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Just when I thought I had considered every risk to investing in mutual funds, here comes another. Remember how money-market funds compete by waiving part of their management fee? A money fund paying 5.5%, for example, decides to waive its 0.5% fee. With that saving, it's suddenly yielding 6% and showing up as an attractive choice in the newspaper
tables. Many money funds still do that, and there's no reason not to pocket the extra dough so long as you're quick to switch to a cheaper fund if the waiver is ever withdrawn.
Now, it turns out, a huge proportion of stock and bond funds are doing it, too. The trouble is, with a stock or bond fund, it's not so simple to sell out if the fund stops waiving fees. Unlike money-market funds, which aim to keep a stable $1 price, stock and bond funds can go up in value. That's the goal, of course, but gains do leave you liable to Uncle Sam for capital-gains taxes. On an $8,000 investment that grew over two years to $12,000, you could be liable for $800 in capital-gains tax, not a nice prospect if you want to sell a fund to escape higher fees after a waiver is revoked.
How widespread are fee waivers? The mutual-fund trackers at Lipper Inc. in Summit, N.J., report that 45% of all funds, including money-market, bond, and stock funds, waive at least part of their management fees. And among the 4,500 general-equity funds Lipper follows, 38% don't charge management fees. The average fee waiver amounts to 0.36% of assets.
MIND-NUMBING MYSTERIES.
The practice, moreover, seems to be on the rise among growing fund companies that are anxious to compete. TIAA-CREF, for one, waives 0.5% on each of its 10 funds, slashing by up to 65% the expenses fund holders pay.
Saving money is usually to the good, of course. But to me, fee waivers are sort of sneaky. Some fund companies like the waivers because, in effect, it allows them to boost their management fee later without having to ask shareholders for a vote of approval. What's more, these waivers often are hard to spot, if only for the mind-numbing mysteries of mutual-fund expenses.
As an example, check out the proposed terms of a deal by Edward J. Hennessy Inc. to take over management duties of the two O'Shaughnessy funds, Cornerstone Growth (OSCGX) and Cornerstone Value (OSCVX). These funds were set up in November, 1996, by James P. O'Shaughnessy, whose book What Works on Wall Street rode the best-seller lists the same year. Cornerstone Growth now costs investors 1.1% of assets annually. So, if you had $10,000 in the fund, you'd get charged $110 a year between the management fee, commissions, and other operating costs. At Cornerstone Value, this so-called "expense ratio" currently runs 1.7%. It's higher, in part, because fixed costs are spread over fewer assets.
DOLLARS IN THE DETAILS.
Now, O'Shaughnessy hopes on June 30 to win fundholder approval to sell Hennessy its contract to manage the funds. As part of the deal, Hennessy has agreed to keep the management fee the same as O'Shaughnessy's: 0.74% of assets. It also got him to cap the funds' total expenses -- that's the management fee plus operating costs -- at 2% of assets, even if that means having to waive part of his management fee.
All of that is good -- for now. The cap on expenses, however, would be mandatory for only two years. After that, if enough assets don't stay in the funds to spread out fixed costs, then their expense ratios could rise, and Hennessy would be under no obligation to keep waiving its management fee.
Something just like that is going on now with Hennessy's two current funds, Hennessy Balanced (HBFBX) and Hennessy Leveraged Dogs (HDOGX), which takes its name from the "Dogs of the Dow" strategy it follows. The balanced fund, with $23 million in assets, costs investors 1.6% of assets annually, including a 0.6% management fee. Yet the "Dow Dogs" fund, $5 million in size, costs fund holders just 1.2%. Why? In part because the 0.6% management fee is being waived. If it weren't, the fund's expense ratio would be at least 1.8% annually, plenty higher than the 1.4% average-expense ratio of a domestic equity fund in Morningstar's database.
Were the world a better place, no investor would have to pay a moment's attention to any of this detail. And with a money fund, which carries no capital-gains tax potential, you don't need to. But before buying your next stock or bond mutual fund, check in the prospectus to see if the fund's manager is waiving expenses. You can probably find a comparable fund with comparable fees -- without a waiver to worry you.
Barker covers personal finance in his weekly column, The Barker Portfolio, for Business Week from Melbourne Beach, Fla. And he appears every Friday on Business Week Online EDITED BY BETH BELTON
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