Competition in the mutual fund industry: evidence and implications for policy.

• Author: Coates, John C., IV

Since 1960, the mutual fund industry has grown from 160 funds and $18 billion in assets under management to over 8000 funds with $10.4 trillion in assets. Yet critics--including Yale Chief Investment Officer David Swensen, Vanguard founder Jack Bogle, and New York Governor Eliot Spitzer--call for more fund regulation, claiming that competition has not protected investors from excessive fees. Starting in 2003, the number of class action suits against fund advisers increased sharply, and, consistent with critics' views, some courts have excluded or treated skeptically evidence of competition and comparable fees of other funds. Skepticism about fund competition dates to the 1960s, when the SEC accepted the view that market forces fail to constrain advisory fees, in part because fund boards rarely fire advisers. In this Article, we show that economic theory, empirical evidence, and careful analysis of the laws and institutions that shape mutual funds refute this view. Fund critics overlook the most salient characteristic of a mutual fund: redeemable shares. While boards rarely fire advisers, fund investors may "fire" advisers at any time by redeeming shares and switching into other investments. Industry concentration is low, new entry is common, barriers to entry are low, and empirical studies--including new evidence presented in this Article--show higher advisory fees significantly reduce fund market shares, and so constrain fees. Fund performance is consistent with competition exerting a strong disciplinary force on funds and fees. Our findings lead us to reject the critics' views in favor of the legal framework established by section 36(b) of the Investment Company Act and the lead case interpreting that law (the Gartenberg decision), while suggesting Gartenberg is best interpreted to allow the introduction of evidence regarding competition between funds.

1. INTRODUCTION II. BACKGROUND: CRITICISM OF THE MUTUAL FUND INDUSTRY AND AN OVERVIEW OF FUND FEE REGULATION A. Industry Critics: Stuck in the Sixties B. The Critics' Views: Conflicts and Beholden Boards C. Current Legal Framework Regulating Mutual Fund Fees III. THE STRUCTURE AND PERFORMANCE OF THE MUTUAL FUND INDUSTRY A. Trends in the Number and Concentration of Assets in Mutual Funds and Fund Complexes B. Absence of Barriers to Entry and Expansion of Funds C. Numerous Distribution Channels and Trends in Distribution Costs Promote Competition D. Price Reductions as Evidence of Competition E. Trends in Fees and Expenses are Consistent with Price Competition F. Changes in Market Shares Offer Evidence of Competition G. Summary IV. INVESTOR MOBILITY ACROSS FUNDS PROVIDES IMPORTANT EVIDENCE OF PRICE COMPETITION A. Prior Research on the Direct Effect of Fees B. Our Findings on the Strength of the Relationship Between Fees and Assets of Funds and Complexes V. THE COMPETITIVE MARKET FOR MUTUAL FUNDS IS CONSISTENT WITH "ANOMALIES" NOTED BY CRITICS A. Fees Paid by Institutional and Retail Investors Are Consistent with a Competitive Market B. Economies of Scale and Scope in Funds and Complexes C. Price Dispersion Among Funds D. Switching Costs E. Investor Ignorance and Cognitive Biases VI. IMPLICATIONS OF COMPETITION IN THE FUND INDUSTRY FOR LAW AND POLICY A. Section 36(b) of the ICA and Gartenberg B. Economic Effects of ICA Section 36(b) C. Legal and Economic Analysis Suggests Limiting Principles for Law and Regulation 1. Government-Determined Prices Should be Avoided 2. Mandatory Bidding for Investment Advisory Contracts is not Necessary to Ensure Eompetitive Pricing D. The Gartenberg Framework E. The Gartenberg Dicta F. Refinements to Gartenberg VII. CONCLUSION APPENDIX I. INTRODUCTION

   Despite enormous growth and acceptance of mutual funds by millions of individual and institutional investors, mutual funds have periodically been accused of charging excessive fees. From an economic perspective, competition is the best guardian against excessive fees. With price competition, fund advisers cannot set fees above the competitive level without driving themselves out of business. The periodic attacks on the mutual fund industry start with a correct premise--that mutual fund boards rarely fire advisers--but reach a faulty conclusion--that the structure of mutual funds prevents competition. As a result, fund critics never seek direct evidence as to whether competition exists, much less whether it is a strong force constraining fund advisers. Nor do the most vocal critics take competition into account when they promote proposals for more regulation of what is already the most heavily regulated sector of the financial services industry. In this Article, we find that price competition is in fact a strong force constraining fund advisers and discuss the implications of that finding for policy. In particular, we consider how courts should interpret the existing law most directly relevant to advisory fees (section 36(b) of the Investment Company Act (ICA)).

   We begin with a brief review of recent, prominent criticisms of mutual funds, which we trace historically to a belief, initially formed in the 1960s, that competition is not an important force in the mutual fund industry. That view was fostered by a 1962 study by researchers at the Wharton School that presented evidence and analysis that was on the cutting edge at the time, but which is today primitive and misleading. Nevertheless, that 1960s view continues to shape law and policy, in part because of a more general problem arising at the intersection of law and social science, where the legal custom of relying on precedent sometimes rigidifies not only case outcomes in law but also "common wisdom" about facts relevant to law. That legal custom--which differs significantly from the methodology of social science--has led courts and fund critics to continue to embrace the conclusions of the 1960s view of the fund industry without any re-evaluation of its theoretical or empirical basis.

   In the core of this Article, we review the structure, performance and dynamics of the mutual fund industry, and show they are consistent with competition. Concentration and barriers to entry are low, actual entry is common and continuous, pricing exhibits no dominant long-term trend, and market shares fluctuate significantly. We then present the results of our direct estimate of the effects of competition on fees, set out in more detail in the Appendix. Specifically, we find that enough investors are sensitive to advisory pricing that higher fees significantly reduce fund market shares. (1) We also address "pricing anomalies" and other claims by skeptics of mutual fund price competition. Among other things, we explain why differences in fees paid by institutional and retail investors are consistent with competition, why economies of scale do not dictate ever-decreasing fees in a competitive market, why price dispersion among similar funds is consistent with competition, why "switching costs" are not a significant constraint on price competition among funds, and why the presence of uninformed, unsophisticated, or irrational investors does not undermine our general finding that price competition is a strong constraint on fund advisers.

   We then consider the implications of our findings and analysis for regulatory or judicial policy. We argue that the evidence of competition in the market for mutual funds suggests caution for legal intervention in setting fees. Economic analysis and continuing changes in the mutual fund industry suggest the importance of competitive market conditions as a factor to be considered under the Gartenberg legal framework. In particular, we argue, evidence of competition itself, and of fees paid by comparable funds, should be both admissible as evidence and a significant component of judicial analysis in cases under section 36(b).

2. BACKGROUND: CRITICISM OF THE MUTUAL FUND INDUSTRY AND AN OVERVIEW OF FUND FEE REGULATION

   In the last five years, mutual fund industry critics have spoken out frequently and sharply about what they perceive to be the industry's shortcomings. (2) A continuing thread through these criticisms is the assertion--rarely supported by logic or evidence--that the competition is not a strong force when it comes to mutual funds. "While market forces of competition ... should serve to limit fees," writes Yale University Chief Investment Officer David Swensen in a top-selling book, "mutual-fund complexes seemingly defy the laws of economics...." (3) New York Governor Eliot Spitzer, touting a settlement of charges unrelated to advisory fees against a prominent mutual fund complex in 2004, wrote, "The advisory fees that mutual funds charge their shareholders greatly exceed those charged to institutional customers.... [Thus,] I refused to join in a settlement ... that did not provide investors with some form of compensation for the advisory fee overcharges...." (4) Two academics were equally conclusory: "In the advisory services marketplace, price competition seems particularly weak." (5) Most recently, the Chief Economist of the U.S. Securities and Exchange Commission (SEC) released a memo arguing that "investor assets tend to be 'sticky' and may allow certain agency conflicts to persist" in the mutual fund industry. (6)

   Reflecting these critical views, the number of lawsuits attacking mutual fund advisers for excessive fees rose dramatically starting in 2003. (7) Over 500 class actions and derivative suits were filed against mutual fund advisers, and cases involving mutual funds accounted for almost 10% of all federal securities class actions in 2003 and 2004. (8) The majority of the cases initiated in those years are still working their way through the courts. (9) In a number of cases in which shareholders have attacked advisory fees as excessive, courts have excluded expert testimony and other evidence of the competitiveness of the fund industry, of its effect on fees, and of comparable fees...