As has become widely known in the past few years, the mutual-fund industry is more concentrated than ever, especially because of the growing use of index funds. Whether this is a problem and how to respond have been the topics of considerable debate. Commentators have laid out several possible reforms, including antitrust responses, regulations that limit the number of companies in an industry that an index fund may invest in, and the wholesale removal of some mutual funds’ power to vote. But many of these responses would disadvantage index funds, which would be unfortunate because index funds have greatly benefited individual investors.
Despite their growth, mutual funds have changed little in their basic legal structure since the 80-year-old Investment Company Act. To be sure, there has been significant innovation in indexing techniques, and Vanguard has been particularly innovative both in adopting its fund-owned internal structure and in developing techniques for managing tax liability between its ETFs and its open-ended mutual funds. But we haven’t moved much beyond the idea of large investment companies that serve as intermediaries, holding investments for individuals. Modern public markets would benefit from more imagination about the legal structures and relationships for holding and managing individuals’ money.
In particular, given our highly connected world, and given developments like robo-advisers and requirements that brokers track the tax basis of most investments, there’s no reason that either passive indexing or active management needs to occur through a distinct investment company – a mutual fund. To put it more formally, there is no need to couple investment decision-making with the legal ownership of the underlying instruments used to achieve investment objectives.
Instead, for example, we might imagine a distributed programmatic fund, where the “fund” is just a series of instructions to be executed by the ultimate customer’s broker – in effect an ongoing script for the broker to follow because the customer has subscribed to it. Thus, instead of owning shares in an investment company (mutual fund) that itself owns shares in a thousand different public companies, an investor would pay a firm like Vanguard or Blackrock for what amounts to a subscription to a feed of instructions that the investor’s broker would execute to acquire or sell individual companies’ shares under various conditions. That may sound unwieldy, but making it simpler for investors would just be a matter of user-interface design.
Of course, for individual customers, such an arrangement could have different tax implications than those of existing mutual funds (though that would not be an issue for IRAs and other qualified brokerage accounts). In addition, the arrangement would raise several nontrivial questions. For example, what about the possibility of front-running the purchase instructions of such a “fund”? Would this mechanism increase trading costs or indexing errors? These issues could be addressed through contract, regulation, or technology – or simply treated as one of the many costs that any system of investment management will have.
In any event, this kind of distributed fund would have many benefits. First, it addresses concerns about concentration by aligning, at least in theory, voting power with economic benefit – a sort of self-help version of pass-through voting. That is, individual investors (rather than intermediaries) would own the shares of public companies, as they more commonly did in the past, and they would be free to vote or choose their own advisory services without any changes to corporate-governance law. Second, decoupling investment decisions from the holding of investments could improve efficiency, allowing companies to specialize in one or the other rather than both. Third, such an arrangement also could reduce the barriers to entry for mutual-fund competitors, which would no longer need to set up an investment company.
This mechanism would also reduce the costs and complexity for individual investors who want to depart from a fund’s investment plan. For example, consider an individual investor who objects to owning shares in Facebook for moral, political, or financial reasons. If that investor owns a mutual fund that buys Facebook shares, it is extremely difficult for the investor to counteract or “undo” the fund’s position. The investor would need to detect (with a delay) the fund’s purchases of Facebook shares and then tediously and imprecisely adopt counteracting positions, using short sales or options, in their own account. In doing this, the investor would run the risk of large indexing errors and potentially unbounded losses from mismatched long and short positions. If an investment manager’s strategy were conveyed as instructions to a broker, however, individual owners could simply amend or filter those instructions: “Buy whatever the manager of this indexing service directs my account to buy, except for shares in Facebook.” There could even be professional services that would exclude or deemphasize investments in particular companies in order to match a customer’s political or other objectives and could be overlaid on top of professional programmatic funds.
In short, there could be surprising benefits to new fundamental legal and business structures for managing individual investment in public corporations.
This post comes to us from Shawn Bayern, Associate Dean for Academic Affairs and the Larry & Joyce Beltz Professor of Torts at Florida State University College of Law.