MUTUAL FUND DEBACLE:
ECONOMIC FOUNDATIONS, FUNDAMENTAL PROBLEMS AND FIRST STEP GOVERNANCE REFORMS
James L. Bicksler
Rutgers University, School of Business
The Mutual Fund Industry: Historical Perspectives and Present Trends
An important function of financial markets is to channel savings from households into financial assets, such as common stocks and fixed income securities, to help individuals finance their future retirement, college expenditures, etc. Mutual funds are a popular vehicle used by many households to help achieve these goals because they offer alternative portfolios characterized by different time horizons, expected returns and assessed risks. Indeed, mutual funds are invested in by 95 million plus and by 54 million households whose fund shares have a market value of $7 to $7.5 trillion. Indeed at the end of 2002, mutual funds managed 21 percent of $10.2 trillion retirement market 1 of the U.S. and 98 percent of $18.5 billion 529 college savings plans market. However, recently, there has been increasing recognition of John C. Bogle's point that there is much that is "plain wrong" in the mutual fund industry that disadvantages the purchasers of mutual fund shares. For example, Warren Buffet has said that the mutual fund industry has engaged in "blatant wrongdoing" that has "betrayed the trust of so many millions of shareholders." Likewise, Senator Peter G. Fitzgerald, Republican from Illinois and the Chairman of the Senate Subcommittee on Financial Management, the Budget, and International Security, has indicated that mutual funds are "the world's largest skimming operation ... a trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings."
To put the relevancy of the mutual fund debacle in perspective for the working class, Senator Daniel K. Akaka, Democrat from Hawaii and Ranking Minority Member of the Senate Subcommittee on Financial Management, the Budget, and International Security, has stated "I have found the betrayal of trust of mutual fund investors appalling because mutual funds are investment vehicles that the average investor relies on for retirement, saving for children's college education, or other financial goals and dreams. In one example directly related to workers and retirees in the State of Hawaii, Putnam Investment had been responsible for managing $440 million for the State of Hawaii Employees Retirement system, which administers retirement and survivor benefit for over 96,000 state and country employees in Hawaii, before the company was fired due to late trading abuses that one of our witnesses Mr. Scannell helped to bring to the attention of regulators." Indeed, Professor Eric Zitzewitz of Stanford University estimates that late trading occurred in, at least, one of six mutual fund families. The economic loss to fund shareholders of late trading was $400 million per year. The economic loss to mutual fund shareholders as a result of market-timing is $5 billion per year. It should be noted that valid criticisms of the mutual fund industry and its wrong-doings and the resulting financial wealth transfer from the fund shareowners to the mutual fund investment advisory companies has come from many quarters including (1) U.S. Senators, (2) state attorneys general, (3) a former mutual fund company founder and chairman of a mutual fund complex, (4) a mutual fund whistle-blower and (5) academics, both law school professors and economics and finance professors.
Understanding the mutual fund debacle requires understanding of the economics of mutual fund companies, including the value drivers of the market price of mutual fund management companies and the potential governance conflicts between the management company and the mutual fund shareholders. In particular, there are five important, though overlapping and interrelated, economic dimensions of mutual funds that need emphasizing. They are:
- Conflicts of Interests - Agency Problems in Mutual Funds
The Investment Company Act of 1940 is quite clear that mutual funds are to be operated for the benefit of the purchasers of the mutual fund shares. Thus, the mutual fund director's sole fiduciary responsibility is to the purchasers of the mutual fund shares. John C. Bogle, the Founder and former CEO of the Vanguard Group has reminded us of "An Elementary Principle, Too Often Ignored" which is "that funds should be managed and operated in the best interest of their shareholders, rather than in the interests of advisors, underwriters, or others." Indeed, even the Investment Company Institute currently acknowledges that mutual funds should be run in the best interest of the share purchasers. Mutual funds have a number of potential agent-principal problems where questions can be legitimately raised whether the best interests of the mutual fund shareholders are being served. Among these principal-agent issues are:
- Whether the independent directors are acting in the best interests of the fund shareholders when negotiating the investment fee advisory contract?
- Whether it is the best interests of the fund shareholders to pay a commission to a marketing distributor to "grow" the fund?
- Whether the fund industry's "soft dollar" practices are in the best interests of fund shareholders?
- Firm Economies of Scale and Scope in Mutual Funds
Two important economic concepts that provide relevant economic foundations to formulate a reasoned judgment about the "fairness" or "unfairness" of investment management fees charged by mutual fund companies are (1) economies of scale and (2) economies of scope. Both concepts focus on the reduction of average costs as the fund increases the amount of money under management. The reduction in average costs means that marginal costs are below average costs. Marginal costs being below average costs, as money under management increases, could be a result of several factors such as (1) corporate efficiency, (2) declining labor market costs (3) the use of high-level capital equipment including back-office and trading technology and (4) volume discounts on the purchase of factor inputs. Of course, the specific forces resulting in a decrease in average cost per unit are very dependent on the specific industry and specific company. In the money management business, going from $100 million to $500 million to $1 billion under management does not increase expenses by a factor of 5 or 10. Indeed, incremental costs for the investment portfolio task increase minuscule particularly if the investment opportunity is the same or decreases. This means there are significant economics of scale and/or scope. Jack Bogle has referred to the economies of scale in the mutual fund industry as "staggering." In the case of the Vanguard funds the only mutual fund firm having a mutual organization, Vanguard focus is providing services on an "at cost" basis. This resulted in average expense ratio for Vanguard funds declining from 0.59% in 1980 to 0.27% in 2002 for a decrease of 54%. On the other hand, the mutual fund industry's fund assets grew from $115 billion in 1980 to $6.7 trillion in 2002 for an increase of 60 times. However, fund expenses were $0.8 billion in 1980 to $72 billion in 2002, for an increase of 90 times. Bogle appropriately questions what happened to the "staggering" economies of scale when and where there were "modest" incremental expenditures." Bogle concludes that the fees charged to mutual fund investors were excessive. Indeed, the excessive mutual fund fee schedule cost mutual fund investors hundreds of billions of dollars. No wonder Bogle concludes that the mutual fund industry's decisions are made for the best economic interests of the management company's owners and not the mutual fund shareholders. Bogle also points out two empirical truths which are the fees charged mutual fund share purchasers (1) were good for the managers and the advisory company and (2) bad for the fund shareholders.
- Lack of Investor Mutual Fund Sophistication
The standard paradigm of rational investor choice is that investors, including mutual fund investors, formulate their investment choice decisions in the context of achieving an optimal utility maximizing portfolio in expected return-assessed risk space. Further, mutual fund costs, including investment management fees are specifically integrated into expected returns and, thus, into the optimal portfolio choice analysis. This is clearly not the approach of mutual fund share purchasers. Instead, as an old mutual fund cliché states, "mutual funds are not bought, they are sold." This marketing focus of mutual funds is central to both (1) mutual fund asset growth and (2) cash flow profitability of mutual fund investment management. Surrogate empirical evidence in this regard is provided by Professors Elton, Gruber and Busse who concluded that, "investors buy funds with higher marketing costs than the best - performing funds." Further, "all that is necessary for inferior funds to exist and grow is a set of uninformed investors and a set of distributors who have an economic incentive to sell inferior products. In a market where arbitrage is impossible, we may be disappointed, but we should not be surprised when inferior products exist and even prosper." In related reasoning and anecdotal evidence Robert Pozen, the former President of Fidelity Investments, indicated that "only 19% of investors surveyed by the SEC could give an estimate of expenses for their largest mutual funds."
The importance of marketing and the business side of mutual funds adopting a marketing culture has been emphasized by both John Bogle and Michael Price. Specifically, Bogle has stated that "we have changed from a profession of stewardship into a business of salesmanship, and the conglomeration is part of that." Likewise, Michael Price has stated, "the professional managers, the marketing types were running the show, guys who succeed based on the amount of assets under management and the growth in those assets, rather than from the performance of the money which is backward. With the huge bucks at stake, you had the professional marketers taking over."
- An Absence of Competition in the Determination of Mutual Fund Investment Advisory Fees
How important are "excessive" mutual fund fees to mutual fund investors? Senator Peter J. Fitzgerald, Republican from Illinois and the Chairman of the Senate subcommittee on Financial Management, the Budget, and International Security, has stated that "the general consensus of the panelists at the November hearing was that illegal late trading, and illicit market timing were indeed very serious threats to investors but that those fees were a even more serious threat to American investors. We heard extensive testimony from industry expert who forcefully noted that small differences in mutual fund fees can add up to enormous differences in investment returns over time but that poor disclosure of those fees makes it very difficult for investors to compare funds."
With regard to the fairness of mutual fund advisory fees, Eliot Spitzer, the Attorney General of the State of New York, has stated "The advisory fees that mutual funds charge their shareholders greatly exceed those charged to institutional customers. If mutual fund customers were charged the lower rate for advisory fees paid by institutional investors, they would save more than $10 billion each year." (Emphasis is provided by Eliot Spitzer). Indeed, Professor John P. Freeman of the University of South Carolina Law School has stated with regard to mutual fund fees that "Price gouging over advisory fees is rampant, and the industry is in denial."
Interestingly, Mr. Pozen argues that "pricing trends in the mutual fund business defy common sense." In a sense, I can understand the reasoning and frustration embedded in Mr. Pozen's view of the lack of common sense permeating the setting of mutual fund fees. However, an explanation of the puzzle of the determination of mutual fund fees can be best understood in the context of (1) there is a lack of competition (i.e. there are not multiple bidders or an auction process) in the determination of who is awarded the investment management contract of a mutual fund and (2) a more realistic description of the mutual fund fee process is that it is an economic outcome that is a result of the fund sponsor's right hand negotiating with its left hand. Interestingly, Warren Buffet implies the same point when he proposes as one of his mutual fund reforms that the mutual fund directors be required to look at alternative fee arrangements with other investment management companies and to state that it is their opinion that their adopted investment management fee arrangement is competitive.
That is why Michael Price has made a telling point when he stated that "Directors need to have backbones. You know what the shocking thing to me is? That nobody has had a contract cancelled by a board of directors. Even where a chairman was messing around with the fund, the board didn't cancel the contract. What does it take to get fired in the business?" Adding support to Price's point is Warren Buffett's view that "So what are the directors of these looted funds doing? As I write this, I have seen none that have terminated the contract of the offending management company (although naturally that entity has often fired some of its employees). Can you imagine directors who had been personally defrauded taking such a boys-will-be-boys attitude?" The answer to Price's question as to what it takes to get fired is that when your right hand is negotiating with your left hand you are not going to be fired come hell or high-water. Thus, it is no surprise, as Baer and Gensler state, that "mutual fund boards fire their advisers with about the same frequency that race horses fire their jockeys." Once again, this is the economic result of, to use Warren Buffett's terminology of there being "no-honest-to-God negotiations."
- The SEC Regulatory Efforts: Are They Effective?
The discussion over whether SEC's regulatory behavior has been effective or not effective in promoting competitive market outcomes via public policy has been a long raging debate going back, at least to the 1960's. Instead, the intellectual interchange over the impact of the SEC on the efficiency of securities markets includes the spirited debate between George J. Stigler, a Chicago economic libertarian and the recipient of the Nobel Prize in Economic Science in 1988, and Irwin Friend, a prominent scholar in financial economics and former President of the American Finance Association, is the classic conceptual-analytical and empirical interchange where polar conclusions were derived. However, over the last few years the performance of the SEC, for whatever reasons, has been abysmal. First, the fundamental triggering events of the Enron debacle were uncovered not by the SEC but by the private sector. Indeed, the Senate Government Committee chaired by Senator Joseph Lieberman, a Democrat from Connecticut, concluded in its study dated October, 2002 that there was a "systemic and catastrophic failure" of regulation of Enron by the SEC and that "investors were left defenseless."
The Peter Scannell, the whistleblower at Putnam Investments, fiasco was also a poor reflection on the SEC regulatory behavior. The essence of the Scarnell affair was that market abuses, which are prohibited at Putnam according to their mutual fund prospectus, were in fact, quite common. Alternatively stated, market abuses at Putnam Investment were "seemingly accepted practices for those investors with influences for those investors with influences and money." Scannell's communications with the SEC, unfortunately, lead nowhere. This is in contrast to his meeting with the Massachusetts Deputy Secretary of State and Massachusetts Chief of Securities Enforcement who immediately grasped the economic and financial enormity of the events within a short time period, then serve Putnam Investment with subpoenas requesting relevant information. The Scannell affair aptly emphasize that implementation and execution are crucial for regulation to effective and that key instances in the recent past the SEC's performance has been sadly lacking.
The productivity of the SEC in achieving its public policy goals is very much a function of the leadership, vision, execution, motivational and teamwork talents of the chairman. These talents are rare not only in the public sector but also in the private sector. Thus, it is not surprising that at times in its history, the SEC has floundered, lost it's sense of purpose and the staff, now numbering 3100 people, has become dispirited. Indeed, in the recent past, such as during Harvey Pitt's two years reign, the motives and actions, such as his the proposed appointment of William Webster as Chairman of Accounting oversight board, were questioned and questionable.
This, however, should come as no surprise Nobel Prize in Economic Science recipient, Paul A. Samuelson recognized the essence of the regulatory conundrum back in 1967. Specifically, Professor Samuelson stated then that,
"Self-regulation by an industry tends usually to be self-serving and often inefficient, there is a danger that government commissions, set up .... Originally to regulate an industry, becoming more concerned to protect it from competition than to protect the customer from the absence of competition .... The SEC must itself be under constant Congressional scrutiny lest it lessen rather than increase the protection the consumer receives from vigorous competition."
Summary Conclusions Of The Economics Of The Mutual Fund Industry
The major points regarding the economic characteristics of the mutual funds are:
- There are important and persistent conflicts of interests between fund management (i.e. the advisory company) and the shareholders of the mutual funds
- These economic conflicts of interests involve not only the process of the determination of investment management fees but also include issues involving 12b-1 fees, soft dollars, etc.
- The independent directors do not effectively represent the best financial interests of the mutual fund shareholders
- There are substantial economies of scale and scope in mutual funds
- Mutual fund management fee schedules do not reflect, in a meaningful way, these economies of scale and scope
- There is a lack of meaningful financial disclosure to actual and potential mutual fund investors. Hence, there is a lack of transparency with regard to relevant information parameters that should drive the investor choice of which mutual fund to purchase
- There is a lack of sophistication by inventors as illustrated by the Elston-Gruber-Busse study indicating that investors are willing to buy identical funds (i.e. products) that have higher loads and higher 12 b - 1 fees.
- The investment management fees are "unfair" (i.e. too high). This is a result of the lack of competition in the market for mutual fund investors
Some Suggested Mutual Fund Program Proposals: Some Preliminary Economic Perspectives and An Evaluation of Their Merits and Limitations
Two important dimensions for setting appropriate public policy from the standpoint of libertarian economists are (1) individual choice, (2) competitive markets, and (3) transparency. The role of government, including government regulation, is limited except when, for example, parties have sufficient market economic power preventing the functioning of competitive markets. Further, individual choice and its end results, the efficiency of resource allocation is strengthened if there is firm transparency where relevant investor informational parameters are provided. This will, in turn enhance investor awareness and improve investor choice of mutual funds. Hence, individual rational choice of mutual funds and competitive markets are intertwined. Further, rational investor choice of mutual funds is dependent upon transparency of relevant investor choice parameters provided by mutual funds.
The structure of this discussion will be organized under three overlapping categories. They are (1) Better Mutual Fund Governance, (2) Better Mutual Fund Investor Transparency and (3) Reducing or Eliminating Mutual Fund Agency Conflicts.
- Better Mutual Fund Governance:
- Requiring the Chairman of Mutual Fund Boards To Be Independent
- Require that 75% of Directors Be Independent
Evaluatory Comments: In determination of the structure of the board, the emphasis should be on results and not on the false hope that there is a major ratio of inside directors versus outside directors. Results will be dependant on execution of individual directors that in turn, will depend on the "backbone" and knowledge of corporate value additivity strategies and tactics of individual directors. To conclude, mandating that (1) chairperson of mutual fund boards be independent and (2) at least 75% of mutual fund directors be independent are not high priorities of mine in terms of mutual fund reform.
- Better Mutual Fund Transparency:
- The requirement that the breakdown of the composition of the portfolio into it's constituent securities be provided quarterly or even more frequently big mutual funds is not necessary or desirable change. Indeed, it would result in disincentives to, for example, do the necessary detective work to ferret out the underprice securities. The flip side would be that it would create more incentives for other investment managers to free-rider (i.e. free load) on the investment research of others.
Evaluatory Comments: This data will constitute useful inputs to investors to assess returns, risks, costs and fees each of which will enable investors to make more informed choices in the selection and purchase of individual mutual funds. The information specified should not be required in as much as it results in disinventives for professional Investors to do the necessary security analysis and results in the convergence of intrinsic values and stockmarket prices
- The purpose of a mutual fund prospectus is to provide relevant informational inputs to prospective investors to make informed, ideally optimal, investment choice decisions. These informational inputs that are generally required of two types: They are (1) prospective investment returns and (2) assessed investment risks. Both of these parameters are ex ante in nature. By definition, they are not available. Thus, historical information parameters will have to be provided with the hope that there is a linkage from ex post to ex ante. In the pursuit of this task, the following information inputs, among others, should be provided.
- Investment Portfolio Goal
- Historical Portfolio Composition
- Historical Investment Performance Including the Sharpe ratio
- Historical Turnover Ratio
- Investment Management Fees with Decile Comparisons
- Other Expenses with Breakdown
- Benchmark Investment Performance Comparisons to Mutual Funds with Similar Investment Product Lines and the S&P 500, and other more appropriate indices, for 1, 3, 5 and 10 year time periods.
- Mutual Fund Late Trading and Market Timing:
- Because late-trading is an illegal activity, the penalties should be strictly enforced. For market timing, mutual funds should clearly disclosure their policy. Ideally, mutual funds should ban these activities and monitor and enforce their market- timing policy.
Evaluatory Comments: Both late-trading and market timing are mechanisms where wealth is transferred from mutual fund shareholders to parties engaging in these transactions. Obviously, the mutual fund shareholders are better off if there are criminal and civil penalties for late-trading activity and that individual funds take the initiative in eliminating market-timing. Further, redemption fee should be increased significantly to discourage rapid buying and selling of mutual fund shares.
- Reducing or Eliminating Agency Conflicts:
- At minimum complete specifics of soft dollar transaction should be disclosed
- Sales activities wherein dollar incentives are given to third parties to encourage purchase of mutual fund should be, at minimum, disclosure but preferably eliminated. This would certainly include arrangements with broker-dealer to sell shares
Evaluatory Comments: Better understanding of the impact of soft dollars on mutual fund shareholders is necessary. Accordingly, the SEC should undertake a study investigating these impacts. As to the impact of brokerage-dealers being compensated for their sales efforts, it is clear that they have incentives to steer investors into a particular fund or fund family despite whether it is appropriate or not for the investor. Obviously, such behavior is not in the best interests of potential investors. This activity should be constrained or eliminated.
- Summary Comments:
Another positive suggestion would be the creation of a Mutual Fund Governance Board to improve the bottom-line investment results for mutual fund investors by eliminating or reducing activities not in the interest of the fund shareholders.
- Senator Frank Lautenberg,'s Democrat from New Jersey, reaction to the mutual fund debacle was that he was "shocked and appalled by the unscrupulous actions of mutual funds principals who are paid to protect all fund investors, without discrimination or favoritism. But instead of working to enhance shareholder value, some directors and fund investment advisors have used their trusted positions to line their own pockets and the pockets of their industry cronies."
- A dark and seamy side of the market timing games that transpired at Putnam is chronicled by the SEC Statement of Peter T. Scannell. This includes war stories that transpired at Putnam including (1) some sample interactions between management (i.e. Managing Directors, Senior Vice Presidents, etc.) and members of Preferred Services Specialist Group, (2) reactions of market timing spreadsheets of Mr. Scannell, (3) blocked computer access to certain years of market timing transactions, etc. Also detailed are some specifics of the "roughing up" incident where Mr. Scannell was taken to Quincy at Medical Center's emergency room. This horrific attack resulted in headaches, dizziness, emotional trauma, etc.
- One company recently in the news, due both to Comcast's $47.7 billion to purchase it and their recent shareholders' annual meeting is Walt Disney. Over the years, Walt Disney has been the poster child of "ineffective" independent directors. Indeed, according to one historical caricature of Walt Disney is that "Eisner sets its agenda, He brooks little discussion at board meetings and certainly not heated disagreement and seldom loses a vote. He discourages directors getting to know one another outside of board meetings, the better to remain the sole source of information for each." More recently, the shareholders at Walt Disney Co. withheld 43% of vote for Michael Eisner. This clear no-confidence signal in Eisner was, as one pundit noted a ringing indication that "few executives have received such an overwhelming vote of no confidence." Interestingly, Disney's board of directors still has proclaimed unanimous support in Eisner. Further, the history of directors is shocking to say the least. Specifically, the Chancery Court of Delaware in their Memorandum Opinion of the Walt Disney concluded that, "It is rare when a court imposes a liability o directors of a corporation for breach of the duty of care, and this Court is hesitant to second-guess the business judgment of a disinterested and independent board of directors. But the facts alleged in the new complaint do no implicate merely negligent or grossly negligent decision making by corporate directors. Quite the contrary, plaintiff's new complaint suggests that the Disney directors failed to exercise any business judgment and failed to make any good faith attempt to fulfill their fiduciary duties to Disney and it's stockholders. "Indeed, the facts that are alleged in Disney" if true, do more than portray directors who, in a negligent or grossly negligent manner, merely failed to inform themselves or to deliberate adequately about an issue of material importance to their corporation. Instead, the fact alleged in the new complaint suggest that the defendant directors consciously and intentionally disregard their responsibilities, adopting a "we don't care about the risks" attitude concerning a material corporate decision, knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct, in my opinion, that may not have been taken honestly and in good faith to advance the best interests of the company. Put differently, all of the alleged facts, if true, imply that the defendant directors knew that they were making material decisions without adequate information and with out adequate deliberation, and that they simply did not care if the decisions caused the corporation and it's stockholders to suffer injury or loss. Viewed in this light, plaintiff's new complaint sufficiently alleges a breach of the directors obligation to act honestly and in good faith in the corporation's best interests for a Court to conclude, if the facts are true, that the defendant director's conduct fell outside the protection of the business judgment rule." The relevant point and/or question for mutual funds is, for example, do independent directors truly represent the best interests of the mutual fund shareholders or are they shills for an investment management company in approving "excessive" investment management fees?
- Professor John Freeman provides some ad hoc evidence that illustrates the unfairness of fees charged the retail client of mutual funds. Namely, that Alliance Capital fee schedule for its various clients (i.e. retail and institutional) was:
93 basis points (i.e. .93 percent) for retail customers of the $17.5 billion Alliance Premier Growth Fund.
11 basis points (i.e. .11 percent) for managing the investment growth portfolio of Vanguard U.S. Growth
24 basis points (i.e. .24 percent) for managing a $672 million investment portfolio for the Kentucky Retirement System
20 basis points (i.e. .20 percent) for managing a $1.7 billion investment portfolio for the Minnesota State Board of Investment
18.5 basis points (i.e. .185 percent) for managing the $730 million equity investment portfolio for the Missouri Retirement System
10 basis points (i.e. .10 percent) for managing the $975 equity investment portfolio for the Wyoming Retirement System
Given the presence of (1) strong economies of scale and scope factors for managing investment portfolio of various sizes it is difficult to rationale the fee schedule charged by Alliance Capital. More specifically, as only one case in point, how does one rationalize the fee schedule where 10 basis points is charged for the investment management of $975 million equity portfolio for the Wyoming Retirement System and over 9 times the fee rate for a portfolio over 17 times as large for the retail customers of the $17.5 billion Alliance Premier Growth Fund. This is a clear case of discriminatory pricing.
- A neat table labeled "A Tale of Two Funds" summarizing the similarities and differences between MFS and Putnam mutual fund woes and problems of MFS and Putnam. Note that, at this time, MFS has had less fund withdrawals than Putnam even though its actions seem less reprehensible.
|A TALE OF TWO FUNDS
|Amount of market timing
|Fines and Restitution
|To be determined
||CEO quits and is suspended
Source: Faith Arner, "In a Scandal, Being Nice Helps: Why MFS is Faring Better Than
Bad-Attitude Putnam in the Mutual Fund Mess," Business Week, February 23, 2004
- There are numerous reasons constituting why investors should prefer ETFs (i.e. Exchange Traded Funds) to mutual funds. Add to this list the absence of any trading penalties/costs for the ETF owner as long as he/she continues to own the ETF shares and it's tax superiority over open-end mutual funds. The absence of such costs-penalties is another reason why ETFs should outperform mutual funds of comparable portfolio composition. An excellent discussion of ETF's is detailed in Gastineau.
- The standard academic perspective on optimal portfolio choice under uncertainty is the single period mean-variance portfolio model of Harry M. Markowitz. Markowitz's single period portfolio choice model has been extended to a multi-period scenario via Robert C. Merton's continuous time portfolio rebalancing model. A more recent extension has been the integration of human capital into the investor's opportunity set. As a side-note, Harry M. Markowitz was co-recipient of the Nobel Prize in Economic Science in 1990 while Robert C. Merton was a co-recipient of the Nobel Prize in Economic Science for 1998.
- It is interesting that John Bogle argues that the most important factor in assessing the desirability of investing in a specific mutual fund is a low expense ratio. Two other factors that Mr. Bogle feels are also important are the tenure of the investment team and the portfolio turnover ratio (i.e. how much trading for the fund). Two other dimensions that Bogle suggests are relevant in the investor choice of a specific mutual fund are (1) whether the fund caps the size of the money manager and (2) whether the fund is part of a conglomerate.
- The Boudoukh et. al. paper provided empirical evidence indicating that there were abnormal return opportunities available to mutual funds that engage in late trading using stale prices. Curiously, Jeffrey Molitar of the Vanguard Group argued that Boydoukh et. al. was a border line unethical paper which should have been re-titled "Here's How to Steal Money from Your Fellow Shareholders."
- A side-bar story to Eric Zitewitz's research is that in Summer, 2003, he made $500,000 profit from a market timing operation. Perhaps, even more interesting, Professor Zitewitz's annual returns were only 10% on an annualized basis while his assessed returns from such a trading strategy is in 35% to 70% range.
- One classification of mutual fund fees are:
- Disclosed Costs
- Management Fees
- Administrative Fees
- 12-(b)-1 Fees
- Undisclosed Costs-Transaction Costs
- Brokerage Commissions
- Bid-Ask Spreads
- Market Effects
- Many of the alleged mutual fund cases involving wrong doing via improper trading have been filed by New York Attorney General Eliot Spitzer. Indeed Eliot Spitzer, despite a relatively small staff 29 investor protection lawyers compared to the 1,000 enforcement officers of the SEC, has aggressively, perhaps brilliantly, led a wave of investigations of mutual fund companies and now other financial services companies. As of March, 2004, there are, at least 15 other state attorney generals investigating mutual fund late trading.
- Robert Pozen, now Chairman and CEO at MFS, a mutual fund, provides an interesting matrix in his book entitled The Mutual Fund Business. The matrix presents a code of ethics for five mutual fund families. The five mutual fund families are (1) Fidelity Investments, (2) Vanguard Group, (3) Capital Research and Management, (4) Merrill Lynch Asset Management and (5) Franklin Templeton Group. The code of ethics focuses on decision areas of (1) participation in initial public offerings, (2) participation in private placement investments, (3) minimum holding period between buying and selling of the same security, (4) restrictions on buying or selling of a security which the fund is trading and (5) short selling restrictions. The code of ethics is applicable to fund portfolio managers, other executives and traders and individuals accessible to trade information.
- Representative Richard H. Baker's comments with some sarcasm regarding "boastful testimony" from the mutual fund industry as how they have avoided major scandal. Representative Baker quotes the Testimony of Paul. G. Haaga, Jr. Executive Vice President, Capital Research Management Company and Chairman, Investment Company Institute before the "Hearing on Mutual Fund Industry Practices and Their Effect on Individual Investors Before the House Committee on Financial Services," 108 Congress, March 21, 2003.
- What has been the ex post investment performance of active equity mutual funds? Here are some broad generalizations.
- Most mutual funds provide useful diversification
- Most funds choose a risk class and stayed within this risk class over time
- Funds, before expenses, did no better than indexes of the same volatility
- Funds, after expenses, performed below average
- Not many, if any, mutual funds performed consistently better on a risk adjusted basis than market averages
- Expenses were too high, especially expenses searching out underpriced securities.
- The history of empirical investigations of the ex post performance of mutual funds is too extensive to provide an in-depth comprehensive review. However, a few summary evaluatory comments are:
- Jensen's empirical study which showed that "the evidence on mutual fund performance discussed above, indicates not only that these 115 mutual funds were an average not able to predict security prices well enough to outperform a buy-the-make-and-hold policy, but also that there is very little evidence that any individual fund was able to do significant by better than that which we expected from mere random chance."
- Gruber's empirical study concludes that actively managed mutual funds underperformed on a risk-adjusted basis relevant portfolio investment benchmarks. That is, investment management in actively managed equity mutual funds was non-superior (i.e. resulted in inferior investment results) because their performance yielded negative risk adjusted returns. Why does money flow to or stay in such mutual funds? According to Gruber, it is because the decisions both (1) initially resulting in the flow of funds to the mutual fund and (2) Continuing to retain the shares at the fund is a product of three types of investors. They are (1) unsophisticated investors who fall to fund advertising and broken advice, (2) institutionally disadvantaged investors who opportunity set far investing their pension contributions is restricted to such funds and (3) tax disadvantaged investors who find that, for tax reasons, they are locked in their already purchased but inferior funds.
- A mutual fund investment compensation fee schedule that has incentive dimensions has both (1) a priori economic appeal and (2) empirically demonstrable positive results for fund shareholders. The a priori justification is that if investors do better-worse (i.e. on a relative, such as in comparison to the S + P 500 and not absolute basis), then investment management should be rewarded-penalized. It is the classic win-win or lose-lose scenario wherein the investment management's economic interests are more directly linked to the economic. Empirically, Elton-Gruber-Blake found the incentive-based mutual fund investment managers had an average, risk adjusted returns 1% greater than mutual funds that did not have investment incentive contracts. Part of this performance differential is attributed to the lower fees charged the shareholders. An interesting question is why do only 4% of equity mutual funds have an investment incentive fee.
- An alternative view leading to a different economic conclusion, namely that investor markets which include mutual funds are competitive markets, is detailed in Baumol, Goldfeld, Gordon and Koehn. Their conclusion is derived by regression estimates and economic reasoning. Both, however, are flawed due to measurement error of the boundaries of the market and also due to their non-sequitur reasoning based on arguments that investors can always redeem their shares (i.e. vote with their feet), free entry by firms into the mutual fund indirectly rational investor choice, etc. These conclusions are inconsistent with an array of empirical evidence, some of which is provided here by Gruber and Elton-Gruber-Blake and Freeman.
- It is important to note the different fiduciary responsibilities of the directors of (1) the mutual fund and (2) the investment management/advisory company. The directors of the mutual fund fiduciary responsibilities include negotiating the best deal, such as the least expensive investment management fee and other fees, for the mutual fund shareholders. The directors of the investment management company fiduciary responsibilities are to the equity shareholders (i.e. owners) of the investment management company. These constitute two quite different economic constituencies.
- The Gartenberg 1 and 2 decisions represent an interesting amalgam of law and economies. Whatever the merits are or are not of the legal reasoning in these cases, the economic underpinnings of Gartenberg are woeful lacking in rigor and lead to erroneous and perverse conclusions.
GLOSSARY OF TERMS:
ECONOMICS, FINANCE AND THE LAW
Active Investment Selection - Portfolio Management: A security selection approach that attempts to identify mispriced securities (i.e. alpha securities that have abnormal returns in excess of that assessed firm an equilibrium valuation approach) and purchases the "underpriced" securities.
Active Investment Management: A security selection approach that attempts to identify mispriced securities (i.e. alpha securities that have abnormal returns in excess of that assessed from an equilibrium valuation approach).
Activist Institutional Investors: Institutional investors, such as public (i.e. state and local) pension plans and Taft-Hartley pension plans, who are desirous of changing the corporate governance structure of companies whose behavior puts the economic interests of management before those of the firm's shareholders.
Adverse Selection: Providing false information or signals indicating a willingness to sell or merge. This false information emanates from the firms unhealthy financial conditions and desire to complete the transaction before information is publish.
Agency-Principal Problem: In the context of the modern corporation, it is the principals (.e. shareholders) hiring an agent (i.e. management team) to represent their best interests (i.e. maximize the firms equity share price) in economic resources decisions of the firm.
Antifraud Rules: A vehicle that helps enforce securities laws, both State and Federal. For example, the SEC Act of 1934, Rule 10b - 5 details, in general, act that they regard as fraudulent and manipulate with regard to buying and selling securities and/or affecting information that affects investors decisions with regard to security prices.
Audit Function: The derivation of the firm's balance-sheet and income and testifying as to it's accuracy with GAAP.
Back-End Load Fees: Included redemption fees, contingent deferred sales charges, etc.
Breakpoints: A fee schedule which is reduced as the magnitude of funds invested increases. The points at which the fees are reduced are termed the "breakpoints"
Business Judgment Rule: A rule regarding the appropriate decision behavior of corporate board members. It's bottom-line implication is courts will not second-guess decisions and actions of directors made on a good faith, informed and honest basis.
Capitalism-Free Enterprise System: A structure of how economic resources are allocated. It emphasizes private initiatives private and choice corporations that are publicly traded on an exchange and competitive markets.
Canary Capital Partners: A hedge fund that transferred wealth from several mutual funds of strong capital management via market timing(i.e. a series of rapid trades)
Closed End Mutual Fund: Is a mutual fund whose shares are traded on an exchange and whose price may be higher, lower or at its net asset value.
Conflict of Interests: Where 2 parties do no always coincide. The standard scenario is where manages and shareholders' economic interests diverge. However, on occasion, lawyers, accountants, investment bankers, etc., economic interests may diverge from those of the shareholders.
Contracting Agent Problem: Are the result of the contractor's agent having incentives to take actions that will enhance his/her welfare at the expense of the contractors welfare.
Corporate Governance: Deals with issues relating to whether corporate executive management and its agents (i.e. outside law firms, accountants, etc.) make decisions ex ante that are in the best interests of the shareholders or whether they transfer wealth from the shareholders to their own pockets.
Corporate Scandals: Scenarios where firms deliberately and knowingly create and distribute misleading and false information "pumps" up inappropriately the stock market prices of the firm.
Directors of Corporate Boards: Are the elected representatives of the shareholders. Are elected in a two-step process where (1) the candidates are first nominated and (2) the election occurs and the votes are counted.
Dissident Shareholder: A shareholder or roalition of shareholders who undertake a proxy contest to obtain representation on the board of directors.
Duty of Care: The responsibility of individuals to thoroughly review the relevant materials in a thoughtful detailed manner.
Duty of Loyalty: The responsibility of putting shareholders' financial interests as the number one priority.
Economies of Scale: The reduction in average per unit cost that occurs when production increase in investment assets under management. That is, for mutual funds, there is thought to be significant economies of scale when a mutual fund's assets increase from $100 million to $300 million to $1 billion.
Economies of Scope: The reduction of the average per unit cost for a multi-product firm whose products are similar but not identical. For example, Fidelity Investments may have 50 mutual funds (i.e. equity, fixed income, money market, international sector funds, etc.) Their Fidelity Investors centers provide marketing and service functions to all Fidelity Investors. Thus, in essence, the reduction in average per unit cost can and does result from the total costs of an Investor canter line allocated to many mutual funds and not having a separate Investor Center for each mutual fund.
Efficient Financial Markets: A financial market where there are no arbitrage opportunities (i.e. all securities are "fairly" priced).
Employee Retirement Income Security Act (ERISA) of 1974: A law that details of number of requirements regarding funding, funding requirements, fiduciary responsibilities, etc. Also established Pension Benefit Guarantee Corporation to guarantee minimum pension payments.
Exchange Traded Funds (ETF's): A variant of an investment unit trust and have dual trading process. Are more tax efficient than open-end mutual funds.
Fiduciary Duty: The legal requirement of putting the shareholders' economic interests first.
Free Markets: Competitive markets where there is freedom of entry by new firms.
Free Markets Versus Regulatory Solutions: Is a query concerning the relative economic merits of whether competitive markets or government reform is referable in terms of achieving a public policy goal.
Free Rider Problem: The scenario where a small shareholder does nothing (i.e. takes no action) but is the recipient of a wealth increment due to, for example, a hostile tender offer initiated by another party.
Front-End Load Mutual Funds: Mutual funds that have a sales fee which presumably reflects distribution costs. The sales fee is levied at the time of purchase.
Fund of Funds: A portfolio comprised solely of a number of mutual funds.
Hedge Funds: Investment capital pools that utilize numerous alternative investment strategies. They are not mutual funds and are subject to far less regulation than mutual funds.
Independent Director: Details certain characteristics of a person such as not an officer of the corporation, not related to CEO, does not have a specific financial interest in the transaction, etc. Note that the concept of independent director does not to his/her thought and or action process. This means that an "independent" director can still be a shill for incumbent executive management.
Index Portfolio Investing: A passive investment strategy where you purchase an index or surrogate thereof representing a portfolio of stocks. Typically, it is a buy and hold investment strategy where neither market or sector timing nor stock picking is involved.
Index Portfolio Investing: A passive investment strategy where you purchase an index or surrogate thereof representing a portfolio of stocks.
Institutional Investors: Constitute the spectrum of financial institutions such as commercial bank, life insurance company, pension funds (both public or corporate), mutual funds, hedge funds, etc.
Investment Management Fee: The fees charged by the management company to the mutual fund purchasers. The fees reflect a number of component expenses including the fees to manage the investment portfolio.
Investment Company Act of 1940: Placed a number of regulations and restrictions and, in general, set standards of appropriate behavior for mutual funds. For example, it prohibited mutual fund from borrowing to lever the portfolios expected returns and risks. It also placed restriction on a number of other investment parties including investment advisors.
Investment Company Institute: The trade association of mutual funds pushing for changes in legislation that advantages mutual funds.
Late Trading: Is the trading (i.e. buyer or selling) of shares at the 4:00 p.m. EST closing prices for the NYSE and do not reflect the subsequent firm financial information that has been made public. It's like placing a bet at half-time of a football game at the odds of game before kickoff
Managed Funds Association: The trade association for hedge funds, lobbies and promotes the best interest of hedge funds.
Managerial Entrenchment: The placing of mechanisms (i.e. anti takeover tactics) that reduce the probability of a corporate control change. In this scenario, management's actions are thought to be motivated by their self-interest and not the investors' self-interest.
Market Competition: A scenario in which firms are price takers and purchasers benefit vie a vies monopoly and oligopoly market scenarios.
Market Timing: Is the rapid trading (i.e. purchases and redemptions) of mutual funds
Mutual Fund Expense Ratio: Charges to mutual fund for investment management, marketing, custodial charges, etc. but not for trading costs
Mutual Fund Family: A group of mutual funds run by a single investment management company. The mutual funds may run the gamut from money market funds to fixed income funds to international funds to sector funds, etc.,
Mutual Fund Wrap Account: A portfolio made of a combination of mutual funds chosen/ recommended by an investment advisor. The investment advisor fees are above and beyond the fees charged by the various mutual funds.
National Association of Security Dealers (NASD): Is the self-regulatory association for the securities industry. In the context of mutual funds, NASD the SEC rules for fund advertising, marketing brochures, etc. It also sets limits on the magnitude of the loads that the mutual fund charge before such loads are excessive. Likewise, the NASD details the magnitude of the loads that can be charged and have the mutual funds labeled "no-load funds." Is this an oxymoron?
Net Asset Value (NAV): The calculation of the price of open-end mutual funds. NAV is determined in the market price of all of the securities in the fund at the time of closing of the exchange minus any expenses, such as redemption fees, divided by the fund's total outstanding shares.
No Load Mutual Funds: Are mutual funds that do not have a front-end load expense or a small front -end load expense. Figure that out (i.e. how can a no-load mutual fund a front-end load expenses?).
Open End Mutual Funds: A mutual fund whose shares do not trade on an exchange. Instead, the shares are bought or redeemed at net asset value calculated on prices at the closing of the market.
Passive Investment Management: An investment strategy based not on stock picking but choosing a well-diversified portfolio via, for example, purchase of index fund.
Retail Investor: Are individuals/households who purchase securities/portfolios as contrasted to institutional investors.
SEC: A federal agency funded by congress with the purpose of regulation of financial markets. Among its regulatory mechanisms are disclosure requirements and enforcement power.
Self-Dealing: A transaction in which a person, such as a CEO or corporate director has an economic interest in both sides of a transaction. An example would be if the wife of the CEO were to sell at an inflated price a piece of real estateto the firm in which her husband was the CEO.
Soft Dollars: The opportunity to receive products and services in exchange for incurring trading commissions.
Stakeholders: Groups other than shareholders and bondholders that have an economic interest in the firm. Such groups would include workers, suppliers, customers and local cities where the firm has its headquarters or plants.
Stale Pricing: Is the pricing of a mutual fund's shares based on out-dated pricing. This is a result of the fund prices reflecting close at market prices (e.g. prices at 4:00 p.m. EST for the NYSE and not subsequent important financial events that happen past 4:00 p.m. EST.
Transparency: The disclosure in understandability terms of the relevant informational parameters necessary to accurately estimate the corporate value of the firm and it's constituent securities.
12b-1 Fees: A rule instituted by the SEC in 1980 to allow the mutual fund, rather than each mutual fund shareholder, to pay distribution expenses to the underwriting of the fund's share. The SEC found a number of abuses regarding 12b-1 fees due to mutual funds billing expenses unrelated to marketing expenses.
Value Investing: The purchase of "under priced" or "mispriced" securities.
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