Mutual Fund Supermarkets Charge 40 Basis Points?

In a recent Wall Street Journal Op-Ed article by Vanguard founder Jack Bogle, he reaffirmed studies like the one from Morningstar showing that one of the strongest predictors of mutual fund performance is how low their annual expense ratios are. In addition, he shared data that fees on actively-managed funds continue to rise despite increasing asset sizes:

Conclusion: The huge economies of scale available in managing other people’s money have largely been arrogated by fund managers to their own benefit rather than to the benefit of fund shareholders.

In a letter to the Editor, Neil Hennessy, president and chief executive of fund manager Hennessy Advisors Inc. shot back, listing his own reasons for keeping his fund fees north of 1% (100 basis points) annually.

For one of our typical funds, federal and state registration fees have increased 44%, legal fees have increased 73%, and audit fees have increased 30%. [...] Also, while no-transaction fee platforms didn’t exist in the 1960s, today funds pay as much as 40 basis points to be on the platforms offered by the likes of The Charles Schwab Corp. and Fidelity Investments.

According to this Investment News article, other mutual fund managers also feel this way.

His grievances are shared by many in the fund industry, said Don Phillips, a managing director at Morningstar.

“I think a lot of people would be afraid to do what Neil did and that is to out the distributors,” he said. “The asset managers are taking all the blame for high fund expenses, while the distributors are completely off the radar.”

I thought this was an interesting debate. I had no idea it cost that much for smaller mutual funds to get the accessibility of being part of a mutual fund “supermarket” like Schwab or Fidelity. However, that cost does allow investors to buy the funds with no transaction fee (NTF) at these places, which no doubt encourages more activity. In the long run though, 40 basis points is a huge ongoing drag. Here is an old 2004 Forbes article I found on fund supermarkets that also confirms the 35-40 basis point number.

I logged into Fidelity and found that all 10 non-institutional Hennessy retail funds were on the Fidelity NTF list. However, their expense ratios were also in the 1.30% to 1.70% range – well above average even for active funds. Hennessy isn’t exactly doing all they can to save money for the investor.

It would be nice if smaller mutual funds had a more open marketplace to distribute themselves, since it would seem a huge percent of their cost is just marketing. Of course, that’s also true for a lot of other things we buy, from breakfast cereal to basketball shoes. At the very least, an investor should always try to buy direct from the fund provider whenever possible.

In the end, I’m happy that I can buy most of my mutual funds “wholesale” from Vanguard with their at-cost philosophy, along with some “loss-leader” index funds from Fidelity. Shop smart! :)

Hat tip to Barry Barnitz of Bogleheads.

Comments

  1. I never understood how Bogle and others would rail against expense fee differences of .4 to 1% and then say stay fully invested while a bear market drops 30-60%. I would worry about avoiding one of those, vs a .4% difference (even if its annual).

  2. Thad, over time, stock gains are positive, after all they represent real companies and real profits.

    But if you are paying 1% per year over an investing lifetime of 50 years, that’s 50% of your lifetime’s wealth that you’ve given away to investment managers. Think about how angry people are about giving 25% or 38% of their income to Uncle Sam. Why would you then voluntarily give up 50% of what’s left to someone else when you could keep it for yourself?

  3. Good post.

  4. @Chuck:

    1% per year over 50 years is not 50% of your lifetime’s wealth, it is 1% of the value of your account per year for 50 years. Of course the money you give up this way is significant, but not near as significant as half of your lifetime wealth.

  5. I’m going to guess that 0.4% fee from the distributors is based on his fund and his company. In other words I doubt Fidelity and Schwab are charging everyone 0.4% to list their funds on their sites. Maybe they’re charging him a flat fee that works out to 0.4% for his size but would be 0.001% for a much larger company. I’m just guessing here.

  6. While this is a valid concern, buying through a fund supermarket like fido or schwab is generally not more expensive than buying directly from the fund company in my experience. Generally, unless it’s thru a 401k or similar, you are still buying a retail version of the fund rather than an institutional version even if you buy direct. Does anyone dispute this? Am I mistaken?

  7. @Mark – The problem is that this model hurts all fund investors, whether they use the fund supermarket or not, since they have pay so much to distributors to be on the preferred NTF list. The resulting higher expense ratio applies to everyone. But yes, if you do still want to buy the fund, I would just use a supermarket for simplicity.

    For example Bridgeway is available at Fidelity but not NTF – I have to pay a whopping $75 per trade. However, if I buy direct at Bridgeway.com’s brokerage system, I don’t pay an trade commissions. The resulting savings can (ideally) be passed onto investors.

  8. @Frank -

    1% times 50 is not precise, and I didn’t mean for it to be. It’s an estimate. (Of course it can’t be 50% because the potential balance is declining due to the fee! (1 – 0.01) ^ 50 = 0.605 or 60.5%.) Precision is not the point. It’s the order of magnitude that matters, and it’s on the order of half.

    But do the math. Contribute $10,000 per year (makes the math more confusing, and less bad for the fee, but more realistic so let’s see what happens) to a fund earning 5%, for 50 years. You end up with 2,318,561.65. Subtract 1% of the account value each year, and you end up with 1,634,749.64. 30% of your lifetime’s wealth is GONE. For what? Does it matter if you give $1200K (50%) or $700K (30%) to your mutual fund manager? (When other other choice is zero??) What could you have done with $700,000 for yourself? Or your family? Or for charity?

    If you invest a lump sum, you lose 40% to fees. (Also, 40% of the $10,000 that was invested in the first year was lost to fees.) Obviously, because (1- 0.605 ~ 40%) as in the first paragraph.

    People say 1% isn’t much so what’s the big deal? It’s a huge deal because that 1% is relentless. And saying it’s “not near as significant as half” is nuts. It’s very much near as significant as half. And nowhere near 1%.

  9. You’re giving contradictory advice:
    “an investor should always try to buy direct from the fund provider whenever possible”
    “I would just use a supermarket for simplicity.”
    but as you said, “The resulting higher expense ratio applies to everyone. ” so either option really makes no difference since no fund is going to pull out of a supermarket platform, they’ll be paying the platform fees whether we buy direct or platform

  10. @meg – Hmm… you’re right. I should clarify.

    The main point is that I haven’t found any fund that is part of a mutual fund supermarket NTF program that I actually want to invest in. Probably because they are too expensive for the above reasons. The best fund also don’t need the extra publicity. Dodge & Cox, Bridgeway, Vanguard, Longleaf Partners, Hussman – any fund that I even had a mild interest is not NTF at Fidelity. Many of these you can buy direct, so I would do that instead.

    *If* I for some reason wanted to invest in a Janus fund or something, then I would just use the fund supermarket. I should get something back for those higher fees right? In this the little something back would be simplicity, convenience, and no transaction fees.

  11. @Chuck – I agree, 1% is a very big deal. Much bigger than most investors realize. Especially if we are entering a period of low inflation and low returns. Giving away 1% of a 6% return is so much worse than 1% of a 10% return.

  12. corntrollio says:

    I believe Bridgeway is NTF at E*Trade. It really depends on what supermarket you have an account with.

    People often don’t understand how fees work and how much they can truly cost you over the aggregate. The problem is that these fees are compounded over many years, and you can almost treat it as a compounded negative interest rate.

    There are even some 401(k) plans I’ve looked at where you would be better of investing the money in a taxable account because none of the choices had a fee lower than 1.5-2% and certainly none of the choices were index funds. I imagine the employer was likely getting kickbacks from the broker managing the plan, and if the employees had sued the employer for violating its fiduciary duties, they probably would have won. In this case, the company managing the plan was one of the investment banksters that no longer exists independently.

  13. If Bridgeway is not at the big 3 – Fidelity, Schwab, and TD Ameritrade which all charge around 40 basis points, I can only guess that E-Trade is significantly cheaper somehow.

    Agreed on some of the incredibly horrible 401k plan options out there.

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