John Morley (who will begin as an Associate Professor of Law at the University of Virginia School of Law next fall) and Quinn Curtis (a doctoral student at the Yale School of Management) have written Exit, Voice and Fee Liability in Mutual Funds, which is forthcoming in the Yale Law Journal. They have some thoughts on Jones v. Harris, the recent decision of the United State Supreme Court regarding mutual fund fees, and here is a taste:
In our view, the Jones opinion is built on fundamental misunderstandings about the structure of mutual funds. The problem, as we explain in a forthcoming article in the Yale Law Journal, is that investors in open-end mutual funds have almost no incentive to vote, lobby boards of directors or sue for excessive fees. This is true even for large and sophisticated investors and even if the mutual fund market isn’t very competitive.
Unlike investors in ordinary companies, investors in mutual funds can redeem their shares for net asset value. NAV is unaffected by expectations about future fees or portfolio changes. In fact, it’s possible for shares in two funds with different expected returns to have the same NAV.
So imagine two mutual funds with identical NAVs and different expected returns. Investors in the low-return fund won’t bother trying to improve the fund’s returns by voting in a new slate of directors or suing for excessive fees. They’ll simply move to the higher-return fund, whose shares can be purchased for the same price as those of the low-return fund. Shareholders of ordinary companies can’t switch so easily, because ordinary company share prices reflect expected returns. A low-return company’s shares can only be sold at a low price, and a high-return company’s shares can only be bought at a high price. The desire to avoid paying the difference is what might motivate shareholder activism in low-return ordinary companies.
Mutual fund investors can be expected to be extremely passive under any reasonable view of mutual fund market competition. Even the commentators who are most skeptical of competition agree that at least some portion of the market is competitive. And one or two competitive funds are all that investors need to make switching more appealing than activism.
And what about unsophisticated investors who don't switch funds because they don’t have the time or understanding to do so? They don’t vote or sue for the same reasons they don’t switch.
The argument for excessive fee liability after Jones seems to be that boards (who are effectively unelected) and plaintiffs’ attorneys (who are completely unsupervised) will keep mutual fund fees low when competition, for whatever reason, fails to do so. But what's the point in pretending that mutual fund shareholders are involved owners when we know that they never will be?
There are more honest and effective ways of regulating mutual funds. One approach would be to regulate mutual funds like products. Mutual funds effectively look like products, because investors can simply refuse to stop buying, the way that product consumers can.
Many product markets are imperfect, just as the mutual fund market is alleged to be, and product regulators have developed a set of tools to deal with these imperfections. Consumer voting, boards and fee liability are not among those tools. But direct price caps, anti-trust laws and consumer-protection regulations are. We don’t know whether additional regulation is necessary. But we do know that if it is, it ought to resemble this set of conventional product regulations, rather than shareholder rights.
Comprehensively reshaping mutual fund regulation in the way we propose was beyond the Court’s power in Jones. But the Court did more than it should have to entrench what we think is a very strange and ineffective system.
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