The Department of Labor wants to smoke out those nefarious hidden fees that beset 401(k) plans.
That’s the purpose of 408(b)(2) – the Fee Disclosure Rule – and its companion act that requires this data be submitted to plan investors starting at the end of August. Yet we’ve already seen an initial series of reports, white papers and mainstream media articles that focus on the long-disclosed mutual fund expense ratio.
Mutual fund expense ratios have three critical traits.
First, since their advent, registered investment companies have been required to report their financials, including their expense ratio, on a semi-annual basis. This gives mutual fund expense ratios something few other investment products possess – clear measurability.
Second, these accounting reports also contain the fund’s actual investment performance. The Securities and Exchange Committee, of course, discourages funds from highlighting performance by requiring them to issue that now famous caveat “past performance cannot guarantee future results.”
So, unlike a mutual fund expense ratio, we can’t throw around mutual fund performance in an easy to remember (and misleading) sound bite.
Finally, several academic studies, culminating with Mark M. Carhartt’s famous 1997 paper “On persistence in mutual fund performance,” (Journal of Finance, 52, 57-82) show a strong correlation between high costs and lower performance.
Of course, Carhartt focused on many factors, including mutual fund loads and turnover, not just on a mutual fund’s expense ratio. Furthermore, “investment costs” (Carhartt was correct not to mislabel them “expenses”) was merely his third conclusion when it came to maximizing fund performance.
His primary conclusion advised avoiding funds with persistently poor performance and his secondary conclusion stated funds that did well this year tended to do well next year (but not in the years thereafter).
The first trait – the ready availability of a fund’s expense ratio – has long plagued mutual funds, as it puts them at a disadvantage versus investment products not required to disclose their fees in a readable format like a mutual fund expense ratio.
Leveling this playing field would seem to be part of the problem the DOL wants to address. The second trait – the de facto silence on fund performance – and the short-hand version of the third trait – the misstatement of Carhartt conclusion as “high expense ratio funds always lead to lower investment performance” – compounds the impact of the first trait.
Here’s how the truth can defeat the naïve thinking that lower expense ratios are always good.
During the “Lost Decade,” the popular stock indices and their low expense ratio index fund counterparts were all either flat or actually lost money (a rarity for any given 10-year period). On the hand, in 75 percent of the Lipper categories, the average (actively managed and higher expense ratio) mutual fund beat the best performing index. If more investors knew these performance figures, maybe those “low cost” index funds would be less attractive.
Mutual fund expense ratios might get all the press, but 401(k) plan sponsors are advised to look beyond those fees and assess, as Carhartt concludes and alludes to, the impact and true value of their other fees.