2017-12-30 09:31:02
Why Are Mutual Fund Fees So High? This Billionaire Knows

The billionaire investor Ronald S. Baron flashed the grin of a proud father at his annual investor jamboree in November, as the chief executives of his favorite companies explained how slashing prices stoked their bottom lines.

That is, until a shareholder in one of his mutual funds drew an awkward parallel.

“Excuse me — Schwab is charging a very low fee,” a woman pointed out, after a presentation by Walter W. Bettinger II, the chief executive of the discount broker Charles Schwab. “God bless him, but no one ever said Baron’s fees are little.”

You can say that again.

Mr. Baron’s mutual funds charge some of the higher investment fees around, and the fees have held steady despite a $1 trillion exodus out of old-school mutual funds into cheaper, better performing rivals that track a variety of indexes and investment styles.

In a global economy where competition and Amazonian price destruction have forced companies to cater to cost-wary customers, the mutual fund industry is a rare outlier. Fees on most actively managed mutual funds, which house the retirement savings and other assets of millions of Americans, have barely budged.

The reasons for that — quiescent mutual fund boards, complacent investors and a general unwillingness to call a halt to one of the great gravy trains in financial history — are all visible inside Mr. Baron’s fund family.

The Baron Funds group manages $26.4 billion in assets on behalf of hundreds of thousands of small and large investors. An old-fashioned stock picker, Mr. Baron achieved renown in the 1990s and the 2000s for successfully betting on small companies.

But his performance has suffered in recent years. In 2014, 2015 and 2016, his flagship fund, Baron Growth, trailed the Standard & Poor’s 500 stock index by an average of seven percentage points.

This year, the results have been better: He is up 27 percent, compared with 20 percent for the S. & P.

The 13 Baron funds impose fees that were 54 percent higher than last year’s industry average — and vastly higher than what a comparable exchange-traded fund would charge.

In November, Baron reduced fees on three of its smaller funds. But the largest, Baron Growth, with $6.3 billion in assets, still charges 1.3 percent of assets. That is a third higher than the median level for similar funds, according to Morningstar.

Since 2010, investors have withdrawn, in net terms, just over $5 billion from the growth fund, according to Morningstar. But many have stuck around.

Mr. Baron, 74, is perhaps best known for his annual investment conference, now held at the Metropolitan Opera House at New York’s Lincoln Center and in its 26th year. Mixing rock stars, pop entertainment (Barbra Streisand and Paul McCartney have performed in the past), patriotism (this year celebrated the 100th anniversary of President John F. Kennedy’s birth) and triumphant chief executives, the gala is a giddy ode to American capitalism.

Few fund companies offer a comparable perk, and some 5,000 Baron fund holders travel to New York to attend.

At the conference in November, with markets hitting new highs each day, investors were exultant. But there was a lingering concern.

“The fees are very high,” one man said to a friend as they exited the Chris Rock comedy show. “You really have to have the market go up to do well.”

Even longtime fans acknowledge they are paying up.

“I won’t say performance warrants the fees they charge,” said Barry Edelman, a Las Vegas retiree and a 20-year Baron shareholder. “But I appreciate how they differentiate themselves from the competition.”

When the shareholder asked Mr. Baron why his rates were so much higher than Schwab’s, the audience response was telling: The opera hall erupted in sympathetic laughter — and applause.

Mr. Baron has been getting flak for his funds’ high costs for years.

“They will always be expensive,” said Christopher Franz, an analyst at Morningstar, which won’t give the fund its highest rating because of the steep fees.

Mr. Baron is unapologetic about the high fees. He argues that his skills and experience — and the arduous task of researching small growth companies — justify the fees.

“Since inception, 98 percent of our funds have beaten their benchmark,” he said in an interview. “If you want the lowest fee, you should not invest with us.”

But if you want to bet on American growth stocks, “you can double your money in 10 years,” he said. He frequently sticks with his top picks for decades.

While this year has been stellar, over a longer stretch his performance is less robust.

For a five-year period, Baron Growth is up 13 percent, but the iShares Russell 2000 Growth fund, an exchange-traded fund that tracks Mr. Baron’s preferred benchmark index, is up 96 percent. And iShares carries a fee of just 0.24 percent — a sliver of what Mr. Baron charges.

Mr. Baron believes that the true measure of his success is performance since his fund’s launch in 1994. A $10,000 investment in his main fund then would be worth $163,207 today, according to Baron data. That compares with $57,889 for the Russell growth index and $84,904 for the S. & P. 500, per Baron.

Mr. Baron’s funds are not the only ones refusing to budge on fees. In fact, the average fee for 2,000 actively managed mutual funds has remained 0.84 percent of total assets for the past three years, according to Morningstar.

Some, like the Capital Group and Fidelity, have gotten the message and have reduced their fees over this period.

Industry experts say there are several reasons that active mutual fund fees have not succumbed to broader pricing trends in the economy.

The first is their power. While more than $1 trillion has left higher-fee funds in favor of passive competitors, that still leaves some $10 trillion. That generates about $100 billion in fees for fund companies. And it suggests they don’t need to cut fees to retain assets.

It’s dizzyingly complicated for investors to figure out what fees they’re paying. With funds’ multiple share classes, varying structures and oceans of boilerplate, even sophisticated investors may not realize they are paying up for a laggard.

Another reason for elevated fees, experts say, is lax oversight.

Every mutual fund is overseen by a board of trustees — a mix of executives from the fund company and mostly independent officers that must, by law, look out for investors’ interests.

But are these boards truly effective advocates for investors?

A number of lawsuits brought against major investment companies, including Axa, BlackRock and Pimco, allege that trustees are not pushing hard enough for lower fees. The judge overseeing the BlackRock case in 2015 declined to dismiss the suit, saying the allegations raised questions about “rubber stamping” by boards.

BlackRock has said the suit lacks merit.

At the Baron fund family, the fee oversight is complicated by the fact that Mr. Baron, the largest shareholder in the investment company and the manager of its largest fund, has a financial incentive to keep fees high. In addition to his salary and bonus, tied to performance among other measures, he gets a reward based on a percentage of the fees his funds bring in, according to regulatory filings.

That is unusual. At most fund companies, compensation packages reward managers for beating their benchmarks — not collecting fees.

“Compensation based on fees is worrisome,” said Linlin Ma, an economist at Northeastern University and a co-author of a recent paper that examined incentives for mutual fund managers. “That means that the portfolio manager will spend more time increasing fees and the result is worse performance.”

William A. Birdthistle, a former mutual fund lawyer and the author of a book that examines the inner workings of the fund industry, argues that one of the reasons some fund boards are not more aggressive about pushing for lower fees is that trustees tend to be closer in outlook and sympathy to the fund company that hired and pays them. Often, they carry thin credentials and have served on these boards for decades.

While the average age for independent mutual fund directors is 66, some directors stay on boards into their 80s and even 90s. Such long tenures often make directors weak voices for investors, he said.

Baron funds are overseen by nine directors. Seven are listed as independent. Four of those seven have served as trustees since Mr. Baron established his first funds 30 years ago.

One of them, David A. Silverman, has zero financial experience: He is a doctor with an expertise in infectious diseases.

The lead independent trustee, Raymond Noveck, worked as a managing director at Baron from 1985 to 1987.

“Trustees have very little incentive to fight managers,” Mr. Birdthistle said. “Kicking and scratching is unlikely to lower fees but certainly will antagonize the manager, which is the one institution that can arrange for the trustees’ dismissal. Besides, trustees will tell themselves, if a fund’s fees really are too high, the market will sort things out and investors simply won’t invest in the fund.”

The board has taken steps to recruit trustees with bulkier backgrounds, most recently Tom Folliard, a former chief executive of CarMax.

In a statement, Baron Funds said that it regularly assessed its board’s effectiveness and that the long tenure of some members was a sign of the board’s experience and expertise. It said fees were approved via data and analysis from an outside party. The board also said it was represented by an independent lawyer.

One clear winner of this arrangement is Mr. Baron. “In 1970, my net worth was minus $15,000,” he said in the interview. “Now my children and I have over $670 million invested in our funds.”

Forbes pegs his wealth at just over $2 billion — and he is not shy about showing it off.

His office in Manhattan’s General Motors Building is a museum of trophies and curiosities, from paintings by Andy Warhol and Roy Lichtenstein to Kennedy’s rocking chair. He has invested about $150 million in a 59-acre beachfront estate in East Hampton, N.Y., that he bought in 2007.

Mr. Baron’s investment philosophy — that over the long term the stocks that he picks will keep doubling — is fired by a relentless optimism that he attributes to his life’s good fortune.

A grandchild of immigrants from Poland and Russia, Mr. Baron grew up scraping for extra cash in Asbury Park, N.J. He worked his way through college and law school, which he left without getting a degree.

In 1982, after a stint as a Wall Street analyst, he founded his investment firm.

His timing was perfect. It was the start of a bull market, and he developed an expertise in picking small companies that would grow into big ones such as Charles Schwab, Vail Management Company and Tesla.

It was the heyday of the individual stock picker. Peter Lynch at Fidelity and Bill Miller at Legg Mason gained cultlike followings, accumulating billions of dollars in assets and gracing the covers of the personal finance magazines that lionized them.

Mr. Baron’s star power was of a lesser variety, but it was not insubstantial. He became a regular television commentator and won a reputation as the longest of long-term investors, holding positions for decades. His assets peaked at $28 billion in 2015.

“We have made $23.6 billion for our clients,” Mr. Baron said.

Mr. Baron cultivates an intimate relationship with his investors; many have been with him since the beginning. His investment letters are rich with personal details as well as his market views.

But it is his annual investor gala, which he pays for himself, that defines him. Onstage, he cultivates a grandfatherly mien, bragging about how much money the chief executives of his portfolio companies made for Baron shareholders. His chief maxim is “We invest in people,” and he treats management as family.

There are warm bear hugs onstage for some. Others get personal advice.

Spotting a top executive from the data firm FactSet, another portfolio holding, he offered to connect her with his longtime tax lawyer. “It’s incredible what he has done,” Mr. Baron said.

A surprise auction is part of the atmospherics, and this time a Model 3 from Tesla was raffled off. Tim McGraw and Faith Hill performed.

As the event ended, attendees streamed out of Lincoln Center into a freezing evening. Mr. Baron, without a coat, greeted them on the plaza. He hugged and kissed old friends and posed for selfies with new ones.

Nobody complained about the fees.