Mutual Fund Advisory Fees: The Cost of Conflicts of Interest

Abstract

In the early 1970's, America's mutual fund industry was suffering net redemptions, meaning it was contracting in size. Fund marketing efforts were in disarray, thus prompting the Securities and Exchange Commission (SEC) to embark on a special study analyzing the problems then plaguing the industry. From that starting point, the SEC moved to loosen restrictions on fund marketing in order to foster a more competitive environment.

One consequence of this loosening was the explosive growth in mutual funds. Today's industry boasts more than 10,000 funds, with assets exceeding $7 trillion, an average annual asset growth rate since 1974 exceeding twenty percent. A consequence of this staggering growth is that fund sponsors, the SEC, fund investors, and the courts must now confront a new wave of challenges. Despite its phenomenal marketing success, the fund industry now finds aspects of its conduct under attack from various quarters. The popular press and a prominent regulator, Eliot Spitzer, are focusing attention on the industry's fee structure and the perceived inadequacy of mutual fund governance, including the gap between prices charged funds for advisory services versus prices fetched elsewhere in the economy for those same services.

This article examines whether the chief product that shareholders buy when they invest in mutual funds - professional investment advice - is being systematically over-priced by fund managers. The emphasis is on advisory fees imposed on equity mutual funds. Part II explains how the industry's unique management structure accounts for the alleged lack of price competition in the delivery of management advice perceived by the industry's detractors. Part III examines two questions related to economies of scale in the fund industry. First, do economies of scale exist for the delivery of investment management services to equity fund shareholders? Second, if so, are those economies being shared fairly with the funds' owners by the funds' agents, the investment advisors? Part IV studies causes for the status quo, including the industry's statutory scheme, the quality of the SEC's regulatory efforts, and the reception given fund critics by the courts. The Article concludes with a set of proposals for changing the present competitive environment in which fund advisory fees are set, disclosed, and evaluated.

Keywords: Mutual fund, advisory fees, advisory services, pension fund fees, tiered structure, fund insdustry, shareholders, portfolio, Gartenbarg test, Section 36, Vanguard equity

JEL Classification: K00, K22