November 10, 2010
Regulatory Implications of Arbitrariness
Posted by Jeff Schwartz

As I noted in my last post, the arbitrariness of the stock market poses both fairness and efficiency concerns.  Out of concern for fairness, there may be a role for government in protecting investors from arbitrary and disparate market outcomes.  Efficiency concerns point to policies that would dampen the appeal of actively managed mutual funds.

Disparate market returns stem from market volatility.  If the market just went up by the same amount every year, everyone would earn the same thing.  To bring about greater equality of returns, therefore, regulation could seek to dampen the market’s swings.  Indeed, our current disclosure regime has been shown to reduce market volatility, and I have argued that this provides some justification for the regulatory structure. 

Government could also enact measures directly targeted at protecting retirement savers from market turbulence.  A range of proposals could be envisioned along these lines:  from the least intrusive—better education about market risk and risk management—to the most—replacing the 401(k) retirement paradigm with a funded government system.  What I think is most interesting is the prospect of government insurance of stock-market returns.  A study done by the Center for Retirement Research at Boston College showed that in retrospect the government could have guaranteed investor returns of 6% (investors in this case would have forfeited any returns above 6% in exchange for a guarantee of at least that amount).  Looking prospectively, the study concludes that under certain assumptions, the government could offer a 4% return guarantee with a 6% cap.  I have my concerns about the feasibility of this structure, which I’ll discuss in my next post, but at least in the abstract, it looks like a promising way to make saving more equitable.  

A range of policy options is also available for addressing the inefficiency of actively managed funds.  The least interventionist measures would involve better disclosure.  My suspicion is that part of the popularity of actively managed funds stems from their branding.  A 401(k) investor may not realize that a “growth” fund is actively managed, and charges a high fee for its services.  Therefore, better disclosure of both fund strategy and fees may be justified.  In a step in the right direction, the Department of Labor recently adopted new and improved fee disclosure regulations for 401(k)s. 

More interventionist steps are also imaginable.  For instance, 401(k) defaults could be set to index funds.  Because 401(k) investors tend to stick to default choices, this would likely have a material effect in channeling fund flows away from these instruments.  More thought is necessary about the type of regulation, and, indeed, whether any is advisable.  But a variety of alternatives seem to be available to make the allocation of investor resources more efficient.

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