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Should fund companies waive fees in down markets?
The media is filled with criticisms of the mutual fund industry. Nothing wrong with that since a nice blend of positive and negative news keeps things balanced and investors aware. However, many have taken a shot at the industry for continuing to collect handsome fees while its end clients lose money. I'm a vocal critic of some industry practices, but there are three very good reasons why expecting fund companies to waive fees in down markets is simply unreasonable.
Follow the food chain
Fund companies don't collect the entire MER. Some of that is due to regulatory requirements (which contribute to operating expenses) while about 40% goes to distribution - i.e. financial advisors and their firms. If fees are cut, fund companies won't be the only ones feeling the pain. Distributors would be expected to share in the pay cut, in such an occurrence.
However, many financial advisors provide services that extend beyond the mere recommendation of mutual funds. Retirement, tax, and estate planning are included in the suite of services many provide their clients. The 'bundled' nature of the current compensation structure makes it nearly impossible to attribute the portion charged specifically for investment advice.
Hence, a reduction or elimination of a fee for any length of time is simply not feasible.
Dealer/advisor liabilities
Consider also that dealers and their registered advisors assume liabilities (i.e. primarily for errors) that are related to portfolio and transaction values - regardless of market conditions - so it makes sense that they'd continue to collect fees even when markets are in a freefall.
In addition, most dealer businesses operate on already thin margins so cutting fees in already tough times would likely put many firms out of business. This would be an undesirable side effect of fulfilling the wishes of some unhappy clients since they would risk losing the advice they so much depend on, particularly in tougher times.
Investment constraints
The regulatory environment in which mutual fund managers operate is such that they face some significant constraints on their portfolio management activities. Mutual funds cannot invest more than 10 percent in a single holding, nor can they short stocks. Fund managers also face many firm-specific constraints, such as limits on how much cash equity managers can hold.
It's unfair to expect a firm to waive fees during weak markets - which is when taking selective, concentrated bets could most benefit a portfolio. Prohibiting certain activities and then punishing firms for not realizing the benefits of such activities makes no sense.
Hedge funds
Before their more recent mainstream popularity, hedge funds made most (if not all) of their fees based on performance bonuses. They once had little to no base fee. Greater demand and a more retail focus have resulted in a bump up in fees.
It's now quite common for hedge funds to charge flat fees equal to 2 percent of fund assets, in addition to generous performance incentive fees - which are often 20 percent of net profits. Hedge funds, however, operate under relatively low regulation and face none of the constraints related to shorting/leveraging, portfolio concentration, or other aspects to which mutual funds are subject.
Conclusion
It's natural for clients to question whether funds should continue to charge fees during down markets. Such a sentiment is, in part, a natural bi-product of the most recent and painful bear market. Fees are rarely at issue during booming markets.
That having been said, expecting funds to waive fees during down markets is unrealistic. Such expectations, however, could be imposed upon hedge funds since they face few, if any, regulatory constraints and take a greater share of fund assets in the form of fees.