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Serving Two Masters Can Cost Investors Plenty
ohn Bogle, chairman of the well known Vanguard Group mutual fund company, recently announced a disturbing finding: "There are some 30 million fund shareholders out there, faceless and voiceless, entranced by receiving the magnificent blessing of the bull market without realizing that they have earned far less than their fair share. They deserve better from the directors they have elected to represent them and to protect their interests." (Bloomberg Personal, 12/97).
Bogle joins several critics of excessive mutual fund expenses that you, as fund investors, pay to a fund's investment management company (that picks the stocks), and for fund marketing (to attract other investors), operations and services.
The problem is acute. According to Bogle, the expense ratio of the average equity fund has risen from 1 percent to 1.55 percent in the past 15 years, at the same time that assets invested in funds have risen 55 fold. In other words, fund expenses have risen from $300 million to $23 billion. Quite simply, it has not become 55 times more difficult or expensive to pick stocks.
Sky high expenses are charged to investors at the same time that investment management is enormously profitable as a business. Bogle states that many fund managers now are booking pretax profit margins of 35% to 40% and, if one excludes marketing expenses, that pretax profit jumps to 50% to 60%!
Who is responsible for this? As with publicly owned corporations in general, mutual funds have officers and directors in place to serve the interests of shareholders. However, according to Bogle, the problem with mutual funds is that they serve two masters, not one. The second master is the fund's investment management company.
Unfortunately, the balance of interests tilts away from the investors and toward the second master, the investment management company. Why? Bogle cites four reasons. First, look at who is in charge. The chairman of the board of directors usually is the chairman and CEO of the management company. One of every three or four fund directors typically is a senior officer and principal owner of the investment management company. And it is not unusual for the investment management company to approve most, if not all, of the fund's board members, according to Bogle.
Second, Bogle states that fees paid to fund directors considered to be independent are substantial and so far above fees ordinarily paid to corporate directors that "serious questions arise about the existence of some subtle quid pro quo". The ten highest paying Fortune 500 companies pay an average of $78,000 per year. By comparison, the ten highest paying mutual funds pay their directors $150,000 per year.
Third, most mutual fund directors ordinarily own only nominal shares in the mutual funds that they govern, according to Bogle. As a result, their interests are not aligned with the shareholders' interests.
Those factors give the investment management company de facto control over the mutual fund, Bogle opines. But the fourth and final factor is the clincher. In addition to picking the stocks, the management company typically also provides "virtually every service necessary to the fund". Bogle cites fund administration, portfolio management and distribution.
Why should investors care that no one is watching their cash register? Bogle suggests that this breach of duty explains why only 28 of 262 professionally managed mutual funds have beaten the S&P 500 stock index over the last 15 years. He states that the "principal reason for these consistent shortfalls is the drag of fund expenses".
To be fair, some funds may need to charge above average expenses to their investors. For example, these may be funds that have little money under management (say less than $50 million), or focus upon micro/small capitalization stocks (looking for the overlooked needle in the haystack), or principally pick emerging market/international stocks.
However, plain vanilla, large or medium capitalization domestic stock funds are a different story. Investors, money managers, retirement plan sponsors and trustees ought to avoid these kinds of funds if they have above average expense ratios, unless they have above average returns possibly worth the premium.
What large/medium cap equity funds underperform their peers but, nonetheless, charge investors expenses well above average? To answer that question, we conducted several searches of our advanced analytical database. We found numerous funds. Below are some of the more well known funds to avoid:
AIM Blue Chip B;
Alger Growth B;
Hancock Growth B;
Jundt Growth 1;
Kemper Growth B;
Merrill Lynch Fundamental Growth B;
New England Capital Growth B;
Phoenix-Engermann Growth B; and
State Street Research Capital B.
Bogle notes that Congress is considering reforms. Meanwhile, mutual fund directors would be wise to comply with their fiduciary obligations. They should start by serving their only true master, the fund investors, in minding their cash register.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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