His proof? An obscure 2001 study in the University of Iowa Journal of Corporation Law. It concludes that investment advisory firms charge mutual funds -- which are often their own in-house funds -- twice what they charge outside pension funds for stock-picking services. If true, it means mutual-fund shareholders are forking out an extra $10 billion a year.WRESTLING MATCH. The Iowa study is now at the center of a wrestling match between Spitzer and the Investment Company Institute (ICI), the trade group for mutual-fund companies. On Jan. 6, the ICI disputed those figures. But cut through the mind-numbing statistical arguments, and it's clear how to settle this fight: The SEC must force mutual funds to reveal costs uniformly and clearly -- to spur competition and help confused investors.
The controversy began last fall, when Spitzer targeted fees in settlement discussions with fund companies. His most potent weapon: the findings of University of South Carolina law professor John P. Freeman and Florida State University finance professor Stewart L. Brown. They concluded that the average actively managed mutual fund investing in large-cap stocks paid 0.52% of fund assets for investment advice, vs. the 0.21% that pension funds paid for large-cap portfolio management. The gap arises, says Freeman, because most fund boards rubber-stamp the advisory fees. Why? The fund chairman is also usually chairman of the advisory firm that runs the fund.
On Jan. 6, the ICI shot back, charging that the authors ignored key differences between mutual funds and pension funds. Pension funds don't have to prepare prospectuses or shareholder reports. Nor must they keep track of the tax consequences of their trading for each individual account. And many managers bundle the costs of rent and computers into the fees they charge funds. For an "apples-to-apples" comparison, insists the ICI, look at the fees some funds pay subadvisers -- outside portfolio managers who specialize in specific sectors or strategies. Measured this way, mutual funds pay just 3 basis points more for stock-picking, ICI President Matthew P. Fink says.
Not so fast, says Spitzer. He says the ICI's rebuttal focuses on a sliver of the fund industry because only 10% to 20% of mutual funds use subadvisers, who must compete for business. "With respect to the vast majority of mutual-fund dollars under management, the fees being charged are exorbitant and not the result of an arm's-length negotiation," says Spitzer.SHELL-SHOCKED. The brouhaha helps make Spitzer's point: There's no way for average investors to know what they are paying for core advisory services. Currently, fund documents must reveal the management fee that shareholders pay as part of the overall expense ratio. But that fee may include costs such as rent and legal bills. At a time when shell-shocked investors are being told to shop carefully, they need to know what they're paying for stock-picking expertise to invest wisely.
The SEC has opposed Spitzer's quest to force fees down through settlements, arguing that the government shouldn't be setting fees and can use its rule-making authority to require more disclosure. The agency plans to shine a brighter light on hidden trading costs and "soft dollars," the rebates funds receive from brokers that execute their trades. But if the SEC is going to rely on disclosure, it must ensure uniform standards on how costs are revealed.
That means it must make funds unbundle the management fee. That way, investors can separate the funds with astute practices and smart asset managers from those that are wasteful or that hire mediocre portfolio managers. Only then can investors be smart shoppers. By Amy Borrus and Paula Dwyer