The Mutual Fund Industry vs. Mutual Fund Investors, Part Two

Last week I discussed the Investment Company Institute's (ICI) misleading assertions about mutual fund expenses in the amicus brief they filed in the Jones v. Harris Associates case. Given that the case, which will be argued before the Supreme Court on November 2, could have a wide-ranging impact on the mutual fund industry, I was hardly surprised to see the ICI in full spin mode. But I nevertheless remain amazed at their ability to try to convince us that one plus one equals three.

This week, I'll take a look at how the ICI's brief deals with the core issue of the Jones v. Harris Associates case.
Harris Associates serves as the investment advisor for the Oakmark family of mutual funds. Like many mutual fund advisors, Harris Associates also manages money for a number of institutional clients -- pension funds, endowment funds, and the like. The case was brought by shareholders of some of the Oakmark funds, who claim the fees they pay Harris Associates for this advisory function are much higher than the fees paid by Harris's institutional clients.

The discrepancy in the fees paid by mutual fund clients versus those paid by institutional clients is not unique to Harris Associates. Research has demonstrated that in many cases institutional clients pay less -- in terms of dollars and expense ratios -- for investment advice than do the shareholders of the firm's mutual funds.

It's not hard to imagine why this is so. Institutional clients negotiate directly with the fund manager, and have a vested interest in paying as little as possible for the manager's services. Mutual fund shareholders, on the other hand, are represented in these negotiations by the fund's board of directors, which is often chaired by the CEO of the mutual fund manager -- the manager is essentially negotiating with themselves. It's the functional equivalent of a car salesman negotiating the price you'll pay for your new vehicle with himself.

"Did you get me a good deal, Larry?"

"I did, but boy that guy drives a hard bargain."

Obviously, this arrangement is difficult to defend. In fact, in doing so, the mutual fund industry is a bit schizophrenic. On one hand, they tout the independent board as one of the industry's strengths in protecting fund shareholders. But when asked to address the dearth of instances in which fund directors have been successful in negotiating meaningful fee reductions, the industry argues that such reductions aren't really necessary, because fund investors who are displeased with the fees they're paying can simply sell their shares and move on to a lower cost alternative. So, according to the ICI's logic, we have strong boards that are essentially unnecessary, without any evidence offered in support of either assertion.

But most curiously, the ICI's brief seems to skirt around the core issue of the case, which, as I noted, is why Harris Associates charges their fund investors so much more for investment advisory services than they charge their institutional clients.

Instead of addressing this directly, the ICI engages in a lot of hand-waving and misdirection. They make numerous claims about how competitive the mutual fund industry is (thereby implying that it's impossible for prices to be artificially high in a competitive marketplace). They point out, correctly, that mutual funds require a whole host of services that their institutional clients do not. There are legal fees, compliance fees, statements to print and send, and call centers to staff, all of which make mutual funds more expensive to manage than a typical institutional account.

But that's not the point. What's at issue is the difference in the price these two parties pay for one specific service -- investment management. How much are the mutual fund shareholders paying for the manager's investment expertise, and how does that compare to what the institutional clients are paying?

The ICI's response? Essentially, "Beats me." Trying to determine that, according to the ICI, is "enormously complicated ... an [investment] adviser provides multiple services to a fund, and the exact allocation of payments to each function is uncertain."

The ICI and the firms they represent would like to help, but gosh, it's complicated ... one of life's great mysteries, really. What makes this assertion particularly striking, says Professor William Birdthistle of the Chicago-Kent College of Law is that "an industry that is premised upon selling its ability to determine good returns on investment is arguing that it is incapable of determining the comparative return on investment of its own clients -- even street vendors know whether they make greater profits from selling hot dogs versus drinks, but investment advisers expect courts to believe that they cannot compare whether their institutional or retail clients generate greater returns?"

The mutual fund industry's position on this issue seems to leave us with one of two conclusions. Either they truly are incapable of developing a sound basis for comparing the amounts paid for investment advice by their institutional clients and mutual fund clients -- in which case one would have to question the basic premise of their existence -- or they're simply trying to stymie any real inquiry into the economics of their industry -- which would create serious questions about the industry's ability to balance their self-interest against the interest of their mutual fund shareholders. Seems like a tricky position to find oneself in, no?

Quite a few years ago, a lawyer friend of mine shared with me some advice that one of his law professors had given him, which I couldn't help thinking of as I read the ICI's brief: If the facts are on your side, argue the facts. If the law is on your side, argue the law. If neither is on your side, bang on the table. Reading their brief, it appears as if the ICI has decided that neither the facts nor the law are on their side, so they've resorted to table banging. It would seem to be a strange strategy to use before the Supreme Court, but what do I know?

Image via Flickr user laura padgett CC 2.0