The Vanguard Group

Exhibit VII

Back to Opening Statement
Back to Full Testimony

Memo Re: Investment Company Institute Releases on "Total Shareholder Costs of Mutual Funds"

A recent ICI Study (Total Shareholder Costs of Mutual Funds: An Update; September 2002) updates other studies it has provided over the past four years, purporting to show the costs of mutual fund ownership. Once again, the study relies on the sales-weighted costs of funds, rather than the more relevant asset-weighted data. Once again, it fails to report the continuing rise in fund expense ratios, or even present those expense ratios for analysis. Once again, it ignores the impact of low-cost index and institutional funds. Once again, it relies on sales charge calculations that appear to significantly understate this component of annual costs. And once again, it ignores three extremely large components of fund shareholder costs (financial adviser fees, portfolio turnover costs, and out-of-pocket fees).

Here is another way of looking at the ICI equity fund cost figure of 1.28%:

  Basis Points
ICI Figure 128  
Corrected for sales charge calculation +15 E
Corrected for Index and Institutional funds +12  
Total 155  
Financial adviser fees1 10 E
Portfolio Transaction costs 70 E
Out-of-pocket costs 5 E
Opportunity Cost (cash drag2) 30  
Total 270  

Conclusion: The actual costs of mutual fund ownership appear to be more than 100% higher than reported by the ICI.


1. Many Costs Ignored. The ICI study simply excludes many of the costs of fund ownership. Equity fund transaction costs—an obvious cost of fund ownership—can be estimated at about 70 basis points a year. (Most independent experts would place it at a substantially higher amount.) Out of pocket fees are simply ignored; account maintenance fees, redemption fees, and penalty fees (deducted from the accounts of investors who redeem their "deferred load" funds before having paid the requisite annual total sales charge) would add further costs.

2. Operating Expense Ratios Rise—Dollar Expenses Soar 86-Fold. The 98 basis point decline in the ICI's version of total shareholder costs-from 226 basis points in 1980 to 128 basis points in 2001—came about entirely from lower distribution costs, which fell 109 basis points, from 149 to 40. Operating expenses actually rose—from 77 basis points to 88 basis points, despite the fact that equity fund assets rose 7,600%(!) during that period—from some $45 billion to $3.4 trillion . . . meaning that total fees (excluding 12b-1 fees) rose from $350 million in 1980 to $30 billion in 2001.

3. Sales Charge Costs Substantially Understated. Much of the alleged decline in distribution costs appears spurious, the result of amortizing front-end sales loads over a longer holding period than the facts justify (i.e., if a 6% sales charge were amortized over 10 years, it would average about 0.6% per year; over five years it would average about 1.3% per year). For their holding period data, the ICI relied on a 1990 study of redemption rates by the Wyatt Company, which in turn calculated redemption rates on a share purchase made in 1974. But in 1974 the equity fund redemption rate was 8% of assets (an average 12-year holding period); in 1990 it had risen to 38% and in 1998-2002 it averaged 39% (a 2.6 year holding period). Thus, if calculated using current redemption rates instead of data that are nearly 30 years old, the reported ICI front-end sales charge cost of 47 basis points could easily reach 90 basis points.

4. Expenses of Low-Cost Funds Rise Sharply. The ICI's original 1998 shareholder cost study reported that the lowest cost decile of funds had a 27% increase in costs from 1980-1997 (from 71 basis points to 90). Excluding Vanguard (which operates on an at-cost basis) from that group would suggest an increase of at least 33% for the lowest cost group of funds. (The ICI has eliminated this information from subsequent updates of the study.)

5. The Flaws of Sales Weighted Data. The long-term decline in fund costs reported in the studies is profoundly flawed by calculating cost on a sales-weighted rather than an asset-weighted basis. It also ignored the fact that the expenses of the average fund are about 30% higher than the asset-weighted expenses. The 1999 study shows (in basis points):

Average Cost
Average Cost
Fund Cost
1980 1998 1980 1998   1980 1998  
Money Market 55 42 -24 55 51 -7 67 62 -7
Bond 154 109 -29 210 124 -41 216 151 -30
Equity 226 135 -40 231 132 -43 241 193 -20

The use of sales-weighted data reflects not a fall in fund costs, but a change in consumer preferences toward lower-cost and index fund and away from higher-cost funds. Price competition is properly defined, however, not by the actions of consumers, but by the actions of producers.

6. Indexed and Institutional Funds are Responsible for Much of the Reported Decline. Since 1980, index funds and institutional funds (for very large investments) have come to the fore, seriously distorting the equity fund cost analysis. ICI figures show that the reported 1998 equity fund sales-weighted cost of 135 basis points would rise to 153 basis points if they were excluded. If further adjustment is made by also excluding the three largest fund complexes, the cost rises to 165 basis points.

7. Operating Costs Continue to Rise. The most recent ICI Study (September 2002) calculates total shareholder cost for equity funds of 128 basis points on a sales-weighted basis; a further reduction of seven basis points from the 135 total for 1998. However, sales costs declined by 12 basis points, meaning that operating expenses continued their long-term rise, moving up by five basis points from 83 to 88, another 6% increase.

1. Assumes 1% average fee paid on estimated $300 billion of equity fund assets. Back.
2. If stock returns average 9% and Treasury bills average 3%, the 6% spread on an average 5% cash position would be 30 basis points. Back

Back to Opening Statement
Back to Full Testimony