Mutual Fund Advisory Fees: The Cost of Conflicts of Interest

Abstract

I. INTRODUCTION In the early 1970s, America's mutual fund industry was suffering net redemptions, meaning it was contracting in size.1 Fund marketing efforts were in disarray, thus prompting the Securities and Exchange Commission (SEC) to embark on a special study analyzing the problems then plaguing the industry. From that starting point, the SEC moved to loosen restrictions on fund marketing in order to foster a competitive environment.2 By mid-1973, as the SEC's distribution study neared completion, the industry's total assets stood at less than $55 billion,3 with those assets held by fewer than 800 funds.4 Today's industry boasts more than 10,000 funds,5 with assets exceeding $7 trillion,6 an average annual asset growth rate since 1974 exceeding twenty percent.7 Over that same time span, fund sponsors have prospered greatly. In 1998, assets held by Merrill Lynch's own family of funds exceeded the fund industry's total net assets twenty-five years earlier.8 In early 1999, fund sponsors' annual revenue was estimated at $55 billion,9 equaling the industry's total assets twenty-five years earlier. A consequence of this staggering growth is that fund sponsors, the SEC, fund investors, and the courts must now confront a new wave of challenges. Despite its phenomenal marketing success, the fund industry now finds aspects of its conduct under attack from various quarters. The popular press is focusing attention on the industry's fee structure and the perceived inadequacy of mutual find governance.10 Scholarly articles published by finance academics have ridiculed board-approved 12b-1fees11 paid by fund shareholders.12 Law review commentators offer uncomplimentary evaluations of those who control fund management and policies.13 The SEC has weighed in, questioning changes are needed in the current system.14 Another federal agency, the General Accounting Office, recently issued a detailed report finding that mutual funds generally do not attempt to compete on the basis of costs (i.e., price is muted).15 If the SEC's aim a quarter-century ago truly was to spur innovations to set the stage for retail price within the industry,16 then, as we shall see, there is still a lot of work to be done. Indisputably, price is in investors' best interests. In the absence of competition, costs increase, resulting in a drag on performance.17 The absence of price within the fund industry is by no means conceded by industry insiders, leaving observers faced with ambiguous and often contradictory data that can lead one to conclude that competition is up-and so are costs.18 This strangeness-tremendous popularity, proliferating consumer options, and less than robust price competition-arises in the realm of the most tightly regulated financial product sold in the country today. In the words of a former SEC chairman, [n]o issuer of securities is subject to more detailed regulation than a mutual find.19 Unfortunately, as we shall see, decades of SEC-commissioned studies, rule-making, and jawboning have led to a system that, for the most part, works beautifully for those who sell funds to the public, or sell services to funds, but much less admirably for the industry's investors. This Article examines whether the chief product that shareholders buy when they invest in mutual funds-professional investment advice-is being systematically overpriced by fund managers. The emphasis is on advisory fees imposed on equity mutual funds. Part II explains how the industry's unique management structure accounts for the alleged lack of price in the delivery of management advice perceived by the industry's detractors. Part III examines two questions related to economies of scale in the fund industry. First, do economies of scale exist for the delivery of investment management services to equity fund shareholders? Second, if so, are those economies being shared fairly with the funds' owners by the funds' agents, the investment advisors? …