(Dow Jones) Opponents of one proposed Wall Street reform, a financial transaction tax, have been quick to point out it will make owning mutual funds more expensive for small investors. Investors should always keep an eye on the fees that eat up returns, but the arguments seem overheated.
Estimates suggest the burden the tax would place on mutual fund investors would, while real, be smaller than other controversial fees investors have paid for years, to Wall Street rather than the government. Moreover, a tax could do some unintended good, tilting the playing field farther against actively managed mutual funds and in favor of index funds.
Index funds are the holdings most experts believe best suit small investors, but which have long had a hard time competing against funds that generate bigger profits and marketing dollars for the fund industry.
In December, Rep. Peter DeFazio, D.-Ore, introduced the "Let Wall Street Pay for the Restoration of Main Street Act of 2009," calling for a tax of 0.25% on stock and derivative trades. Supporters hope the proposal, variations of which have been around for decades, would rein in Wall Street traders whose outsize bets helped create the conditions that led to the financial crisis.
Opponents claim it would mean fewer buyers and sellers in the stock and derivative markets, and thus increase trading costs across the board. These critics have also gotten a lot of mileage by arguing the tax would be borne by small investors in particular. That's because, although investors who trade less than $100,000 worth of stocks each year would be exempt, mutual fund portfolio managers buying and selling on behalf of mom and pop would pay.
The Investment Company Institute, the fund industry's main trade group, estimates the tax would boost operating costs of the average index mutual fund by about 0.05 percentage points and the average active fund by 0.14 percentage points. Those figures aren't insignificant: As the ICI points out, the 0.05-point jump would increase index funds' annual costs by a third, and compounded over decades, reduce American's retirement savings by thousands of dollars.
But does the transaction tax really pose a dire threat to Main Street? Take a look at the size of those prospective costs in the context of another much-criticized expense fund investors pay, the 12b-1 fee.
Named for the regulation that permits them to pay fund marketing expenses, such as commissions to brokers, many consider use of 12b-1 fees to be wasteful. The ICI itself says some critics view them as "dead weight," and last year, Mary Schapiro, chairman of the Securities And Exchange Commission, told Congress their purpose was "sometimes unclear" and promised to put them under review.
Moreover, 12b-1 fees loom much larger than a transaction tax would, at least in terms of direct costs. Fund researcher Morningstar calculates 12b-1 fees boost the average mutual fund's annual expense ratio by 0.36 percentage points. Since some funds don't charge investors 12b-1s, their hit to funds that do is even greater, 0.58 percentage points annually.
The fund industry doesn't seem nearly as determined to warn Main Street about the pitfalls of this questionable cost. For its part, the ICI supports the fees, which it says represent a service rendered to investors.