Last week's Supreme Court case has once again brought mutual fund fees to the national spotlight, but a decision by the court might not come for several months, if it comes at all. And judging from the justices' comments, they appear reluctant to get involved in the day-to-day workings of fund companies and more inclined to trust the judgment of fund boards, the purview of the Securities and Exchange Commission and the workings of the free market.
The well-publicized case Jones v. Harris Associates has investors wondering if the fees they pay for mutual funds are too high, who determines what fees they pay and what they can do about it.
Investors are less inclined to worry about fees when they are seeing double-digit growth in their portfolios, but last year's severe drop in assets brought fees to the forefront again. In some cases, funds were so battered they reached critical breakpoint levels that required them to raise fees to cover expenses.
"It is common knowledge on Wall Street that advisory fees are frequently excessive and can seriously erode fund investors' returns," said Ira Schochet, president of the National Association of Shareholder and Consumer Attorneys. "Despite this widely acknowledged problem, decades of misapplied and overly restrictive lower court decisions have effectively denied a remedy to tens of millions of investors."
Mutual fund industry leaders maintain that market competition and efficiency have driven down fees dramatically over the years and investors can and do switch funds in order to find the lowest fees possible.
"The fund industry is virtually a textbook case of a competitive market," said Paul Schott Stevens, president and CEO of the Investment Company Institute. "More than 8,000 mutual funds vie daily for the dollars of cost-conscious investors. If investors are happy with the price, performance and service of their fund, they stay and invest more. If not, they walk, because it only takes a couple phone calls or a few clicks of the mouse to move to another fund. In any given year, 25% to 70% of mutual fund advisors experience net outflows."
According to the ICI, average fees and expenses paid by equity fund investors fell 57% from 1980 to 2008, and fees and expenses for bond funds fell 63%.
Currently it is pretty easy for an inquisitive investor to figure out what they are paying in fees and compare it to other funds, but it takes a little effort. Many quarterly performance statements don't list fees, but the information is readily available in a variety of places, such as the fund's website, in prospectus information and on websites like Morningstar and Lipper.
"You can just look it up on Morningstar and it's right there," said Chief Justice John Roberts during last week's hearing. "As an investor, you can make whatever determination you'd like, including to take your money out."
Many of the justices were skeptical about relying on the market to determine what fees are reasonable, but they didn't see many alternatives.
"It makes a lot more sense to have the SEC regulate rates than to have courts do it," Roberts said.
The SEC has not filed a mutual fund fee suit since 1980.
"I sense a real reluctance on the part of the court to intervene in the operation of the market and become more heavily involved in setting or reviewing fees for mutual fund advisers," said James Gregory, an attorney at the New York-based firm Proskauer Rose.
Advisor fees are determined by a fund's board of directors, the vast majority of whom are comprised of independent directors. Directors typically spend months researching information on funds and their competitors.
"Our legal mandate is to serve as 'watchdogs' on behalf of investors," said Michael Scofield, independent director of Evergreen Funds and chairman of the Independent Directors Council. "We take that responsibility seriously, aware that we oversee funds vital to the financial security of our shareholders. We trust that the Court will recognize there is no substitute for the experience, knowledge and business judgment directors bring to our work."
During its climb up the legal system, Jones v. Harris Associates has morphed from its original goal of gaining fee equality for retail and institutional investors to its new attempt to reverse an appeals judge's controversial ruling, throw out 27 years of legal precedent that favors fund companies and challenge the way the $10 trillion mutual fund industry charges fees.
When the case was first heard in a Chicago district court in 2004, its focus was on whether it was unfair that Oakmark Funds' investment advisor, Harris Associates, charged retail investors nearly twice what it charged institutional investors and pension funds, thereby violating Section 36(b) of the Investment Company Act of 1940, created to limit excessive investment advisor fees.
"The disparity in the actual amounts paid by the two sets of clients is striking," the shareholders said in court papers.
Individual accounts are almost always more expensive to manage than institutional accounts due to the customer service required to support retail clients through phone banks and the mandatory mailing of prospectus information. Investors in 401(k) accounts are typically a lot more passive than other retail investors, however.
"The expenses of marketing and distribution used by mutual funds to attract investors are of no benefit to an employee in a 401(k) plan," said Jerome Schlichter, an attorney with the St. Louis-based firm Schlichter, Bogard & Denton. He said 401(k) investors also don't have the flexibility to "vote with their feet" that other investors have.
"They have a limited choice, based on what their employer picks," he said. "They don't have the universe of 8,000 mutual funds to choose from."
The district court found the Oakmark fees to be in line with its competitors and ruled that the market, not the judiciary, should determine manager fees. The plaintiffs appealed to the U.S. Court of Appeals for the 7th Circuit in Chicago, which affirmed the lower court's order.
A 7th Circuit judge extended the standard set in 1982 in the case Gartenberg v. Merrill Lynch Asset Management, and said that investment advisors can charge whatever fees they want as long as they aren't excessive and don't involve fraud.
The plaintiffs appealed to the Supreme Court, arguing that the Gartenberg standard is inappropriate, relies too heavily on the marketplace and that most mutual fund fees are too high.
The Supreme Court is expected to issue a decision in the spring, but some doubt the result will be surprising.
"Their decision won't be as dramatic as folks expect," said David Hearth, a partner in the investment management practice at Paul Hastings. "As nobody found a major defect with Gartenberg, their decision will most likely reflect a Gartenberg-type status quo. All roads are heading back to Gartenberg."
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