Thursday, January 4, 2018

One of the Great Gravy Trains in Financial History

The New York Times recently covered the puzzling persistence of high mutual fund fees.  The article focuses on Baron Funds, a mutual fund family led by Ronald S. Baron. It points out that Baron's fees exceed the industry average by 54 percent.  Despite the high fees and finishing ahead of their indexes this year, the funds lag behind their benchmarks over a five year period. Baron argues that investors should take a broader view.  According to Baron, an investor that bought his flagship fund in 1994 would have roughly doubled the return otherwise obtainable from holding the S&P 500 over the same period. 

Notably, and not addressed by the Times, the content of Baron funds has changed since their launch.  Investors should not expect today's large Baron funds to replicate their early performance.  Although Baron funds once made concentrated bets on small companies, the funds have changed as they have grown.  One 2012 article, pointed out that Barons changed its investment policies after a large stake in Sotheby's imploded.  Baron changed the rules so that "no new investment can account for more than 10 percent of any of [the] funds."  

Mutual funds get away with high fees for a variety of reasons.  Selling an investment may have tax consequences. Ordinary investors also struggle to understand exactly how much they pay asset managers.  Many rely on commission-compensated financial advisers. Mutual funds frequently pay a financial adviser to sell fund shares and a trail commission while the assets remain with the fund.  Unsurprisingly, financial advisers may leave client assets in these higher-fee funds.    

Today's retail distribution channel also does a poor job of educating clients about fees.  Many clients fail to grasp even how their financial adviser gets paid.  One survey found that about a quarter of those over the age of fifty either incorrectly believe that their financial advisers give advice for free.  A sizable percentage know they pay something but don't understand how much they pay their advisers.  With so much confusion about how financial advisers get theirs, it's unsurprising that many investors lose track of mutual fund manager compensation.

In theory, a mutual fund's directors should look out for the interest of the fund's shareholders.  The Times called on Professor William Birdthistle to explain how mutual fund directors often identify more with the fund companies that pay them than shareholders.  Birdthistle also has an excellent book on the mutual fund industry that goes into much more detail about mutual fund governance issues.

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