Market forces, which would normally put pressure on excessive or needless fees, had done little to solve the problem. As the New York Times summarized the report after its release, “one of the hallmarks of a market society is that the successful are rewarded and the unsuccessful penalized. But this rule does not seem to apply to mutual fund investment advisers, because there is no relationship between performance and fees.” Mutual funds simply stuck with investment advisers, whether they delivered good returns or not.
As a consequence, when the SEC commissioned its own study in 1966, it echoed the Wharton report, arguing that competitive forces had failed to place pressure on fees, despite the fact that the mutual-fund industry had grown swiftly in the intervening years. For that reason, the SEC recommended that Congress enact legislation punishing so-called “excessive” fees. But this went nowhere, and fees continued to creep upward.
The same happened to institutional investors such as pension funds. These pools of investor dollars originated during World War II, when the government imposed price and wage controls. Corporations padded employee paychecks by expanding retirement benefits. Banks offered to invest these accounts, but treated them as a “loss leader”: they charged little in the way of management fees because they could make money from the funds in other ways: brokerage commissions and interest on the money when they lent out the funds.
But then, in the late 1960s, Morgan Bank imposed a 25 basis-point fee on institutional investors. Conventional wisdom held that Morgan’s pension clients would go elsewhere. But they didn’t. In fact, they continued to stick to Morgan and the other banks hired to handle their assets even as rates continued to head ever higher, hitting 50 basis points by the following decade.
Mutual funds fared even worse. Their expense ratios (which reflect all costs associated with fund management, including investment advisers) kept climbing through the 1970s and beyond. Among equity funds, the average asset-weighted expense ratio, which stood at .54 percent in 1960, hit .58 percent in 1970, and then went even higher: to .64 percent in 1980 and .89 in 1990. Yet in the same period, the amount of money in mutual funds increased 24-fold. So much for economies of scale.
Some individual investors rebelled against rising fees, moving into the first passive index funds, introduced in the 1970s. But most investors stayed put, even as fees went higher. In recent years, some economists studying the mutual fund industry have argued that fees leveled off and even began to decline by the 1980s or 1980s. But some scholars of finance have cast doubt on that claim, arguing that modest declines in expense ratios reflect a decline in transaction costs, not investment fees.
Regardless of the timing, though, one thing seems clear: asset management is a market to which change has come very, very slowly. Despite the longstanding, overwhelming evidence that the fees that come with actively-managed funds doom these investment vehicles to mediocrity over the long run, neither individual nor institutional investors have acted on their discontent in droves.
Until now. A steady drip of defections from actively-managed funds to passive funds -- and more generally, from high-fee funds to low-fee funds -- has turned into a torrent. It’s about time.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
This article was provided by Bloomberg News.