Competition in the Mutual Fund Industry: Evidence and Implications for Policy

By Coates, John C., IV; Hubbard, R. Glenn | Journal of Corporation Law, Fall 2007 | Go to article overview

Competition in the Mutual Fund Industry: Evidence and Implications for Policy


Coates, John C., IV, Hubbard, R. Glenn, Journal of Corporation Law


Since 1960, the mutual fund industry has grown from 160 funds and $18 billion in assets under management to over 8000 funds with $10.4 trillion in assets. Yet critics--including Yale Chief Investment Officer David Swensen, Vanguard founder Jack Bogle, and New York Governor Eliot Spitzer--call for more fund regulation, claiming that competition has not protected investors from excessive fees. Starting in 2003, the number of class action suits against fund advisers increased sharply, and, consistent with critics' views, some courts have excluded or treated skeptically evidence of competition and comparable fees of other funds. Skepticism about fund competition dates to the 1960s, when the SEC accepted the view that market forces fail to constrain advisory fees, in part because fund boards rarely fire advisers. In this Article, we show that economic theory, empirical evidence, and careful analysis of the laws and institutions that shape mutual funds refute this view. Fund critics overlook the most salient characteristic of a mutual fund: redeemable shares. While boards rarely fire advisers, fund investors may "fire" advisers at any time by redeeming shares and switching into other investments. Industry concentration is low, new entry is common, barriers to entry are low, and empirical studies--including new evidence presented in this Article--show higher advisory fees significantly reduce fund market shares, and so constrain fees. Fund performance is consistent with competition exerting a strong disciplinary force on funds and fees. Our findings lead us to reject the critics' views in favor of the legal framework established by section 36(b) of the Investment Company Act and the lead case interpreting that law (the Gartenberg decision), while suggesting Gartenberg is best interpreted to allow the introduction of evidence regarding competition between funds.

I. INTRODUCTION
II. BACKGROUND: CRITICISM OF THE MUTUAL FUND INDUSTRY AND AN OVERVIEW
     OF FUND FEE REGULATION
      A. Industry Critics: Stuck in the Sixties
      B. The Critics' Views: Conflicts and Beholden Boards
      C. Current Legal Framework Regulating Mutual Fund Fees
III. THE STRUCTURE AND PERFORMANCE OF THE MUTUAL FUND INDUSTRY
      A. Trends in the Number and Concentration of Assets in Mutual
         Funds and Fund Complexes
      B. Absence of Barriers to Entry and Expansion of Funds
      C. Numerous Distribution Channels and Trends in Distribution Costs
         Promote Competition
      D. Price Reductions as Evidence of Competition
      E. Trends in Fees and Expenses are Consistent with Price
         Competition
      F. Changes in Market Shares Offer Evidence of Competition
      G. Summary
IV. INVESTOR MOBILITY ACROSS FUNDS PROVIDES IMPORTANT EVIDENCE OF PRICE
     COMPETITION
      A. Prior Research on the Direct Effect of Fees
      B. Our Findings on the Strength of the Relationship Between Fees
         and Assets of Funds and Complexes
V. THE COMPETITIVE MARKET FOR MUTUAL FUNDS IS CONSISTENT WITH
     "ANOMALIES" NOTED BY CRITICS
      A. Fees Paid by Institutional and Retail Investors Are Consistent
         with a Competitive Market
      B. Economies of Scale and Scope in Funds and Complexes
      C. Price Dispersion Among Funds
      D. Switching Costs
      E. Investor Ignorance and Cognitive Biases
VI. IMPLICATIONS OF COMPETITION IN THE FUND INDUSTRY FOR LAW AND POLICY
      A. Section 36(b) of the ICA and Gartenberg
      B. Economic Effects of ICA Section 36(b)
      C. Legal and Economic Analysis Suggests Limiting Principles for
         Law and Regulation
         1. Government-Determined Prices Should be Avoided
         2. Mandatory Bidding for Investment Advisory Contracts is not
            Necessary to Ensure Eompetitive Pricing
      D. The Gartenberg Framework
      E. The Gartenberg Dicta
      F. Refinements to Gartenberg
VII. CONCLUSION
      APPENDIX

I. INTRODUCTION

Despite enormous growth and acceptance of mutual funds by millions of individual and institutional investors, mutual funds have periodically been accused of charging excessive fees. …

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