A MOST INGENIOUS PARADOX: COMPETITION VS. COORDINATION IN MUTUAL FUND POLICY.

AuthorLipton, Ann M.

INTRODUCTION I. COMPETITION II. COORDINATION III. REGULATORY MISFIRES IV. A BALANCING ACT CONCLUSION INTRODUCTION

Mutual fund regulation is plagued by conflicting impulses. On the one hand, funds are critical investment vehicles that millions of Americans depend on for retirement. These Americans have varying levels of sophistication and resources, and mutual fund regulation is designed to ensure that they are sold products that are appropriate for their needs and risk tolerance levels, at a reasonable fee.

Mutual funds are also, increasingly, a devastatingly powerful economic force. As trillions of dollars flows into these vehicles, the asset managers who control them exercise tremendous influence over where capital flows, how corporations will govern themselves, and what priorities corporate managers will pursue. Regulation is therefore needed not only to ensure that this power is used to benefit investors in the funds, but also to address the very real legitimacy problem that arises when private actors are able to exercise such overweening authority over resource allocation throughout the economy.

Unfortunately, the regulations needed to address these two very different types of problems are often at cross-purposes. Regulations that benefit retirement savers in the short-term may, in the long-term, increase asset managers' power in uncomfortable ways. Asset managers' long-term stewardship over portfolio investments may neglect the immediate interests of individual fund beneficiaries.

This Essay will discuss some of the tensions inherent in mutual fund regulatory policy and discuss potential paths forward.

  1. COMPETITION

    The mutual fund has become the most popular vehicle for American investment. (1) These shell entities permit retail investors to reap the benefits of a diversified portfolio under professional management, for a fee that is deducted periodically from fund assets. As regulatory changes encouraged employers to favor 401(k) plans over traditional pension plans, (2) retirement assets gradually shifted into mutual funds, and now U.S. investment companies hold assets worth $26 trillion. (3) Though institutions--like pension funds--may also invest in mutual funds, and some retail investors purchase shares outside the context of retirement planning, mutual funds are also overwhelmingly used as retirement vehicles for individual savers. (4)

    For those who choose to invest in mutual funds, a wide variety of options are available. Many mutual funds track an index--namely, a sample of companies selected according to some specific criteria, such as to mirror the market more generally, or to mirror the performance of large cap companies--and the fund (and thus fund investors) pay a licensing fee to the index creator. (5) Alternatively, for higher fees, investors can choose a mutual fund subject to "active" management, namely, a bespoke selection of investments chosen by the fund portfolio manager. (6) These categories--index, or passive, investing, versus active investing--are not necessarily all that far apart; though many index funds track a broad, widely followed index created by an independent entity, (7) many indexes are created by affiliates of the mutual fund companies themselves according to specific criteria, and are followed by only a small number (or even a single) fund. (8)

    Unfortunately, many retail investors purchase shares of funds that underperform relative to other available options, whether due to their investment selection, fees, or a combination of both. Multiple funds track the exact same index, differing, in practical effect, only in the fees charged. (9) Active funds, or bespoke indexes, may not be any better. Frequently, they charge high fees that erode into investment returns, and cannot consistently outperform the cheaper passive funds that follow a broad segment of the market. (10) Retail investors may find themselves investing in funds that take on too much risk relative to their needs, and as a result see the value of their investment collapse just when they need it for retirement. (11) Funds may bill themselves as following particularly strategies--such as "sustainability" or "ESG" or value or growth--but the fine print demonstrates that the proposed strategy does not match the funds' investments or its voting and engagement behavior. (12)

    In a functioning market, competition would eliminate these high-fee, underperforming funds. And to some extent, that has happened; fees have dropped overall, (13) and investors have dramatically reallocated their dollars from active to passive funds in the past several years (which probably explains the proliferation of purported "index" funds that appear to reallocate what would otherwise be management fees into index licensing fees). (14) Yet problems in the market persist, in large part because many retail investors are either unsophisticated about their options, or cannot afford the search costs associated with identifying more suitable choices. (15)

    Retail investors' lack of sophistication has been extensively documented. (16) Investors have trouble understanding fee disclosures, and basic financial concepts such as the value of diversification. (17) They frequently chase past performance as representative of future returns. (18) Those who invest exclusively through a 401(k) plan are even less sophisticated than investors as a whole, and less capable of making prudent financial judgments. (19) Mutual fund sponsors are aware of these problems and can exploit them by targeting the most expensive funds to the least sophisticated investors. (20) The result is that the market's invisible hand is not sufficient to weed out the more predatory funds and asset managers. (21)

    There are a number of potential solutions to this problem. For starters, funds and fund sponsors could be more tightly regulated. Greater restrictions could be placed on fees, rather than the relatively light-touch approach that exists now. (22) Funds that follow broad indices could come with disclosure requirements comparing their fees to similar funds. (23) Fiduciary obligations could be placed on index providers who create bespoke indexes or modify their indexes after consultation with the funds they serve. (24) Regulators could restrict retail investors' ability to invest in more esoteric funds, with licensing or sophistication requirements, (25) not unlike current standards that limit certain investments only to wealthy and sophisticated buyers. (26)

    Alternatively, there could be more robust regulation of sales channels. Currently, funds may be sold through brokers, registered investment advisers, or dual-registered entities, and varying degrees of fiduciary responsibility are placed on each. (27) Brokers and dual-registered entities in particular may operate under conflicts that discourage them from offering the cheapest and most appropriate products to their customers. (28) These conflicts could be regulated more tightly, and reforms could be made to the commission structures to discourage sales of subpar funds. (29)

    Many funds are offered as options in a menu of choices provided by an employer as part of a 401 (k) plan, and though certain fiduciary obligations attach to employers when constructing these menus, these are quite minimal. (30) Some progress has been made inducing lower fee options in 401 (k) plans, (31) but there still may be far too many choices for investors to reasonably parse. (32)

    There are likely many reasons we have not adopted these measures--including, but not limited to, legal roadblocks (33) and the lobbying power of the financial industry, (34)--but at least one issue concerns the inescapable reality that for most retail investors, there should not be many investment options at all. Most retail investors would do best with a passive fund that rebalances to limit risk as their retirement date nears. (35) In fact, when the Obama administration proposed stronger fiduciary obligations for brokers, one of the main objections was that the rules would, as a practical matter, require brokers to sell the same limited set of products to all clients. (36)

    That said, however optimal a cheap, simple, passive strategy may be for retail investors, the curtailment of investors' choices would result in an extraordinary concentration within the asset management industry. There is no need to have multiple competing complexes if most investors are following a limited set of broad market indexes; indeed, William Birdthistle proposed that a single asset manager, BlackRock, handle all of America's retirement plans. (37) That presents a problem not only for the industry itself, but also for all of corporate America: through its mutual funds, a single financial institution would control a sizeable equity stake in every U.S. publicly traded company. The power and influence represented by holdings of that size would present a significant economic and political problem: It would allow a single, private actor to set the agenda for a massive swath of the economy.

    To be sure, that concentration is already occurring. In the past decade, "[t]he share of assets managed by the five largest firms rose from 35 percent at year-end 2005 to 53 percent at year-end 2019, and the share managed by the 10 largest firms increased from 46 percent to 64 percent." (38) The three largest index fund managers, BlackRock, Vanguard, and State Street, together constitute the largest investor in 88% of the SVP 500, (39) with holdings averaging at around 22% per company, up from 13.5% in 2008. (40) Nearly a third of the companies in the S&P 500 have four or fewer shareholders holding roughly 20% of their stock. (41) The growth and consolidation of the industry has resulted in "a concentration of corporate ownership, not seen since the days of J.P. Morgan and J.D. Rockefeller." (42)

    Numerous commenters have sounded the alarm over the political power exercised by this kind of...

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