Bill Gross is Right: Mutual Funds are Too Expensive
PIMCO's Bill Gross is a rare commodity in the mutual fund industry. Yes, the bond fund manager's record at the helm of PIMCO Total Return, which has outpaced the Barclay's U.S. Aggregate Bond Index by nearly 0.5 percent since its 1997 inception, is reason enough for that distinction. But Gross might be even more noteworthy for his candor in an industry in which that trait is lacking. A fine example of that is on 
display in Gross's August 2009 Investment Outlook:
... [T]hose who sell investment "potions" must wrap their product with an extra large ribbon because history is not on their side. Common sense would dictate that the industry as a whole cannot outperform the market because they are the market, and long-term statistics revealing negative alpha for the class of active managers confirms it. Yet, what a price investors are willing to pay! A recent Barron's article pointed out that stock funds extract an average 99 basis points [0.99 percent] or virtually 1% a year in fees from an investor's portfolio. Bond managers are more benevolent (or less pretentious) at 75 basis points, and many money market funds manage to subsist at a miserly 38 [basis points].Hearing that mutual funds are too expensive isn't exactly earth-shattering, of course (Allan Roth recently wrote a great article describing just why mutual fund expenses are so important). But it's refreshing to read a successful mutual fund manager taking issue with the fees charged by his active manager brethren -- fees that, as Gross points out, cannot be justified by the promise of outperformance, simply because mutual fund managers as a group are bound to earn the returns of the market before costs.
Ironically, the A class shares of Gross' Total Return fund currently carry an expense ratio of 1.08 -- well above the 0.75 percent that he says the average bond fund charges. I suppose that Gross believes that a manager who's demonstrated the rare ability to add value over the long-term -- which he's clearly done -- deserves an above average fee for his services.
Despite the vast number of former high-flyers who were unable to sustain their performance -- Legg Mason Value Trust's Bill Miller being a recent example -- Gross's stance is at least more defensible than that of many of his colleagues, who charge above-average fees despite any track record that would indicate they're worthy of them. As long as Gross continues to outperform, his investors will be content to pay up for his services, and his employer, Allianz Global Investors, will be more than happy to capitalize on that fact.
That aside, Gross's larger point stands: mutual fund fees are high, and grossly disproportionate to the value added by fund managers. Even worse, while paying one percent or so in fees might seem insignificant in a market providing double-digit returns, those expenses are much more confiscatory in an era of more modest returns, which Gross foresees.
Consider the following. If equity returns average 10 percent annually over the coming decade, and bonds provide six percent, stock investors will, before fees, earn a very nice four percent "equity premium," healthy compensation for taking on the increased risk of stocks. Stock fund expenses of one percent would consume 25 percent of that premium, leaving investors with a more modest -- if still rewarding -- premium of three percent.
But what if Gross and others are correct, and we're in for a continuing stretch of lower returns?
If equity returns over the coming decade average only five percent, and bond returns are four percent, stocks will provide a very slim one percent premium over fixed income before costs. But that one percent expense ratio would totally consume that premium, leaving stock investors with bond-like returns in exchange for assuming equity risk. All of a sudden, those seemingly "modest" expenses take on a whole new dimension.
Yes, expenses matter in all environments. But their importance is enhanced in periods of below-average returns. Everyone in the industry -- from Bill Gross to the most anonymous fund manager at the smallest mutual fund -- recognizes the truth of this elementary math. Unlike Gross, however, most keep quiet about it, lest investors wise up.