Jones v. Harris And Mutual Fund Fees
On Monday, the Supreme Court heard arguments on the case of Harris Associates v. Jones. The plaintiffs are three shareholders in the Oakmark mutual fund family, while the defendant is Harris Associates LP, which manages the funds. The claim is that Oakmark charges excessive fees for its mutual fund -- individual investors are charged roughly twice as much as institutional investors -- and has violated the "fiduciary responsibility" set out for it by Congress.
As Simon Johnson and James Kwak point out, as the trial was working its way through the lower courts, a surprising argument broke out. Chief Judge Frank Easterbrook, siding with the mutual fund noted:
"Mutual funds come much closer to the model of atomistic competition than do most other markets...It won't do to reply that most investors are unsophisticated and don't compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest...Harris Associates charges a lower percentage of assets to other clients, but this does not imply that it must be charging too much to the Oakmark funds. Different clients call for different commitments of time. Pension funds have low (and predictable) turnover of assets...In competition those joint costs are apportioned among paying customers according to their elasticity of demand, not according to any rule of equal treatment."
An interesting dissent came from law and economics guru Judge Richard Posner:
"The panel bases its [decision] mainly on an economic analysis that is ripe for reexamination on the basis of growing indications that executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation. . . . Competition in product and capital markets can't be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds. Mutual funds are a component of the financial services industry, where abuses have been rampant."
So again, institutional investors investing in a mutual fund, say a pension fund bringing $50,000,000, secures a percentage fee rate half that of an individual bringing $25,000 to the fund. These fees are taken out of the amount invested every year regardless of performance. Let's imagine a rate at 1.4% for the individual and a rate of 0.7% for the pension fund. They each put a $1 into the fund, and after 10 years of 8% returns (before fees), the individual has $1.87, and the pension fund has $2.01. After 30 years, the individual has $6.59, and the pension fund has $8.15. They were each in the same fund, facing the same market risks, but they have much different returns years later -- so the stakes are high.
Judge Easterbrook takes an efficient market stance, and says since markets are working any differential has to be the result of characteristics of the individuals. It's equally easy to conclude that someone who is bringing more money and more sophistication to the table, as the institutional investor does, can say "charge me the marginal cost of providing this service or I won't buy" more credibly. Now that rate cascading down to the regular folks with $25,000 is what the efficient markets are supposed to do; that's how a rising tide of informed investors raises the boats of all us regular noise traders who can't dedicate our full time and our full knowledge to finance.
This is how it is supposed to happen in financial markets -- smart investors bring the price of a financial instrument to its 'true' value, making a tidy profit, and then regular people can buy it at the correct value, increasing value for all. The disturbing implication is we have a situation where there are multiple equilibria; one for savvy insiders, and a worse one for people who aren't finance professionals. Why aren't these converging at mutual funds?
There's a lot of talk about how competitive the mutual funds market is with its 8,000 funds -- it is worth noting statistics from this abstraction of "How Does Size Affect Mutual Fund Behavior?" (Pollet/Wilson) "the largest quintile [20%] at the start of the decade controlled over 86% of all mutual fund assets...In comparison, the smallest quintile [controlled] only 0.27% of all mutual fund assets." I'm not sure if this is a worrisome number, but it is worth noting that it is a top-heavy industry.
Now should the funds charge less for larger clients? There are fixed costs to adding a client: they have to mail you a summary, and the stamp costs the same for both. This is why for even straightforward index funds there are still minimums requirements to opening and maintaining an account. There's a headache for people who flip funds quickly with hot money, which is why many funds charge a fee for those who withdraw money in a short term timeframe. So these don't strike me as relevant reasons.
All the money should go to the same pool, but perhaps individual investors need to have greater liquidity, as they are more likely to leave the fund. I wonder how this actually plays out: the expectation from a 10% chance of the $25,000 client leaving a fund would be the same as a 0.005% chance of the $50m client leaving that same fund, so the liquidity arguments would strike me as more dangerous for the largest clients. Liquidity arguments are incredibly important for hedge funds and other leveraged strategy vehicles that involve pair-trading, less so for mutual funds.
There's a vein in the mutual fund research that argues that funds have severe mean-regression as they get larger. It's easier to make a higher profit with a clever idea with $25K than with $50m; you move the market too much with $50m and people take notice of the clever thing you are doing and replicate it, weakening it. Also see the Pollet/Wilson piece for another argument (changing strategies mid-stream to accommodate larger pools of money has its costs).
But perhaps there are internal numbers that work out that justify this differential of fees. If so, why aren't the funds shouting them from the rooftops? In an age when individuals have had a lot of their financial risks shifted to them from institutions, where every single individual is expected to be a financial entrepreneur of his or her own future, the idea that individuals are getting hit with much larger fees than larger agents should worry all of us for our financial futures. Making sure that informed traders at the largest institutions are negotiating the price to its optimal setting for all of us, instead of for their insider status, is the definition of how the price mechanism is supposed to work, and can work if fiduciaries are allowed to take these differentials into account.