EVENTS

Date:	Monday, April 9, 2007
Time:	12:00 PM -- 2:00 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

April 2007

Is There a Better Way to Regulate Mutual Funds?

Mutual funds have become the investment of choice for millions of Americans, with over $10 trillion in assets currently under management. A significant portion of these assets is used to save for retirement, and small variations in fees and expenses can, over time, substantially reduce the value of investors' portfolios. A sound regulatory policy would encourage the lowest costs for investors. For the last forty years, the Securities and Exchange Commission (SEC) has attempted to achieve this result by requiring fund boards to include a larger proportion of independent directors and encouraging boards to press advisers for reduced fees and expenses. Yet the industry, which consists of dozens of fund families and thousands of funds, still exhibits a wide disparity in costs to investors that is not characteristic of a price-competitive market.

In their new book, Competitive Equity: A Better Way to Organize Mutual Funds (AEI Press, 2007), Peter J. Wallison of AEI and Robert E. Litan of the Brookings Institution argue that the SEC's approach has been wrong and indeed counterproductive--and that the only way to drive down the costs for investors is to encourage price competition among mutual fund advisers. To achieve this result, they propose a new and optional structure for the mutual fund industry, which they outlined and discussed at an AEI conference on April 9, the final event in a continuing series on mutual fund regulation entitled "Is There a Better Way to Regulate Mutual Funds?"

Robert E. Litan
Brookings Institution and Kauffman Foundation

The current regulatory framework for mutual funds, established by the Investment Company Act of 1940, has undergone minimal change over the past sixty years. The industry today, however, bears little resemblance to what it looked like in the 1930s. Today there are nearly 8,000 funds of many different types, in which investors have placed over $10 trillion in assets.

The mutual fund industry is structurally competitive. Concentration is low, with the top twenty-five fund families holding 71 percent of assets--a market share below that of twenty years ago. In addition to stiff intra-industry competition, mutual funds now face competition from new collective investment vehicles such as exchange-traded funds, separately managed accounts, and hedge funds. Asset growth in each of these areas is growing at a faster rate than in mutual funds.
 
Despite all the hallmarks of a competitive industry, mutual fund expense ratios have not converged closely on a single price, or in this industry's case, to something close to a single expense ratio. For example, within a sample of 811 class-A shares of U.S. equity funds, there is a 300 percent variation between the highest and lowest cost funds, even after the top and bottom three percent of expense ratios are removed as outliers. There are substantial disparities of expense ratios even among the same kind of fund, such as S&P 500 index funds. The fact that a competitive industry would exhibit such massive price dispersion is puzzling and is the question that Competitive Equity attempts to answer.
 
Peter J. Wallison
AEI

The wide dispersion in the expense ratios for U.S. funds exists because mutual fund advisers do not compete with one another on the basis of price. Instead, they try to compete and set their funds apart by advertising performance or other factors. The reason advisers do not compete on the basis of lower expense ratios is because they are not free to set their own fees.

In fact, the approval of advisory fees by boards of directors makes mutual funds, in effect, a rate-regulated industry. In a process similar to the way electric company rates are set by public utility commissions, boards of directors use a "cost plus" system to approve advisory fees and other expenses; the adviser reports his costs, and the directors approve a fee taking into account those costs plus a "reasonable" profit. As a result, advisers have little incentive to lower their marginal costs to attract more investors and earn higher profits. If the adviser lowers his fees and fails to attract more investors, he loses income, but if he does succeed in attracting more investors and his profits increase, the board is likely to pass these profits along to investors by negotiating a lower advisory fee or through fee breakpoints. Therefore, advisers have little incentive to operate more efficiently and compete on price.
 
The way to introduce vigorous price competition into the mutual fund industry is to eliminate the fee-approval role of boards of directors and allow advisers to set their own prices. In this spirit, Competitive Equity advances a proposal for a new, optional form of collective investment vehicle, the "managed investment trust" (MIT). The MIT is to be structured as a contract between investors and the investment adviser, not as a corporation, and hence does not have a board of directors.

Because prices would be set competitively, the SEC's major concern about the conflict of interest between investors, who want low fees, and advisers, who want to charge high fees, will no longer be an issue. Competition will drive down costs and keep advisers from exploiting investors. The other major advantage is that investors' money will be held by a bank trustee with a professional, full-time staff responsible for monitoring the day-to-day operations of the fund. Because the staff will be constantly reviewing the advisers' transactions, it will be far more capable than part-time boards of directors of monitoring the other potential conflicts of interests and discovering abuses such as late trading and market timing. Finally, the MIT would be an optional structure, and would not replace existing funds. Investors who are content with their current funds would not have to make any changes.

AEI research assistant Daniel Geary prepared this summary.