Is the Fund Industry Truly Competitive?

Ryan Leggio: One of the issues the Supreme Court will be reviewing, which was mentioned not only in the majority opinion of Judge Easterbrook and the dissenting opinion of Judge Posner, is the competitiveness of the mutual fund industry.

And that's where I want to go to next, because there is a big disagreement between you two and between the industry and the plaintiffs in this case.

Professor Coates, I'll start with you. The Investment Company Institute in their brief to the Supreme Court wrote, and I quote, "The mutual fund industry is virtually a textbook case of a competitive market, with many firms vying for cost-conscious investors." Question: do you basically agree with that statement?

John Coates: Yes, it's factual. There are 8,000 funds, thousands of fund complexes. Even within a given segment there are numerous competitors all seeking to attract investor flows. Investment can be moved quickly and easily from one fund to another across the vast majority of accounts. Not all of them, but the vast majority.

And more importantly, new flows into the fund industry for which there is no impediment to choice have completely dominated the funds that have already been invested over the years.

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So if you started with 1980 as your benchmark, the assets that were in place in 1980 are down to 5% of the current assets. That's how big the fund industry has grown over that period, and during that period every new investor has been able to make a free choice.

And finally, the evidence that's in the research that I've conducted shows that there's a very sharp price sensitivity between investors, so they look at fees and they choose to put their money in funds that have lower fees on average.

Leggio: There's no question that Morningstar research also indicates that investors are very cost conscious and look for the lower-cost funds. In addition, there are somewhere around 8,000 different mutual funds out there. Isn't the industry competitive, Professor?

William Birdthistle: The number of products that are available and the size of the industry don't really suggest anything necessary about the industry's competitives. They are helpful, they would be good indicia generally. But we have more direct ways of asking whether or not the industry is actually competitive. Which is, for instance, to compare the fees and performance.

And as I said a second ago and I'll repeat now, we have something just out of this month's "Journal of Finance" that repeats a study that was found originally in 1966 by William Sharp, repeated by multi-million book selling author, Burton Malkiel. Numerous financial studies again and again repeat that fees and performance do not travel together. As fees go up, performance goes down.

I think it's true to suggest that there are some price-sensitive customers in the market, and I think those are the customers that go to low-fee, competitive index funds. It's also true, and these studies demonstrate, that there is an enormous pool of investors that are not particularly price sensitive.

And I think when you compare the findings of people as diverse and disparate as the American Enterprise Institute, which also found that there was a lack of competitiveness here, Judge Richard Posner, who also found that there was a lack of competition here.

And in fact even Don Phillips, the esteemed head of this division of Morningstar, said when looking at a study that demonstrated that the fees were not competitive in this market, said, "This study is dead on in its methodology and findings. The study is very damning. It shows that retail mutual funds are not competitively priced."

I'm happy to defer to the judgment and the impartial wisdom of Morningstar on that issue.