Mutual Funds, Crazy Eddie-Style

Why they’re slashing fees.

The marketing of mutual funds has generally been a high-toned affair. Television advertisements with high production values, shots of white colonial homes and grandparents with large, prosperous broods. Newspaper ads that describe performance with dry black-and-white charts.

But in recent weeks, ‘80s consumer-electronics discounter Crazy Eddie seems to have hijacked mutual-fund marketing. “In fact, we’ve even lowered the expenses on many of our equity index funds to just 10 basis points” ($1 for every $1,000 invested), Fidelity trumpeted in late August, as it slashed management fees on its S&P 500 index fund by nearly 50 percent. “That’s right—index funds covering the areas of the market you want from a name you trust and with lower expenses.” Not to be outdone, E-Trade on Sept. 7 cut the fees on its S&P 500 index fund to nine basis points. These fees are so low, they’re insane!

Under assault from regulators, new competitors, and consumers who have finally become hip to the ravages of high fees, mutual funds are chopping prices. Investment News notes that many mutual-fund companies are resorting to “blue-light specials,” by offering waivers on fees. And Lipper reported that between July 31, 2003, and July 31, 2004, 528 mutual funds decreased fees at the portfolio level, while only 124 increased them. The reductions are long overdue, and they’re good news for mutual-fund investors.

Mutual funds were the default destination for much of the new money that flowed into the market in the 1990s. From 1988 to 2000, the percentage of American households owning mutual funds rose from 24 percent to 49 percent in 2000. But the industry fees went largely unchallenged during the bull market. Given economies of scale, mutual-fund expenses should have fallen sharply—it shouldn’t cost five times as much to manage $100 million in stocks as it does to manage $500 million. But they didn’t. As mutual funds proliferated and specialized, they spent lots of money on advertising, research, marketing, and personnel. According to this Investment Company Institute study, the “simple average expense ratio” for stock mutual funds actually rose from 1.47 percent in 1990 to 1.64 percent in 2002.

In the past few years, however, serial underperformance, a series of trading scandals, and the advent of Exchange Traded Funds brought the industry’s growth to a halt. In 2003, according to the ICI’s 2004 Fact Book (see Page 80), the number of households with mutual funds actually fell to 53.3 million from 54.2 million, and the percentage of U.S. households with mutual funds dropped to 47.9 percent.

These declines have forced mutual-fund companies to become more aggressive in pursuing customers—especially with their commodity products. There’s no substantive difference between an S&P 500 Index fund offered by Fidelity and one offered by any other mutual-fund company, except for expenses. And when returns are meager—as of this morning, the S&P 500 was down 0.76 percent for the year—a few basis points can mean the difference between showing a profit and a loss for the year.

Investors are also becoming more intelligent consumers of financial services products. In the 1990s, mutual funds were in the happy position of being the natural point of entry for investors. If people chose to put cash into mutual funds in their 401(k) plans, companies could lock up assets for a decade or more and collect a reliable stream of fees each year. When the market was posting double-digit returns each year, the fact that management took 1 percent or more out of the return each year could be easily overlooked. No longer. Consumers have increasingly been schooled to take fees into account when considering mutual funds. Meanwhile, ETFs—securities that track indexes but trade like stocks—offer lower costs for people who plan to buy and hold.

Of course, not all the expense reductions have been voluntary. As part of his crusade to clean up the mutual-fund business, New York State Attorney General Eliot Spitzer has forced mutual-fund companies to slash fees as a form of penance for their participation in late-trading and rapid-trading schemes. In March, he got Bank of America and Fleet Boston to reduce fees by $160 million over five years. In May, Strong Capital agreed to cut fees by 6 percent over a five-year period. A few weeks ago, Invesco and AIM “agreed to $75 million in fee reductions over the next five years.”

Add it all up, and mutual funds have suddenly become a less lucrative business. And in a world in which brand loyalty may be increasingly trumped by price, mutual-fund companies will be forced to act more like mass merchandisers and less like asset managers. Retailers routinely offer attractive goods at below cost to get people in the door—remember Wal-Mart’s $29 DVD player last Christmas? By slashing expenses on index funds to Crazy Eddie lows, Fidelity and E-Trade have placed their $29 DVD players in the windows. Now they have to hope the customers will start lining up.