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January 18, 2010 |
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What Transaction-Tax Foes Don't Say |
(Dow Jones) Opponents of one proposed Wall Street reform, a financial transaction
tax, have been quick to point out it will make owning mutual funds more
expensive for small investors. Investors should always keep an eye on
the fees that eat up returns, but the arguments seem overheated.
Estimates suggest the burden the tax would place on mutual
fund investors would, while real, be smaller than other controversial
fees investors have paid for years, to Wall Street rather than the
government. Moreover, a tax could do some unintended good, tilting the
playing field farther against actively managed mutual funds and in
favor of index funds.
Index funds are the holdings most experts believe best suit
small investors, but which have long had a hard time competing against
funds that generate bigger profits and marketing dollars for the fund
industry.
In December, Rep. Peter DeFazio, D.-Ore, introduced the "Let
Wall Street Pay for the Restoration of Main Street Act of 2009,"
calling for a tax of 0.25% on stock and derivative trades. Supporters
hope the proposal, variations of which have been around for decades,
would rein in Wall Street traders whose outsize bets helped create the
conditions that led to the financial crisis.
Opponents claim it would mean fewer buyers and sellers in
the stock and derivative markets, and thus increase trading costs
across the board. These critics have also gotten a lot of mileage by
arguing the tax would be borne by small investors in particular. That's
because, although investors who trade less than $100,000 worth of
stocks each year would be exempt, mutual fund portfolio managers buying
and selling on behalf of mom and pop would pay.
The Investment Company Institute, the fund industry's main
trade group, estimates the tax would boost operating costs of the
average index mutual fund by about 0.05 percentage points and the
average active fund by 0.14 percentage points. Those figures aren't
insignificant: As the ICI points out, the 0.05-point jump would
increase index funds' annual costs by a third, and compounded over
decades, reduce American's retirement savings by thousands of dollars.
But does the transaction tax really pose a dire threat to
Main Street? Take a look at the size of those prospective costs in the
context of another much-criticized expense fund investors pay, the
12b-1 fee.
Named for the regulation that permits them to pay fund
marketing expenses, such as commissions to brokers, many consider use
of 12b-1 fees to be wasteful. The ICI itself says some critics view
them as "dead weight," and last year, Mary Schapiro, chairman of the
Securities And Exchange Commission, told Congress their purpose was
"sometimes unclear" and promised to put them under review.
Moreover, 12b-1 fees loom much larger than a transaction tax
would, at least in terms of direct costs. Fund researcher Morningstar
calculates 12b-1 fees boost the average mutual fund's annual expense
ratio by 0.36 percentage points. Since some funds don't charge
investors 12b-1s, their hit to funds that do is even greater, 0.58
percentage points annually.
The fund industry doesn't seem nearly as determined to warn
Main Street about the pitfalls of this questionable cost. For its part,
the ICI supports the fees, which it says represent a service rendered
to investors.
The transaction tax could in fact offer a small benefit to
Main Street investors that its opponents overlook: creating a financial
incentive to promote better investment choices. While the costs would
be borne in some measure by all mutual funds, actively managed funds,
which are more profitable than index funds while generally
underperforming them, would pay more simply because they tend to trade
more.
George Sauter, chief investment officer of Vanguard Group,
staunchly opposes the transaction tax, believing it would raise trading
costs and fail to reign in Wall Street excesses, but says "it
absolutely works to the disadvantage of a fund manager that has high,
even moderate, turnover."
While Sauter thinks the tax is a mistake, resisting the urge
to trade is a value Vanguard has long promoted. "We think investors
should absolutely buy and hold," he says. "When they trade it tends to
be at the wrong time. People make knee-jerk reactions."
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