GAO-01-655R SEC's Report on Mutual Fund Fees

United States General Accounting Office

Washington, DC 20548

May 3, 2001

The Honorable John D. Dingell

Ranking Minority Member

Committee on Energy and Commerce

House of Representatives

Subject: SEC's Report Provides Useful Information On Mutual Fund Fees And

Recommends Improved Fee Disclosure

Dear Mr. Dingell:

This letter responds to your request that we comment on the findings and

recommendations in the December 2000 Report on Mutual Fund Fees and Expenses

by the Securities and Exchange Commission's (SEC) Division of Investment

Management. In this report, the SEC staff presents the results of its own analysis of

the trend in mutual fund fees, including the results of its statistical analyses that

identified how various fund characteristics affect fee levels. In addition, the report

describes the approaches the SEC staff proposes be taken in response to the

recommendation in our report Mutual Fund Fees: Additional Disclosure Could

Improve Price Competition (GAO/GGD-00-126, June 7, 2000). In this letter, we

discuss the findings of the SEC staff's report and compare them to those of our

report. We also comment on the SEC staff's proposed response to our

recommendation calling for additional disclosure of fee information to mutual fund

investors.

Results in Brief

The results of the SEC staff's comprehensive statistical analyses and other findings

generally corroborate the findings of our own report and provide considerable

additional information regarding the trend in mutual fund fees. The SEC staff's

report also contains several staff recommendations to the agency's Commissioners,

and Commission approval has already been granted to recommendations relating to

after-tax return disclosure and fund governance. In response to our recommendation

that mutual fund investors' quarterly account statements disclose the specific dollar

amount of fees they paid, SEC staff recommends that investors receive additional fee

information in funds' annual and semiannual reports. The SEC staff's proposal would

provide investors with additional information regarding fees in a form that facilitates

comparison among funds. However, it will not provide information specific to each

investor, nor will it be provided in the most frequent and relevant source -the

quarterly statement. Therefore, it may be less likely to increase investor awareness
Page 2 GAO-01-655R SEC's Report on Mutual Fund Fees

and spur additional price competition among mutual funds to the same degree as our

recommendation sought to do.

Background

We undertook our June 2000 report on mutual fund fees as the result of

Congressional concerns that fees charged by mutual funds had not declined despite

the growth in mutual fund assets. Our report presented information on how the

growth in assets could produce cost efficiencies for funds; however, because

comprehensive cost data for mutual fund companies was not available, we were

unable to determine whether fund companies had experienced the type of

efficiencies that would have allowed them to reduce their fees. Our report also

showed that the fees charged by 77 of the largest mutual funds1

 had generally

declined but that not all had reduced their fees. Our report also discussed various

factors that are expected to ensure that mutual fund fees are set competitively. One

such factor was direct competition among mutual funds, which we found occurs

primarily on the basis of service and other fund characteristics rather than on price.

In addition, our report found that, although mutual fund companies make extensive

disclosures of the fees they charge, these disclosures do not include the specific

dollar amount of fees each investor paid. Finally, our report noted that funds' boards

of directors are tasked with overseeing the fees their funds charge but that opinions

as to the effectiveness of these directors' oversight were mixed.

Because of the limitations in the various factors that are relied on to produce price

competition among mutual funds, we recommended that investors receive additional

information to heighten their awareness and understanding of the fees they pay,

which could serve to spur additional price competition in the industry. Specifically,

our report recommended that SEC require that the account statements that are

provided to mutual fund investors on a quarterly basis include the dollar amount of

each investor's share of the operating expense fees deducted from their funds.

Because such calculations could be made in various ways, we also recommended that

SEC consider alternative means of making such disclosures, taking into account the

cost and burden on investors and the industry. One alternative means of disclosing

such information was by having mutual funds produce an estimate of an investor's

individual expenses using an average of the total value of fund shares owned

multiplied by the fund's expense ratio for the period covered by the account

statement. Alternatively, mutual funds could report to investors the dollar amount of

expenses paid by fund shareholders for preset investment amounts, such as $1,000,

which could be used by investors to estimate the amount of fees deducted from their

own mutual fund shares.

 1

 These 77 funds included all of the largest stock, bond, and hybrid funds in existence from 1990 to

1998. Specifically, this included the 41 stock funds with assets over $8 billion, 31 bond funds with

assets of $3 billion, and 5 hybrid funds with assets over $8 billion. Collectively, these 77 funds had

combined assets of $1,157 billion in 1998 and represented nearly 28 percent of the $4,177 billion in

total industry assets invested in these three types of funds.
Page 3 GAO-01-655R SEC's Report on Mutual Fund Fees

SEC Report Presents Similar Findings and Provides Additional Analyses of

Fund Fees

The SEC staff report's findings on the trend in mutual fund fees were generally

comparable to ours. Using data for all stock and bond mutual funds in existence at

the end of 7 selected years from 1979 to 1999, the staff's report finds that the average

asset-weighted expense ratio2 of these funds has increased from 0.73 percent in 1979

to 0.94 percent in 1999. However, the SEC staff attributed this increase generally to

funds' shift over time from charging loads, which are not included in the expense

ratio, to charging 12b-1 fees,3

 which are included in the ratio. Although finding that

fees had increased since the late 1970s, the SEC staff also found that the 1999

weighted average expense ratio of 0.94 percent represented a decline from its 1995

level of 0.99 percent. This was comparable to the finding in our report that the

average asset-weighted expense ratio of the top 46 largest stock funds,4

 which peaked

in 1994 at 0.81 percent, declined to 0.65 by 1998.

SEC's report also presented additional analyses on the level of fees across different

fund types and how fund characteristics affect fee levels. The SEC staff found that

various fund characteristics generally correlate with fund expense ratios, including

finding that older funds had lower ratios than newer funds5

 and that larger funds had

lower ratios than smaller funds. The staff's report also presented the results of an

econometric model that showed how various fund characteristics affect fund

expense ratios. Using this model, the SEC staff found that funds in families6

 with

more assets tended to have lower expense ratios than did funds in families with

fewer assets.

SEC also found that many large funds were already past the breakpoints in their fee

structures and, as a result, may not automatically reduce fees as the assets in these

funds grow. One way that mutual funds whose assets are growing can pass on costsaving economies7

 to their investors is by establishing breakpoints in their

management fee structure. Such breakpoints result in lower fees being charged as

total fund assets reach various predetermined levels.8

 However, after analyzing

information for the 100 largest funds from 1997, 1998, and 1999, the SEC staff found

 2

 The 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.

3

 Rule 12b-1 allows mutual funds to pay marketing and distribution expenses from fund assets. These

fees are used to compensate sales professionals and others for selling fund shares as well as for fund

advertising and promotion.

4

 These 46 funds included all of the largest stock funds in existence from 1990 to 1998, which

comprised all such stock funds with assets over $8 billion. Also included in the 46 funds were 5 hybrid

funds that also invest in bonds and other debt securities.

5

 However, SEC’s econometric model that attempted to identify the factors affecting funds’ expense

ratios found that as funds get older, their expense ratios increase. However, their report notes that

this result was largely attributed to four older funds with higher expense ratios than their peers.

6

 A fund family is a group of individual mutual funds that frequently includes one or more funds that

invest in stocks, bonds, money market instruments, or combinations thereof, managed by the same

firm.

7

 Such economies are operational efficiencies that arise as fund assets grow. For example, such an

economy occurs when a fund’s assets increase by 100 percent but the fund operator must increase its

staffing costs by only 10 percent to accommodate this growth.

8

 For example, a fund’s management fee could be 0.35 percent on assets up to $5 billion, 0.30 percent

on assets between $5 billion and 10 billion, and 0.27 percent on assets above $10 billion.
Page 4 GAO-01-655R SEC's Report on Mutual Fund Fees

that many of these funds' assets are already greater than the last breakpoints in their

fee structures. As a result, if the assets in these funds grow, their investors will not

receive further automatic fee reductions. This lack of breakpoints may result

because the funds have already achieved whatever economies of scale exist so that

fees may remain stable as assets grow. Alternatively, if economies of scale do exist,

the lack of breakpoints could be a symptom that competitive forces are not sufficient

to force funds to pass on savings to investors.

The SEC Staff Report Proposes Additional Fee Disclosure

The SEC staff's report included recommendations regarding after-tax returns, fund

governance, and 12b-1 fees. It also made a recommendation for additional fee

disclosure that responds to the recommendation in our report. In its report, the SEC

staff recommended that investors receive information showing standardized after-tax

mutual fund returns and, on January 18, 2001, the Commission approved rule

amendments requiring funds to provide such disclosures. SEC officials told us that

they viewed this as an important new disclosure because taxes affect investor returns

to a greater degree than do fees. In their report, the SEC staff also recommended

various changes to the fund governance provisions, including changes that would

likely increase the percentage of independent directors that must be part of a fund's

board of directors. The Commission approved these changes on January 2, 2001. The

SEC staff's report also recommends that the Commission consider reviewing the

requirements of the 12b-1 rule in light of changes in fund marketing and distribution

since the rule's adoption in 1980. We believe that these actions should help provide

important information to investors and could enhance oversight in the mutual fund

industry.

After considering the costs and benefits of the recommendation in our June 2000

report, the SEC staff's report recommends a variation of one of the alternatives we

discussed. In its report, the staff proposes that mutual fund investors be provided

with information on the dollar amount of fees paid using preset investment amounts.

In addition, the SEC staff proposed that this information be presented to investors in

the annual and semiannual reports prepared by mutual funds. Specifically, the SEC

staff proposed requiring funds' annual reports to present a table showing the cost in

dollars associated with an investment of a standardized amount (such as $10,000)

that earned the fund's actual return and incurred the fund's actual expenses paid

during the period. In addition, the SEC staff suggested that the Commission could

require that this table also present the cost in dollars, based on the fund's actual

expenses, of a standardized investment amount that earned a standardized return

(such as 5 percent). This would result in investors receiving additional information

regarding fees. However, the staff's proposed disclosures would not be specific to

each investor, nor would they be provided in the most relevant and frequent source

as our report recommended and, as a result, may be less likely to increase investor

awareness and improve price competition as effectively as the disclosures we

recommended.
Page 5 GAO-01-655R SEC's Report on Mutual Fund Fees

SEC Staff's Proposed Additional Fee Disclosure Will Not Provide Investors With

Account-Specific Information

The additional disclosures the SEC staff proposed should provide mutual fund

investors with more information about the expenses associated with owning mutual

fund shares in a form that will allow investors to compare fees across funds as they

can with the current information disclosed about fees. However, the proposed

disclosures will not provide investors with information showing, either precisely or

approximately, the dollar amount of the fees they paid on their own fund shares. It is

our view that receiving this account-specific fee information would be more likely to

increase investors' awareness of the fees they pay and could encourage them to

evaluate the relative value of the returns and service they receive from their mutual

funds. As noted in our June 2000 report, financial products and services that report

their charges directly in dollar terms to their users often have providers that attempt

to compete more explicitly on the basis of price. Examples of these include the

discount brokerage industry that developed to offer reduced charges for

commissions or banks that offer no-fee checking accounts. Such competition is not

totally absent from the mutual fund industry, as SEC officials noted that several lowfee mutual fund families receive a significant portion of the total of dollars invested in

mutual funds.

In its report, the SEC staff noted that placing dollar amounts of fees paid in investors'

account statements entails various administrative difficulties and additional costs to

the industry and ultimately to investors. In discussing their report with us, one of the

primary difficulties the SEC officials cited was that the quarterly statements are often

prepared by third-party broker-dealers and not the mutual funds themselves. In many

cases, only these broker-dealer firms maintain the account-specific information for

each investor. They said it would be difficult for each mutual fund to provide these

broker-dealers with fee information that could be used to determine the specific fee

paid by each investor. In a letter to SEC, a representative of a committee working

under the auspices of the Securities Industry Association listed the various steps

believed to be needed to implement our original recommendation. For example, the

letter noted that firms' systems would not only have to calculate the fee applicable to

each investor, but also allow such amounts to be recalculated if errors were

discovered in the expense information. The committee representative's letter also

stated that firms in the industry were concerned that the added complexity of

preparing statements with such fee information could result in firms' failing to mail

such statements to investors within the 5-day time period currently required.

Our report also discussed the costs of providing such information to investors.

Comprehensive data on the exact costs of fully implementing our recommendation

were not available. However, the preliminary estimates provided by industry

participants and presented in our report did not appear to be prohibitive.9

 In

discussing their report's recommendations with us, SEC officials acknowledged that

they were unable to assess whether the industry's estimates of the administrative

effort required to implement fee disclosure specific to each investor were realistic or

 9

 For example, we determined that the cost for one broker-dealer based on the total amounts its

officials estimated they would incur to produce such statements were less than a dollar per account

for initial development costs and less than a dollar per account each year thereafter.
Page 6 GAO-01-655R SEC's Report on Mutual Fund Fees

reasonable. In addition, because we recognized the possibility of such administrative

challenges and potential for additional costs, our report noted that mutual funds

could likely provide some information that would allow the fees specific to each

investor to be approximated rather than determined exactly. Such disclosures would

still serve to make investors more aware of the fees they paid.

The SEC staff also noted that the disclosures they are proposing will allow investors

to compare fees across funds because the information will be for comparable time

periods and a standardized dollar amount invested. In contrast, the staff said that

including specific dollar amounts in quarterly statements would generally not allow

investors to compare across funds because of likely differences in performance, type

of fund, holding periods, and the dollar amounts invested. However, for

comparability purposes, investors could use the useful fee information already

provided by the existing disclosures, which presents fees in terms of percentages of

funds' net asset value. In addition, any additional disclosures that present investors'

fees in dollar amounts could be accompanied by comparable disclosures showing

such fees in percentage terms, which would facilitate comparison across funds.

SEC's Proposed Additional Fee Disclosure May Not Be Provided to Investors in the

Most Relevant Source

Although the SEC staff's recommendation will improve fee disclosures, we believe

that it may be less effective in increasing investor awareness and spurring additional

price competition among funds because it would be provided to investors less

frequently and in reports that may receive less investor attention than account

statements. The SEC staff's report recommends that additional fee information be

included in funds' annual and semiannual reports rather than in investors' account

statements, which are provided at least quarterly. However, this less frequent

distribution will likely reduce the immediacy of the information to investors.

Furthermore, as part of conducting work on this letter, we contacted officials of three

industry research organizations to discuss the SEC staff's report and its

recommendations. These officials told us that investors generally pay more attention

to the quarterly statements than they do to other information pertaining to their

mutual fund investments, such as the annual and semiannual reports, because the

quarterly statements report the specific value of the investors' account. One of the

officials said that his firm's research has shown that, when investors receive

statements that specifically show the dollar amount of the fees they are charged for

other financial services, it generally triggers actions on the part of both the investor

and the financial institution. According to this official, investors receiving such

information frequently engage in discussions regarding the services they have

received in exchange for the fees paid. Similarly, financial institution representatives

tend to be more active in contacting the investors to review the activity in the

account and how progress is being made toward the investors' financial plans. He

said that the type of presentation that we have advocated would likely have this same

beneficial effect.

SEC officials explained that they are suggesting that this information be included in

the annual and semiannual reports because these documents contain more

information than the quarterly statements and thus will allow investors to better

understand the fee information in an appropriate context. Although the SEC staff's
Page 7 GAO-01-655R SEC's Report on Mutual Fund Fees

rationale has merit, its impact on investor awareness of fees may be reduced because

such disclosures will not be in the documents that investors likely pay most attention

to-the quarterly statements. The SEC staff could expand on its proposal, even

without providing account-specific fee information, by requiring that the brokerdealers that prepare investors' quarterly statements periodically include in them the

additional disclosures that the SEC staff's report recommends be included in funds'

annual and semiannual reports. In doing so, SEC would increase investors' general

awareness of the fees they paid.

In addition to their proposal for increased fee disclosure, the SEC staff's report

indicated that they intend to continue to assist investors in becoming more educated

about fees and to encourage the industry to be more active in this area as well. The

SEC officials we spoke with noted that any additional fee disclosures would have to

be accompanied by an extensive and ongoing investor education effort to ensure that

investors understand and make effective use of the new disclosures. One example

noted by the staff of their efforts to educate investors was the mutual fund cost

calculator found on the SEC Web site. The staff also pointed out that such

calculators have subsequently been added to the Web sites of several mutual fund

companies.

Agency Comments

We provided a draft of this letter to the Chairman, SEC. In his letter (reproduced in

the enclosure), the Director of SEC's Division of Investment Management noted that

both the SEC staff’s and GAO’s reports had concluded that mutual fund investors

could benefit from additional information about fees as a way of heightening investor

awareness and understanding of the fees and their effects. However, the SEC staff

disagreed with several aspects of our draft letter. First, the SEC staff took exception

to our statement that its proposal to include fund fee information in annual and

semiannual reports would not provide investors with either precise or approximate

dollar amounts of the fees paid on their mutual fund shares. We agree that the staff's

proposed disclosures, which would provide investors with the dollar amount of fees

that would have been paid on a $10,000 investment in the previous period, could be

used by investors to estimate the amount of fees they likely incurred on their own

shares. However, we believe that providing account-specific dollar amounts of fees

paid-either precisely or approximately calculated for investors-would be the most

effective means of increasing investor awareness of fees and of potentially increasing

price competition among funds. Short of that, we suggested that providing preset fee

disclosures as part of, or along with, the quarterly statements would allow investors

to calculate for themselves the fees they paid. Although the SEC staff's proposed

disclosures would also allow investors to estimate their fees, their proposal would

impose a larger burden on investors to collect and use two separate documents to

calculate the fees they paid.

The Director's letter also discusses the SEC staff's decision to recommend that the

additional fee disclosures be placed in funds' annual and semiannual shareholder

reports rather than the quarterly statements. Although they acknowledge that the

quarterly statements are an important source of information and are provided more

frequently, they state that the proposed fee disclosures are more appropriately placed

in the shareholder reports alongside the information about the fund's operating
Page 8 GAO-01-655R SEC's Report on Mutual Fund Fees

results and fund management's discussion of fund performance. This will allow, the

letter notes, investors to evaluate the costs they pay against the services they receive.

We agree that presenting investors with any new fee disclosures in a way that

explains the information and provides a context for evaluating it is most likely to

ensure that investors understand and appropriately use it, and our report noted that

explanatory and contextual information could also be provided in quarterly

statements. As previously stated, we believe that providing the fee information in

separate documents provided at different times from the account-specific

information places more burden on investors and may reduce its impact on

awareness and price competition.

Finally, the Director's letter indicates that implementing the original recommendation

in our June 2000 report could be costly. Noting that our report stated that the cost

could be "a few dollars or less per investor," the SEC staff calculated that this could

produce a cost of $480 million if providing such disclosures costs $2 for each of the

estimated 240 million investor accounts. As we have stated, our original report

acknowledged that SEC should attempt to balance the cost and burden on the

industry, the burden placed on investors to calculate and estimate the fees they are

charged, and the benefits of the additional information to investors. Although neither

we nor SEC developed definitive cost estimates, we recognize that the proposals that

would likely most benefit investors may be the most costly, and informed judgements

will be needed in making decisions about the trade-offs. The proposal advocated by

the SEC staff is probably the lowest cost option, but it may not provide as much

benefit as similarly low cost alternatives due to the placement in annual and

semiannual reports. Furthermore, we believe that factors in addition to

implementation costs are also important in determining the most appropriate

disclosures. For example, if providing account-specific fee information increases

investor awareness and encourages additional price competition in the industry, fees

for investors could be reduced overall.

Objectives, Scope, and Methodology

To complete our work, we analyzed the SEC staff's report and compared its findings

with those of our June 2000 report. To determine the rationale for SEC's

recommendations, we interviewed SEC officials. We also discussed SEC's report and

recommendation with selected industry research organization officials. We

conducted our work in Washington, D.C., from February to March 2001 in accordance

with generally accepted government auditing standards.

_______________

As agreed with you, unless you publicly release its contents earlier, we plan no

further distribution of this letter until 30 days from its issuance date. At that time, we

will send copies to the Honorable Laura S. Unger, Acting Chairman, SEC. We will

also make copies available to others upon request.
Page 9 GAO-01-655R SEC's Report on Mutual Fund Fees

If you have any further questions, please call me at (202) 512-8678 or Cody J. Goebel,

Assistant Director, at (202) 512-7329.

Sincerely yours,

Richard J. Hillman, Director

Financial Markets and

 Community Investment

Enclosure
Page 10 GAO-01-655R SEC's Report on Mutual Fund Fees

Enclosure Enclosure

Comments From the Securities and Exchange Commission
Page 11 GAO-01-655R SEC's Report on Mutual Fund Fees

Enclosure Enclosure
Page 12 GAO-01-655R SEC's Report on Mutual Fund Fees

Enclosure Enclosure

(250026)