and hybrid fund data.

Source: GAO analysis of Investment Company Institute data.

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

 

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.

Mutual Fund Assets

Increased Dramatically in

the 1990s

Table 1.1: Growth in Mutual Fund

Assets, 1990-1998

Mutual Funds Contract with

Investment Advisers to

Conduct Their Operations
Chapter 1

Introduction

Page 26 GAO/GGD-00-126 Mutual Fund Fees

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.)

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. An 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

 

3

 In some cases, the adviser may contract with other firms to provide investment advice, becoming a

subadviser to those funds.

Mutual Fund Fees Include

Operating Expenses and

Sales Charges
Chapter 1

Introduction

Page 27 GAO/GGD-00-126 Mutual Fund Fees

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 “frontend 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.

 

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.
Chapter 1

Introduction

Page 28 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

 

8

 Correlating Total Expenses to the Performance of Four and Five Star Equity Funds, Financial

Research Corporation and Wechsler Ross & Partners (Mar. 2, 1998).

Mutual Fund Investors’

Total Costs Vary Depending

on How Shares are

Purchased

Long-Term Impact of

Annual Fees on Mutual

Fund Investment Returns

Can Be Significant

Various Federal Statutes

Apply to Mutual Fund

Activities
Chapter 1

Introduction

Page 29 GAO/GGD-00-126 Mutual Fund Fees

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

 

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 1

Introduction

Page 30 GAO/GGD-00-126 Mutual Fund Fees

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

Objectives, Scope, and

Methodology
Chapter 1

Introduction

Page 31 GAO/GGD-00-126 Mutual Fund Fees

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
Chapter 1

Introduction

Page 32 GAO/GGD-00-126 Mutual Fund Fees

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.
Chapter 2

Data Inadequate For Determining How Asset

Growth Affected Adviser Costs

Page 33 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.

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.

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

 

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.

Fund Asset Growth

Expected to Produce

Economies of Scale

Many Agree that Mutual

Fund Advisers Experience

Economies of Scale
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 34 GAO/GGD-00-126 Mutual Fund Fees

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

 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).
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 35 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

Fund type Portfolio appreciation

Investor share

purchases Totals

Stock funds 56.5% 43.5% 100%

Bond funds 54.2% 45.8% 100%

Totals 56.1% 43.9% 100%

Source: GAO analysis of ICI data.

 

3

 The Third White Paper: Are Mutual Fund Fees Reasonable? (September 1998 Update), Lipper

Analytical Services, Inc. (Sep. 1998).

Substantial Asset Growth

From Portfolio

Appreciation Should Also

Result in Economies of

Scale

Table 2.1: Source of Asset Growth for

All Stock and Bond Funds From 1990 to

1998
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 36 GAO/GGD-00-126 Mutual Fund Fees

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

 

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.

Cost Data Not

Generally Available for

Mutual Fund Advisers’

Overall Operations
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 37 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

Fund and Other

Industry Officials

Report that Mutual

Fund Operating Costs

Have Risen

New Services Increase

Operating Costs
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 38 GAO/GGD-00-126 Mutual Fund Fees

advisers are also increasingly providing information and account access

services over the Internet.

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.

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.

 

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 Café:

Blue Plate Special, Financial Research Corporation (Jan. 18, 1999).

Distribution Costs Also

Increasing

Fund Advertising Costs Also

Increasing
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 39 GAO/GGD-00-126 Mutual Fund Fees

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.

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

 

7

 1999 Investment Management Compensation Survey, Association for Investment Management and

Research and Russell Reynolds Associates (Jul. 20, 1999).

Personnel Costs Also

Increasing
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 40 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

 

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 Café: Inside Scoop, DeRemer & Associates and Wechsler Ross & Partners (Aug. 1998)

Information Technology

Expenditures Also Increase

But May Eventually Reduce

Adviser Costs
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 41 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

 

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.

Asset Growth Has

Varying Effects on

Fund Advisers’ Costs

Adviser Costs Do Not Rise

Smoothly

New Accounts Also

Increase Adviser Costs
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 42 GAO/GGD-00-126 Mutual Fund Fees

$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.

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.

Dollars in millions

Fund type Total assets

Estimated fund adviser and

provider fee revenuesa

1990 1998

Percentage

change 1990 1998

Percentage

change

Stock $256,766 $2,396,410 833% $2,544 $22,931 801%

Bond 268,529 698,365 160 2,408 5,933 146

Totals 525,295 3,094,775 489 4,952 28,864 483

Source: GAO analysis of data from ICI.

 

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.

Fee Revenues Have

Increased Significantly

Table 2.2: Growth in Mutual Fund Assets

and Estimated Fund Adviser and Other

Service Provider Fee Revenues 1990-

1998
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 43 GAO/GGD-00-126 Mutual Fund Fees

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.

Dollars in millions

1990 1991 1992 1993 1994 1995 1996 1997 1998

Percentage

change

1990-1998

Total assets $164,425 $232,985 $303,339 $409,755 $432,241 $595,857 $745,889 $954,725 $1,157,219 604%

Total fee revenue $1,128 $1,640 $2,157 $2,986 $3,255 $4,488 $5,387 $6,347 $7,428 559

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

 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.

Table 2.3: Assets and Fee Revenues for 77 Largest Mutual Funds for 1990-1998
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 44 GAO/GGD-00-126 Mutual Fund Fees

Type of

fund 1990 1991 1992 1993 1994 1995 1996 1997

Percentage

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.

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.

 

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.

Table 2.4: Average Fees Collected For Stock and Bond Funds In Dollars Per Account from 1990 to 1997

Data for Some Mutual

Fund Advisers

Indicates Profitability

Has Been Increasing
Chapter 2

Data Inadequate For Determining How Asset Growth Affected Adviser Costs

Page 45 GAO/GGD-00-126 Mutual Fund Fees

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.

Table 2.5: Change in Revenue and

Expenses From Prior Year and

Resulting Operating Margin for Public

Asset Management Companies
Chapter 3

Mutual Fund Operating Expense Ratios

Generally Declined

Page 46 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 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 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.

 

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.

Studies Also Find

Mixed Trend in Fees

Across Industry

Some Studies Find Declines

in Mutual Fund Fee Charges
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 47 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

 

3

 Morningstar.Net Commentary: Revisiting Fund Costs: Up or Down?, Scott Cooley, Morningstar, Inc.

(Feb. 19, 1999).

Other Studies Found Fees

Rising

Criticisms Raised Regarding

the Methodologies Used by

Some Fee Studies
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 48 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

Dollars in millions

Average size of fund

Largest Funds 1990 1998

Percentage

change

 46 stock funds $1,828 $21,459 1,074%

 31 bond funds 2,551 5,828 128

Total for largest funds 2,135 15,029 604

All other funds in industry

 Stock funds 159 602 279

 Bond funds 206 291 41

Total for all other funds 178 484 172

Source: GAO analysis of data from ICI; Morningstar, Inc.; and Barron’s Lipper Mutual Funds

Quarterly.

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

Largest Mutual Funds

Generally Grew Faster

Than Industry Average

Table 3.1: Average Size of Stock and

Bond Mutual Funds from 1990 to 1998

Among Largest Funds,

Average Expense

Ratios Declined for

Stock Funds but Less

so for Bond Funds
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 49 GAO/GGD-00-126 Mutual Fund Fees

bond funds was 66 cents in 1990 and 64 cents in 1998, a decline of 3

percent.

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,

Figure 3.1: Average Expense Ratios for

77 Largest Stock and Bond Mutual

Funds From 1990 to 1998
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 50 GAO/GGD-00-126 Mutual Fund Fees

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.

Type of fund

Number of

funds 1990 1991 1992 1993 1994 1995 1996 1997 1998

Percentage change

1990-1998

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.

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.

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.

Funds that reduced fees Funds with no change in fees Funds that raised fees

Type of fund Number Percentage Number Percentage Number Percentage

Total number of

funds

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

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

Asset Growth Usually

Resulted in Lower

Expense Ratios but

Not All Funds Made

Reductions

Most Large Funds Had

Reduced Expense Ratios

Table 3.3: Change in Operating Expense Ratios Charged by 77 Largest Stock and Bond Funds 1990-1998
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 51 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

 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.

Funds With More Asset

Growth More Likely to

Reduce Expense Ratios, But

Not all Funds Made

Significant Reductions
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 52 GAO/GGD-00-126 Mutual Fund Fees

Percentage change in assets

Change in operating expenses +1,000 +500 to 1,000 +200 to 500 +200 to 0 Decline in assets Total

Reduction over 30 percent 14 2 16

Reduction between 10 and 30 percent 7 7 1 15

Reduction under 10 percent 4 2 2 8

No change 1 1 2

Increase under 10 percent 1 1

Increase between 10 and 30 percent 1 1

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.

Percentage change in assets

Change in operating expenses +1,000 +500 to 1,000 +200 to 500 +200 to 0 Decline in assets Total

Reduction over 30 percent 1 1

Reduction between 10 and 30

percent 4 3 2 1 10

Reduction under 10 percent 1 2 1 4

No change 1 1 2

Increase under 10 percent 1 2 3

Increase between 10 and 30

percent 2 5 1 8

Increase over 30 percent 2 1 3

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

Table 3.4: Relationship of Asset Growth and Change in Operating Expense Ratios for Largest Stock Funds 1990-1998

Table 3.5: Relationship of Asset Growth and Change in Operating Expense Fees for Largest Bond Funds 1990-1998
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 53 GAO/GGD-00-126 Mutual Fund Fees

decrease in the expense ratio for the funds in the bottom 20 percent of

asset growth averaged only 5 cents per $100 of assets

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 highfee funds declined from $1.22 to 92 cents; the average ratio charged by 48

low-fee funds remained relatively flat at about 54 cents.

 5

We 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.

Funds with Higher

Operating Expense Ratios

Made Greater Reductions

Than Funds With Lower

Ratios
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 54 GAO/GGD-00-126 Mutual Fund Fees

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.

Figure 3.2: Average Operating Expense

Ratio From 1990 to 1998 for Funds With

Above and Below Average Fees in 1990
Chapter 3

Mutual Fund Operating Expense Ratios Generally Declined

Page 55 GAO/GGD-00-126 Mutual Fund Fees

Asset size of average fund (dollars in millions) Operating expense ratio (in dollars per $100 of assets)

Type of fund 1990 1998

Percentage

change 1990 1998 Percentage change

High fee funds $1,515 $15,162 901% $1.22 $.92 -25%

Low fee funds 2,510 14,948 496 .54 .54 0

Total 2,135 15,029 604 80 68 -15%

Source: GAO analysis of data from Morningstar, Inc., and Barron’s Lipper Mutual Funds Quarterly.

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
Chapter 4

Competition in Mutual Fund Industry Does

Not Focus on Fees

Page 56 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.

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.

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 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

 

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.

Mutual Fund Industry

Exhibits

Characteristics of

Monopolistic

Competition

Characteristics of a

Monopolistically

Competitive Market
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 57 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

Large Numbers of

Competing Funds and Fund

Complexes Exist
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 58 GAO/GGD-00-126 Mutual Fund Fees

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

Figure 4.1: Number of Mutual Funds from 1984 to 1998
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 59 GAO/GGD-00-126 Mutual Fund Fees

increased by 94 from 1990 to 1998 compared to an increase of 201 from

1984 to 1990.

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.

 

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.

Figure 4.2: Number of Mutual Fund

Famillies for Selected Years From 1984

Through 1998
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 60 GAO/GGD-00-126 Mutual Fund Fees

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 brokerdealer 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.

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

 

3

 “Improving Price Competition for Mutual Funds and Bonds,” before the Subcommittee on Finance

and Hazardous Materials, House Commerce Committee, September 29, 1998.

Although Some Barriers

Exist, Most Saw Relative

Ease of Entry into Industry

Alternative Financial

Products Also Represent

Competition to Mutual

Funds
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 61 GAO/GGD-00-126 Mutual Fund Fees

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.

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 welltrained customer service staff.

Mutual Funds Offer

Differentiated Products
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 62 GAO/GGD-00-126 Mutual Fund 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

 

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).

Mutual Fund Industry

Generally Does Not

Attempt to Compete

On Basis of Fees
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 63 GAO/GGD-00-126 Mutual Fund Fees

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

 5

 Industry-Wide Expense Trends: Should Industry Growth Necessarily Translate into Lower Average

Expense Ratios?, Blue Plate Special, Mutual Fund Café, Financial Research Corporation (Jan. 5, 1998;

http://www.mcafe.com/pantry/bps_010598.html).
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 64 GAO/GGD-00-126 Mutual Fund Fees

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 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

 .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).

Opinions Were Mixed on

the Effect of Competition

on Fees
Chapter 4

Competition in Mutual Fund Industry Does Not Focus on Fees

Page 65 GAO/GGD-00-126 Mutual Fund Fees

enough to produce fierce price competition, but he found price

competition conspicuously absent among mutual fund advisers.

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.

Competition on the Basis of

Price Not Completely

Absent
Chapter 5

Mutual Funds Are Not Required to Disclose

Actual Amounts Charged to Individual

Investors

Page 66 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.

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,

Required Fee

Disclosures Do Not

Provide Amounts Paid

by Individual Investors

in Dollars
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 67 GAO/GGD-00-126 Mutual Fund Fees

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.

 

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.
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 68 GAO/GGD-00-126 Mutual Fund Fees

FEES AND EXPENSES OF THE FUND

The following describes the fees and expenses that you may pay if you buy and hold 

shares of the fund.

Shareholder Fees

(fees paid directly from your investment)

Maximum sales charge imposed on purchases

(as a percentage of offering price) 5.75%

Maximum sales charge imposed on reinvested dividends 0%

Maximum deferred sales charge 0%

Redemption or exchange fees 0%

Example

This Example is intended to help you compare the cost of investing in the fund 

with the cost of investing in other mutual funds.

The Example assumes that you invest $10,000 in the fund for the time periods 

indicated and then redeem all of your shares at the end of those periods. The 

Example also assumes that your investment has a 5% return each year and that 

the fund's operating expenses remain the same. Although your actual costs may 

be higher or lower, based on these assumptions your costs would be:

Annual Fund Operating Expenses

(expenses that are deducted from fund assets)

Management Fees 0.34%

Service (12b-1) Fees 0.25%

Other Expenses 0.11%

Total Annual Fund Operating Expenses 0.70%

One year $ 642

Three years $ 786

Five years $ 942

Ten years $1,395

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

Figure 5.1: Example of a Fee Table

Required as Part of Mutual Fund Fee

Disclosures
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 69 GAO/GGD-00-126 Mutual Fund Fees

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 recordkeeping, 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

 

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.
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 70 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

 

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.

Charges for Other

Financial Services

Typically Disclosed in

Dollars
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 71 GAO/GGD-00-126 Mutual Fund Fees

Type of product or

service Disclosure requirement

Deposit accounts Depository institutions are required to disclose itemized fees,

in dollar amounts, on periodic statements.

Bank trust services Although covered by varying state laws, regulatory and

association officials for banks indicated that trust service

charges are generally shown as specific dollar amounts.

Investment services

provided by individual

investment advisers

When the adviser has the right to deduct fees and other

charges directly from the investor’s account, the dollar

amounts of such charges are required to be disclosed to the

investor.

Wrap accountsa Provider is required to disclose dollar amount of fees on

investors’ statements.

Stock, bond, or other

securities purchases

Broker-dealers are required to report specific dollar amounts

charged as commissions to investors.

Real estate property

purchases

Brokerage commissions generally are specified as a

percentage of 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

Table 5.1: Fee Disclosure Practices for

Selected Financial Services or Products
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 72 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

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

Mutual Fund Fees Are

Not a Primary

Consideration for

Investors

Various Other Factors Get

Greater Consideration Than

Fees
Chapter 5

Mutual Funds Are Not Required to Disclose Actual Amounts Charged to Individual Investors

Page 73 GAO/GGD-00-126 Mutual Fund Fees

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, 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

 

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 Café: Blue Plate Special , Financial Research

Corporation, (Boston, MA: Jan. 5, 1998).
Chapter 5

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Page 74 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

 

11 “Pricing Structure Trends: Prime Destination for Net Flows is Back-End Loaded Shares,” Mutual

Fund Café: Blue Plate Special, Financial Research Corporation (Boston, MA: Feb. 1, 1999).

Investors Appear More

Aware of Sales Loads than

Operating Expense Fees
Chapter 5

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Page 75 GAO/GGD-00-126 Mutual Fund Fees

Dollars in millions

Distribution method

Sales by third-party sales forces Direct sales by advisers to investors

Year 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

Table 5.2: Sales of Mutual Funds for Select Years 1984 to 1998 by Type of Distribution Method
Chapter 5

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Page 76 GAO/GGD-00-126 Mutual Fund Fees

4,000 investors and potential investors queried cited mutual fund loads as

their preferred means of paying for investment advice.12

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 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.

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. A 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.

 

12 1996 Series on Personal Financial Advice: Payment Practices Preferred by Customers (Report 5 of 9),

Dalbar, Inc. (Boston, MA: Nov. 1996).

Opinions Varied on

Adequacy of Current

Fee Disclosures

Most Officials Found

Disclosures Adequate

Some Expressed Concerns

Regarding the Adequacy of

Mutual Fund Fee

Disclosures
Chapter 5

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Page 77 GAO/GGD-00-126 Mutual Fund Fees

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

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. 

 

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.

Disclosing to Investors

Actual Dollars Paid in Fees

Was One Suggested

Improvement
Chapter 5

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Page 78 GAO/GGD-00-126 Mutual Fund Fees

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.
Chapter 5

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Page 79 GAO/GGD-00-126 Mutual Fund Fees

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 upfront 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

Industry Representatives Raised

Concerns Over the Effort to

Produce, and the Usefulness of,

Such Statements
Chapter 5

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Page 80 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Less Costly Means of Calculating

the Individual Dollar Costs of

Fees Might Be Considered
Chapter 5

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Page 81 GAO/GGD-00-126 Mutual Fund Fees

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.

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.

Another Option Was to

Provide Comparative Fee

Information
Chapter 6

Mutual Fund Directors Required to Review

Fees

Page 82 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.

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.

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.

Mutual Funds’

Organizational

Structure Embodies

Conflict of Interest

Over Fees

Mutual Funds Organization

Includes Two Primary Legal

Entities
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 83 GAO/GGD-00-126 Mutual Fund Fees

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.

 

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).
Chapter 6

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Page 84 GAO/GGD-00-126 Mutual Fund Fees

Figure 6.1: Comparison of

Organizational Structure of Typical

Corporation and Typical Mutual Fund
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 85 GAO/GGD-00-126 Mutual Fund Fees

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

Figure 6.1: Continued
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 86 GAO/GGD-00-126 Mutual Fund 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.

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.

 

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.

The Organizational Structure of

One Mutual Fund Family

Appears to Minimize the

Potential Conflict of Interest
Chapter 6

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Page 87 GAO/GGD-00-126 Mutual Fund Fees

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.

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

 

7

 Index funds invest in the securities represented in a broad-based index such as the Standard & Poor’s

Index.

Mutual Fund Directors

Have Specific

Responsibilities

Regarding Fees
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 88 GAO/GGD-00-126 Mutual Fund Fees

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.

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

 

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.

Federal and State Laws

Provide Responsibilities for

Mutual Fund Directors
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 89 GAO/GGD-00-126 Mutual Fund Fees

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.

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

 

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).

Fund Adviser

Responsibilities Increased

After Concerns Over Fees
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 90 GAO/GGD-00-126 Mutual Fund Fees

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 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

 

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).

Court Decisions Have

Shaped Directors

Responsibilities
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Mutual Fund Directors Required to Review Fees

Page 91 GAO/GGD-00-126 Mutual Fund Fees

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

 

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.
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 92 GAO/GGD-00-126 Mutual Fund Fees

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

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.

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

 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 .

Standards Criticized as

Lacking Specific Guidance

For Assessing Fees

Opinions on Boards’

Effectiveness in

Overseeing Fees Vary

Fund Officials Say Boards

Are Effective in Lowering

Fees
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 93 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Some Officials Criticized

Directors’ Effectiveness in

Overseeing Fees
Chapter 6

Mutual Fund Directors Required to Review Fees

Page 94 GAO/GGD-00-126 Mutual Fund Fees

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.

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

 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.

SEC and ICI Proposed

Reforms to Increase

Director Independence and

Knowledge
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Mutual Fund Directors Required to Review Fees

Page 95 GAO/GGD-00-126 Mutual Fund Fees

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.

 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 96 GAO/GGD-00-126 Mutual Fund Fees

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.

Conclusions
Chapter 7

Conclusions and Recommendations

Page 97 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Recommendations
Chapter 7

Conclusions and Recommendations

Page 98 GAO/GGD-00-126 Mutual Fund Fees

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.

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

Agency and Industry

Comments and Our

Evaluation
Chapter 7

Conclusions and Recommendations

Page 99 GAO/GGD-00-126 Mutual Fund Fees

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
Chapter 7

Conclusions and Recommendations

Page 100 GAO/GGD-00-126 Mutual Fund Fees

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
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Conclusions and Recommendations

Page 101 GAO/GGD-00-126 Mutual Fund Fees

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 102 GAO/GGD-00-126 Mutual Fund Fees

Note: GAO comments

supplementing those in the

report text appear at the

end of this appendix.
Appendix I

Comments From the Securities and Exchange Commission

Page 103 GAO/GGD-00-126 Mutual Fund Fees

See comment 1.
Appendix I

Comments From the Securities and Exchange Commission

Page 104 GAO/GGD-00-126 Mutual Fund Fees
Appendix I

Comments From the Securities and Exchange Commission

Page 105 GAO/GGD-00-126 Mutual Fund Fees
Appendix I

Comments From the Securities and Exchange Commission

Page 106 GAO/GGD-00-126 Mutual Fund Fees
Appendix I

Comments From the Securities and Exchange Commission

Page 107 GAO/GGD-00-126 Mutual Fund Fees
Appendix I

Comments From the Securities and Exchange Commission

Page 108 GAO/GGD-00-126 Mutual Fund Fees

See comment 2.
Appendix I

Comments From the Securities and Exchange Commission

Page 109 GAO/GGD-00-126 Mutual Fund Fees
Appendix I

Comments From the Securities and Exchange Commission

Page 110 GAO/GGD-00-126 Mutual Fund Fees

The following are GAO’s comments on the Securities and Exchange

Commission’s May 10, 2000, letter.

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.

GAO’s Comments
Appendix II

Comments From the National Association of

Securities Dealers Regulation, Inc.

Page 111 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.
Appendix II

Comments From the National Association of Securities Dealers Regulation, Inc.

Page 112 GAO/GGD-00-126 Mutual Fund Fees

Now on p. 27; see

comment 4.

See comment 3.

See comment 2.

See comment 1.
Appendix II

Comments From the National Association of Securities Dealers Regulation, Inc.

Page 113 GAO/GGD-00-126 Mutual Fund Fees

Now on p. 74; see

comment 7.

Now on p. 42; see

comment 6.

Now on p. 29; see

comment 5.

See comment 4.
Appendix II

Comments From the National Association of Securities Dealers Regulation, Inc.

Page 114 GAO/GGD-00-126 Mutual Fund Fees
Appendix II

Comments From the National Association of Securities Dealers Regulation, Inc.

Page 115 GAO/GGD-00-126 Mutual Fund Fees

The following are GAO’s comments on the National Association of

Securities Dealers Regulation’s May 8, 2000, letter.

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.

GAO’s Comments
Appendix II

Comments From the National Association of Securities Dealers Regulation, Inc.

Page 116 GAO/GGD-00-126 Mutual Fund Fees

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 117 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.
Appendix III

Comments From the Investment Company Institute

Page 118 GAO/GGD-00-126 Mutual Fund Fees

See comment 3.

See comment 2.
Appendix III

Comments From the Investment Company Institute

Page 119 GAO/GGD-00-126 Mutual Fund Fees

See comment 4.
Appendix III

Comments From the Investment Company Institute

Page 120 GAO/GGD-00-126 Mutual Fund Fees
Appendix III

Comments From the Investment Company Institute

Page 121 GAO/GGD-00-126 Mutual Fund Fees

The following are GAO’s comments on the Investment Company Institute’s

May 3, 2000, letter.

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

GAO Comments
Appendix III

Comments From the Investment Company Institute

Page 122 GAO/GGD-00-126 Mutual Fund Fees

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
Appendix III

Comments From the Investment Company Institute

Page 123 GAO/GGD-00-126 Mutual Fund Fees

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.
Appendix III

Comments From the Investment Company Institute

Page 124 GAO/GGD-00-126 Mutual Fund Fees

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

Thomas J. McCool, (202) 512-8676

Cody J. Goebel, (202) 512-7329

In addition to those named above, Michael Burnett, Suzie Bright, Melvin

Thomas, Darlene Wall, and Desiree Whipple made key contributions to this

report.

GAO Contacts

Acknowledgments
Page 126 GAO/GGD-00-126 Mutual Fund Fees
Page 127 GAO/GGD-00-126 Mutual Fund Fees
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