April 2006

An Economist's View of Mutual Fund Regulation

Economists sometimes ask basic questions about regulation that reflect a broader perspective on issues than is usually taken by those who wrestle with regulatory issues day to day. Paula Tkac, an economist at the Federal Reserve Bank of Atlanta, has written a widely circulated paper that asks very basic questions about mutual fund structure. In her view, a mutual fund is simply a collective investment product offered by an investment adviser. Why, she asks, interpose an intermediary corporation of which the investor is a shareholder? And does it make sense to apply all the rules of corporate directors’ fiduciary duties to the simple relationship between an investor and an investment adviser? At an April 14 AEI conference--the seventh in a continuing series entitled, “Is There a Better Way to Regulate Mutual Funds?”--Ms. Tkac discussed her paper and the questions it raises. David Musto of the Wharton School and Michael Scofield, a director on the board of Evergreen Mutual Funds, responded.

Peter J. Wallison
AEI

Under the Investment Company Act of 1940, mutual funds must be structured as corporations with boards of directors. At the first conference in this series, Steve West presented his idea of eliminating the authority of a mutual fund’s board of directors to approve the fee of an investment adviser. At today’s conference, Paula Tkac will discuss her thesis that mutual fund boards should be eliminated entirely. The crux of her argument is that mutual fund investors are customers, and investment advisers are service providers. Because mutual funds involve considerably less risk than other forms of investment and investors can move fairly freely from fund to fund, the investor should be able to contract directly with the adviser, eliminating the middleman--i.e., the corporation and its board.

While there is a conflict of interest between the investor and the adviser over the fee, the same conflict always exists between consumers and the providers of other services. For example, there is a conflict between the auto mechanic, who would like to charge high costs for repairs, and the car owner, who wants his car fixed for the lowest possible price. Yet in this example, there is no third party negotiating the repair costs on the car owner’s behalf. The fundamental question of Paula Tkac’s paper is: is there some reason that mutual fund investors--unlike all other consumers of services--cannot fend for themselves? Why do they need the assistance of a board to protect them from abuse? To answer these questions, it is also necessary to address the issue of how sensitive investors are to the fees the advisers charge, as well as the performance of their funds. These questions are the subject of the conference today.
 
Paula Tkac
Federal Reserve Bank of Atlanta

The current regulatory structure for mutual funds, under which they are defined as investment companies that require boards of directors, is improper given how the industry actually functions. Whereas the value of a share of stock of a public company depends on the firm’s future profitability and the perception of the management, mutual fund investors carry considerably less liability. The value of a mutual fund share does not depend on market demand, but on the value of the underlying securities. Further, investors can have them redeemed at the net asset value (NAV) at any time. Shareholders of a traditional corporation need a board of directors to monitor the management and deter bad practices that could result in making the share value drop. The agency problem between mutual fund investors and the investment adviser is far less pronounced.

Most investors in open-end mutual funds tend to view themselves not as owners of the underlying securities, but as customers buying a product from a specialist or service provider and paying fees for that service. This outlook is contrary to the governance structure instituted by the Investment Company Act of 1940. Under the 1940 Act, the board has the role of negotiating fees with the investment adviser on behalf of the investors. However, investors can and do observe the fees themselves, either directly in fund literature or by tracking the performance net of fees. Because investors can observe and compare prices and make their decision accordingly, the conflict of interest between the adviser and the investors--in that the adviser wants higher fees and the investor wants lower fees--is no different than the conflict that exists between car owners and auto mechanics. There is no need for a board of directors to mediate between the investors and the investment advisers.

Critics of this proposal point to instances in which actions taken by advisers have hurt investors. Two classic examples are the market timing scandals of 2003 and instances in which advisers invest money in types of securities contrary to the investors’ wishes. Although these are problematic, it is necessary to point out that the advisers do not have an incentive to take any action that can harm performance. If a fund performs badly, less people invest their money, and then the advisers collect fewer fees. Not only can the aforementioned problems can be handled without boards, but the boards did not even catch the problems when they were occurring.

Another major criticism of the proposal to eliminate boards is that mutual fund investors are uninformed and need to be protected. In light of recent surveys, one cannot deny that financial illiteracy is fairly widespread among mutual fund investors. However, this does not automatically imply the need for paternalistic regulation. In fact, even though mutual fund investors may lack sophistication, there is evidence to suggest that they do respond to changes in the market and vote with their feet. After the market timing scandals, there was a significant flow of money away from the disreputable funds. Also, given the increase in popularity of low-cost funds, it seems that investors are aware of fees. To enable investors to respond even better to changes in the market, Congress should eliminate the taxes incurred when one liquidates one mutual fund in order to move the funds into another.

Because fees are observable, they do not a pose a conflict of interest that must be dealt with by a board of directors. Moreover, if it were possible for investors to contract directly with the advisers, the mutual fund industry would be opened to increased competition, which could lead to greater innovation and diversity in terms of price and kinds of products. Another option for regulators would be to allow an alternative structure without a board and let the investors decide the structure under which they want to invest their assets.

David Musto
Wharton School

Mr. Musto argued that fund managers have an incentive for efficient corporate governance by boards of directors. He explained that it is better for a manager to work for a fund whose board is strict and will fire managers for poor performance. It reflects better on the manager if he is kept by a board that will fire bad advisers than if he kept by a board that never fires anyone. However, the board must have an incentive to fire managers that perform poorly, and it is good if that incentive is tied to their compensation. Mr. Wallison asked Mr. Musto to clarify the issue of the board’s incentive to fire managers, and Mr. Musto indicated that the directors’ desire to keep a good reputation factors into their incentive to fire people.

Michael Scofield
Evergreen Mutual Funds

Mr. Scofield noted that boards have been criticized from two directions. Critics such as Elliot Spitzer have claimed that mutual fund boards have done too little, and critics like Paula Tkac say they do too much. One of the best regulatory developments since 2003 has been the chief compliance officer (CCO) requirement. Simple disclosure cannot uncover everything, which is why persistent investigation by the CCO is of utmost importance. Also, since the scandals of 2003, the boards must evaluate redemption fees to deter market timing.

Without the board of directors, there would be no one to select the independent audit firm or review disclosure documents. Advisers will not disclose their own abuses, so a board is still necessary to detect them. This is particularly true in regard to soft dollars. In addition, the board of directors is necessary to remedy innocent or negligent mistakes made by the advisers. For example, advisers can misprice the NAV, purchase prohibited securities, and exceed investment limitations. The board is necessary to resolve those issues and ensure proper restitution to the investors. A watchful board is particularly important because investors cannot recognize incremental changes in fund performance caused by malfeasance. If investors had to rely on disclosure, either they would not find out about abuses, or they would find out too late. Boards serve as spokesmen for the shareholders and take on industry-wide issues. Most recently, they have been quite questioning of the use of 12b-1 fees. Further, there must be a board of directors to whom the CCO can report in case of fraud.

Also, while investors are free to switch funds and vote with their feet, doing so is costly. If there were no board and the adviser decided to raise fees by ten basis points, the investors might decide to move from one fund to another and incur a sales load. If this motivates investors to opt solely for a no-load fund, they will rule out 80 percent of mutual funds, which is bad for the industry. However, if there had been a board, it could have simply rejected the fee increase and spared the investors from wanting to switch funds.

AEI staff assistant Dan Geary prepared this summary.