Pooling Money: The Future of Mutual Funds

The Future of Mutual Fund Regulations in the United States

103 comment The Future of Mutual Fund Regulations in the United States peter wallison The purpose of the research that Bob Litan and I conducted on the subject of mutual fund regulation was to understand and address the very broad distribution of expense ratios in the U.S. mutual fund industry. As shown in figure 1, which represents 811 class A equity mutual funds, the distribution is extremely wide, almost 300 percent. That is the case even after we removed the highest and lowest 3 percent in order to eliminate outliers. This puzzled us a little because the mutual fund industry is supposed to be competitive, and in most competitive industries the dispersion of pricing is much narrower. The SEC has also been concerned about this phenomenon over the years. In response, it adopted a theory suggested by scholars at the Wharton School in 1966. The idea suggested by the Wharton scholars was that there was a conflict of interest between the manager of the fund, on one hand, and the fund and its shareholders, on the other, and that the only way to address the conflict was to make the directors of mutual funds more independent of their investment managers . The directors would then negotiate fees more aggressively with the manager , and that in turn would bring fees down. Examining the evidence presented in figure 1, I believe that you would call this theory a failure. The directors might be reducing fees, but the distribution of expense ratios—which I will call “pricing”—in the industry doesn’t look very competitive. Nevertheless, some might argue that although there is a wide disparity of expense ratios for these 811 funds, close to half of all shareholders are in 5 10 15 20 25 30 Expense ratio Frequency 0.55 0.60 0.65 0.70 0.75 0.80 0.85 0.90 0.95 1.00 1.05 1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50 1.55 1.60 1.65 1.70 1.75 Figure 1. Distribution of Expense Ratios of Class A Shares of U.S. Equity Mutual Funds (811 Funds) Source: Morningstar (www.morningstar.com [December 7, 2006]). some very large funds that are run by very large management companies and that the pricing of those managers is actually more competitive. However, if you look only at the value funds, growth funds, and blend funds of the ten largest U.S. fund families in panels A, B, and C of table 1, you still see very substantial disparities in expense ratios. Another compelling fact for us was the dispersion of pricing in the S&P index funds. If you examine the expense ratios of those funds, net of rule 12b-1 fees, there is also an exceedingly wide distribution, which again you would not expect to find in a competitive market (table 2). There are a lot of reasons why fund price distribution might be so wide, and many have already been presented in the preceding chapters. Investors may be uninformed , they may not fully understand the information that they’re given, or they may not always be presented with the information that they should have. However, many of those arguments seem hard to credit, since there is nothing about the mutual fund market that makes it different from markets in which equally uninformed customers somehow manage to cause prices to converge. A distribution as wide as the one in the mutual fund market does not fit with what you would expect to find in a truly competitive market. Accordingly, we attempted to develop a hypothesis that would explain the distribution , and we concluded that the board’s method of addressing the issue of fees and expenses is the problem. Consider yourself what you would do if you were on the board of directors of a mutual fund. How could you get a real sense of whether the manager was charging too much in fees? The only practical way is to look at the manager’s profit, and that is how most boards appear to do it. If the manager is earning very high profits, it’s probably charging too much to the fund. But looking at the profit fosters a cost-plus pricing system, similar to what you see with electric utilities. Utility commissions usually look at the utility...