The Investment Company Act has been the curse of mutual funds since it was first passed in 1940 (the “'40 Act”). If you’re old enough to remember the Roaring Twenties, then you’re old enough to remember the proliferation of unregulated investment pools that precipitated the market crash of 1929.Many unsuspecting folks lost their entire nest eggs in these pools and their lives suffered for it.
As a result, the sale of investment pools were severely restricted. It wasn’t until Glass-Steagall allowed banks to commingle funds of trusts through the Banking Act of 1933 that investment pools returned. Their full scale return to public investors didn’t occur until the passage of '40 Act.
There was a major difference between the two acts that redound to today. There’s much less regulatory overhead in a trust company’s “common trust fund” versus an investment company’s “mutual fund.” The reason for this difference speaks volumes regarding the current issue of the fiduciary standard.
Congress, at least during the Depression, assumed the fiduciary duties of trust companies held those corporations to a higher standard than their investment company counterparts. As a result, in exchange for permitting the sale of their mutual funds to the public, investment companies were required to disclose all their expenses (among other things) on at least a semi-annual basis.
“Aye!” as Shakespeare might say, “There’s the rub!” For nearly four generations, mutual funds alone among all investment products found themselves subject to these voluminous and measurable (not to mention, costly) disclosure requirements.
With such disclosure, natural competition made it difficult for mutual fund costs to vary too widely, especially when it comes to expense ratios. Moreover, in the last decade or so, retirement plans in particular have seen even loads and 12b-1 fees dwindle to no more than a quarter of all 401(k) plans.
Many consider this a good thing. But some don’t, and continue to paint all 401(k) plans with the same mutual fund expense ratio brush, much to the detriment of 401(k) plan sponsors (see “401(k) Plan Sponsors and the Mutual Fund Expense Ratio Wild Goose Chase").
These reports make it sound like the new Fee Disclosure Rule will surprise many when they see their mutual funds are consuming a lot more of their retirement savings than they think, and they provide the difference between index fund expense ratios (which can be as low as 3 basis points) with the average 401(k) mutual fund expense ratio (which, according to the ICI, is more like 74 basis points). These writers suggest there’s something obviously significant about this difference.
There’s not (and for the reasons why, see the article referenced above).
Here’s the best advice we can give 401(k) fiduciaries and plan sponsors: When it comes to fee disclosure, ignore mutual fund expense ratios and concentrate on the service provider fees. Granted, some of these fees may come in the guise of mutual fund revenue sharing expenses, but these mutual fund kickbacks are generally not counted in the fund’s formal expense ratio, but in its 12b-1 or load schedule.
A recent study concludes mutual funds without 12b-1 fees and loads perform just as well as their index benchmarks, suggesting those differences in expense ratios really amount to nothing. It’s the 12b-1 fees and loads that most hurt investment performance.
But, there’s another gift many 401(k) plan sponsors will receive from the DOL’s Fee Disclosure Rule: The gift of apples-to-apples cost comparisons. No longer will mutual funds alone be subject to expense disclosure – now all other investment products will suffer the same indignity. And this is good news for 401(k) plan sponsors, for, according to the Investment Company Institute, mutual funds account for only half of all 401(k) investments.
That means, for that past three decades, 401(k) plan sponsors had expense data on just half their plans’ investments. That’s all about to change. And once we see several years of expense disclosure, perhaps those who write about the “evils” of mutual fund expense ratios will then turn their keyboards towards more balanced reporting.
Of course, astute 401(k) plan sponsors and their advisers will already be way ahead of them.