Regulatory agencies are created to act in the public interest but often end up acting in the interests of those regulated. This is known as regulatory capture. The theory of regulatory capture may be given both a broad and narrow interpretation. Under a broad interpretation, a group of entities seeking regulatory favor or “a special interest” affect state intervention in various areas, including taxation, monetary policy and legislation. Under a narrow interpretation, special interest groups manipulate regulators directly.
Mutual fund assets in the U.S. currently exceed $16 trillion, and these assets generate more than $100 billion per year in revenue to firms that manage mutual funds. Thus, there are ample incentives and financial means for investment management firms to influence the political and regulatory process. The potential for a regulatory employee to be hired by a special interest is one means by which a special interest can influence regulators directly. And not surprisingly there is a busy and well-documented revolving door between the Securities and Exchange Commission and the financial services industry.
My recent paper, available here, shows that the SEC has been effectively captured in both a broad and narrow context. Broadly, the investment management industry has succeeded in manipulating advisory fees, distribution fees and soft-dollar commissions. In a narrow context, the Commission has slow-walked the disclosure of information crucial to investors and has failed to reform the fund distribution system in spite of clear abuses and documented evidence that distribution fees are deadweight costs.
A mutual fund is a unique investment vehicle in that it is a captive of the investment management firm that creates the fund and manages its portfolio. In the 1960s the SEC and the University of Pennsylvania’s Wharton School of finance found that mutual funds were overcharged for portfolio management services relative to institutional portfolios, whose investment advisory fees are determined by arms-length bargaining. The 1970 amendment to the Investment Company Act of 1940, and the Senate Report underpinning the legislation, neutered the SEC with respect to advisory fees in favor of “men of ability and integrity” in the investment management industry. In 2001 John Freeman and I found that the system in place was functioning well for special interests but poorly for investors. We found that the overcharging of investment management fees persists relative to public pension funds, with mutual funds paying roughly double advisory fee rates for portfolio management services. In a recent paper, I estimated that fund investors pay about $35 billion per year in excess advisory fees.
Soft-dollar commission arrangements are deals that allow brokerage firms to charge, and mutual funds to pay, above average commission rates in exchange for “research” provided by the brokerage industry. They have been characterized by David Swenson, Chief Investment Officer of Yale University, as “the slimy underbelly of the investment world, [which] deserves a harsher name that reflects the odious nature of the kickbacks they describe.” Research costs are a normal expense item for investment advisory firms and under other circumstances would reduce profitability. Under a safe harbor, enacted in 1975 as Section 28(e) of the Securities Exchange Act of 1934, firms are allowed to impose these costs on mutual fund investors. Moreover, such costs are totally opaque to investors who are charged hundreds of millions of dollars a year in excess commissions. Although initially forced to accept soft-dollar arrangements, over the years the SEC has continued to loosen its interpretation of what is included in “research,” leading to increased industry profitability as a result of SEC actions.
The imposition of distribution fees on mutual fund assets may be one of the all-time regulatory coups by any industry. In the late 1970s the mutual fund industry was experiencing net redemptions. The industry convinced the SEC to impose distribution (marketing) fees on the assets of existing shareholders in order to increase fund assets by attracting new shareholders. Marketing fees are normally an expense item of the investment management firm, but the SEC, by imposing Rule 12(b)-1, allowed these firms to profit from the increased assets without bearing the associated marketing costs. An analogy would be if the banking authorities allowed banks to impose a quarter of a percent fee on checking accounts in order to market checking accounts to new customers. The banks could argue, as the investment management industry did, that eventually costs would decrease as a result of scale economies. The anticipated cost savings never materialized, and the industry continues to impose marketing fees even though mutual fund assets have increased exponentially since 1980.
Moreover, the originally envisioned quarter of a percent fee has morphed into a typical 1 percent annual fee. The incremental three quarters of a percent supports Contingent Deferred Sales Charges (CDSLs) that allow brokers and other sales personnel to camouflage sales commissions in the form of increased expense ratios over a number of years to amortize sales commissions. CDSLs have been controversial because of documented abuses. In 2002, at a meeting of the SEC Historical Society, Kathryn McGrath, former Director of the SEC’s Division of Investment Management, said that “My biggest failure, I think, was trying to tackle and clean up Rule 12b-1…There was too much money flowing through 12(b)-1 fees to make it touchable.”
In 2007 it was estimated that 12b-1 costs totaled about $12 billion.
Of the information available to fund investors, expenses are the best predictor of future returns. Empirical studies show that the bulk of mutual fund investors are unaware of the fees charged on funds. Disclosure requirements in most areas of consumer finance are detailed and voluminous. This is not the case for mutual fund fees.
Actual dollar amounts for fees paid on funds are never explicitly disclosed. The fund investor receives no invoice and writes no checks for fees. Rather the fees are periodically deducted from fund balances. In 2001 the General Accounting Office recommended that the SEC require quarterly statements that would disclose specific dollar amounts deducted from the value of the shares owned. The Mutual Fund Reform Act of 2004 made a similar recommendation.
The industry argued, without irony, that the incremental $60 million in costs was prohibitive for a (then) $7 trillion industry where 50 to 60 percent profit margins are the norm. The SEC sided with the industry. As former SEC Chairman Arthur Levitt said after his retirement, “To the industry, one of the greatest design features of funds is the way they artfully camouflage fees as a percentage of assets.”
As a result of abusive CDSL sales practices and empirical confirmation that distribution fees are deadweight costs, the SEC has faced increasing pressure to reform Rule 12(b)-1. In 2010 the Commission proposed cosmetic changes. The result was as essentially Potemkin reframing of Rule 12b-1 into Rule 12b-2. Under the new rule CDSLs remain unreformed, but distribution fees are re-labeled as marketing fees. The rule has not been implemented and currently sits in limbo.
In addition to percentage annual expenses disclosed in the Expense Ratio, there are other and very substantial expenses that remain undisclosed. Actively managed mutual funds incur trading costs including commissions, bid/ask spreads and the market impact of trades. Because actively managed mutual funds trade in large blocks of securities, trading costs can be substantial.
Recent research finds average trading costs in excess of average expense ratios. These costs combined to cause a total annual drag on expenses in the neighborhood of 2.5 percent. Trading cost information is material even though the SEC allows it to be hidden. It is highly relevant to investors when deciding which funds to purchase or sell.
In response to the late trading and market timing scandals of the early 2000s, the U.S. Congress held extensive hearing and crafted legislation that would have reformed the worst abuses in the industry, including the abolition of distribution fees and soft-dollar commissions. In 2003, the U.S. House of Representatives overwhelmingly passed a bill that, among other things, mandated that the SEC require funds to reveal some of these costs. The Commission issued a detailed concept release in response. Although sponsors of a Senate bill constituted a majority in the Senate Committee on Banking, Housing and Urban Affairs, the bill died at the sole discretion of the Committee Chairman, Senator Richard Shelby of Alabama, who failed to bring the bill to a vote. Once mutual fund reform died in the U.S. Senate, the Commission lost all interest requiring fund companies to disclose trading costs.
Senator Peter Fitzgerald of Illinois had this to say about the mutual fund industry:
The mutual fund industry is now the world’s largest skimming operation – a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the Nation’s household, college, and retirement savings.
Since 2004, mutual fund assets have more than doubled, and the siphoning and skimming have continued unabated. The SEC has the power to unilaterally blunt some of the worst abuses if it is willing to act in the public interest.
 Freeman, John P. and Brown, Stewart L., Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, 26 Iowa J. Corp. L. 609 Spring 2001 Available at SSRN: https://ssrn.com/abstract=923879 or http://dx.doi.org/10.2139/ssrn.923879
Stewart L. Brown, Mutual Fund Advisory Fee Litigation: Some Analytical Clarity, 16 J. Bus. & Sec. L. 329 (2016), Available at: http://digitalcommons.law.msu.edu/jbsl/vol16/iss2/2
This post come to us from Stewart L. Brown, Emeritus Professor of Finance at Florida State University. It is based on his recent paper, “M
utual Funds and the Regulatory Capture of the SEC,” which is forthcoming in The Journal of Business Law and available here.