Investors Might Be Paying Too Much for These Index Funds
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Investors might think index funds are a great way to capture market returns. Most index funds charge practically nothing: One of the largest, Vanguard Total Stock, charges just 0.04% a year; the average stock index fund’s expense ratio is down to 0.09%, less than a dime for every $100 invested. That has dropped from 0.27% in 2000, according to the Investment Company Institute, the fund industry’s lobbying group.
Yet the industry’s method of calculating fees, on an asset-weighted basis, obscures a surprising fact: Hundreds of billions of dollars are sitting in share classes of index mutual funds that charge well above 1% in annual fees. Many of these funds do nothing more than track broad market benchmarks like the S&P 500. Yet their fees are on par with actively managed funds and, in some cases, even exceed them, topping 1.6% a year.
Virtually all fund families offer the same mutual fund portfolio via different share classes; each share class has different fees and expenses to reflect the sales agreement and different shareholder services. The share class of a fund found in a 401(k) plan, for instance, will usually have different fees than the same fund bought through an advisor.
BlackRock (ticker: BLK), JPMorgan Chase (JPM), Invesco (IVZ), Guggenheim Partners, and Wells Fargo (WFC) all have share classes of S&P 500 funds that charge more than 1%. The C-class shares of Rydex S&P 500 (RYSYX) sits atop the fee charts for S&P 500 funds with a 2.33% expense ratio, according to research firm CFRA. Other high-fee funds include the C-shares of Invesco S&P 500 Index(SPICX), which charge a 1.29% expense ratio; JPMorgan Equity Index (OEICX), at 1.05%; and Wells Fargo Index (WFINX), at 1.2%. All of these firms offer cheaper share classes.
High fees reduce market returns. A $50,000 investment in an S&P 500 fund charging 1% would cost nearly $500 a year more in fees compared with a low-cost product from Fidelity, Schwab, Vanguard, or others. BlackRock’s iShares S&P 500 Index Fund Investor C1 (BSPZX) has a 1.08% expense ratio. A $10,000 investment a decade ago would be worth $31,170 today, including reinvested dividends, versus $34,570 for Vanguard 500 Index Admiral Sares (VFIAX), which charges 0.04%.
Capturing nearly all of the market returns was the original idea behind the launch of the first index fund in 1976 (the Vanguard Index Trust). Decades later, with so many inexpensive mutual funds and exchange-traded funds now available, there’s no reason for investors to pay more than a few hundredths of a percentage point in expenses, says Tony Isola, an adviser with Ritholtz Wealth Management. “These high-fee funds are taking advantage of the indexing trend but defeating the purpose behind it,” he says.
It’s easy to see the appeal of high-fee funds for some in the financial industry. Funds that passively track a benchmark essentially run on autopilot; they need to be adjusted periodically, but human capital costs are minimal. Computers run the show, with no need for analysts to dig into stocks or bonds. Operating costs have come down so much that Fidelity recently launched four index mutual funds with zero expense ratios—essentially betting that it can break even, or come out slightly ahead, without charging direct fees. Fidelity may lend securities in the fund to generate income and cover its expenses, according to the funds’ prospectuses.
High fees reduce market returns. A $50,000 investment in an S&P 500 fund charging 1% would cost nearly $500 a year more in fees compared with a low-cost product from Fidelity, Schwab, Vanguard, or others. BlackRock’s iShares S&P 500 Index Fund Investor C1 (BSPZX) has a 1.08% expense ratio. A $10,000 investment a decade ago would be worth $31,170 today, including reinvested dividends, versus $34,570 for Vanguard 500 Index Admiral Sares (VFIAX), which charges 0.04%.
Capturing nearly all of the market returns was the original idea behind the launch of the first index fund in 1976 (the Vanguard Index Trust). Decades later, with so many inexpensive mutual funds and exchange-traded funds now available, there’s no reason for investors to pay more than a few hundredths of a percentage point in expenses, says Tony Isola, an adviser with Ritholtz Wealth Management. “These high-fee funds are taking advantage of the indexing trend but defeating the purpose behind it,” he says.
It’s easy to see the appeal of high-fee funds for some in the financial industry. Funds that passively track a benchmark essentially run on autopilot; they need to be adjusted periodically, but human capital costs are minimal. Computers run the show, with no need for analysts to dig into stocks or bonds. Operating costs have come down so much that Fidelity recently launched four index mutual funds with zero expense ratios—essentially betting that it can break even, or come out slightly ahead, without charging direct fees. Fidelity may lend securities in the fund to generate income and cover its expenses, according to the funds’ prospectuses.
Other expenses also jack up fees, notably 12b-1 fees. These fees are meant to compensate brokers or advisors for fund distribution or investment advice, and they’re considered “trailing” fees because they stay in place long after a fund has been sold to the investor. Almost all of the high-fee S&P 500 funds on the market include 12b-1s, making it imperative for investors to look under the hood.
The iShares S&P 500 Index Investor C-1 has a management fee of 0.04% but charges 0.9% in 12b-1s, for instance. Investors in the A shares (BSPAX) pay 0.25% in 12b-1s, reducing the net expense ratio to 0.36% in fees, and the I shares (BSPIX), with a $2 million minimum, lowers total fees even further, to 0.11%.
But with its expense ratio of 2.33%, the C-shares of Rydex S&P 500 Index fund may well be the most expensive S&P 500 index fund in America. In return for tracking the S&P 500, the fund charges a management fee of 0.75%, 12b-1 fees of 1% and “other” expenses of 0.58%. Those other expenses don’t include fees embedded in the returns of swap contracts the fund uses, representing an “indirect cost” to investors, according to the fund’s prospectus.
Rydex has sold this fund since May 31, 2006. It has returned an average 4.9% since then, trailing the S&P 500’s 7.4% return, according to FactSet. Over that period, the Rydex fund returned 83.1% cumulatively versus 145% for the S&P 500. Rydex sells classes of the fund with lower fees. Rydex parent company Guggenheim didn’t respond to requests for comment.
Investor complacency has allowed many funds to roll along without much fee scrutiny. A rising stock market over the past 10 years has helped, giving investors less of an incentive to dig into fees, says Jonathan Smith, CEO of DT Investments, an advisory firm in Chadds Ford, Pa., that consults to high-net-worth clients. “If people see an 8% return while everyone else is getting 12%, they may still be happy, especially if they don’t see a benchmark on their statement.”
Many investors who use a broker or advisor may not even be aware of what they’re paying in fund fees. Trust accounts, for instance, often report performance on a six-month lag and don’t break out fund fees from the trust’s own advisory fees, says Smith. “I consult on $500 million in assets, spread across 10 clients,” he says, “and in every situation they had no idea what they were paying before they became clients.”
Look Closely at Annuities
Another pool of high-fee funds sits in variable annuities, insurance contracts that hold stocks, bonds, or other financial assets in “sub-accounts.” Industry-wide, these sub-accounts hold more than $106 billion in index funds with expense ratios averaging 0.59%, according to data from Morningstar. That’s partly because these funds don’t have to compete against low-cost versions that investors may buy outside the insurance wrapper, says Todd Cipperman, founder of Cipperman Compliance Services, a financial consulting firm based in Wayne, Pa.
Funds in annuities can be packed with “trailing commissions,” fees that compensate brokers for selling products, says Jeffrey Cutter, a financial advisor in Falmouth, Mass. “People’s chins are on the floor,” he says, when they find out the total costs in annuities, which can add up to nearly 6% in administrative and fund expenses.
Another factor: Insurance salespeople must provide investors with reams of disclosures, including fund prospectuses, when they sell a variable annuity. But the prospectuses are complex and voluminous, running hundreds of pages, and fees may be buried deep within the paperwork. “The problem is there’s so much disclosure that people get overwhelmed, and it becomes less than clear what the fees are,” says the compliance expert Cipperman.
The Securities and Exchange Commission recently proposed rules to allow insurance carriers to provide investors with summary prospectuses. But providing summary prospectuses would be voluntary, and the new rules wouldn’t do anything to address underlying fund fees. “They can still charge whatever they want so long as they don’t breach their fiduciary duty that the fees aren’t too high,” says Cipperman.
Barron’s found hundreds of funds held in variable annuities with sharply higher fees than what investors would pay for identical funds outside annuity wrappers. The Rydex Variable Nasdaq 100 fund is a popular choice, showing up in sub-accounts issued by carriers such as Nationwide, Principal, and Prudential, according to Morningstar. The fund has an expense ratio of 1.66%, well above the 0.2% for Invesco QQQ Trust (QQQ), an ETF with the identical portfolio. A spokesman for Nationwide said the firm “does not set nor establish the expense ratios of third-party funds.” Principal declined to comment on the expense ratio of the Nasdaq fund. Prudential did not reply to requests for comment.
Similarly, Lincoln ChoicePlus variable annuities include the LVIP SSgA Bond Index fund, with an expense ratio of 0.6%. The fund tracks the U.S. bond market, but at a much steeper cost than funds outside the annuity world; Schwab U.S. Aggregate Bond Index (SWAGX), for instance, charges 0.04%. Lincoln says the fund’s expense ratio includes 12b-1 fees that are “required to pay for distribution, marketing, advertising, and promotional costs of a mutual fund.” Lincoln also says that it provides a 0.12% fee waiver for the fund, reducing the “effective expense ratio” to 0.35%.
While low-fee share classes may not be available in annuities, investors have plenty of choices elsewhere. They can demand lower-fee shares from their advisor. They can also swap into a cheaper share class of the same fund. That generally isn’t a taxable event, says financial advisor Michael Kitces, but make sure your brokerage firm processes it as an exchange, and not a sale. No matter what, paying less for market returns is always a good idea.
Write to Daren Fonda at daren.fonda@barrons.com
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