After years of suffering from compressing fund fees while money flows to index funds, fundsters now face a public cry for free mutual funds.

In an op-ed in yesterday's Wall Street Journal William Birdthistle and Daniel Hemel call on the industry to offer index funds that charge no fees at all. After all, even tiny fees of 9 basis points cost investors money! Fundsters might laugh if they weren't feeling all the pricing pain.

Birdthistle, a Chicago-Kent College of Law professor (a frequently cited fund industry critic), and Hemel, a University of Chicago Law School assistant professor, miss several key points.

First, current fees on broad market index funds cost investors very little proportionately. In Birdthistle and Hemel's example, a $10,000 starting investment gains six percent annually over three decades but "suffers" from fees of 9 bps. That $10,000 initial investment, with no additional contributions, grows to $55,989.82 ... versus the $57,434.91 it would have been without the 9 bps fee. That's a 2.5 percent drop, not a giant cost by any stretch: compare that to the six percent charged by realtors (split between the buying and selling side) on the sale of a home!

Second, if investors no longer pay anything for an index fund, then they're no longer its real customers. That distinction belongs, perhaps, to its securities lending clients. Or perhaps to firms that want data on investors and are willing to pay. All the backlash lately against Facebook is rooted, at least in part, in the cold, hard truth that people who use a service they do not pay for are not the true customers of that service and should not be surprised when they are not treated like customers.

Third, the two professors completely ignore the reality of how index funds and ETFs are increasingly used: not directly by individual investors, but indirectly by home office portfolio builders, ETF strategists, roboadvisors, and the like, firms building portfolios out of those funds and charging a fee for doing so. Even with free underlying funds, investors would not be avoiding investing fees entirely; they'd simply be shifting them to new partners that focus not on securities selection but on asset allocation and tactical movement (i.e. market timing!). So much for the death of active management.

Fourth, and perhaps most importantly, the comparison to an abstract index is rarely the right test of benefit for a pooled investment product like a mutual fund. The better test is a comparison with how individual investors do when directly investing in securities themselves as opposed to investing in index funds or active funds. Any kind of pooled investment offers a steadying effect on investor behavior, especially for those who simply invest in the fund and let it be without moving money around regularly. 

Edited by: Neil Anderson, Managing Editor


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