TheChek News Flow

“Nation states must today be prepared to give up their sovereignty”, according to German Chancellor Angela Merkel, who told an audience in Berlin that sovereign nation states must not listen to the will of their citizens when it comes to questions of immigration, borders, or even sovereignty.

“In an orderly fashion of course,” Merkel joked, attempting to lighten the mood. But Merkel has always had a tin ear for comedy and she soon launched into a dark speech condemning those in her own party who think Germany should have listened to the will of its citizens and refused to sign the controversial UN migration pact:

“There were [politicians] who believed that they could decide when these agreements are no longer valid because they are representing The People”.

“[But] the people are individuals who are living in a country, they are not a group who define themselves as the [German] people,” she stressed.

Merkel has previously accused critics of the UN Global Compact for Safe and Orderly Migration of not being patriotic, saying “That is not patriotism, because patriotism is when you include others in German interests and accept win-win situations”.

Her words echo recent comments by the deeply unpopular French President Emmanuel Macron who stated in a Remembrance Day speech that “patriotism is the exact opposite of nationalism [because] nationalism is treason.”

The French president’s words were deeply unpopular with the French population and his approval rating nosedived even further after the comments.

Macron, whose lack of leadership is proving unable to deal with growing protests in France, told the Bundestag that France and Germany should be at the center of the emerging New World Order.

“The Franco-German couple [has]the obligation not to let the world slip into chaos and to guide it on the road to peace”.

“Europe must be stronger… and win more sovereignty,” he went on to demand, just like Merkel, that EU member states surrender national sovereignty to Brussels over “foreign affairs, migration, and development” as well as giving “an increasing part of our budgets and even fiscal resources”.

The Blackstone Group doesn’t generally suffer from the kind of shock that some investors may get when they open their most recent brokerage statements.

Blackstone (ticker: BX) specializes in locking up money for long periods in illiquid assets like real estate and private equity. The inconvenience of not being able to sell right away has its advantages, and Blackstone’s 71-year-old chairman, CEO, and co-founder, Stephen Schwarzman, isn’t shy about sharing the firm’s money-making record. In private equity, it has made an average of 15% a year after fees since inception, and in real estate, 16%.

Barron’s recently visited Schwarzman at the firm’s Park Avenue headquarters. We asked whether Blackstone has grown too big, whether it should convert from a partnership to a regular C corporation (so the stock can be included in index funds), and about succession planning and the firm’s relations with the Saudis.

Barron’s: What is Blackstone’s competitive advantage?

Schwarzman: There tends to be a discount for large deals, because few firms in the world can do them. For example, our $20 billion Thomson Reuters (TRI) deal [for a majority stake in its financial-data unit]. We did that in private conversations. There was no auction. We got a chance to study the business. That’s a real advantage.

We’re one of the few firms in the world with an established brand and presence everywhere. If you’re a seller, our reputation for closing on the terms that were agreed upon is as good as it could be. We also have an exceptional bond of trust with people who give us money. In a normal year, we raise as much as our three biggest competitors combined.

How do you keep size from working against you as you grow larger and put more money to work?

Size would not work for you if you kept putting your money into the same strategy. Inevitably, your returns would go down. That happens with liquid-securities managers. What we do is cut off a strategy at a particular size and then come up with a new strategy that’s compelling. Part of Blackstone’s DNA is to innovate, not just for the purpose of innovating, but for finding new areas that have good returns for the risk.

How do you find these new areas?

We have businesses that generate a lot of intellectual capital. That enables us to see trends and patterns and avoid risk and lean into return. We can see things that other people can’t see—not because we’re smarter, but because we have more data.

For example, in real estate, we own major asset classes all over the world. We can tell more or less without consulting anybody what’s happening economically in different locations. We also have private equity in those countries. The real estate cycle and the private-equity cycle aren’t necessarily correlated one for one. We can get advance warnings of when something looks interesting or when to avoid it.

Some large pensions have begun to do their own private-equity investing. Is that a trend that concerns you?

There are few pension funds and sovereign-wealth funds with the size, interest, and aptitude to do those functions well. They have the handicap of very limited compensation ability. It hasn’t particularly changed our business model.

You’re making a push for retail investors and insurance money. Why?

Those capital pools are extremely large. And they’re not addressable by many organizations. We went into retail, for example, nearly 10 years ago. We hired a large staff, because once you sell something you have to service the people, and you need to put that infrastructure in place before you fundamentally have any revenue. Most organizations find the thought of losing cash during the development period unappealing. But we looked at how retail investors didn’t have the opportunity to buy alternative assets and decided if we can develop the right products for them, it would be a win-win.

In insurance, that’s a large market with a real problem generating earnings growth. If we can increase their yield, they have a lot of money they can allocate our way. Their regulatory restrictions make them avoid the very high-return products that we have. On the other hand, if you can increase an insurance company’s return by a half or full percentage point, or two points, that’s material. In our high-return products, that’s a very low amount of excess return.

How is your $40 billion infrastructure fund coming?

We’re becoming quite busy at the moment looking at projects. I can’t say any more, just because my lawyers won’t want me to.

You’ve had a good relationship with President Donald Trump. How often do you speak with him these days?

I’m not commenting.

What’s next for house prices?

Interest rates have been going up, which constrains some of the appreciation. But I’m not worried particularly about a decline in house prices.

On the C-corp conversion, you’ve said you’re learning from the experience of others. What are you gathering?

It is interesting that inclusion in index funds seems to be working out for KKR (KKR). I think it will be interesting to evaluate things in light of this market decline to see how trading in their securities compares with ours and the other alternative managers.

What are your thoughts on recent weakness in the leveraged loan market?

We were discussing it this morning at our private-equity meeting at some length. At Blackstone, we’re the largest owner of leveraged loans in the world. We’ve had a lot of experience with this asset class, and it has been good for us and our investors. It has the advantage of typically being floating-rate, so if central banks have a bias toward raising rates, you’re insulated rather than being trapped in a fixed rate.

We went through the global financial crisis and had almost no losses in leveraged loans. So you wouldn’t think people would be overreacting in a time period like the current one where global growth is estimated to be sort of 3.5%. Nevertheless, there’s a liquidity imbalance. Investors want liquidity from mutual funds that own these loans, forcing fund managers to sell. If there’s no one to buy, then those securities for technical reasons will gap. And that’s what’s going on. It’s leading to a repricing of those loans, and leading buyers to get a better deal than they had two months ago.

What about the attention being paid to weak covenants?

Our covenant packages have basically been about the same. In that sense, our risk has not changed. That may not be the case with everyone. One of the interesting things is that companies service and pay back debt. Covenants don’t. Covenants allow you to better control a credit, particularly when a company gets into trouble. They allow you to stop certain behaviors, but not necessarily create behaviors. So the risk to leveraged loans is bad credit analysis.

If you have a well-trained group with excellent risk parameters and a highly predictable process for evaluating credit, then you shouldn’t be experiencing any material difference in outcomes. Particularly because this is typically senior debt. In our firm, we do a lot of work much lower in the capital stack by buying equity-and-leverage structures. And we do very well with the equity. So worrying about senior debt historically has not been an enormous concern.

Are you rethinking taking investment money from Saudi Arabia, given its involvement in the October murder of journalist Jamal Khashoggi?

We deal with the government, and we’ve been doing that for decades. Our approach is to maintain consistent relationships.

What has changed during your time at Blackstone, and what has stayed the same?

There’s much more regulatory engagement than there was in 1985. The infrastructure for doing deals is much more developed. There are many, many more investors in alternative assets. When we started, alternatives were probably 3% or 4% of institutional holdings, and they’ve grown to 20% or 25%. We’ve gone from just private equity to real estate, credit funds, hedge funds, and more. Each asset class is now global. The sophistication of what we do after we buy an asset is different and improved. Alternatives have become much more professional with better risk assessment. And the internet has enabled better research. But despite all of the transparency, the returns in these asset classes have remained pretty much the same over 33 years, which in itself is remarkable.

Blackstone trades at a modest valuation. Why not repurchase stock more aggressively?

The reason we haven’t historically is that when we go into new investments, our returns are often terrific. So we’ve tried to always have a lot of money around to either buy at the right time in the cycle or to help start a new initiative. That has served us well. The firm has grown enormously, remained under control, and delivered great returns. But we now have a share-repurchase program, and as shares look less expensive, buying becomes more interesting.

How do you feel about succession?

We have three people in senior management. Tony [James, 67] is still here. He told me he wanted to retire in his 70s and make sure somebody else is in place. We’ve been training Jon [Gray] for three years. He became president in February, and Tony moved to executive vice chairman. So Tony still does the investment committees and other initiatives, and Jon is chief operating officer.

And the job isn’t keeping you from lowering your golf handicap or anything like that?

I don’t play golf. It takes too long. The more mature the firm gets, the more fun it is for me, because we can keep doing new things and pioneering new areas. One thing about finance: It never stays the same.

Thanks, Steve.

While the best investing strategy for these unusual times might be constantly watching cable-TV news to anticipate President Donald Trump’s tweets, it seems more broadly effective to use an out-of-favor strategy: buying upside VIX calls.

We know that concerns remain about the integrity of Cboe Volatility Index, or VIX, options and futures trading since February, when VIX spiked 115% in a day. But VIX options offer a relatively inexpensive way to trade an erratic stock market.

Some may hope that Wednesday’s historic rally of more than 1,000 points on the Dow Jones Industrial Average suggests equity market weakness is ending, but the opposite is likely to be true. The move was strong and unusual and reminiscent of the days before the financial crisis when the stock market moved like an angry drunk.

Hence, it seems reckless to not add a chaos trade to the portfolio. In the past, investors did that by buying upside VIX $20 calls. The calls were cheap—often 20 cents to 50 cents a contract—and paid off big if the market tanked. February’s extraordinary VIX move killed the trade, making many institutional investors risk adverse. But the old VIX trade is coming back, albeit at higher strike prices to reflect riskier realities.

A review of VIX trading patterns indicates that some investors are buying upside VIX calls around the Federal Reserve’s January interest-rate-setting committee meeting. If rates rise, or the Fed is too hawkish, stocks could suffer. VIX February $37.50 and $40 calls, which capture the meeting’s Jan. 30 conclusion, are among the most widely owned VIX options. The next meeting concludes on March 20, but is not yet a major trading event, which largely reflects an institutional bias about trading too far before events.

VIX calls should perform well—provided the market functions—if Trump upsets Wall Street by firing Fed Chairman Jerome Powell or Treasury Secretary Steven Mnuchin, or if another major cabinet secretary departs. The calls also protect against incendiary tweets like Trump’s infamous “Tariff Man,” or developments in the ongoing investigation of the Trump campaign.

Moreover, using options to reduce risk aligns with almost certain key trends of 2019: risk management and a renewed appreciation for the cost-of-capital.

Institutional investors increasingly talk of focusing on the return of capital, rather than the return on capital. The word play indicates a focus on not losing money, rather than seeking higher returns. A senior brokerage firm executive recently told his advisors that he now considers himself his clients’ risk manager.

Cost-of-capital is a phrase rarely uttered in the past decade, but it underpins everything. When money is cheap, as it was, and especially when it is difficult to realize decent returns with bonds, investors walk out the proverbial risk curve that starts with the safety of fixed income, moves through stocks, and ends around emerging market and high-yield debt. Because money is cheap, the risk of not making money exceeds the cost of borrowing money to make money. Now, the cost-of-capital will increase as rates rise, and this will be transmitted throughout the economy, prompting investors to reduce leverage and risk.

Liquidity, meanwhile, is already lower in the S&P 500 index futures market that helps determine prices in the stock and options markets. Futures also help dealers hedge risk.

Liquidity concerns may seem counterintuitive. Many days produce high volumes in reaction to news, but a Goldman Sachs analysis of S&P 500 futures trading suggests that dealers and institutions are no longer trading in size. The absence of liquidity, which influences equity trading, may even explain why stock indexes are making unusually sharp moves in reaction to news.

Bottom line: The markets are changing. Have you?

After a broad selloff in preferred stocks during the first half of the year, several U.S. exchange-traded preferreds from European issuers have become more attractive income plays. These include investment-grade offerings from global insurers Aegon and Prudential , and the Dutch bank ING Groep .

Although preferreds initially held up well when the Federal Reserve started pushing up interest rates, the average preferred has lost more than 10% since June, and some have slid as much as 20% since July. That was largely caused by the 10-year Treasury yield breaking through 3%. That is the benchmark for pricing these preferreds, which are issued in denominations of $25 to appeal to small investors.

Domestic and foreign companies issue these securities on U.S. exchanges to raise capital that’s typically perpetual. That means it doesn’t need to be paid back like a bond at a set time and price. This places preferreds lower down on the capital structure, pushing up dividend yields, which are often taxed at a cheaper rate than interest on debt.

The recent price correction has increased their attractiveness, especially if you believe that long yields are pretty close to their peak. Barry McAlinden, a senior credit strategist at UBS ’ Chief Wealth Office, thinks that 10-year yields will not move much above 3.2% over the next year, which he believes bodes well for preferreds.

In early November, the 10-year Treasury yield hit 3.24%—its highest level since 2011. But Treasuries have since rallied, with the yield cut to 2.74%. This should have reversed the selloff of preferreds, but hasn’t.

Aegon (AEH), Prudential (PUK.A), and ING Groep (ISF) are now paying yields well north of 6%, taxable at the low rate of 15% to 20%, which makes their payout equivalent to a bond yield above 7%. They now trade at prices that protect investors against losses in case these preferreds are called—which the issuers can do at any time.

In mid-June, Aegon preferred was trading at $26.40; on Dec 24, it closed at $24.80, paying a current yield of 6.43%. Prudential’s was selling at $27 in early July; it’s now trading at $25.18 with a yield of 6.45%. And in early July, ING’s issue hit $26.40 before sliding to $25.11, paying 6.35%.

Both the Prudential and ING preferreds can be called only at the end of a quarter, assuring minimum payments of $0.41 and $0.40, respectively. The Aegon issue gives only 30 days’ notice, which could mean less than a full quarter’s payment. But since it’s trading below par, investors would receive a capital gain if the security were called, as well as all accrued dividends. And if the companies don’t call these shares, investors would continue to collect a tidy, tax-efficient yield.

A further plus for the Aegon and ING issues is that both are cumulative. This means that if there is ever a suspension in dividends, the companies must pay back all missed payments before restarting the dividend on their common shares. Common dividends are financials’ lifeblood. Their survival depends on paying a dividend.

These European preferreds are remnants of a once sizable asset class. The international banking accord Basel III put an end to traditional $25 European bank preferreds by requiring that they be convertible into stock in case of trouble. That way, these securities are able to shift liability from banks (and potentially their nations’ central banks) to investors. These Aegon, Prudential, and ING issues are among the few remaining legacy preferreds that won’t convert to equity, selling at a compelling price.

With no deal in sight between the United Kingdom and the European Union, London’s FTSE All-Share index is down about 13% this year on Brexit worries. Some stocks have suffered an even harder pounding.

One is a global security company G4S (GFS.UK), whose shares stand around 196 pence ($2.48), down a third from their 2018 high of 291. (Its unsponsored depositary receipts trade in the U.S. under the symbol GFSZY at about $12.50, but they aren’t as liquid.)

The market takes a dim view of G4S, but Alexander Roepers, chief investment officer of Atlantic Investment Management, says the market is wrong. He recently added the shares to what is the firm’s biggest European position, and says they could be worth about 340 pence, based on operational changes that could be announced in 2019.

Though a mid-cap valued at about $4 billion, G4S is a global industry giant, operating in 90 countries, with roughly 80% of operating profits coming outside the U.K. There might be short-term fallout from Brexit, but it probably won’t last.

That’s not the only concern. G4S’ cash-solutions business, about 16% of revenue, handles physical currency, and many investors expect cash use to diminish in favor of electronic payments. But there’s little evidence of that, as the Fed’s latest data show nearly $1.7 trillion of U.S. currency, for example, in circulation, up from less than $1.4 trillion at year-end 2015.

The stock is also down, Roepers adds, because of an underwhelming third-quarter update on Nov. 7, when G4S said that its secure solutions division, about 77% of revenue, had organic sales growth of 2.5%—about one percentage point lower than expected. This division includes professional security staff, software, and technology systems. (Another 7% of revenue comes from custody, detention, and rehabilitation services.)

While corporate-wide revenue growth is in the low-to-middle single-digits percent, there is a gem inside the cash-solutions business that could provide a catalyst for the stock next year, Roepers says. G4S said on Dec. 13 that it is reviewing options for the separation of its cash-solutions business, which includes secure transport, such as armored cars; processing; recycling; management; and logistics for cash and valuables. It also includes the new Cash360 division, which isn’t being valued properly by the market, Roepers maintains; once separated, its value will be more obvious.

Cash360 has a contract for about 5,500 Walmart (WMT) stores in the U.S. Its secure cash-management system, installed at customers’ premises, automates their typically painstaking manual cash-counting procedures. The system can credit cash to the customer’s bank “the moment it hits the G4S machine”—as much as two days faster than conventional methods.

For companies such as Walmart and Target (TGT), which also is installing the system, that could mean tens of millions in extra interest earned, plus a significant reduction in cash-management costs, says Roepers. G4S shares trade at a ratio of enterprise value (market cap plus net debt) to 2018 estimated earnings before interest and taxes of about 10 times. But Atlantic Investment values the group at 12 times 2020 estimates. That produces a sum-of-the-parts 340 pence for the shares.

G4S’ price/earnings ratio is also at the low end of its historical range, at 10 times analysts’ consensus earnings estimates for next year, versus a more typical 15 to 16 times. G4S will provide more details on the separation next March, with its full-year 2018 results.

Roepers points to the late-2008 spinout of the Loomis (LOOMB.Sweden) cash-handling unit by former owner Securitas (SECUB.Sweden). Since then, Loomis’ annual total share return is 21%, and Securitas’ is 12%, versus G4S’ about 3%. If it follows the script, the separation of G4S’ cash business could bring shareholders cash.

Get Ready for Europe’s Next Crisis

For much of the past decade, the euro area has been an anchor dragging down the global economy. It is in danger of being so again.

The European Central Bank, the European Commission, and European politicians have repeatedly made destructive choices at the expense of Europeans and the rest of the world ever since the first rumblings of the financial crisis. The consequences have been catastrophic unemployment, especially among the young; rising poverty; and—perversely, given their stated objectives—government debt burdens that are increasingly difficult to sustain.

At the same time, Europe’s domestic weakness has curtailed spending on goods and services from its trade partners; instead, they have been forced to absorb the resulting glut of excess European productive capacity.

Sometime around 2015, it seemed as if Europe had finally turned a corner. None of the bloc’s fundamental problems had been fixed, but the generalized financial panic had stopped, and monetary stimulus had begun to kick in. The depreciation of the euro helped by boosting exports, and the collapse in oil prices helped by reducing spending on imports, although the bulk of Europe’s recovery was driven by rising domestic spending on consumption and investment.

Now, the brief and overhyped “euroboom” of 2017 has completely faded. The latest official data show the euro area growing at the slowest annual rate in more than four years. Real gross domestic product grew at an annual rate of just 1.2% in the first nine months of 2018. The bloc grew 2.7% in 2017, 2.1% in 2016, 2% in 2015, and 1.6% in 2014.

Read more: Why the Euro Won’t Replace the Dollar

It would be easy, but wrong, to attribute the slowdown to temporary idiosyncratic factors. Italy’s borrowing costs have been elevated since May, for example, while German vehicle exports were temporarily hit by the introduction of new pollution standards for diesel engines. In fact, the slowdown is broad-based across all of the biggest economies—Germany, France, Italy, and Spain—which together account for roughly three-quarters of the bloc’s output. (The hit to the French economy from the recent “yellow vest” protests won’t show up in the GDP data until the fourth-quarter numbers are published next spring.)

Worst of all, Europe’s slowdown is being driven by a steady and grinding reduction in the growth rate of private consumption, rather than some temporary volatility in investment spending or the trade balance. French consumer spending is growing at its slowest rate since the beginning of 2013. Italian consumption has flatlined and is in danger of shrinking outright. The deceleration of private spending is most extreme in Germany, with consumption growing at its slowest pace since the financial crisis. Spain is the strongest of the big four economies, but it, too, has experienced a notable slowdown relative to its average since 2014.

Consumption is ultimately what makes business investments profitable, so if European consumers keep cutting back, European businesses will either have to sell more abroad as exports or cut investment. Either choice would be bad news for the rest of the world. Producers elsewhere would lose out if global consumers were forced to absorb the glut of excess European production, while investment cuts would reduce European demand for imports.

Recent surveys of European businesses suggest the situation is only getting worse. IHS Markit reported that “backlogs of work fell for the first time in almost four years” in December as businesses adapted to “the reduced inflow of new business.” Focusing on Germany, Markit’s survey found that business “optimism was the lowest recorded for over four years,” marking a “stark contrast from the situation this time last year.” In France, Markit’s “latest flash data pointed to an outright contraction in France’s private sector for the first time in 2½ years.” In Italy, “output fell at the fastest pace in 67 months.” Spain is a relative bright spot in terms of actual orders and activity, but even there, “business expectations were at their lowest level since June 2013.”

Other macro data suggest that the danger for Europe is more likely recession than overheating. Consumer prices excluding food, energy, alcohol, and tobacco have consistently been growing just 1% each year for the past six years. There has been no upward trend, despite the ECB’s previous commitment to restore inflation to its target of “below, but close to, 2%” and its subsequent asset-purchase program. Moreover, unemployment remains crushingly high across much of the bloc. (The major exception is Germany, but even there, the official jobless rate is depressed by millions of low-paid part-time workers.)

These are the kinds of conditions that normally make policy makers cautious about inadvertently pushing their economy into recession. Europe’s incomplete monetary union makes it especially fragile, and for all of the reforms made since 2011, the integrity of the common currency has not been tested by a broad-based downturn.

Yet the ECB seems convinced that its job is done. At its most recent meeting on Dec. 13, the central bank confirmed that it would stop adding to its bond portfolio by the end of the month. The next step would be to start raising interest rates, perhaps as soon as next summer.

Admittedly, the ECB has not committed to tighten on a fixed schedule and ECB President Mario Draghi emphasized in the postmeeting news conference that officials chose to “keep optionality as a dominant feature” of their policy stance. According to him, their future choices will depend “on the situation of the economy” rather than arbitrary concerns about the calendar or the size of the balance sheet.

The problem is that Draghi will be retiring next year. In the worst-case scenario, he would be replaced by someone as incompetent as his predecessor, Jean-Claude Trichet, as part of some grand compromise to appease politicians in Northern Europe. The likelier outcome is that Draghi’s replacement would have sound economic judgment, but lack the Italian’s skills at getting what he wants out of a diverse group of independent-minded officials. With Europe’s economy slowing down, this is a risk to watch.

Investors might think index funds are a great way to capture market returns. Most index funds charge practically nothing: One of the largest, Vanguard Total Stock, charges just 0.04% a year; the average stock index fund’s expense ratio is down to 0.09%, less than a dime for every $100 invested. That has dropped from 0.27% in 2000, according to the Investment Company Institute, the fund industry’s lobbying group.

Yet the industry’s method of calculating fees, on an asset-weighted basis, obscures a surprising fact: Hundreds of billions of dollars are sitting in share classes of index mutual funds that charge well above 1% in annual fees. Many of these funds do nothing more than track broad market benchmarks like the S&P 500. Yet their fees are on par with actively managed funds and, in some cases, even exceed them, topping 1.6% a year.

Virtually all fund families offer the same mutual fund portfolio via different share classes; each share class has different fees and expenses to reflect the sales agreement and different shareholder services. The share class of a fund found in a 401(k) plan, for instance, will usually have different fees than the same fund bought through an advisor.

Altogether, $190 billion is held in share classes of equity index mutual funds with expense ratios of more than 0.17%, including more than $53 billion in funds that charge above 0.5% to track U.S. stock indexes, according to data from Broadridge Financial Solutions . Many of these funds are held in accounts at full-service “wirehouse” brokerage firms, along with banks, independent broker-dealers, and registered investment advisory firms. They also show up in retirement plans such as 401(k) and 403(b) accounts, according to Broadridge.

BlackRock (ticker: BLK), JPMorgan Chase (JPM), Invesco (IVZ), Guggenheim Partners, and Wells Fargo (WFC) all have share classes of S&P 500 funds that charge more than 1%. The C-class shares of Rydex S&P 500 (RYSYX) sits atop the fee charts for S&P 500 funds with a 2.33% expense ratio, according to research firm CFRA. Other high-fee funds include the C-shares of Invesco S&P 500 Index(SPICX), which charge a 1.29% expense ratio; JPMorgan Equity Index (OEICX), at 1.05%; and Wells Fargo Index (WFINX), at 1.2%. All of these firms offer cheaper share classes.

High fees reduce market returns. A $50,000 investment in an S&P 500 fund charging 1% would cost nearly $500 a year more in fees compared with a low-cost product from Fidelity, Schwab, Vanguard, or others. BlackRock’s iShares S&P 500 Index Fund Investor C1 (BSPZX) has a 1.08% expense ratio. A $10,000 investment a decade ago would be worth $31,170 today, including reinvested dividends, versus $34,570 for Vanguard 500 Index Admiral Shares (VFIAX), which charges 0.04%.

Capturing nearly all of the market returns was the original idea behind the launch of the first index fund in 1976 (the Vanguard Index Trust). Decades later, with so many inexpensive mutual funds and exchange-traded funds now available, there’s no reason for investors to pay more than a few hundredths of a percentage point in expenses, says Tony Isola, an adviser with Ritholtz Wealth Management. “These high-fee funds are taking advantage of the indexing trend but defeating the purpose behind it,” he says.

It’s easy to see the appeal of high-fee funds for some in the financial industry. Funds that passively track a benchmark essentially run on autopilot; they need to be adjusted periodically, but human capital costs are minimal. Computers run the show, with no need for analysts to dig into stocks or bonds. Operating costs have come down so much that Fidelity recently launched four index mutual funds with zero expense ratios—essentially betting that it can break even, or come out slightly ahead, without charging direct fees. Fidelity may lend securities in the fund to generate income and cover its expenses, according to the funds’ prospectuses.

Other expenses also jack up fees, notably 12b-1 fees. These fees are meant to compensate brokers or advisors for fund distribution or investment advice, and they’re considered “trailing” fees because they stay in place long after a fund has been sold to the investor. Almost all of the high-fee S&P 500 funds on the market include 12b-1s, making it imperative for investors to look under the hood.

The iShares S&P 500 Index Investor C-1 has a management fee of 0.04% but charges 0.9% in 12b-1s, for instance. Investors in the A shares (BSPAX) pay 0.25% in 12b-1s, reducing the net expense ratio to 0.36% in fees, and the I shares (BSPIX), with a $2 million minimum, lowers total fees even further, to 0.11%.

But with its expense ratio of 2.33%, the C-shares of Rydex S&P 500 Index fund may well be the most expensive S&P 500 index fund in America. In return for tracking the S&P 500, the fund charges a management fee of 0.75%, 12b-1 fees of 1% and “other” expenses of 0.58%. Those other expenses don’t include fees embedded in the returns of swap contracts the fund uses, representing an “indirect cost” to investors, according to the fund’s prospectus.

Rydex has sold this fund since May 31, 2006. It has returned an average 4.9% since then, trailing the S&P 500’s 7.4% return, according to FactSet. Over that period, the Rydex fund returned 83.1% cumulatively versus 145% for the S&P 500. Rydex sells classes of the fund with lower fees. Rydex parent company Guggenheim didn’t respond to requests for comment.

Investor complacency has allowed many funds to roll along without much fee scrutiny. A rising stock market over the past 10 years has helped, giving investors less of an incentive to dig into fees, says Jonathan Smith, CEO of DT Investments, an advisory firm in Chadds Ford, Pa., that consults to high-net-worth clients. “If people see an 8% return while everyone else is getting 12%, they may still be happy, especially if they don’t see a benchmark on their statement.”

Many investors who use a broker or advisor may not even be aware of what they’re paying in fund fees. Trust accounts, for instance, often report performance on a six-month lag and don’t break out fund fees from the trust’s own advisory fees, says Smith. “I consult on $500 million in assets, spread across 10 clients,” he says, “and in every situation they had no idea what they were paying before they became clients.”

Look Closely at Annuities

Another pool of high-fee funds sits in variable annuities, insurance contracts that hold stocks, bonds, or other financial assets in “sub-accounts.” Industry-wide, these sub-accounts hold more than $106 billion in index funds with expense ratios averaging 0.59%, according to data from Morningstar. That’s partly because these funds don’t have to compete against low-cost versions that investors may buy outside the insurance wrapper, says Todd Cipperman, founder of Cipperman Compliance Services, a financial consulting firm based in Wayne, Pa.

Funds in annuities can be packed with “trailing commissions,” fees that compensate brokers for selling products, says Jeffrey Cutter, a financial advisor in Falmouth, Mass. “People’s chins are on the floor,” he says, when they find out the total costs in annuities, which can add up to nearly 6% in administrative and fund expenses.

Another factor: Insurance salespeople must provide investors with reams of disclosures, including fund prospectuses, when they sell a variable annuity. But the prospectuses are complex and voluminous, running hundreds of pages, and fees may be buried deep within the paperwork. “The problem is there’s so much disclosure that people get overwhelmed, and it becomes less than clear what the fees are,” says the compliance expert Cipperman.

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The Securities and Exchange Commission recently proposed rules to allow insurance carriers to provide investors with summary prospectuses. But providing summary prospectuses would be voluntary, and the new rules wouldn’t do anything to address underlying fund fees. “They can still charge whatever they want so long as they don’t breach their fiduciary duty that the fees aren’t too high,” says Cipperman.

Barron’s found hundreds of funds held in variable annuities with sharply higher fees than what investors would pay for identical funds outside annuity wrappers. The Rydex Variable Nasdaq 100 fund is a popular choice, showing up in sub-accounts issued by carriers such as Nationwide, Principal, and Prudential, according to Morningstar. The fund has an expense ratio of 1.66%, well above the 0.2% for Invesco QQQ Trust (QQQ), an ETF with the identical portfolio. A spokesman for Nationwide said the firm “does not set nor establish the expense ratios of third-party funds.” Principal declined to comment on the expense ratio of the Nasdaq fund. Prudential did not reply to requests for comment.

Similarly, Lincoln ChoicePlus variable annuities include the LVIP SSgA Bond Index fund, with an expense ratio of 0.6%. The fund tracks the U.S. bond market, but at a much steeper cost than funds outside the annuity world; Schwab U.S. Aggregate Bond Index (SWAGX), for instance, charges 0.04%. Lincoln says the fund’s expense ratio includes 12b-1 fees that are “required to pay for distribution, marketing, advertising, and promotional costs of a mutual fund.” Lincoln also says that it provides a 0.12% fee waiver for the fund, reducing the “effective expense ratio” to 0.35%.

While low-fee share classes may not be available in annuities, investors have plenty of choices elsewhere. They can demand lower-fee shares from their advisor. They can also swap into a cheaper share class of the same fund. That generally isn’t a taxable event, says financial advisor Michael Kitces, but make sure your brokerage firm processes it as an exchange, and not a sale. No matter what, paying less for market returns is always a good idea.