June 15, 2007
Securities Exchange Commission
File No. 4-538
Regarding Rule 12(b)(1)
We've heard much about mutual fund sales practices and how load fund shares are sold as well as the various forms of compensation. There are problems with the way no-load funds are sold, too.
Supermarkets like those of Schwab and Fidelity have thousands of funds, and the investors make the call, so bias isn't really a problem. However, costs are.
We understand Schwab charges fund companies 40 basis points to participate in its no-transaction-fee program, and Fidelity charges about 35 basis points. The problem is that it only costs those firms about 10 to 15 basis points to service the accounts, and the remainder amounts to a direct transfer from fund investors to the supermarkets.
In raising its fee to 40 basis points about three years ago, Schwab cited new added advice services available to investors as
part of Schwab's effort to find a middle ground between full service and discount. Unfortunately,
even the Schwab customers who don't use those
services have to pay.
Now here's the part that would make even those
service-bundlers in Redmond, Washington blush: You're paying for those services even if you don't buy your fund through Schwab or Fidelity. Schwab and Fidelity prohibit funds in their no-transaction-fee lineups from offering a lower-cost share class to investors who purchase the fund directly from the fund company.
Schwab has often argued that its program actually
lowers fund expenses by bringing in more assets
and because they charge less than many participants
would have to pay to service the accounts themselves. If that's true, though, there would be no
problem with allowing fund companies to offer
differently priced shares directly. Likewise, it's
difficult to explain the lack of cheap bond funds
other than those from Schwab and Fidelity that are
available in their own supermarkets.
Defenders of supermarket fund costs often argue that the marketplace should decide. If fund investors feel expenses are too high, they say, those investors should actively seek out lower-cost funds. While this idea has some validity, the supermarket rule against offering cheaper shares is meant to prevent competition on fees. In order to level the playing field, Schwab and Fidelity should either lower their fees to a modest premium above costs or they ought to allow fund companies to offer cheaper share classes for direct investments.
In sum, most of the middlemen are forcing higher
costs on investors while stifling competition. Fund
boards should look closely at whether these arrangements are in fund holders' best interests and
pull out if they decide that fund holders would be
better off without them.
Robert E. Frey, CFP