November 2, 2009
The Supreme Court has a chance to rein in excessive mutual fund fees. Don't hold your breath—A Commentary by Simon Johnson and James Kwak ’11
The following commentary was posted on Washingtonpost.com on November 2, 2009.
The Supreme Court has a chance to rein in excessive mutual fund fees. Don't hold your breath.
By Simon Johnson and James Kwak ’11
Yesterday the Supreme Court heard arguments in a case on excessive compensation in the financial services industry. Commentators looking for a news hook are analogizing the case to the current debate about excessive pay on Wall Street and the legality of government measures to regulate compensation practices. That's a bit of a stretch. But this case could be even more important on its own, even leaving aside the financial crisis.
Jones v. Harris Associates (summary here) concerns the management fees mutual fund advisers charge the funds. If you have any mutual fund investments, whether in investment accounts or your 401(k), a percentage of your money is siphoned off every year by the company managing those funds. This case is not about whether some Wall Street trader is really worth $100 million; it's about your money.
The mutual funds at issue here, the Oakmark Funds, were created, marketed and advised by Harris Associates. This is the norm for the mutual fund industry. Although each fund is technically a separate company, for most practical operating purposes it is a product created by a fund management company, and the fund management company is free to charge its captive mutual funds whatever fees it wants. The one check on these fees is the fact that funds must disclose these fees to investors, who theoretically should refuse to invest in funds that pay high management fees.
The plaintiffs in the suit, investors in various Oakmark Funds, contend that the fees charged by Harris Associates to its own funds are excessive and violate the fiduciary duty that a fund manager owes to its mutual funds under the Investment Company Act of 1940. In particular, they point out that Harris Associates charges much lower fees to clients with real bargaining power (pension funds that independently come to Harris Associates looking for fund management services) -- for a hypothetical $3 billion fund, about $11.5 million as opposed to $29 million.
A three-judge panel of the Court of Appeals for the 7th Circuit, in an opinion by Chief Judge Frank Easterbrook (527 F.3d 627, for those counting), ruled that the fees are not excessive because they are set by the market:
"Mutual funds rarely fire their investment advisers, but investors can and do 'fire' advisers cheaply and easily by moving their money elsewhere. Investors do this . . . when [the advisers' fees] are excessive in relation to the results -- and what is 'excessive' depends on the results available from other investment vehicles."
In this context, Easterbrook claims that fiduciary duty obliges a fund adviser only to be transparent about the fees it charges; otherwise it can charge whatever it can get away with.
The real link to the financial crisis is that even after the near-collapse of the financial system due in part to a blind faith in the ability of markets to set prices, Easterbrook repeats the most blatant error of the efficient-markets advocates: "It won't do to reply that most investors are unsophisticated and don't compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest." (Apparently cherry-picking citations is not confined solely to blogs. Despite the fact that the relationship between noise traders and informed traders has been a major topic of serious financial research, Easterbrook supports his outdated assertion with a single, purely theoretical law review article from 1983.)
Easterbrooks' claim is simply false both as a matter of theory (for anyone who has read finance since the 1980s -- see Justin Fox's "The Myth of the Rational Market" for an overview) and as a matter of empirical fact. Rather than bore you with the details, we'll refer you to the brief by Robert Litan, Joseph Mason and Ian Ayres on why competition in the mutual fund industry fails to yield efficient prices. But the bottom line is that a combination of behavioral fallacies make many investors believe that they can buy high performance, even though the vast majority of, if not all, high performance in the industry is due either to luck or failure to account for risk. Mutual fund companies prey on this weakness by, for example, starting a dozen small funds quietly and then marketing only the one that, through sheer chance, outperforms the market three years in a row.
Remarkably, a dissent (to the motion for the entire court to re-hear the case) was written by none other than Judge Richard Posner (537 F.3d 728) -- perhaps the most important figure in the largely successful, decades-long movement to rewrite large parts of the law on the basis of free-market theory. Posner minces no words:
"The panel bases its [decision] mainly on an economic analysis that is ripe for reexamination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. . . . Competition in product and capital markets can't be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant."
The Supreme Court is the one court in the country that can change and has changed the law to achieve some policy objective. However, the court is unlikely to take advantage of this opportunity to rein in mutual fund fees. Not only does the court have a conservative majority, but it also has relatively little expertise in economic and financial issues (compared with the 7th Circuit, for example). It can take the easy way out and resolve the case on the sole question of what "fiduciary duty" means. Or it could limit itself to deciding what standard should be used in reviewing mutual fund fees and then tell the 7th Circuit to hear the case again. Most likely it will either sign off on the efficient-markets myth or dodge the question in one of these ways.
One hundred years from now, there may still be debates about whether skilled traders can earn above-market returns in illiquid markets. But we believe it will be common knowledge that above-market performance in stock-picking mutual funds is purely a matter of chance and that today's high-priced mutual funds will be seen as the equivalent of snake oil and leeches. The Supreme Court could bring us closer to that day. But don't count on it.
Simon Johnson is a professor at MIT Sloan and senior fellow at the Peterson Institute. James Kwak is a Yale law student and former software entrepreneur. They blog about economics at The Baseline Scenario.