Myths about mutual fund fees: economic insights on Jones v. Harris.

• Author: Johnsen, D. Bruce

1. Introduction II. Mutual Fund Organization, Regulation, Scholarship, and Case Law A. Fund Organization and Regulation B. The Scholarly Literature C. Excessive Fee Case Law--Gartenberg and Jones III. The Economics of Mutual Fund Organization A. Mutual Funds as an Open Access Commons B. The Irrelevance of Fees C. Scale Economies in Fund Management D. Quality Assurance IV. Summary and Concluding Remarks "If mutual fund customers were charged the lower rate for advisory fees paid by institutional investors, they would save more than $10 billion a year."--Eliot Spitzer (1)

1. Introduction

   In 1962, the Wharton School of Finance and Commerce at the University of Pennsylvania published the influential Wharton Report, (2) a study of the mutual fund advisory industry requested by the U.S. Securities and Exchange Commission (SEC). Among other things, the Wharton Report found that while assets under management and fund size in the industry had grown dramatically, fund advisers were doing little to reduce fees, in spite of what it asserted were obvious economies of scale in fund management. (3) The Wharton Report concluded that fee competition in the industry was weak or altogether absent. (4) The SEC followed in 1966 with a report to Congress drawing the same conclusion and recommending various statutory amendments to protect fund investors from excessive fees. (5) Congress responded in 1979 by amending the Investment Company Act of 1940 (ICA) to add section 36(b), imposing on fund advisers a "fiduciary duty with respect to the receipt of compensation for services" and allowing private suits by fund shareholders for excessive fees. (6)

   One of the first private suits under section 36(b) was the 1981 case of Gartenberg v. Merrill Lynch Asset Management. (7) Over 80 private suits that have since been filed in federal court (8) have relied on the Second Circuit's Gartenberg approach, under which a defendant's liability depends on a multi-factor test aimed at "whether the fee schedule represents a charge within the range of what would have been negotiated at arm's-length in the light of all of the surrounding circumstances." (9) Many of these cases have generated protracted and economically complex trials, but none have resulted in verdicts for plaintiffs.

   Seventh Circuit Judge Frank Easterbrook recently rejected the Gartenberg approach in Jones v. Harris Associates L.P., citing with approval a Third Circuit decision finding that "adherence to the statutory procedures, rather than the level of price, is the right way to understand the 'fiduciary' obligation created by [section] 36(b)." (10) Relying on the common law of trusts, Easterbrook observed that "a fiduciary duty differs from rate regulation. A fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation." (11) Easterbrook reasoned that adherence to fiduciary procedures such as "candor in negotiation, and honesty in performance" is what the statute requires. (12) In a competitive industry, which is surely an accurate characterization of the mutual fund industry by any structural standard, informed investors are free to take their money and invest it elsewhere if performance, net of fees, falls short of expectations. Although the competitive process is imperfect at weeding out investor errors, in his words it is "superior to a 'just price' system administered by the judiciary." (13)

   Following the Seventh Circuit's denial of the plaintiff's petition for rehearing en banc, Judge Richard Posner, Easterbrook's Seventh Circuit and University of Chicago Law School colleague, and fellow law and economics pioneer, (14) wrote a pointed dissent, chiding Easterbrook for creating a circuit split where none had existed before without first giving advance notice to the entire court. (15) In Posner's view, there is substantial evidence that competition over advisory fees is insufficient to offset the structural conflict inherent in the board of director system for setting compensation. (16) Although Easterbrook and Posner have lined up on the opposite sides of significant financial issues in the past, (17) their disagreement in Jones v. Harris is notable as a point of economic and legal interest, as well as important to the commercial health of the $9.6 trillion mutual fund industry. (18) On March 9, 2009, the U.S. Supreme Court announced that it had granted certiorari in Jones v. Harris, with oral argument set for its October 2009 term. (19)

   The dramatic growth and innovative management of mutual funds over the past four decades is good reason to be skeptical of those who criticize fund fees as excessive and fund organization as mired in conflicts of interest. Indeed, in Gartenberg and other high-profile excessive fee cases the defendant advisory firms created, promoted, and managed funds that were tremendously popular and attracted investor dollars by the billions as a result. This essay argues that critics have failed to fully understand the economics of mutual fund organization, and that this has led them mistakenly to rely on various myths about fund management that encourage frivolous private suits for excessive fees. Once these myths are fully revealed, Easterbrook's procedural rule is the only economically sensible way to approach section 36(b)'s fiduciary duty without risking additional frivolous and protracted private suits.

   Each myth consists of an incorrect positive statement of economic theory and any number of normative policy implications thought to follow from it. Myth 1, most essentially, is that fund shareholders own the fund's investment returns. The normative implication is that they should share any returns accruing to their manager's superior stock-picking skill. In the language of economic theory, however, a mutual fund is an open access common pool subject to virtually free investor entry and exit. 20 For the universe of potential fund investors, the returns accruing due to a fund manager's superior skill are a nonexclusive rent for which they must compete by buying shares at current net asset value and periodically paying the associated management fee and other expenses thereafter. Entry (or "crowding") by rational shareholders will continue until all expected rents are either transferred to the manager in the form of fee payments or dissipated by added administrative expenses, transaction costs, and forgone investment opportunities. Fund shareholders own a pro rata share of existing net assets at any moment. Going forward, they can expect a normal competitive return on those assets, but, owing to fund flows, they have no exclusive claim to prospective investment returns resulting from superior manager skill.

   Myth 2 is that a reduction in advisory fees will increase investor returns dollar-for-dollar. Regardless of the level of the advisory fee, in an open-access commons, any abnormal returns to a manager's superior stock-picking skill will be competed away by investors chasing the prospect of capturing the associated rents. Based on their collective assessment of manager performance and share purchases or sales, rational investors determine fund returns net of fees, that is, fund flows endogenize investor returns. Holding manager stock-picking skill constant between two funds, the fund with the lower advisory fee will simply have larger total assets than the high-fee fund. No public investor can expect to capture a share of any fee reduction in the form of higher investment returns. 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. (21)

   Myth 3 is that fund management is subject to declining average cost, or scale economies, owing to fixed costs that do not vary with total portfolio assets. The Wharton Report asserted this conclusion without careful analysis. (22) The normative policy implication embraced by the SEC and Congress and embedded in section 36(b) is that scale economies should be passed on to fund shareholders in the form of lower advisory fees as total fund assets increase. (23) That pre-1970 fees remained steady in the face of substantial industry growth in assets suggested to many that the competitive process had failed.

   (20.) Some current fund shareholders are locked into their current funds because they must pay back-end loads to exit, or they have accrued tax liability that must be paid on exit. Of these investors, many have the ability to transfer between funds within their family at very low cost. Further, it is equally clear that many fund shareholders do not face load or tax impediments to switching. Finally, much of the investment dollars invested in funds in any given year is new to the industry. The weight of the empirical evidence discussed infra demonstrates that the flow of investment dollars is highly elastic with respect to fund performance. See Ippolito, infra note 29; Choi & Kahan, infra note 264; Sirri & Tuffano, infra note 110. Even for those shareholders who face tax liability on liquidation, this "cost" accrued at the time they experienced capital gains, so the true cost of the tax liability on liquidation is the cost of finding the cash to cover the tax liability. To the extent there is a capital gain, however, the shareholder should have the cash to more than cover the tax liability.

   Scale economies exist when the average per-unit cost of producing an economic good consumers demand declines as output of that good rises. But assets-under-management is not an output investors demand, nor is it an accurate characterization of what fund advisors produce. Simply because the average cost of management declines as total fund assets rise is no reason to conclude asset-based advisory fees should decline as fund assets rise. Drawing such a conclusion requires an economic theory of contract choice defining...