The fund industry doesn't have a pricing crisis yet. But if it doesn't take some action, it will. Over the past several years, individual firms have taken a few stabs at creating more consumer-friendly pricing — slashing 12b-1 fees on certain shares classes, for example, or implementing performance fees. But the effort has been far too spotty to stave off the real threat of unwelcome (and quite possibly counterproductive) regulatory intervention.
Despite all-in price declines in some areas (according to Morningstar, average mutual fund expense ratios are down about 10 basis points since 2002), investors and regulators are scrutinizing the value of individual price components, and measuring them against the real value-add asset managers and financial advisors provide. Recent agitation over 12b-1 fees (SEC Chairman Christopher Cox calling them “loads in drag,” for example), and similar concerns about 401(k) fee disclosure are case in point.
What's needed is an industrywide approach that proactively drives change, and generates some headlines along the way. So what might an industry to-do list of potential reforms include? How about eliminating or adding waivers to loads, reducing front-end fees on closed-end funds and adding performance fees for most managers?
First, a look at loads. Open-end fund loads are practically an anachronism. Already most A-share trades are load-waived (according to Strategic Insight, it's up to 85 percent or more). B shares are clearly out of favor and have limited use, but are still hanging around, and C shares' level-load model competes with fees on advisory accounts.
In an interesting development, some fund firms have recently found that by adding a waiver to a prospectus to allow broker/dealers to waive A-share loads on load platforms, they can allow direct investors to access load funds on a no-load basis. The major direct investor platforms (including Fidelity, Schwab, Etrade and Scottrade) are open to this, although most are struggling with implementation issues.
Given that the vast majority of fund sales outside of defined contribution plans (82 percent, according to the ICI) are advisor-directed, and most of those flows are load-waived, most advisors, we deduce, are not making a living on A-share loads. This creates a terrific opportunity — and I can see operations executives all over the industry shuddering here — to simply eliminate the A-share model entirely. Morningstar has perhaps anticipated this new world order with its decision several years ago to evaluate the results of load-waived A-shares as a separate class. Certainly, eliminating A-shares would hurt the minority of advisors still selling front-end load shares, but we could accommodate them by phasing the shares out entirely over time.
Pricing on closed-end funds offers another potential opportunity. Today, all closed-end fund investors who buy at the initial public offering (IPO) pay for all of the fund's underwriting expenses and other up-front fees, which usually come to 4.5 percent of the share price. Investors who buy in the secondary market pay only a transaction fee ($9.99 with TD Ameritrade, for example) to purchase the security. So, it's the same security, but depending on when you buy it, it has two different pricing structures. From a product management perspective, closed-end funds are a great way to more flexibly and effectively manage money; you have a pool of assets you can count on. So why not pay the distribution expenses out of ongoing management fees and expenses instead? This approach would certainly be more appealing to fee-sensitive investors, who balk at paying large front-end fees, and could help generate more investment in closed-end funds.
And finally, let me advocate for a cause I really believe in: performance-based management fees. Managers like Fidelity and Janus, as well as Wachovia's Evergreen Investments, have implemented performance fees, aligning their interests with those of shareholders. But most mutual fund families don't use them, citing operational constraints, difficulties in calculating the fees and potential investor confusion. Of course, it seems to work just fine for hedge funds. Many privately offered investment products have performance fees as well. While this approach is tough to use for strategies where performance can vary widely from a benchmark, performance fees are well-suited to funds that are designed to deliver performance within a range of predictable outcomes.
So whether it is the list of initiatives I have outlined here or some other creative ideas, let's consider getting proactive — before others get proactive for us.