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Rekenthaler Report

2 Legal Decisions Affecting Mutual Funds

The subjects--fees and fiduciary duties.

Half Measures
Judges and I are complements. They don’t understand much about investments, and I understand even less about the law. Unfortunately for them, their job requires them to attempt expertise for the subject that they do not know, whereas my column does not. (That hasn’t prevented me from making such errors in the past, but I will endeavor not to do so today.)

Once again, the legal system’s views on mutual funds have me shaking my head. Earlier this month, a U.S. district court dismissed an excessive-fee lawsuit against J.P. Morgan. The plaintiffs’ failure was not surprising, although it arrived relatively quickly, through summary judgment. Outside 401(k)s, which are governed by different rules (ERISA), fee lawsuits always lose. The court’s logic, though, was ... puzzling.

Plaintiffs made their customary case. (Why they keep trying when they always fail is a mystery.) The fund company, in this instance, J.P. Morgan, pays itself a higher management fee when running its own funds than it receives when subadvising others’. The legal fiction--which has always satisfied courts, including on this occasion--is that the two situations are not comparable because the company’s funds are for retail accounts and the subadvisor relationships are institutional.

Those distinctions matter not, as Vanguard demonstrated 40 years ago, when it convinced investment managers to accept lower fees to run Vanguard’s retail funds than those managers sometimes charged their institutional clients. Because they have smaller accounts, retail investors generate higher operational costs, but they do not require a different investment-management function. The true reason that fund companies pay themselves more is that negotiating with one’s self does not occur at arms’ length.

This is not my quarrel. I disagree, but I can understand why arguments that retail and institutional accounts should be priced differently could appear convincing. Also, that claim has legal precedent. In supporting J.P. Morgan’s claim, the District Court of Southern Ohio did no more and no less than several district courts before it.

Performance vs. Management Fees
My confusion instead comes from the judge relating the funds’ management fees to their investment results. Wrote Judge Sargus in support of J.P. Morgan, “Defendants have shown that the funds’ performance is generally favorable.” This, for me, reveals a fundamental misunderstanding of how funds should be priced.

There exists a method for rewarding fund companies if their funds fare well: performance fees. Although hedge funds are best known for their use of such fees, mutual funds may also install them--with the catch that, unlike with hedge funds, mutual fund performance fees must be symmetrical. Fund companies cannot reward themselves for good deeds unless they also punish themselves for bad ones.

When asked to back their claims of superiority with cold, hard cash, 99% of fund companies demur. Not that I blame them. Outgaining indexes through active investment management, after paying expenses, is a parlous task. It is an endeavor that firms can undertake with hope, but not expectation. Staking a fund company’s revenues on that assignment would border on reckless.

Instead, they use management fees that are established before the performance occurs.  Such fees are not justified because a fund fares well, any more than the ticket price for a sporting event is validated because the team wins that night. Nor are they invalidated should the team lose. They are set because ... well, it’s difficult to know how and why Knicks’ tickets are priced the way they are, or mutual fund management fees either. But performance is not the reason.

Which is how it should be. Otherwise, funds would keep mum--they certainly wouldn’t be rebating their receipts--after their results are poor and then would constantly hit up shareholders for raises when the numbers are good. “Pay us more, we’re worth it!” To continue the sports metaphor, they would act as if they were free agents, clamoring for more money at the slightest of excuses. Even though, as with free agents, their past performance would be only modestly correlated with their future showings. For the most part, if they received their pay increases, they would promptly revert to the mean, or even trail.

Performance fees are for performance, if the fund company dares. Investment-management fees are not.

Say What?
If the Southern Ohio District Court’s reasoning was surprising, its decision was not. The same cannot be said for last week’s 5th Circuit Court of Appeals’ recent ruling that the Department of Labor’s Fiduciary Rule, launched last summer, is illegal. The court ruled 2 to 1 to strike down the statute, which had unanimously been supported by the district count.

Almost nobody saw this one coming, not even the plaintiffs. The suit, financed by several trade-industry groups representing brokers and insurers, was regarded as a Hail Mary effort (oh, those sports metaphors). There appeared to be little hope of overturning rules that had been created after long deliberation, with the involvement of many industry participants, including the organizations that had filed the suit.

Never say never. The Court of Appeals accepted the plaintiffs’ argument that the Fiduciary Rule was regulatory overreach. In extending its ERISA-based fiduciary principles to IRA accounts, the Department of Labor exceeded its authority, stated the court.

Well, no matter. The practical implications of the court’s decision, says Morningstar’s policy specialist Aron Szapiro, will be negligible. “Over the past 18 months, the DOL’s rule accelerated an ongoing, irreversible trend: Clients are increasingly demanding advice in their best interests, and many advisors are changing their business models to deliver it. This focus on best-interest advice is a global trend.”

Thus, it seems that Wall Street will get to roughly the same place as the DOL wished, albeit by taking a different path.

Three columns back, I promised an immediate follow-up to my article on concentrated funds, wherein I would identify the best of what is, overall, an unimpressive breed. I have not yet run those numbers and won’t for a while now, as I am lounging poolside in Morocco. But at some point, I will deliver on that pledge.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for 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.