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Some investors can’t catch a break point

Some investors already reeling from the broad stock market slide are about to discover more bad news in this year's crop of mutual fund annual reports: higher management fees and expense ratios.

Some investors already reeling from the broad stock market slide are about to discover more bad news in this year’s crop of mutual fund annual reports: higher management fees and expense ratios.

Nearly half the country’s mutual funds employ “break point” pricing in setting the fee for the adviser that manages the fund’s portfolio of securities. Under break point pricing, management fees as a percentage of fund assets fluctuate in accordion-like fashion – declining when assets swell and rising when they shrink. The idea behind fee break points is to pass along the benefits of economies of scale to fund shareholders.

During the long bull run of the 1990s, management fees calculated as a percentage of a fund’s assets ticked down as market appreciation and investor purchases combined to boost the size of the average stock fund to just over $1 billion in April 2000. But through August – with the Standard & Poor’s 500 stock index off 26% since last year’s peak – that average had fallen to $726 million. The contraction is triggering higher management fees in funds with break point pricing.

“A lot of fund shops weren’t all that generous in sharing the benefits of economies of scale in the first place, so I would guess it wouldn’t have that big an impact, but obviously the overall trend will be up,” says Russel Kinnel, director of fund analysis at Morningstar Inc. in Chicago.

Consider the Alliance Growth Fund, whose assets declined by $2.53 billion, or 39%, to $3.99 billion over the first eight months of this year. That asset drop in the Alliance Capital Management LLP fund caused the effective management fee for Class A shareholders to increase nearly 7% to 0.74% of assets, according to an analysis done in Denver by Lipper Inc. Thus, a shareholder with $100,000 in Alliance Growth is now paying $46 more in annualized management fees than under the fee structure at the start of this year.

That increase probably seemed inconsequential to investors in a market such as that of 1999, when Alliance Growth returned 25.6%. However, a 7% fee hike in today’s market magnifies the fund’s 33% year-to-date loss.

“That’s a much more powerful dynamic in the perception of expenses,” says Mercer Bullard, founder of Fund Democracy LLC, a shareholder advocacy group in Chevy Chase, Md. “It has a far greater impact in terms of [how] your overall performance [is viewed].”

Brian Reid, a senior economist at the Investment Company Institute, says the Washington trade group hasn’t examined to what extent management fee break points are being triggered or the impact on fund expenses.

In an examination of equity funds in the 100 largest U.S. fund complexes last week, Lipper found that effective annual management fees had risen a maximum 6.6% through August. That figure is now higher, since the stock market has fallen at least 3% since then.

“As assets are peeled back, you are automatically going to get a kicker in the effective advisory fee because you have less break points,” says Jeffrey Keil, Lipper’s Denver-based vice president of portfolio evaluation, performance and board reporting.

Uncertainty over the economy and continued market volatility are expected to prompt investors to move into more-conservative investments – pushing up mutual fund transfer agent fees. Such fees can represent as much as 10% of a stock fund’s expense ratio, and up to 25% for a money market fund, according to Lipper.

In addition, some observers wonder whether increased profit pressure from the troubled equity markets will prompt mutual fund and variable-annuity sponsors to lay claim to previously waived fees through “claw-back” provisions (see accompanying story).

So far, no fund companies appear interested in forgoing automatic fee increases in light of the significant market losses investors have already suffered. “If fees are going up because assets are going down, it’s triggered because that’s the way the fund operates,” says Greg Stitt, spokesman for OppenheimerFunds Inc. in New York. “There won’t be a waiving-type situation. That’s the way the fund operates. If tomorrow assets start going up, then those fees will decrease as well,” he adds.

Mr. Bullard believes, however, that if the market remains in a funk, partial fee waivers could grow in popularity. “When you are in a climate where people are becoming more price sensitive, do you react to losses by raising prices or lowering them?” asks the former Securities and Exchange Commission assistant chief counsel. “Companies could also use this as an opportunity to [waive fees and] grab market share.”