Mr. Gardner Goes to Washington
September 29, 1998
On Tuesday morning, Fool co-founder David Gardner testified before the U.S. House Commerce Subcommittee on Finance and Hazardous Materials, which was holding an oversight hearing on mutual fund fees and price competition. Below is his written statement.
Statement of David Gardner, Co-Founder of The Motley Fool, Inc., to the U.S. House of Representatives Committee on Commerce, Subcommittee on Finance and Hazardous Materials, September 29, 1998.
Mr. Chairman, I'd like to thank you and the other members of the subcommittee for allowing me to appear here today. In 1994, my brother Tom and I started The Motley Fool, a free online financial information and education service. Today our company employs 110 people, all charged with the same mission: to inform, to amuse, and to enrich individual investors. Our site can be found on the Internet and America Online. In the years since we started our online service we've also branched out into other media. We've written several books, we have a weekly newspaper column, and a nationally syndicated radio show. In short, Foolishness is spreading and we hope it continues.
I have been invited to talk about mutual funds, the fees they charge, the importance of those fees to investors, the extent of price competition among mutual funds, and investors' awareness of the fees they pay. It is hard to have price competition when customers aren't aware of prices. When you buy a box of cookies, you know what the price is. It's stamped on the box, or posted on the shelf below it, and it's easy to understand. When you buy a refrigerator, you know the price, and there is usually a sign on it telling you your expected energy costs. When you go to a restaurant, the menu tells you the price of your meal, and it's not that hard to calculate taxes and tips. Even gas stations' signs are simple and visible from the road, so drivers know what they're paying and can easily take price into their considerations, and we have price competition in the food, appliance, restaurant, and gas markets.
Studies, however, show that consumers haven't been considering price when they buy mutual funds. Yet expenses, as I'll discuss shortly, can have a significant impact on fund returns. People do not know what they're paying, and they don't seem to care. The listing of cost and performance by a mutual fund should be as easy to find and understand as the price tag on a box of cookies, and investors should know, or be encouraged, to look for it. Full disclosure in plain English will place reward and opportunity back into the hands of the investor. Of course, if too many people understood what they were paying and paying for, fewer of them might be in mutual funds in the first place.
I. The Magnitude of Mutual Funds
At The Motley Fool, we have not been advocates for the mutual fund industry. As Lipper Analytical Services has demonstrated, the vast majority (94%, as of the most recent 5-year survey) of managed mutual funds have historically underperformed the stock market as a whole, making inexpensive index funds, which attempt to mirror the performance of such market indexes as the S&P 500, a more lucrative investment. It seems strange to us that so many investors are willing to pay the higher fees of managed mutual funds when they can do better with the cheaper index funds, and even better by managing their money for themselves. If mutual funds are wise, we think it's better to be a Fool. We've been saying that since 1994.
Despite everything we've said, though, the American people have continued to pour their money into mutual funds. Last year approximately $378 billion of new money flowed into funds, bringing their holdings to more than $5 trillion dollars. U.S. households owned 78% of fund assets, and about 66.5 million individuals, belonging to 37.4 million households, had investments in mutual funds. About 37% of US households owned funds, and the typical household put nearly two thirds of its investment assets into mutual funds. People in all socio-economic sectors own funds - even 11% of households earning less than $25,000 per year own funds. About one third of fund assets are in retirement accounts, such as IRAs and 401(k)s. This inflow has continued, apparently unaffected by mutual fund fees.
The spread of mutual fund investing has, overall, been good for investors and for America. Investing gives people a stake in American business, and it has historically provided better returns for investors then have savings in banks or in mattresses. Although savings rates have remained low, the growth of investments should supplement (if not replace, but that's another hearing) Social Security and make it easier for people to retire in comfort. For that reason, it is imperative that this Committee concern itself with issues, such as fees, that may endanger investors' returns.
II. Mutual Fund Fees are High, Even When They're Low
Most fees are charged as a percent of funds under management. For example, one hypothetical fund, "The Diversified Wise Growth Fund" (DWGF), might charge 2% of assets, while another, "The Prudent Century Value Fund" (PCVF), might charge 1%. If you do the math, on a $10,000 investment, then, the more expensive DWGF would take $200; the cheaper PCVF would charge $100. That's a significant difference, but it's only part of the story. The fund collects these fees every year, whatever its performance.
The power of compounding, which makes long term investing so lucrative, also magnifies the effect of mutual fund fees. Assuming an annual return of 12%, which is not historically unreasonable (although higher than many funds), the initial investment in the DWGF would become $174,000 in 30 years. Not bad. But the cheaper DWGF, with identical performance, would grow to $229,000. That little 1% difference cost the investor more than $50,000, or more than 30%.
It's not very hard to make the argument that mutual fund fees are too high. It's certainly not obvious that investors are getting value for their fees. It would be one thing if the most expensive funds gave the best returns. (Even Fools will pay money for value.) But, perversely, it appears that the higher the expenses, the lower the returns. According to a recent study by CDA/Wiesenberger Inc., a sample of funds that charged expenses of between 0.51% and 0.99% had annual returns over the past three years averaging 21.13%, while the funds that charged between 1.50% and 1.99% had returns averaging 18.68%. Over thirty years, an average fund in the first range might return twice as much as one in the more expensive range.
You'd think that investors would move their money from these expensive funds to less expensive ones (not to mention managing their money for themselves). Index funds, as I've said before, are much cheaper than managed funds, and they outperform 94% of them. Vanguard's Index 500, for example, had an expense ratio of .17% last year, and it has returned 21.63% annually over the last three years and 18.09% over the last five, and even some funds that have outperformed the market as a whole have expense ratios under 1%.
Price competition does not seem to be a major factor, though. As Barry Barbash, the Director of the SEC's Division of Investment Management, has noted, many individual investors may do more comparison shopping for their VCRs than they do for their mutual funds. And a survey by the Investment Company Institute in 1996 found that fees and expenses were investors' fifth priority when they made their fund purchases.
III. How Much is That Fund in the Window?
One reason that investors probably don't take price into their mutual fund decisions is that mutual fund costs are confusing. The several distinct expenses associated with funds affect investment returns in different ways, and investors may not understand how those costs will affect them. First there is the sales fee, or "load." Loads may be payable at the time of the investment, or when the investor exits from the fund. Loads can confuse the investor because they are traditionally not included in published calculations of fund returns. For example, an investor may invest $5,000 dollars in a fund with a 5% load, then be disappointed to discover that (making the unreasonable assumption that there will be no other fees or expenses) the fund must return more than 5.25% just for him to break even.
Many funds, of course, have no load. But these funds do charge a second type of fee that goes toward the fund's operation, including payments made to the fund manager and administrative expenses. When (or if) investors think about fund fees, this is probably what they're thinking about, and these fees are included in the "expense ratio" of the fund. No-load funds may charge higher management fees than their load counterparts, but they also may not.
Third, funds may levy sneaky 12b-1 fees to pay for advertising, marketing, and distribution. This fee, which ranges from .25% to 1.00% was actually supposed to help investors, under the theory that if fund companies could attract more investors and money, then shareholders would have to pay lower per-share operating costs and a lower expense ratio. That argument was particularly interesting to Smart Money, which noted last month that the Putnam New Opportunities Fund was charging its Class B shareholders a .25% 12b-1 marketing fee for a fund that had been closed to new investors for over a year. In other words, the investors were paying Putnam $20 million per year to sell their fund to nobody.
Fourth, the brokerage costs that the fund incurs when it buys and sells securities may reduce fund returns. The more the fund manager trades, the higher the costs will be; the costs can really mount as a fund turns over its portfolio at a rate as high as 200% a year. These costs come right out of the fund's assets and thus reduce returns, but they are not included in the published expense ratios. Furthermore, this frenzy of buying and selling may generate taxable capital gains, which also reduce the individual's ultimate returns.
IV. Improving Knowledge and Wisdom
Confusing though it might be, price information is published in fund prospectuses, although the tax and brokerage fees may not be readily visible to a reader and may be hard to predict. At the same time, though, it is pretty obvious that mutual fund investors just do not know what they are paying. The Office of the Comptroller of the Currency and the SEC found in 1996 that more than 80% of investors did not know how much their funds charge. That figure is very troubling.
Many mutual fund buyers are not sophisticated investors. They invest in funds because funds are available through their 401(k) plan at work (which may have hidden fees, too), because funds seem safer and easier than individual stocks, because they have been told that funds are the best way to diversify, because brokers or investment advisers have talked them into it, or because of advertising. They don't want to do a lot of homework, and they may not know what they're getting into. A prospectus, even a simplified one, may intimidate them, and they probably don't read them carefully, if at all. If it's too hard for them to figure out what prices are, then they are not being well served. If that's the case, then we all need to work harder to ensure that price information is comprehensible.
The shockingly low level of financial literacy in this country complicates people's confusion. We enjoy tremendous economic freedoms, and we are each responsible for our own financial decisions. At the same time, our schools offer virtually no training in money management or investing. Most schools don't even teach students how to balance their checkbooks, let alone handle debt or plan for retirement. The mutual fund companies may benefit from such ignorance, but one of the tasks of The Motley Fool is to combat it. That is also a task that this Committee, along with the SEC and state and local governments, should strive to accomplish.
I'm honored to be speaking in front of this Committee, of course, but I'm even more excited to be living during and participating in the ongoing Information Revolution, whereby tremendous amounts of information that once was available only to powerful people at big institutions is now available to anyone who has a computer and the $20 per month necessary to connect to the Internet. At the same time, though, this great information is useless unless it is in comprehensible form and the people who get the information have the understanding to use it. The mission of The Motley Fool is to help people obtain, understand, and use this information. I hope the Committee, the mutual fund industry, and the SEC will promote, or continue to promote, these goals.
Mr. Chairman, thank you again for allowing me to address this Committee. I'm now happy to answer any questions you and the Committee may have.