The mutual fund industry is always evolving, and the authors of a new book titled, The Mutual Fund Industry: Competition and Investor Welfare, say it has become a highly competitive industry. They reviewed studies that eventually became the basis for legislation like the Investment Company Act of 1940 that concluded that price competition didn't exist in the mutual fund industry. Over time, the authors argue, the industry has changed dramatically, and they believe the older studies are no longer relevant. They concluded that average investors have plenty of options to choose from and increased competition has led to lower fees on average. U.S. News caught up with Stanley Ornstein, one of the book's co-authors and vice president of Analysis Group, to get his take on the state of the mutual fund industry. Excerpts:
What prompted you to write this book?
Analysis Group was contacted by some investment advisory firms five or six years ago that were facing some of these lawsuits, and they asked us to do a study of the mutual fund industry. … We were struck by the fact that the basis for this law was based on mutual fund data in the 1950s and '60s, and the mutual fund industry had changed so drastically since that time we felt the conclusions reached at that time could very well be no longer applicable today. In the early '60s there were about 100 mutual funds. Today, there's more than 8,000 mutual funds. Maybe there were 50 investment advisers [in the 1960s]. Today there's about 600. … That's the motivation for doing the book.
What were some of your findings?
What we found today is that the mutual fund industry is a highly competitive industry. Investors in mutual funds are quite sensitive to the fees that they pay, and assets are moved around from mutual fund to mutual fund when investors are no longer satisfied with the returns or the fees they're getting in one mutual fund, and they will move someplace else. … Most statistics indicate that over the last 10 to 20 years that about 20 to 40 percent, it varies from year to year, of fund assets are redeemed, which indicates that fund investors are very mobile, and they can move their money at a moment's notice. An example of that is when a fund has some problems and the SEC is investigating it. The amount of money that flows out of that fund within a 24-hour period can be staggering. If you go back to the timing scandals and things like that in 2003 or so, the funds that were really hit—Janus, Putnam, and others—they lost probably about 40 percent of their assets in just a few hours. So, people can move their money, and people do move their money. Our studies about the demand for mutual funds shows that the demand for mutual funds was very sensitive to the level of fees that people were investing in. … You can look at the distribution in something like the investments in the Standard and Poor's 500 index funds. There's probably about 100 or so of those index funds, and 80 to 90 percent of the money invested in those types of index funds are invested in the very lowest fee category. Investors are quite aware of their annual fees and that's shown in the data.
How have expense ratios changed over time?
There's been a big controversy about that over the years, and it all boils down to how you measure these expense ratios and the time period that you look at. Some people have looked at relatively short time period, and they find expense ratios have risen, but those typically are something like five-year periods. … We looked from 1980 to the most recent data we had when writing the book in 2007, and if you look at that period and account for both expense ratios and load fees it's clear that investor expenses have gone down. They were up around a little over 2 percent in 1980, and in 2007 they were slightly over 1 percent. The SEC found similar results in the year 2000. That's measuring both load fees and expense ratios. … Similarly, there's been a very sharp decline in load fees as well. If you go back to the '60s and '70s the average load fee was about 8.5 percent, and today it's about 5 percent, so fees have gone down on average.
How has the popularity of exchange-traded funds affected price competition in the industry?
That's another indication of competition. To have competition you have to have good, close substitute products. These early studies assumed investors were locked into their mutual funds. Most funds at that time were load funds so there could be capital gains problems. Today, most people are not invested in load funds, they're invested in no-load funds. Capital gains are paid on an annual basis, and those people moving from one fund to another are most likely not to have capital gains. That's why they're moving because they're not getting the return they want on their investment. So today there's a lot of options, and that's the fundamental basis to have a good competitive market. … Since 1993 or '94, ETFs have been a close substitute for traditional mutual funds, and that sector of the market has grown phenomenally—from zero to billions and billions invested in that area. The brokerage fees that you pay can be lower than the annual fees that people pay at some mutual funds.
What are the implications of the Supreme Court's ruling in Jones v. Harris Associates?
The implications of the decision for the average investor is that the decision will not have an affect on the fees that they pay one way or the other. Fees are not going to go up or down. What the Supreme Court did in that decision was to maintain the status quo. … Both the plaintiff and defendant said they were quite happy with the Gartenberg standard. It gave the Supreme Court an easy out. They didn't face the difficult question that was raised. … If there's sufficient competition then the law as currently written is subject to some question. … Gartenberg has been around for almost 30 years. Everyone's familiar with the Gartenberg decision. There's a consensus among the courts, and since neither side is really pressing [the Supreme Court] to go one way or the other [the Supreme Court is] sticking with that.
Under Gartenberg, plaintiffs have never won one of these cases. It may be a law that had good intentions, certainly to protect investors in mutual funds from being abused by investment advisers, but the actual application of the law hasn't served that purpose in terms of giving a judgement in favor of the plantiffs. The question is, "Are Gartenberg's standards so high that plantiffs can't meet those standards?" Or, is the question that the world has changed from the '60s and there's sufficient competition, so that, in fact, the fees are within the boundaries that the Gartenberg decision gave in terms of what a range of arms-lengths negotiations would come up with. That's the empirical question, and that's what our book addresses.