This article is adapted from his remarks at two recent conferences in a series of ten that the institute has held on the subject, “Is there a better way to regulate mutual funds?”

Resident Fellow Peter J. Wallison

It may at first seem anomalous to be considering whether there is serious competition for an industry that has almost $9 trillion in assets and over 90 million customers. There is no doubt that mutual funds are today the dominant form of equity and fixed-income investment for Americans. It may also seem anomalous to consider whether changes in regulation are necessary for such an industry that offers to investors the opportunity at limited cost to achieve diversification, and thus limit investment risk. Regulation cannot be much of a problem for an industry that has grown so large.

But regulation has a way of stifling innovation and change in a regulated industry, leaving the field open to competition from less regulated or unregulated alternatives. This is especially true when the market undergoes a profound change, but regulation does not keep pace. Indeed, alternatives often develop because the regulated industry cannot serve a demonstrated need or adapt to a new technology. What this often means is that the talented people in the industry go elsewhere, and the industry stops growing and improving. The people who are hurt in this process are the customers who don't have the knowledge to get out as the industry provides less and less value.

What we should want are industries that are free to change in response to consumer demands, to offer their products in new ways in order to avoid the danger of obsolescence in a constantly evolving market. Accordingly, any study of regulation must also consider whether the regulated industry has the flexibility under its regulatory framework to change and innovate in order to meet new competition.

Among the new competitors for the conventional mutual fund are exchange-traded funds (ETFs) a relatively recent innovation regulated under the Investment Company Act of 1940. They offer the diversification advantage of mutual funds and address some of the tax and other deficiencies that some investors find in mutual funds. ETFs are currently based on indexes but could be managed like conventional mutual funds if the Securities and Exchange Commission approves various exemptions from the Investment Company Act. Separately managed accounts and FolioFN are both ways for investors to achieve diversification through customized portfolios that meet their specific investment objectives.

While mutual funds are currently the dominant form of investment for the retail investor who is looking for diversification, ETFs and customized portfolios of various kinds are growing faster. If we subtract out of the mutual funds' market share the investments made by pension plans and similar collective retirement vehicles, we will probably see that these customized competitors are capturing now, and will capture in the future, a much larger portion of the retail investor market than the gross numbers suggest.

This should be a warning signal for those concerned about excessive, or excessively rigid, regulation. If mutual funds are not meeting the needs of a substantial body of retail investors, something significant is going on.

Advice for a Fee

It seems clear that retail investors are increasingly willing to pay for individualized advice in the management of their assets. This is a major change in the market and has profound implications. For years, mutual fund groups have been proliferating various kinds of funds--balanced funds, bond funds, index funds, income funds, small-cap, large-cap, growth, aggressive funds, maybe even passive-aggressive funds. But it appears that all of these are not sufficiently personalized to meet the needs of today's sophisticated investors who seem to want something even more tailored and customized.

Perhaps this is a passing phase, or maybe there is only a relatively small group of investors who want and are willing to pay for this kind of service. Maybe the growth of alternative investment vehicles will stop as they mine the opportunities in this limited group. But as Americans become more affluent and sophisticated about what the financial world offers, it may well be that they will not be satisfied with the fund categories that the mutual fund industry is economically capable of offering in its current structure.

It is important to keep in mind that it is expensive to create a mutual fund. A mutual fund is a corporation which must comply with the full panoply of costs that are borne by all corporations that offer their shares to the public--even the Sarbanes-Oxley Act. It's hard to imagine that it could be profitable for the mutual fund industry to continue to set up more and more corporations to meet the demands of investors for more and more individualized or specialized portfolios.

At some point, it may be necessary to authorize a less expensive alternative to the corporate form, which is the only form currently recognized by the Investment Company Act. That's why an important component of any study of mutual fund regulation is to consider the competitive position of the industry and what is happening in its market.

The Bogle Critique

Any study of mutual fund regulation and the structure of the industry must take into account the Bogle critique--that of mutual fund industry pioneer and Vanguard Group founder Jack Bogle--and particularly his recommendations for change.

In his latest book, The Battle for the Soul of Capitalism, Bogle outlines his prescription for reform. He cites four elements in his reform agenda: no more than one management company director on the fund board; an independent chairman; a fund staff reporting to the independent chairman, with responsibility for evaluating "the investment performance and marketing results of the manager, the reasonableness of fees paid, and other relevant information"; and a federal statute of fiduciary duty for fund directors.

Bogle's arguments in favor of these reforms are well worth considering, for several reasons. First, the SEC's 2004 regulation that would have required the chair and at least 75 percent of the board of every fund to be independent of the investment adviser was recently struck down by the U.S. Circuit Court of Appeals for the D.C. Circuit because the SEC failed to consider the effect of its rule on efficiency and competition in the mutual fund industry. In the National Securities Market Improvement Act of 1996, Congress required the SEC to consider these factors in connection with its rulemaking.

Second, the only significant scandals in the mutual fund industry's 66-year history were the recent market-timing and late-trading scandals. Both are discussed extensively in Bogle's newest book. The SEC proposed its requirement for an independent chair and an independent supermajority on the board largely as a response to these scandals, and thus implemented two of the four Bogle reforms. I have been trying to figure out how this reform--had it been in effect--would have prevented these scandals.

The SEC has never charged any directors--independent or otherwise--with dereliction in connection with these clearly wrongful acts by the funds' advisers and has never suggested that the directors could have or should have discovered the wrongdoing. So I have never been able to determine how increasing the number of independent directors or making the chair independent of the investment manager would have been a remedy for the one serious scandal that has ever afflicted this industry.

Third, Bogle argues that expenses imposed by investment managers have eaten up very large percentages of the returns investors might have expected from the growth in the value of common stocks. Yet he recommends that that the funds themselves have a paid staff to evaluate the work of the investment adviser. Presumably, that would add even more to the costs that ultimately reduce the yield that an investor receives from appreciation in the value of the fund's portfolio.

More generally, like Jack Bogle, [Brookings Institution senior fellow in economic studies] Bob Litan and I are focusing our own study on what reforms will improve the returns that investors will get from their mutual fund investments. In looking at mutual funds today, we see an industry heavily regulated by the SEC and largely under the control at the board level of majorities of independent directors. From this arrangement, investors obtain the diversification that protects their nest eggs against the kinds of losses suffered by the non-diversified shareholders of Enron and WorldCom.

Almost 60 percent of mutual fund investors are introduced to funds by financial advisers, most of whom are paid in whole or in part by the investors themselves or through 12b-1 fees paid in effect by fund shareholders. How else can one explain the growth of separately managed accounts, in which investors pay advisers to set up special customized diversified portfolios?

One of the alternatives we might consider in our study is the adoption of the reforms that Bogle recommends, but in order to do so we'd have to see how these reforms will cure the problems Bogle cites or give investors more of what they seem to want.

Peter J. Wallison is a resident fellow at AEI.