• Print this Page

Myths v. Facts: Jones v. Harris Associates L.P.

Oral arguments before the U.S. Supreme Court on November 2

The petitioners in Jones v. Harris and their supporters base many of their arguments on a series of myths—about the economic relationship between mutual funds and their advisers, the state of competition in the fund industry, the role of mutual fund directors, and the services advisers provide to funds and institutional accounts.

It’s worth noting that the description of mutual funds that the Jones petitioners and their supporters rely upon is based heavily on analyses written in the 1960s—reports written when Chubby Checker was topping the Billboard charts. “Let’s Twist Again” isn’t the last word in rock music—and the 1962 “Wharton Report” is hardly the last word on mutual funds. The petitioners ignore more than 40 years of rapid growth, innovation, competition, and evolving regulation in the fund industry.

This paper separates the petitioners’ myths from the facts.

Myth: There’s no competition in the fund industry. A fund and its board are “captives” of the adviser who created the fund. The proof is that boards almost never “fire” the adviser.

Fact: Mutual funds compete vigorously to attract their true customers—investors—and to draw investor dollars.

The petitioners misunderstand the fundamental economic relationship between a fund and its adviser. Fund boards are not an adviser’s key “customer”—fund shareholders are. A mutual fund operates as a vehicle for an investment adviser to offer its services to the investing public; indeed, investors usually choose a mutual fund precisely for the benefit of that adviser’s package of services.

And investors do “hire” and “fire” managers on a daily basis.

• Investors face few barriers to moving their money among funds in a given family or between families. No-load funds (or load-waived funds) command a rising share of the market. And at year-end 2008, almost half (47 percent) of mutual fund assets were held in tax-deferred accounts or tax-exempt funds.
• Retail fund investors face even fewer constraints on where they place new dollars they invest.
• Investors vote with their feet. In 2008, 62 percent of fund advisers experienced net cash outflows from their long-term funds. In any given year from 1990 to 2008, between 25 percent and 70 percent of advisers were in net outflow.
• Employers and other fiduciaries who select funds as investment choices for retirement plans also act as vigilant customers. According to the 2009 edition of Deloitte Consulting’s 401(k) Benchmarking Survey, 60 percent of plan sponsors evaluate fund performance quarterly, and 62 percent of plans had replaced an underperforming fund within the last two years.

To survive and flourish, advisers must provide acceptable services at an acceptable price to investors, who have no hesitation in going elsewhere when an adviser fails to meet their expectations.

Myth: Mutual fund fees are almost universally higher than they should be, because almost all funds are part of a conflicted system that supports higher fees.

Fact: The market for mutual funds is far too large, competitive, and dynamic to support the sort of across-the-board excessive fees that the petitioners assume.

The mutual fund industry is virtually a textbook case of a competitive market, with few barriers to entry, firms constantly entering and exiting, and cost-conscious customers—investors and their financial advisers—searching vigorously for better fees, performance, and service among more than 8,000 funds.

• In 2008, investors could choose among 8,022 funds offered by 717 advisory firms.
• Funds and advisers enter and leave the market frequently: In 2008, 597 mutual funds were created; 519 were merged or liquidated. In that same year, 59 fund advisers left the business; 35 entered it. Barriers to entry and exit are low.
• The market is dynamic, and no fund adviser has a guaranteed lock on market share. Of the 25 largest mutual fund complexes in 1985, only 10 remained in that tier in 2008. Even the largest, most successful firms have to compete intensely to stay in the top ranks.
• Market share is highly dispersed. In 2008, the top five fund firms controlled just 38 percent of assets; the top 10 controlled 53 percent; the top 25 held 75 percent.

Myth: Investors don’t respond to fees.

Fact: Mutual funds fees are fully disclosed and widely reported. Investors pay attention to costs and to performance, and overwhelmingly direct their money into funds that charge below-average fees. The result is apparent in the 30-year downward trend in mutual fund fees and expenses.

Investors know and care about fees:

• Investors have ready access to a wealth of information about every mutual fund, including its fees. Mutual funds disclose far more information than is available for other investment products, and investors can access that information through a wide range of channels—fund websites, investing websites like Yahoo Finance, newspapers and magazines, and easy-to-use reports from services like Morningstar and Lipper.
• In surveys, investors consistently name fees as one of the most important factors they consider in choosing mutual funds.

Investors don’t just pay lip service to the importance of fees—they act on their beliefs:

• In the 10-year period ending in 2008, every net new dollar invested in stock funds flowed into funds whose fees were priced below the average. In the aggregate, funds priced above the average experienced net outflows.
• As Columbia University School of Business Dean R. Glenn Hubbard (former chair of the White House Council of Economic Advisors) and Harvard Law School Professor John C. Coates IV wrote in an oft-cited study, “empirical studies … show higher advisory fees significantly reduce fund market shares, and so constrain fees.”
• Hubbard and Coates added that regulating advisory fees through litigation was likely to do more harm than good.

As a result of investors’ sensitivity to fees, the fees and expenses paid by stock fund investors fell by 57 percent from 1980 to 2008. Over the same period, the total charges for investing in bond funds fell by 63 percent.

Even as costs have declined, fund advisers have offered investors a much greater array of services. For example, all leading fund companies offer now web-based and automated telephone services—essentially unheard of 20 years ago.

Myth: Fund boards serve as a rubber stamp on advisory fees.

Fact: Boards, and particularly independent directors, exercise rigorous, detailed oversight on advisory fees.

Fund boards are robustly independent. On 90 percent of fund boards, 75 percent or more of the directors are independent. The majorityof boards are chaired by an independent director or have an independent lead director. Independent directors are generally nominated by other independent directors and represented by independent legal counsel. And 97 percent of independent directors have never worked for the adviser managing the funds they oversee.

The Investment Company Act entrusts independent directors with the primary responsibility for reviewing and approving a fund’s advisory contract, including the fees, on an annual basis. The process of evaluating and approving the contract typically takes several months—and often continues year-round. Independent directors consider and review hundreds, if not thousands, of pages of detailed information, much of it from auditors, legal counsel, and other outside consultants. Directors also continuously evaluate fund performance and assess the quality of services that advisers deliver.

The SEC requires a fund to disclose to shareholders the factors that the board considers in approving advisory contracts and the basis of the board’s approval decision. Complying with this requirement necessitates rigorous review of the contract. The SEC also requires funds to retain and provide to SEC examiners copies of all written materials that their boards considered in approving the contract. In a 2003 review of SEC examinations, the agency concluded that “most boards of directors are obtaining the necessary information” to evaluate fund fees and expenses.

In 1970, Congress enacted Section 36(b) of the Investment Company Act to impose a narrowly tailored fiduciary duty on a fund adviser with respect to its receipt of compensation from the fund. As the Solicitor General said in the United States’ amicus brief in Jones, changes since 1970 “have led to stronger, more independent, fund boards, which are today better equipped to deal with conflicts that arise in the management of funds, including the oversight of fund expenses.” The United States brief further recognized that “the board’s receipt of necessary information and its careful consideration of the Gartenberg factors prior to approving compensation can be strong probative evidence that the adviser has complied with its fiduciary obligation.”

Myth: Gartenberg must be a failed standard, because no shareholder has ever won a trial challenging the fee paid to an adviser since Gartenberg.

Fact: Settlements in Section 36(b) cases have resulted in reduced fees.

It is true that plaintiffs have never prevailed on the merits at trial in a case brought under Section 36(b). However, only a handful of such cases have ever been litigated to final judgment. Instead, numerous cases have been settled by the parties, and many of those settlements have included agreements to reduce advisory fees.

Myth: The best way to assess mutual fund advisory fees is to compare them to the fees the adviser charges institutional accounts.

Fact: Mutual funds and institutional accounts operate in two separate markets. They both may receive portfolio management services from the same advisers—but the precise services, capital commitments, risks, and regulations in serving these two very distinct clients are worlds apart.

Comparing the economics of mutual funds to those of institutional accounts is like comparing the economics of newspapers to those of blogs and other online-only publications.

• Mutual funds and newspapers both bear costs of keeping in touch with many thousands of investors or readers; of printing and distributing reports or newspapers to go to them; and of maintaining service centers to deal with questions and complaints.
• Like blogs, institutional accounts use none of these services and bear none of these expenses.
• When an adviser creates a mutual fund, it must invest its own capital to set up the infrastructure and market the fund until it reaches thousands of shareholders and a critical mass of assets. Many new funds never reach that point, and their advisers’ capital is lost.
• Institutional accounts, by contrast, typically originate when a single client brings a large block of assets to the adviser to manage, often with a multi-year commitment.
• • The average balance in a long-term mutual fund account is less than $26,000; the average balance in an institutional account is more than $41 million.
• Even the adviser’s core service—portfolio management—differs significantly between these two businesses. The adviser must manage a mutual fund’s portfolio to maintain liquid assets to meet daily redemption demands. Institutional accounts don’t pose that portfolio management challenge: their contracts often limit or require advance notice for large redemptions or purchases.
• Mutual funds must meet extensive—and expensive—regulatory obligations under the Investment Company Act of 1940 and other federal securities laws. These include requirements for diversification, disclosure, and regulatory compliance. Institutional accounts bear far fewer regulatory requirements and expenses.

In essence, the plaintiffs want to force investment advisers into a one-price-fits-all model that ignores very real differences among their clients. The likely outcome: mutual fund investors will be faced with diminishing services, due to a forced lower pricing that is unsustainable; increased costs, due to advisers’ increased litigation risk; and eventually less choice and competition, should advisers choose to leave the fund business. This could reverse the positive trend of decreasing costs and increasing services that has benefitted mutual fund investors for the last three decades.

Myth: Jones v. Harris is about executive compensation

Fact: There’s no connection and little parallel between a fund board approving an investment adviser’s contract and a corporate board approving executive pay.

This false comparison arises from Judge Richard Posner’s opinion dissenting from the Seventh Circuit’s decision not to rehear Jones. He argued that the decision by a panel of Seventh Circuit judges was based on ideas about market competition that were “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.”

Any analogy between fund boards’ consideration of advisory fees and a corporate board’s review of executive compensation, however, breaks down in the face of facts.

• When a fund board considers advisory fees, it’s not approving pay for individuals. It’s buying services from an adviser on behalf of fund shareholders—services that the shareholders want and need.
• Fees are approved by independent directors, who are not part of the advisory company. The Supreme Court has recognized independent directors as “independent watchdogs” for investors’ interests. 97 percent of independent directors have never worked for the adviser managing the funds they oversee.
• Fund directors are subject to more legal obligations and requirements than any other corporate directors, to the benefit of fund shareholders.
• As noted, funds compete on fees and face tough competitive pressure to keep fees down. Funds that charge above-average fees are less likely to attract new assets—the key to growth.
• Mutual funds compete for investor dollars in a buyer’s market. Investors have thousands of funds to choose among, and can move easily from one fund to another. This sort of competition drives prices down—as has been demonstrated in the fund industry for almost 30 years.