If Some Mutual Fund Fees Are Too High, How Much Is Fair?

New York Atty. Gen. Eliot Spitzer on Thursday achieved what seemed unthinkable just a few months ago: He got a mutual fund company to cut its management fees.

But Spitzer’s victory in his case against Alliance Capital Management has set off a heated debate in the industry and among its critics: If fund firms have been charging too much, what is the right fee amount -- and who should decide?

The fee issue has grown increasingly controversial over the last decade as the fund industry has mushroomed to $7 trillion in assets while, according to critics, many fund firms have been unable or unwilling to reflect economies of scale in their fees.

Most stock and bond funds take between 1% and 2% of portfolio assets each year as payment for managing the portfolio and to cover other costs, such as keeping track of shareholder accounts, mailing annual reports and, often, compensating brokers who sell the funds.

By contrast, the industry’s low-cost leader, Vanguard Group, charges fees that average about 0.25% on stock and bond funds it sells directly to investors, according to research firm Morningstar Inc.

The industry has long argued that investors are getting what they pay for in terms of performance, service and convenience. But many analysts say the huge fee gulf between Vanguard and most other fund firms suggests gouging is widespread.

Alliance’s fee cut is the first significant chink in the industry’s armor on this issue. As part of a broader settlement of charges related to improper trading in fund shares, the deal Alliance struck with Spitzer calls for a 20% reduction in its stock and bond fund fees starting Jan. 1 and continuing for five years.

Moreover, Alliance Chief Executive Lewis A. Sanders didn’t try to suggest that the company believed its fees were fine as they were. “We embrace it fully,” he said of the fee cut.

Some industry critics predict a wave of fund fee reductions in 2004 by companies implicated in the trading scandal and perhaps by some that aren’t.

“They’re going to be reducing fees or they’re going to be locked up in litigation defending their fees” against charges of cheating investors, said John P. Freeman, a law professor at the University of South Carolina whose research on fund costs has been cited by Spitzer.

But should the industry now consider Alliance’s lower fund fees to be a benchmark for what’s “fair”?

Alliance’s fees have long been among the industry’s highest. Morningstar calculates Alliance’s average stock fund expense ratio at 2.05%, compared with 1.44% for Fidelity Investments and 0.33% for Vanguard.

Even with a 20% cut, Alliance still will charge more than many of its peers.

Comparing fees among fund companies is difficult for any number of reasons, said Jeff Keil, head of global fund review at research firm Lipper Inc. in Denver. “To say, ‘This is the number you should be below,’ well, you can’t,” he said.

For one, a higher-cost fund also may perform better than its peers, justifying greater stock-research costs, Keil said. In addition, one of the largest expenses for many funds is the cost of distribution, meaning payments to brokers or financial planners who pick funds for investors and maintain the accounts. That money doesn’t accrue to the fund manager.

Darren Dopp, a spokesman for Spitzer, said the specific fee reduction negotiated with Alliance wasn’t meant to be used as a benchmark. “We don’t know what ‘fair’ is” when it comes to fund fees, he said.

Dopp suggested that the industry and investors focus on another element of the Alliance settlement: a provision requiring the firm to hire an executive to review and make public how Alliance arrives at its fees.

This officer will ensure the “reasonableness” of Alliance’s retail-account fees by considering factors including the level of fees Alliance charges institutional investors, the costs of providing services and Alliance’s overall profit margins, the agreement says.

“We’d like to see that part of it sweep the industry,” Dopp said.

Critics say many fund firms charge individual investors two to three times the fees that they charge big-money institutions, such as pension funds, to manage the same basic portfolio.

The industry’s argument is that it’s more expensive to service thousands of small accounts than one large account.

Still, some analysts say fund directors who have the responsibility of negotiating fees should adopt a “most favored nation” approach to the process: That is, individual investors should get the lowest basic management fee given to any other investor.

If other charges should apply, fund companies and directors should have to justify them one by one, said Steve Thel, a law professor at Fordham University in New York.

That would leave the onus for judging what’s fair where it is now -- with fund directors. But Spitzer’s requirement that Alliance hire an executive to report on the process adds another layer of oversight and disclosure.

Spitzer’s regulatory rival, the Securities and Exchange Commission, opposes ordering fee cuts or setting benchmarks. But Paul Roye, head of the SEC division that oversees funds, said he agreed with Spitzer on the issue of greater disclosure about the fee-setting process.

Roye said his staff intended to propose that fund directors explain in detail in annual reports “how they decided that fees are reasonable.”

Ultimately, investors must decide whether they’re getting what they pay for, Roye said, but “we’re looking for a better way to portray it” in fund reports.