A Supreme Court ruling handed down earlier this week leaves the mutual fund industry free to continue charging the same fees many investors have called unreasonable, which means investors are still on their own in managing the costs associated with buying funds.
In the case of Jones vs. Harris Associates, the plaintiffs argued that asset manager Harris Associates had charged unreasonable fees for managing three different mutual funds. The court ruled unanimously Tuesday to uphold a legal precedent which had laid out the guidelines for investors seeking to prove a fee was excessive.
The court’s decision pulled off the rare feat of apparently pleasing both sides of a lawsuit. David Frederick of Kellogg, Huber, Hansen, Todd, Evans & Figel PLLC, attorney for the plaintiffs, says he’s “thrilled” by the decision – and the trade organization representing mutual funds, the Investment Company Institute, issued a statement praising the decision for creating “stability and certainty” in how excessive-fee claims are evaluated.
Essentially, a lower court had issued a ruling that ignored a test typically used to evaluate claims of excessive fees and made it more difficult for investors to prove fees were disproportionately high. The Supreme Court overturned that decision and reaffirmed the test, known as the Gartenberg standard.
A clear standard for how courts determine whether a fee is excessive benefits investors and fund managers. And because the Supreme Court is sending the Harris case back to the district court, the plaintiffs will get another chance to make their arguments. But this decision isn’t necessarily a victory for all investors. "Fund companies have generally been successful in court under the Gartenberg standard over the last few decades,” says Ryan Leggio, a mutual fund analyst at Morningstar who has been following the Harris case.
Having recourse to litigation is important for investors who can’t choose their own mutual funds or who would face penalties for switching funds, says Jay Sushelsky, a senior attorney with AARP, which filed an amicus brief in support of the plaintiffs in the Harris case. For investors who can choose their own fund, this decision can highlight the importance of being fully informed of all fees, Sushelsky says.
Here are four tips for evaluating fund fees.
Don’t link high costs with high returns
Many mutual fund investors aren’t aware of the fees they’re being charged, and even when they are, the differences between fees might not seem very big, Leggio says. Investors should know that even a difference of one-quarter to one-half of a percentage point in annual fees can add up to thousands of dollars over an investing lifetime, he says. In shopping around, investors should compare any fund’s fee to the average amount charged by that type of fund and be aware that “higher fees are negatively correlated to outsize returns,” Leggio says.
“The reason you pay more for a Mercedes than a Kia is quality, but in the fund marketplace that doesn’t work,” says Mercer Bullard, a professor of securities law at the University of Mississippi and the president of Fund Democracy, a mutual fund shareholder advocacy group. “It’s a good rule of thumb to only invest in a fund that charges below-average fees,” Bullard says.
Weigh the benefits of active management
Investors should also carefully consider whether it’s worth paying more for an actively managed fund, Bullard says. Actively managed funds have the potential to outperform the market – but they can also underperform, and “research suggests that there’s no way to predict mutual fund performance with enough certainty to warrant assuming active management risk,” Bullard says.
Account for additional costs
When choosing a mutual fund, investors should also evaluate additional expenses that aren’t included in the basic expense ratio listed in the fund’s prospectus, such as any commission you’d pay to your broker to buy the fund, Bullard says. Another data point to look for in a prospectus is the fund’s "turnover rate" – it’s difficult to track down the fund’s transaction costs for making trades, but the turnover rate is a decent indicator, Bullard says. “If you want to keep your expenses down, don’t invest in a fund that has a turnover ratio in excess of 100%,” he says.
Make fair comparisons
Fees paid by stock and bond fund investors have dropped by half since 1980, according to the Investment Company Institute. Competition among mutual funds, and the growing popularity of low-cost exchange-traded funds and notes, will likely continue to drive costs down for all types of funds, says Kevin Mahn, a portfolio manager for SmartGrowth mutual funds. Investors should be sure to compare apples to apples when investigating fees – the costs involved in managing an emerging market equity fund would be higher than those for a fixed-income fund, for example. Investors should also consider other factors along with fees, including the fund’s investment strategy, past returns, level of risk, and the manager’s tenure at the fund, Mahn says.