By James Kwak
Forty years after John Bogle launched the Vanguard 500 Index Fund, passive investment funds now account for about one-third of the mutual fund and ETF market. You would think this would pose a threat to traditional asset managers that charge hefty fees for actively managed mutual funds, and this is true in part. On average, index funds charge 73 basis points less than active funds, and the average expense ratios for actively managed funds have fallen from 106 bp to 84 bp over the past fifteen years (Investment Company Institute, 2016 Investment Company Fact Book, Figure 5.6).
The asset management industry, however, has been quite adept at defending its traditional share of investors’ assets. One response has simply been to go along with the index-fund wave—without lowering fees to reflect the considerably lower expenses of using simple algorithms instead of humans.
In the Wall Street Journal, Micah Hauptman summarized a recent paper by Michael Cooper, Michael Halling, and Wenhao Yang on mutual fund fees. They find, as did previous research, tremendous differences in prices for S&P 500 index funds. The variation between the fees charged for these virtually identical products has actually increased since it was first measured in 2004; in recent years, the difference between the 10th percentile and 90th percentile S&P index funds (by expense ratio) has been a staggering 116 basis points. That means there are people paying well over one percentage point of assets per year for a product that only costs 16 bp at Vanguard (5 bp for a minimum investment of just $10,000). Furthermore, Cooper, Halling, and Yang analyze variation in prices across all U.S. stock mutual funds, in part by identifying funds with similar holdings. Again, they find large price discrepancies that cannot be explained by fundamental fund characteristics.
For an investor, the lesson is very simple: If you are paying more than 16 bp for an S&P index fund (5 bp if you have more than $10,000 in the fund), you should get out and buy a cheaper one instead, unless you’re locked in because of large, unrealized capital gains.
For society as a whole, however, there is a more interesting takeaway. According to very basic economic theory—the kind you get early in your first year—this type of price dispersion cannot occur. It’s as if oil were selling for $16 per barrel in one place and $132 per barrel in another place. Now, that can happen with oil if, say, there’s an embargo or a blockade going on. But the market for U.S. stock mutual funds and ETFs is supposed to be highly transparent and liquid; it usually only takes few minutes and a computer to sell one and buy another. Wide variation among prices for identical products with minimal search and transaction costs is proof that the simple story taught in Economics 101—prices for identical products must converge because buyers will only buy the cheap ones—is sorely incomplete. Something else is going on, and therefore we cannot count on markets to protect investors. (For example, one thing that could be going on is retirement plan administrators only offering expensive index funds to captive plan participants.)
Yet that faith in markets is endemic in large parts of our political and legal systems. For example, Judge Frank Easterbrook of the 7th Circuit dismissed evidence of excessive mutual fund fees in 2008 as follows:
It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest.
As evidence, he cited a purely theoretical law review article written twenty-five years earlier—even though the evidence about index fund price dispersion was already out there for everyone to see. This absolute conviction that the world must operate the way it does in theory is another example of economism in its purest form. (Easterbrook was overruled by the Supreme Court, but on other grounds.)
The asset management industry’s other brilliant revenue-maintaining innovation was the target date fund. The theory behind these funds is plausible, although not entirely compelling. The idea is that you pick the date when you expect to retire, and the funds reallocate your holdings from an aggressive mix (more stocks) when you’re young to a conservative mix (more bonds) when you’re old. I say this isn’t entirely compelling because there is no particularly convincing theory of what your asset allocation should be (well, there’s the CAPM, but that doesn’t hold up in practice), let alone what it should be at any given age. For example, it makes no sense that a very rich person and a middle-income person should have the same allocation just because they are the same age.
That said, target date funds could be a solution for an investor who (a) follows the conventional wisdom that you should shift from stocks to bonds as you age and (b) doesn’t want to have to rebalance manually every few years. But in practice, they are just a clever marketing vehicle for complexity and high fees. I was looking at Fidelity target date funds for a friend (who is locked into Fidelity by her retirement plan, which is not too unusual). Here’s the Fidelity Freedom 2040 fund:
Thirteen U.S. stock funds? Remember, the whole point of a mutual fund is each one is already diversified; if you buy thirteen funds within the same market, you’re just getting lots of overlap in unknown quantities. The sole purpose here is to provide a veneer of sophistication (Wow, I can get twenty-five different investments with just one fund!) to justify a fee of 77 basis points. Vanguard, by contrast, puts your money in four index funds covering the global equity and bond markets, and charges just 16 bp.
Since 2006, the share of 401(k) plan participants holding target date funds has more than doubled, from 19% to 48% (ICI 2016 Investment Company Factbook, Figure 7.14). Because retirement plan administrators typically only offer one series of target date funds (rather than a passive option and an active option), by getting participants to focus on the benefits of target date funds, they can take the passive investing option off the table and quietly funnel everyone into actively managed funds.
Again, the lesson for the individual investor is this: If you are investing in a target date fund, figure out what’s in it, and figure out if you can make essentially the same investments more cheaply. And the lesson for society is this: Even when the products are basically pretty simple (U.S. stock funds), companies will manufacture complexity and barriers to entry in an effort to boost prices well above marginal cost. That’s how the economy works—not the way you learn on the Economics 101 blackboard.