Suit raises questions about fees on subadvised funds

Suing to prove that a mutual fund charges small investors excessive fees is often an exercise in futility. For 30 years, the courts have set the bar so high for plaintiffs in such cases that most suits are dismissed before they get to trial. According to a 1982 legal precedent known as the Gartenberg Standard, the courts will deem a fund's management fee excessive only if it is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining.” Proving that has been impossible, partly because it is difficult to isolate management fees that cover the crucial work of picking stocks and bonds from costs associated with mundane administration. Until now. In December, U.S. District Court Judge Renee Marie Bumb in Newark, N.J., allowed a case known as Kasilag et al. v. Hartford Investment Financial Services LLC to proceed, denying Hartford's motion to dismiss. Jennifer Kasilag is one of six plaintiffs who invested in Hartford funds. The reason for the decision has everything to do with the type of mutual funds the plaintiffs chose to attack.

LEVEL OF TRANSPARENCY

Rather than go after, say, Fidelity Investments, which manages funds in-house and bundles most of its costs in its management fees, Ms. Kasilag's lawyers targeted Hartford's subadvised funds, run primarily by external manager Wellington Management Co. LLC. Because the fees Hartford pays Wellington to pick stocks are specified in public documents and separate from fees for other services, they provide a level of transparency that can better indicate whether the total management fee is too high. Part of the trouble with previous shareholder suits was that plaintiffs would compare a mutual fund's management fees with those of pension plans, arguing that the latter pay a fraction of the cost. Defendants would respond that it was an apples-to-oranges comparison, as mutual funds have additional administrative, advisory and legal costs from handling multiple shareholder accounts baked into their management fees. “We can all intuitively agree that managing a mutual fund is more complicated than managing a single pension plan's portfolio of $100 million, but the question is, how much more complicated?” said Paul Ellenbogen, who as director of board consulting at Morningstar Inc. provides fee advice to fund directors. “How do you quantify that?”

"OUT OF BALANCE'

The breakout of Hartford's subadviser fees provides an answer to that question. According to Ms. Kasilag's complaint, in 2010, Hartford earned $157.6 million in investment management fees from six of its subadvised funds and paid $57.6 million for subadvisory services to Wellington and Hartford Investment Management Co., a subsidiary. More than 90% of the disputed fees are for four Wellington subadvised funds. “If a management fee is higher than the subadvisory fee, and the subadvisers are doing all the work, you have to ask yourself what the management company is doing for its fee,” said Niels C. Holch, executive director of the Coalition of Mutual Fund Investors, a shareholder advocacy group. “It's out of balance.” Hartford executives declined multiple requests to be interviewed. In a statement, spokeswoman Julia Zweig said: “We are confident in the reasonableness of our fee structure and intend to defend vigorously.”

EXPENSIVE QUESTION

Typically, a subadvised fund has one more cost than one that's managed internally: The adviser must monitor the subadviser to make sure its performance is adequate and that it is following its investment mandate. Is it worth paying Hartford $100 million a year to keep an eye on Wellington and Himco? Wellington, which manages $748 billion in assets, is one of the largest, most well-respected money managers in the world. As for administrative costs, many of these should be taken care of by an additional “other expense” fee that Hartford and many funds charge shareholders. According to the Securities and Exchange Commission, the charge usually covers expenses for “payments to transfer agents, securities custodians, providers of shareholder accounting services, attorneys, auditors and fund independent directors.” At the Hartford Healthcare Fund, one of the funds named in the suit, this “other expense” amounted to 0.34% of assets annually. That was in addition to the 0.9% management fee. Mr. Ellenbogen screened actively managed stock funds that disclose their administrative costs separately from their other fees, and found the average cost to be 0.09% of assets.

FEE SPLIT

The type of deal Hartford has with Wellington is commonplace with most subadvised funds. For example, the usual arrangement at Aston Asset Management LP, which manages 23 subadvised funds with $11.5 billion in assets, is that the firm collects half the management fee and the subadviser the other half. Aston, which isn't involved in the Hartford case, declined to make anyone available to be interviewed. It also is typical for subadvised mutual funds to have higher expenses than funds managed in-house. According to a 2011 study by Lipper Inc., the average subadvised equity mutual fund charges 10 basis points more than the average internally managed one. The difference was about 5 basis points for bond funds. Even in cases where two funds are run by the same manager in similar styles, the fees are higher for the subadvised version. For example, retail shares of the Aston/DoubleLine Core Plus Fixed Income Fund, subadvised by DoubleLine Capital LP, have a 0.55% management fee and a total expense ratio of 0.96%. The DoubleLine Core Fixed Income Fund, meanwhile, has a management fee of 0.4% and a total expense ratio of 0.8% for retail shareholders. In the same vein, administrative shares of the Harbor Bond Fund have a total expense ratio of 0.8%, while Pacific Investment Management Co. LLC's Total Return Fund has an expense ratio of 0.71%, even though the funds are run by the same manager in a very similar style. Neither DoubleLine, Harbor Capital Advisors Inc. nor Pimco are involved in the Kasilag lawsuit.

PROFIT MOTIVES

A key argument of plaintiffs in the Hartford case is that competitor The Vanguard Group Inc. offers similar funds run by Wellington for much less. Wellington runs the Vanguard Health Care and the Hartford Healthcare funds. Vanguard has a total expense ratio of 0.35%, compared with the 1.49% charged by Hartford Healthcare's A share class (in addition to the 5.5% front-end commission paid to brokers who sell it). Vanguard's fund is no-load. Wellington declined to comment on the Hartford case. Hartford “urges the court to reject this comparison, arguing that Vanguard is a not-for-profit entity that specifically markets itself as a low-cost mutual fund provider,” according to Ms. Bumb's opinion. Such a defense may not explain Hartford's fees on the subadvisory level. Although Vanguard doesn't seek a profit, Wellington does, whether it is working for Vanguard or Hartford. Vanguard pays Wellington 0.15% as manager of Vanguard Health Care, while Hartford pays Wellington 0.4% to manage Hartford Healthcare, according to current SEC documents. Economies of scale could be partly responsible for the gap. Vanguard's size allows it to negotiate “a far better price when hiring money managers than anyone else,” said T. Neil Bathon, managing partner of Fuse Research Network. Ms. Kasilag's lawyers contend that the disparity reveals that Hartford's subadvisory fee wasn't a product of successful “arm's-length bargaining” with Wellington, as the Gartenberg Standard requires.

BOGLE'S ARGUMENT

The argument that for-profit companies in the mutual fund business serve “two masters” — the owners of the overarching management company and the shareholders of the funds — and fail as fiduciaries as a result is one that Vanguard founder John Bogle has made for decades. Vanguard, the only fund company run at cost, has been silent about the case. Dan Newhall, a Vanguard principal who works on its deals with external advisers, would not discuss Hartford specifically but thinks it is unfair to compare any fund shop with Vanguard because of its unusual structure. But instead of suing, unhappy shareholders should simply relocate their accounts to Vanguard, he said. “There's nothing to keep shareholders from moving from more expensive funds to less expensive funds,” Mr. Newhall said. Such a solution won't help Hartford shareholders who believe that they paid excessive fees in 2010. They will have to wait for a settlement or for a trial.