Just as the Supreme Court is about to hear Jones v. Harris, a new study suggests “muddled thinking in the scholarly literature, in the excessive fee case law, and in regulatory pronouncements” has encouraged the propagation of four false assumptions regarding the impact of mutual fund fees on investor returns. George Mason University Law professor D. Bruce Johnsen refutes these four popular myths in his paper “Myths About Mutual Fund Fees: Economic Insights on Jones v. Harris” (George Mason Law & Economics Research Paper No. 09-49, posted October 7, 2009).
Here are Johnsen’s four myths:
1. Fund Shareholders Own the Fund’s Investment Returns – It’s commonly held that fund shareholders ought to reap any performance benefit once they buy shares of the fund. Economic theory, on the other hand, suggests any excessive performance will dissipate with the entry of rational shareholders. Because of incoming shareholders, current shareholders “have no exclusive claim to prospective investment returns resulting from superior manager skill.”
2. A Reduction of Advisory Fees Will Increase Investor Returns – As with the first myth, the “rent” theory of economics suggests new entrants will capture any expected benefit from lower fees. As a result, low fee funds tend to have larger total assets. “As a first approximation, the level of advisory fees is irrelevant to fund investors. Eliot Spitzer and others who have suggested that lower advisory fees will increase investor returns dollar-for-dollar are simply mistaken.”
3. Fund Management is Subject to Declining Average Cost – Johnsen cites the Wharton Report specifically as the perpetrator of the myth that economies of scale will decrease fund costs. This turns out to be an economic mixed metaphor of sorts. Economies of scale costs decrease as output rises due to demand. “But assets-under-management is not an output investors demand, nor is it an accurate characterization of what fund advisers produce.”
4. Mutual Fund Fees Should Match Pension Fund Fees – Here Johnsen takes a more novel approach. Not only does he employ the well understood “comparing-apples-and-oranges” argument, he goes one step further to explain the economic justification for the appearance of a price disparity. “The economics literature recognizes any number of models that show how market forces overcome the quality assurance problem where information is costly.” In a nutshell, “pension plan sponsors and insurance companies face far lower costs assessing manager quality than do dispersed public mutual fund investors.” As a result “lower fees are exactly what we should expect” for institutional clients.
Johnsen concludes the very nature of the freedom mutual fund investors enjoy preclude them from extracting excessive returns in the guise of lower fees. Indeed, the myth busting professor bluntly states “mandatory fee reductions are likely to injure fund shareholders.” In other words, mutual fund shareholders can’t have their cake and eat it, too.
The problem with mutual funds is that all the power in the relationship lies with the fund family. In reading this abbreviated version, I think the author is saying that retail mutual fund investors can take their money and run when the market goes down and plow it back in when it goes up. That flexibility comes at a premium. However, take a look at a collective investment fund in which the only shareholders are qualified assets. Lower volatility in deposits and withdrawals translates into substantially higher returns and lower net cost – even where there are same managers and same portfolios. In the CIF world the power of the relationship goes back to the RIA.
Lance:
I think you’re right about the author’s statement (I’ll be posting an exclusive interview with him today). However, there is a significant difference between a Registered Investment Company (“RIC”) – a mutual fund – and a Collective Investment Trust (CIT). Although this is worthy of a separate article (I’ll put it on my list), in short, they fall under different regulatory regimes and under different fee structures. In the case of the RIC, adviser fees are paid by the RIC. In the case of a CIT, trust fees (the equivalent of adviser fees) are paid by the individual client, not the CIT. BTW, I’ve always preferred the CIT fee structure because of this.
The author also completely omitted the issue of non-disclosed trading costs in a mutual fund and the resulting impact on net performance. John Bogle and other studies indicate that the trading costs of average mutual funds tends to run at approximately 124 bps. with 100% portfolio turnover. My experience in the transparent CIF world is that the trading expense tends to run in the 5-7 bps. range even with 100% turnover. Why the disparity aside from the disclosure issue?