Some Clarity on Mutual Fund Fees

Abstract

Analyses of mutual fund fees have differed over whether fees are responsive to the forces of competition. Some academic and legal scholars argue that because mutual fund markets possess some of the indicia of competitive markets, fees must approximate marginal costs and thus cannot be excessive. Others argue that structural anomalies in mutual fund governance allow fund managers to overcharge mutual fund investors. This paper resolves the disagreement. It presents compelling evidence that investment management fees, a major component of total fees are immune to the forces of competition. This is accomplished with a combination of financial and legal analysis. We survey the universe of mutual fund assets and fees over time. We find that between 2005 and 2015 total expense ratios declined; principally because investors allocated an increased proportion of their funds to passively managed open end and exchange traded funds. However, over the same period assets on actively managed open end funds more than doubled while investment management fees, also known as advisory fees increased slightly. This outcome is inexplicable in economic terms but consistent with the legal environment the investment management industry operates in. Indeed, we show how the industry has shaped the environment. The genesis of the fee anomaly is the 1970 Amendment to the Investment Company Act of 1940. Studies by the Wharton School and the SEC showed investment management fees higher than fees subject to competitive forces. The Commission recommended that advisory fees should be "reasonable." and enforceable in court. The investment management industry pushed back against this recommendation and successfully killed the Commission's proposal, following which Congress, the Commission, and the industry crafted a "compromise." that made investment advisers fiduciaries with respect to fees and gave investors private cause of action. As evidenced by the inelasticity of management fees, the purported solution to the problem was ineffective. We show how Congress signaled its endorsement of the status quo and how the courts have interpreted the Congressional signal: cases up to and including the recent Supreme Court decision in Jones v. Harris have been uniformly negative for plaintiffs. No plaintiff has ever received an award under the 36(b) statute. As a result of the industry-favoring political and judicial environment, investors in actively managed mutual funds are overcharged by about $30 billion per year. The investment management firms who sponsor and brand actively managed mutual funds earn monopoly profits and excess returns for their owners.