TCS Daily


Small Investors Beware

By John E. Tamny - February 10, 2004 12:00 AM

In a January 13 USA Today interview Eliot Spitzer was asked about his fee negotiations with Alliance Capital. Despite the fact that he has no jurisdiction over fund pricing, the ambitious attorney general has succeeded in bringing down the rates charged to individuals by Alliance, and recently got Putnam Investments to do the same.

Spitzer's actions are curious for many reasons, not least his declaration in the above-mentioned interview that the government should not set fees. Leaving aside the ability of individual investors to fire overcharging fund managers with a mouse click (and be presented with 7,000 other fund options), his definition of what is a high fee bears scrutiny.

In the January 31 USA Today, Spitzer seemed to say that individuals pay high fees when the nominal rate they pay is greater than that charged to institutions. Spitzer said, "individual investors paid 40% more than institutional investors in fees on Putnam funds." According to the Wall Street Journal, Spitzer told the Senate Governmental Affairs subcommittee that "consumers have been ripped off." Is he serious?

This is, after all, basic math. Let's assume that the generic charge for individuals at Putnam is 1% of funds under management, while it's .6 percent for institutions. It's not hard to see that this isn't an apples vs. apples comparison, as in fees earned on 1 percent of $25,000 (a typical small account) are far less than those generated by .6 percent of $25,000,000.

Having done the math myself, I thought there could be no way that Spitzer was arguing the above scenario. There must be something else, as in I must be missing something. Either he and his whole staff chose to skip the math part, or he really thinks the press and his electorate can't do math, let alone operate a calculator.

Rather than continue to wonder, I called his press office and presented one of his staffers with the 1 percent versus .6 percent question. Evidently the attorney general thinks we're all incompetent, because the argument that the press have swallowed so uncritically really is as simple as the one described by me.

With Spitzer succeeding in bringing down fees that by virtue of intense competition must necessarily already be low, the small investor should be very nervous. When prices are set artificially high by elected officials or bureaucrats (farm supports are a good example), the result is usually an excess of the product whose price has been set. Conversely, when prices are set artificially low (New York rent-control apartments for instance), the result is usually a scarcity of said product.

Eliot Spitzer might succeed in reducing mutual fund fees, but make no mistake about whom the unintended victims will be. In a best-case scenario, fund firms will get around Spitzer by charging a maintenance fee on small accounts. Cato Institute senior fellow Alan Reynolds has written that if fees are "arbitrarily constrained, we should expect such maintenance fees on small accounts to grow larger and more prevalent, if small accounts are permitted at all."

In short, mutual fund firms have public and private owners who do not expect them to lose money on customers, large or small. That said, if Spitzer "protects" the small investor through the application of scare tactics that cause fees to drop, it's very likely that rather than lose money, fund firms will simply raise minimum account sizes, and in the process reduce the myriad fund options presently available to the small investor.

Prior to his price-fixing efforts, reasonable people could at least argue about whether Spitzer's actions were good or bad for investors. This time it would be hard for even his most ardent defenders to mount a realistic argument.

Figure we're down to about seven major airlines that compete on price among themselves, along with upstarts like JetBlue and AirTran that bring the prices offered by majors down even more. When it comes to flying, the consumer is clearly the big winner in the arrangement, with choices for where to go growing just as prices are falling.

The mutual fund industry offers even more choice, with 7,000 different mutual funds, all vying for the money of the small investor. For Eliot Spitzer to say with a straight face that mutual funds are overcharging their customers defies all laws of economics.

Sadly, the press continue to give Spitzer a free pass despite statements that at best suggest he needs to be taught basic economics, and at worst, suggest a man so addicted to fawning press coverage that he's even willing to advocate the thoroughly discredited concept of price controls to stay on the front pages.

Economist Walter Williams once said about rent control something along the lines that its negative consequences for cities could only be rivaled by actual aerial bombardment. Here's hoping those who cover Eliot Spitzer heed Williams's words as the former attempts to set prices on investment vehicles that "are still probably the single best vehicle for small investors."

Who said the above? Eliot Spitzer himself.

The author is a frequent TCS contributor who last wrote for TCS about late trading.


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