Charging outsized fees for mutual funds is not illegal, yet economic theory would hold that the popularity of low-priced index funds would force those with high expenses to lower their costs or lose assets. After all, each index fund, by definition, holds the exact same portfolio as its competitors.
But fund analysts say that these high-priced funds have been exempt from the competitive pressures of the marketplace because they are sold by brokers who receive commissions to put investor's dollars into expensive options.
"We've still never got a straight answer for why some firms don't offer institutional shares to their clients. The answer is that they don't get paid on them," said Jon Smith, head of DT Investment Partners, a firm that reviews proposals by financial advisors on behalf of affluent clients.
Brokers say that the fund expenses are compensation for the advice they give clients. The Securities Industry and Financial Markets Association, a trade group for the industry, declined to comment.
It is unclear which investors are buying these high-priced funds and which brokerage firms and financial advisors are directing investors into them, but it is likely the fund shareholders are less sophisticated Mom and Pop type investors.
Institutions and affluent individuals do not typically pay these fees because they often buy fund shares that require minimum investments of up to $1 million but come with lower annual fees.
High expense ratios do not seem to be harming the fund companies. The assets in the Rydex S&P 500 fund have nearly tripled since 2010 as a result of new money flowing in and the jump in the stock market, according to data from S&P Capital IQ.
The high fees for the Rydex and State Farm S&P 500 index funds do not appear to be a fluke. Both firms also have the highest fees in the industry for index funds that track the Russell 2000 index of small companies, according to Lipper data. State Farm declined to comment.
An average investor's lack of financial sophistication is one reason why financial firms have little incentive to reduce expenses on high-priced index funds, said Todd Rosenbluth, director of mutual fund research at S&P Capital IQ.
Essentially, investors who are knowledgeable enough to inquire about expense ratios already gravitate towards low-cost options offered by firms like Vanguard, Schwab and Fidelity, he said, likening the cost of these index funds to AOL's practice of still charging some customers for dial-up Internet access when they already subscribe to broadband.