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 protectshareholders' 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.
spoke with Wallison to get a better understanding of his study's conclusion.
TheStreet.com: How is the board of directors inhibiting competition?
: 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.
How did you draw this conclusion?
We looked at 811 actively-managed funds. We found the lowest expense ratio was 61 basis points and the highest ratios were three times higher, at 170 basis points. (One hundred basis points is equal to one percentage point.)
Doesn't that price disparity prove there is competition?
If there was real competition, there would be less divergence in pricing.
When competition occurs, people get their prices as low as possible. An adviser will cut costs to the point where he is able to attract customers from other competitors. The costs in those markets tend to converge to the margin cost of the most efficient producer. The marginal cost is what's important to a competing business. All they want is to get the last investor who will pay one dollar more than marginal cost.
What is marginal cost?
No one knows until competition begins, when people innovate and become more efficient. If there was real competition, investors would be told the cost of the fund. If you take away the board, then advisors would set their own rates and they would attract investors based on the expense ratio.
If the expense ratios for S&P 500 index funds range from 10 basis points to more than 100 basis points, investors have a clear cut choice for a commodity product. What is preventing investors from seeking out the lowest-cost index fund?
This is something of a mystery. I think the reason is that advisers are not advertising their prices
expense ratios because they cannot really control them. The reason people advertise in a competitive market is that they are able to profit if they can sell one more unit of a product or service at more than their marginal cost of producing it. Without competition, no competitor has an incentive to advertise his prices because customers are not sensitized to the issue of price; they are not told that there is a difference in prices or what this difference might mean to them over the short or long term.
Once advisers are free to set their own prices and to profit from it, they will start advertising their prices and explain to investors why it's important. The first ones to do this will be the low-cost providers. Then everyone else will have to follow suit in order to hold on to their investor bases. In a cost-plus system of rate-making such as is used for mutual funds, there is a positive disincentive to cut costs, since -- as noted above -- that will result in lower profits or at best in breakpoints that force lower fees and don't reward advisers for taking the risk of cutting costs.
Shouldn't the higher-priced index funds go out of business with such a price disparity?
Yes, and they would if they kept their high prices if competition on price were to develop. But what will happen -- as in every other industry where rate deregulation has occurred -- is that the high-cost producers learn how to cut their costs and operate more efficiently. If they don't, they do leave the field.
Wouldn't you agree that the reason these funds continue to exist is in fact because of forces other than boards of directors, such as 401(k) plans and stock brokers?
I think that employer-sponsored plans have an incentive to find the lowest-cost funds, but it is likely that the people who administer the plans don't know much more than anyone else about the effect of higher costs over the long run. This is not true when there is competition on price. You can be sure that the same people in the firm -- if they are asked to select a supplier of, say, paper -- will hear from the producers why it would make sense for the firm to spend less for paper. However, until the advisers themselves begin to advertise their costs in comparison to other advisers, the benefits that come from lower fees and expenses over the long term will not be known either to the plan administrators or their customers. That isn't happening yet, for the same reason that advisers are not advertising their prices to the public.
A stock broker will put an investor into an index fund with a higher expense ratio if it gives him a load. And with 401(k) plans, competition is completely removed from the equation. An employee is locked into investing in the funds his company makes available. If a company signs up with a plan that charges a high expense ratio for an index fund, the investor has no choice and can't go somewhere else. Wouldn't you agree that this is more influential in keeping competitiveness low and fees higher than boards of directors are?
I don't think there are index funds with loads, but I think your point is that loads are an inducement to sales. I agree, and that's true in every industry. However, when competition develops among products, and producers begin talking about their lower prices, what the customer pays at retail becomes important. This tends to eliminate high retail markups unless there is some superior service that goes along with it.