The Mutual Fund Industry vs. Mutual Fund Investors, Part One

November 2, 2009 is D-Day for mutual fund investors. That's the day that the U.S. Supreme Court is scheduled to hear arguments in the Jones v. Harris Associates case. I've written about the case before, and I'm planning on revisiting it again as the date draws closer, but before I do that, I'd like to take a look at the amicus brief filed in support of Harris Associates by the Investment Company Institute (ICI). I'm not a lawyer, but it's a fascinating brief, if only because it provides investors an opportunity to see an industry trying to fight off a case that could fundamentally alter the way they do business.

The ICI, of course, is the trade group that represents mutual fund managers. They don't like being known as a trade group, preferring to claim that they also represent mutual fund shareholders. Indeed, the claim is right there on page one of their brief: the ICI's self-described "core missions" include "advancing the interests of investment companies and their shareholders." (Italics mine.)

But if anyone still bought the idea that the ICI could somehow simultaneously seek to advance the interests of two parties whose interests are in direct conflict, they should be disabused of that notion by the ICI's brief in this particular case, which pits mutual fund shareholders against a mutual fund manager. The ICI, of course, sides with the manager.

In reading the ICI's brief, I was struck by the way they dealt with two different issues that are at the heart of the Harris case. This week I'll take a look at the first of those, and next week, I'll discuss the second.

The first thing that struck me was as maddening as it was unsurprising: The ICI's deliberate conflation of fund expense ratios and fund expenses.

No one checking out at the grocery store was ever told that the bill was 0.45 percent of their income. We pay for things in dollars, not ratios. Yet the ICI consistently -- and deliberately -- implies that dollars and ratios are one in the same. I've written about this bit of misdirection before, but it bears repeating.
Of course the ICI has a very good reason for doing this. Expense ratios are abstract, tiny numbers. To most observers, there's little difference between a fee of 0.2 percent, and 0.5 percent -- you wouldn't walk across the street to save 0.3 percent on bananas. But in the asset management business, those seemingly small differences in percentage points can lead to big differences in dollars.

On a $1 billion mutual fund, for example, a 0.2 percent expense ratio would generate $2 million in fees; 0.5 percent would generate fees of $5 million. Put that way, the difference doesn't seem so small.

Even better, focusing on expense ratios allows the ICI to make assertions like the one made on page five of their brief: "the total cost of investing in mutual funds has experienced a decades-long decline."

This is absolutely, unequivocally false. Expense ratios have declined. The total cost of investing, in dollar terms, has experienced a decades-long increase. To illustrate this fact, I ran a few numbers. I calculated the annual asset-weighted expense ratio for all mutual funds from 1980 to 2008. That number has indeed declined in recent years -- from a high of 0.88 percent in 2004 to 0.78 percent in 2008. I then applied that ratio to each year's total fund assets to estimate the total annual expenses that mutual fund investors have paid.

The results are shown in the chart below. Raise your hand if you can see the decades-long decline in mutual fund costs. I didn't think so. Since 1980, total fund expenses have increased 79-fold, far outstripping the 39-fold rise in assets in that time.
The chart makes clear just why the ICI would like to focus the public's attention away from dollar figures, and toward those tiny percentages.

But don't let their efforts fool you. Behind those expense ratios are real dollars -- dollars that directly detract from the returns you earn on your investment; and dollars representing fees that in fact have been rising enormously over the decades.

Next week, I'll dig into the ICI's amicus brief a bit more, and take a look at how they deal with the issue that's really at the core of the Jones v. Harris Associates case.