Protesting Pays: Fund Forgets Fee Increase

Lo and behold, the fund company backed down. Clients of our firm alone will save about $50,000 per year. If only more stories like this had such happy endings.

The board of trustees of DWS Equity 500 Index Institutional Class, in which Palisades Hudson Asset Management, L.P., invests more than $30 million that we manage for clients, recently endorsed an investment management contract that would have raised the total operating expenses on the $1.9 billion fund from 0.10 percent of assets annually to 0.27 percent. For the contract to take effect, shareholders were required to approve it. Obviously, approval would not be in the shareholders’ interests. But fund-management proposals usually gain approval anyway.

Many competing mutual funds that track the Standard & Poor’s 500-stock index have recently lowered total expenses to about 0.10 percent. We thought it was peculiar that DWS Equity 500 Index Institutional Class would seek a fee increase. We thought the proposal might have been timed to take advantage of recent strong performance, because when good returns are abundant, investors don’t seem to mind higher fees.

The S&P 500 index closed at its all-time high on March 24, 2000. Over the subsequent 30 months, the index lost 44 percent. However, the last few years have seen a significant turnaround in stock prices. Currently, the S&P 500 annual average return over the last three years is about 12 percent.

The five-year numbers still leave much to be desired. Through April 30, the S&P 500 had returned 2.7 percent annually, on average, over the preceding five years. However, before long, months in which the stock market performed poorly, such as August and September 2001, will no longer be included in the five-year tally. Assuming the stock market stays flat from May through September, the five-year annualized return would jump to 6.4 percent. If the S&P 500 returns a modest 5 percent annualized from May 2006 through October 2007, the five-year annualized return through September 2007 will leap to 12.9 percent.

Some Palisades Hudson clients have owned DWS Equity 500 Index Institutional Class for more than five years. We were first attracted to the fund because of its low expense ratio of 10 basis points (one basis point equals 0.01 percent) at a time when most other index funds were charging about 20-35 basis points (bps). Lower cost index funds, investing in efficient markets, should outperform more expensive, actively managed funds in the long run, we reason. For the last few years, this fund has performed as expected. It has trailed the S&P 500 index, which has no fees, by 0.10 percent, equivalent to its annual expense charge.

In April, we received a 290-page proxy document for DWS Funds, including DWS Equity 500 Index Institutional Class. The proxy stated that the fund’s board of trustees had approved an amended and restated investment management agreement that would increase operating fees from 10bps to 27bps. The trustees were seeking shareholder approval for the fee increase. According to the proxy report, the two largest shareholders as of the record date were the Deutsche Bank Savings Plan (21.95 percent of the fund) and Charles Schwab & Co. for the benefit of its clients (14.90 percent of the fund). Deutsche Bank is the parent company of DWS funds. Palisades Hudson clients’ portion of total outstanding shares was 1.8 percent, which was included in the Charles Schwab & Co. figure because all of our client assets of the fund were custodied there.

An S&P 500 index fund owns the stocks selected by the Standard and Poor’s Index Committee for the S&P 500 index. The mutual fund’s investment advisor mainly ensures that the securities in the fund match the securities in the index. Very little management discretion is required. Hence the description of such funds as “passively” managed. Because passive management is so easy to automate, the lack of human involvement leads to lower costs.

For the new investment management agreement to take effect, the majority of outstanding shares of the fund were required to approve it at a special meeting of shareholders on May 5 at 4 p.m. in New York either in person or by proxy.

After reading the proxy document, we contacted DWS Funds. We wanted to speak with the board of trustees to voice our objections to the fee increase, especially after fees on several competing S&P 500 index mutual funds were recently lowered to about 10 basis points. We were told the secretary of DWS Funds, John Millette, would forward correspondence to the board of trustees. Our letter to the board is reprinted beginning on Page 1.

On April 26, we voted against all of the trustees’ recommended proposals and withheld our vote for all trustees who were up for election. On May 18, DWS told us the new contract had been approved by more than 70 percent of shareholders. However, the election of board members was adjourned to June 1, as an insufficient number of votes was cast May 5 and more time was needed to solicit additional votes.

Strangely, the fund’s most recent prospectus, dated May 1, listed the fund’s current expense ratio at the proposed higher annual charge “to reflect approved fee changes to take effect on or about June 1, 2006.” This was odd because the shareholders’ meeting was scheduled to take place on May 5, four days after the prospectus was dated and filed with the Securities and Exchange Commission.

If other investment options existed that were less expensive and therefore expected to perform better, why did we fight this fund? Why didn’t we sell the fund and reinvest in a different one?

We did not simply walk away for three reasons.

• First, across all client accounts, our unrealized gain in the fund was $6 million, nearly all of which was in non-retirement accounts. For each client, we had to consider the tax cost of selling this fund immediately against the higher ongoing future expenses of the fund.
• Second, this fund performed well under its previous expense structure. If the fund maintained the old level of fees going forward, then we would be pleased to continue to invest in it.
• Finally, the investment advisor, when proposing the fee increase, agreed to voluntarily keep fund expenses at 10 basis points through Sept. 30. Our hope was that if we and perhaps other shareholders voiced our complaints clearly enough, the fund’s advisor would offer to keep expenses at 10 basis points indefinitely.

On May 19, one day after we sought comment for this article from two trustees of the fund, DWS Funds told us what we wanted to hear.

“We have not set a timeline on the extension of this waiver [capping fees at 0.10 percent until Sept. 30] but come Oct 1 we will not be changing the net expense ratio of this fund,” read an email from Joe Moran, director of DWS Scudder Distributors Inc. This email is reprinted above.

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