Fund Trustees Helpless As Advisors Raise Fees

• By Max Rottersman
• On 11:50 am EDT, Friday March 20, 2009

HANOVER, NH (ETFguide.com) - Mutual fund advisors are paid a percentage of assets.  With the market's decline, advisory fees have dropped proportionally.  While the amount shareholders pay has dropped, their fee as a percentage of assets is rising.  In other words, many shareholders are shouldering more of the bear market's burden than their fund managers.

In fact, if the stock market doesn't rise, advisory fees paid to the managers will increase by $154 million, more than they would have otherwise been, due to the increase in effective advisory fees.  In addition, many advisors are looking to reduce or eliminate their fee waivers, which further raise costs to shareholders.

Yet, odd as it sounds, voluntary fee waivers can be exploited to raise fees.

A goal of mutual fund management is to raise fees (remember, they're in the business to make a profit) without the board explicitly having to approve it.  This can be accomplished through a fee waiver, or expense cap, initially sold to the board as a way to limit the expenses shareholders pay.  The manager would say, 'even though our advisory fee is 1% and our operational expenses are expected to be 0.50%, we'll put in place an expense cap at 1.25% to make the fund more marketable.  Whatever the expenses come in at, we'll reimburse enough to keep the expense ratio at 1.25%.' 

Here's a table that shows that hypothetical fund's basic expense structure, and how the reimbursement (or rebate) changes as the fund moves from a bull market, to bear market environment.

In the first section, the operational expenses come in as expected, at 0.50%, so the advisor pays an expense reimbursement (rebate) of 0.25% back to the shareholders, bringing the total expense ratio down to 1.25%.  Their advisory fee nets out at 0.75%.

When a fund enters a bear market, look at 'Bear Market Today', expenses generally rise.  Shareholders call into the fund looking for a little hand-holding.  They transfer money between accounts.  They get active; this drives up operational costs from 0.50% to 0.75%.   This means that the advisor now has to reimburse 0.50% to meet the expense cap of 1.25%.  This brings the advisor's net fee down from 0.75% to 0.50%. 

The manager wants, at minimum, to keep their net fee the same.  This is where the expense cap can work against the shareholder. 

The manager tells the board that it isn't their fault that operational fees have spiked. Consultants advise that the voluntary expense cap will need to be removed, or raised, so the advisor's profitability isn't threatened by making such large reimbursements.  Expenses will go up to 1.5%, but that's what shareholders would have paid in the beginning without the expense cap.   The shareholders, it is argued, aren't getting a bad deal now, they were just getting a good deal before (but now have to pay their fair share).

The board isn't raising fees, some consultants might argue, it's just providing relief to the advisor who can't be blamed for the bear market.  Makes sense, right?  But only if you accept the logic of expense caps in the first place.

The advisory fee never should have been 1%.  The board should have negotiated 0.75%.  Most advisors would explain that voluntary expense caps, or waivers, are put in place to attract assets, to make the fund more competitive.  But if that's the case, isn't a voluntary waiver, which can be canceled at any time, underhanded?  Advisors know investors don't read the fine-print.  Why should a long-term shareholder ever get their fees increased? 

A Board should always pay the lowest advisory fee possible for the expected services rendered.  That's their job, to represent the fiduciary and financial interests of the shareholders.  Why should the fund need to ask, or expect, voluntary and often temporary favors from the advisor? The operational fees are what they are, and here again, the board should negotiate the best deal.  Instead of reducing fees, expense caps have the opposite effect, where advisors can pretend that they're reducing them when times are good, but can raise them when no one is looking.

Now, back to the advisory fee breakpoint schedule.  After the Gartenberg case, most large funds instituted breakpoints in their advisory fees.   A breakpoint is the asset level at which the advisor lowers its fee.  Again, breakpoints look like a good deal for shareholders.  They lower fees as the fund grows.  The problem is that though they lower the fees during bull markets they raise them in bear markets (even if the fund performs poorly).

In analyzing my fund fees database of 1,594 funds with breakpoints I found the following average breakpoints.  Again, these are averages; few funds have the same schedules. 

The calculations are tedious, but the net effect is that when the assets fall lower, breakpoints create higher fees.  This will probably total $154 million in 2009.  Because breakpoints are contractual, the Boards have no control over this fact. 

American Funds Washington Mutual (Nasdaq: AWSHX - News) is a good example of of how a combination of a discontinued waiver and breakpoints will leave shareholders poorer.  From 2005 until December, 2008, Capital research rebated 10% of its advisory fee.  They also waived 10% of their 'business management' fee.  The most recent supplement says, 'The waiver was discontinued effective January 1, 2009.'  The board doesn't explain why the waiver has been canceled.  Nor is there any indication that the financial planners and 401(k) sponsors who invest in American Funds, on behalf of their clients, has performed their fiduciary duty in questioning why the waiver was never converted to a permanent reduction in fees.

 

In the above table the yellow bars represent the assets of the fund in both August, 2008 of last year, and the end of February this year.  As the fund's asset have decreased, the breakpoints have boosted the effective advisory fee/management fee ratio from 0.28% of assets to 0.30% of assets.  If assets remain the same the managers of American Funds will collect an additional $7.6 million than they would have when the effective fee ratio was 0.28%. 

In 2008 shareholders received reimbursements of $21.8 million.  In the above scenario, shareholders would have received a rebate of $10.6 million.  Instead, with the elimination of the waiver, shareholders will pay a total of  $117 million, or 0.34% of assets on $34 billion in assets.

Voluntary waivers and breakpoints strain the fiduciary duty between a Board and its shareholders because if assets fall in a fund with breakpoints and/or such waivers, the net fee rate will probably rise; this may not be transparent at the time of purchase if the buyer relies on widely published historic expense ratios.  (Of course, fund counsel will point to the fine-print in the prospectus of supplemental information).

Many shareholders are put into funds that are picked by their 401k plan administrator. Should a company want to move out of a fund family in protest, after an expense cap was eliminated, it may face onerous moving costs.  These issues have not been adequately addressed by regulators.  It now appears the Supreme Court may end up clarifying the role of fund trustees in the advisor contract renewal process; it is much needed

American Funds is not alone.  Here are a few other funds with breakpoints and large potential net fee rate increases: Davis New York Venture Fund (Nasdaq: NYVTX - News),  $6.5 million;  Franklin Income (Nasdaq: FKINX - News), $5.4 milion; Vanguard PRIMECAP, $2.65 million, Oakmark Equity and Income (Nasdaq: OAKBX - News), $2 million; Templeton Growth (Nasdaq: TEPLX - News), $1.8 million; Longleaf Partners International (Nasdaq: LLINX - News), $1.7 million and lastly, an ETF, the iShares MSCI Emerging Markets (NYSEarca: EEM - News) $1.6 million. The list goes on and on.

Let me just close by saying that American Funds has appeared often in my past few columns. Partly this is due to their size and the rest is coincidence. These issues are common across the industry. 

Max Rottersman is a principal of Hanover Technology Group, LLC. His opinions don't necessarily represent the views of ETFguide.com or Yahoo Finance.

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