Date Posted: October 2009
Mutual funds stand ready at all times to sell and redeem common stock to the investing public for the net value of their assets under management. In the language of transaction cost economics, they are open-access common pools subject to virtually free investor entry and exit. The Investment Company Act (1940) requires mutual funds to be managed by an outside advisory firm pursuant to a written contract, which normally pays the adviser a small share of net asset value, say, one-half of one percent per year. Following 1970 amendments to the Investment Company Act imposing a fiduciary duty on advisers with respect to their receipt of compensation, a large number of private civil suits attempting to recover excessive fees have been filed against advisory firms. By failing to account for the transaction costs inherent in mutual fund organization, Congress, securities regulators, financial scholars, and even courts have misidentified a conflict of interest with respect to fund advisory fees, encouraging these frivolous suits. With free investor entry and exit and rational expectations, fund flows endogenize investor returns. Regardless of the level of the advisory fee, any expected abnormal return to a manager’s superior stock-picking skill will be competed away by investors chasing the prospect of capturing the associated rents. With shareholders having a common claim to fund assets, all expected rents will be either transferred to the manager in the form of higher total fee payments on a larger asset base or dissipated by added administrative costs. As a first approximation, the level of advisory fees is therefore irrelevant to fund shareholders. The best they can expect from placing their money in a managed fund is a normal competitive return after adjusting for risk and other factors. With the U.S. Supreme Court having recently granted certiorari in an excessive fee case appealing an arguably maverick opinion by Judge Frank Easterbrook of the Court of Appeals for the Seventh Circuit, it is essential that various myths about mutual fund fees be exposed to careful economic analysis.