Do Fund Companies Have a Duty to Pass Along Economies of Scale?

The Foundation
A mutual fund (or exchange-traded fund) is a special version of a corporation, governed by the Investment Company Act of 1940. As Apple (AAPL) or Exxon Mobil (XOM) are owned by their investors, so too are funds owned by their investors. The structure is similar. Regardless of whether it is established as an investment or operating company, corporations issue shares that are possessed by its owners, and they hire professionals to manage their affairs, in the interests of those shareholders.

If the professionals dissatisfy, the company’s board of directors may choose to replace them. With operating companies, the main decision faced by the directors is whether to retain the CEO. With fund companies, the board doesn’t hire and fire people, but rather organizations. It decides which organization distributes the fund’s shares, and which organization (if different) advises on the investments. It also decides the level of the fund’s expenses.

According to the prevailing doctrine of shareholder value, directors of operating companies have the duty of maximizing the price of their companies’ shares. Thus, if their company generates additional cash through economies of scale, directors bear the responsibility of verifying that shareholders receive most of those monies, through greater corporate profits that boost the stock’s price. The benefits should flow primarily to the company’s owners, not to its managers.

Presumably, that same doctrine should apply to fund directors. After all, they too represent the interest of shareholders. However, the mechanism functions differently for funds than with operating businesses. For funds, better shareholder performance comes not from higher corporate profitability, but instead from lower costs. Better shareholder performance comes when the fund company takes less money from the fund’s coffers, by cutting its expense ratio.

The Reality
So far, so clear. Corporate managements, whether of operating or investment companies, work (indirectly) for the shareholders who hired them. However, as Jack Bogle enjoyed pointing out, this seemingly simple structure implodes with for-profit fund companies (meaning almost all of them). Those who run such firms serve not one, but two sets of shareholders: 1) Those who own the operating business, and 2) Those who own the funds that their operating business offers.

What’s more, those two shareholders’ needs directly conflict. The first group benefits from higher corporate receipts, which occur if a fund’s expense ratio remains flat while its assets increase, while the second group thrives from the opposite behavior. The more aggressively the fund company slashes expense ratios as it grows its asset base, the higher the return for its funds’ shareholders.

If fund directors posed the same threat to fund-company executives as do their operating company’s directors, then the battle would be a draw. To placate the directors of both sides, each of which could fire them (or, in the case of fund-company directors, terminate the organizational relationship), the executives would make Baby Bear’s porridge: neither too hot nor too cold. When their funds gained assets, half the extra revenues would flow to the company's shareholders, while the other half would be retained within those funds in the form of lower costs.

In practice, the split is nowhere near even, because fund-company directors pose little threat to executives. For reasons beyond the scope of this column, fund directors rarely terminate contracts with fund companies (which, again, they may freely do). Nor do they commonly insist upon expense-ratio reductions. The force exerted on fund-company executives comes predominantly from one of their two theoretical masters. Consequently, they listen much more intently to that party.

Legal Matters
This imbalance of power could be remedied, if legislators so desired, by holding fund directors’ feet to a hotter fire. For example, in addition to the current mandates that they observe applicable laws for standards of care, fund directors could be explicitly required to set aside the interests of their sponsoring fund companies, thereby encouraging them to fight harder for fund shareholders.

For example, those who oversee retirement plans covered by the Employment Retirement Income Security Act, enacted in 1974, must abide by a “duty of loyalty” that specifies that they “act solely in the interest of plan participants and plan beneficiaries, with the exclusive purpose of providing benefits and paying reasonable plan expenses.” Such language has led to several hundred lawsuits filed against 401(k) plans over the past several years, with claims that they overcharged participants.

In contrast, fund-company lawsuits have been almost nonexistent, because shareholders lack a ledge on which to grasp. The existing legal standard, established in 1982 and re-affirmed by the Supreme Court in a 2010 decision, requires only that fund expenses not be “so disproportionately large” as “to bear no reasonable relationship to the services rendered.” That test is so difficult to fail that, to date, no fund company has ever done so in a court of law.

As there is no legislative appetite to change the statutes, nor any reason to believe the Supreme Court will revisit its relatively recent response, in practice fund companies may charge whatever they wish, with a high probability that their request will be ratified by the funds’ directors.

Power to the People
Which leaves the marketplace as the ultimate arbiter of fund expenses. The stick has carried little weight, as fund directors have been reluctant to use it and the legal system will not permit it. However, the carrot has been mighty. On a dollar-weighted basis, fund expenses have fallen in half over the past 20 years, because investors have flocked toward cheaper funds. In response, fund companies have launched additional low-cost funds, and have started (although this remains very much a work in progress) to reduce the costs of their existing funds.

In summary, although logic suggests that directors should attempt to maximize shareholder value for funds, as they customarily do with operating businesses, practice dictates otherwise. Neither habit nor the law suggest that fund directors will drive particularly tough bargains for the shareholders they represent. For better or worse, that decision rests in investors’ hands.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.