How Mutual Fund Fees Drive Managers’ Decisions
That’s because mutual funds are run like businesses, according to research done by Assistant Professor Philip English, a Chartered Financial Analyst® who studies investments, mutual funds, and corporate governance.
“We anticipated, both from my own industry experience and from conversations with mutual fund managers, that they would run the fund like a business. If it was making a sufficient profit, they would continue running it; if it wasn’t, they’d either “sell” it [taking the form of a merger] or shut it down,” he said.
English completed his research with Professor William P. Dukes of Texas Tech University and Ilhan Demiralp, now a professor at the University of Oklahoma. English and his colleagues studied the effect of mutual fund fee structure on the timing of exits by managers. They define an exit or failure as mutual fund shares transformed into shares of another mutual fund or cashed out through any method other than voluntary shareholder redemption (which occurs when shareholders “vote with their feet”).
The professors’ research is innovative because even though a lot of studies have been done on mutual funds, prior research has typically concluded that fund failure is associated with poor performance. This research indicates that low revenue for managers is potentially the culprit for a failed fund.
Whether performance is poor also depends, in part, on whose viewpoint is considered.
“For managers, funds perform poorly when they’re not making enough to cover the costs of running the fund and a profit,” English noted. “For shareholders, funds perform poorly when they aren’t providing a return great enough to justify the risk or beat another comparison fund.”
While the manager has a fiduciary duty to ensure best service for the fund shareholders, he is also running a business that needs to profit to survive.
They further determined that fund managers influence the method and timing of a fund exit with higher fees to retain the fee income by merging the fund with in-family mergers—merging into funds that are run by the same investment management company—rather than between-family mergers to funds handled by other companies.
When a between-family merger does become necessary on higher-fee funds, fund managers will delay for as long as possible in order to retain the income. Likewise, they will delay liquidating a fund with high fees for the same reason.
Mutual funds are often considered relatively safe, low-maintenance ways for consumers to invest money. The research “reaffirms the message that low-fee funds should represent the first line of selection for those interested in mutual funds as investments,” English said.
“It also draws into light the possibility that boards of directors don’t actively police the managers of funds as closely as they should, particularly those funds with high fees. We are continuing research along this line and hope to shed some light on this in the near future.”
The group began studying mutual funds because Dukes had a strong disdain for 12b-1 fees, a special set of fees attached only to mutual funds that charge current shareholders in order to defray the expense of marketing and distributing shares of the fund to new shareholders.
It’s a concept that doesn’t make much sense to English. Existing shareholders are required to pay fees so as to convince other investors to buy shares in the fund—but all of the benefits go to the fund manager.
“It’s a mutual fund,” English said. “The performance of it should be testimony to whether they want to buy into that fund.”
The use of 12b-1 fees had long been prohibited, but in the early 1980s, the US Securities and Exchange Commission lifted a ban on fund managers using the assets of the fund to pay for fund distribution expenses.
English’s research indicated that 12b-1 fees also play into exit timing, particularly when managers delay in merging the funds so that they can hold onto the fees. Across all funds, the researchers found a pecking order for mutual fund exit mode and timing, where in-family mergers are favored over between-family mergers or liquidation, and funds with higher fees will be exited at a delay. The same can be said for funds with high 12b-1 fees.
By making these decisions, English said, fund managers are not doing anything wrong. They are just making sure that their businesses serve them well.
“Ultimately the question everyone has is: Are managers taking advantage of shareholders?” he said.
“We’re not saying that managers are setting out to intentionally hurt their investors,” English said. “The managers are running a business, and they are in essence saying if the shareholder doesn’t like what we’re doing, they’ll take their money and go somewhere else.”
“Mutual Fund Exit and Mutual Fund Fees” was published in the Journal of Law and Economics in 2010.