A Better Way to Organize Mutual Funds

With more than 8,000 mutual funds in the U.S., investors can easily find more than one, and often many, that track the same sector of the market. With so much choice, you might conclude that the industry is pretty competitive.

But you would be wrong.

At least, that's the conclusion of Competitive Equity: A Better Way to Organize Mutual Funds, a new book written by Peter J. Wallison, a senior fellow at the American Enterprise Institute, and Robert E. Litan, a senior fellow at the Brookings Institute. They write that "the current regulatory structure for mutual funds prevents the development of robust price competition among funds and keeps investor costs higher than they should be."

Funds are governed by boards of directors, which were created as a line of defense to protect shareholders' interests. They negotiate a fund's contract with the investment adviser, approve fees and review cross-trades between funds in the same family. The Securities and Exchange Commission has been trying to strengthen this role; it has passed a rule, which has been challenged by the courts, that would require 75% of board members, including the chairman, to be independent of the investment adviser.

However in their book, Wallison and Litan argue that boards of directors are actually the main culprit keeping the management fees mutual funds charge unnecessarily high. TheStreet.com spoke with Wallison to get a better understanding of his study's conclusion.

TheStreet.com: How is the board of directors inhibiting competition?

Wallison: In every other industry where deregulation has occurred, this has lowered the cost for the consumer. Mutual funds are regulated internally by a board of directors. They regulate the prices investors are charged. If the board were no longer involved in approving the advisor's fee, competition would develop among advisors. That would lower the expense ratio.

Boards with a lot of members from the company that owns the fund has an interest in keeping fees high, but wouldn't independent directors eliminate this problem?

No. It's a very strange system. It's similar to what happens when a utility commission reviews rates for an electric utility. The commission gets a report outlining all the costs the utility incurs; then it adds a small amount of profit the utility is allowed to earn. [This is] the same thing that happens in the fund business. The manager, or investment adviser, gives the board a cost assessment. The board looks at it, then adds in what it considers a reasonable profit. That's what the investor pays.

Why can't the manager cut his costs and keep the same profit?

There is no reason for the advisor to become more efficient. If he cuts his rate and can't increase the number of investors, he loses a substantial amount of profit. And if he does well, the board institutes breakpoints. Because the fund is supposed to have economies of scale if it gets more revenue, so he has to give the shareholders a break. The course of least resistance and risk is not to cut his rate at all.

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