Industries dominated by fixed costs tend to experience a lot of price competition. You don’t have to look any further than the airline industry to find evidence of this economic axiom. In fact, price competition is often even more fierce in growth industries where price cuts are enabled by economies of scale. For example, the Model T Ford had a price tag of $850 when it was launched – blowing away most rivals priced in the $2000-$3000 range. Within a few years, the Model T MSRP was around $300 – illustrating to the world the new economics of scale.
But price competition seems to have bypassed one particular fixed-cost business – the money management business. This, according to an article in the Journal of Investing that was made available for free recently. The paper by John Haslem of the University of Maryland, Kent Baker of the American University and David Smith of SUNY at Albany has the benign-sounding title “Identification and Performance of Equity Mutual Funds with High Management Fees and Expense Ratios”. But don’t be fooled. The authors rail against what they see as a lack of price competition in the US (and by extension the global-) mutual fund industry before examining the relationship between fees and performance. They even name names – highlighting the US mutual funds with the highest relative fees in the land.
In their words:
“…mutual fund expenses are higher than they would be in price competitive markets with homogenized products, such as index funds. The market lacks competitive pressure that would force fund expenses downward, especially as funds get larger and economies of scale continue. Despite claims by the industry’s trade association, strong price competition does not characterize the fund industry. This general conclusion is consistent with our study’s working hypothesis that large and significant differences exist among certain funds with respect to management fees and expense ratios.”
The first half of their report methodically lists their evidence of this lack of price competition including:
Consistent fees: “While large funds generally have lower expense ratios than small funds, fund shareholders have not come close to fully sharing in the expense savings from scale economies. In an industry with more than $9 trillion in assets, this benefit is more than large. The failure of fund managers to share economies of scale with shareholders reflects the lack of strong price competition in the funds industry.”
Lack of independent oversight: “The failure of mutual fund independent directors to act according to their legal mandate as shareholder “watchdogs” often implicitly supports the self-interest behavior of mutual fund managers. Greater alignment of interests would likely exist between independent directors and shareholders if management did not handpick directors, if directors invested a substantial portion of their wealth in the funds they oversee, and if directors received payment in fund shares.”
Index-hugging: “…some so-called actively managed funds charge large management fees for herding their portfolios around benchmark indexesâ€”closet index funds. Their high expense ratios are not an indicator of strong price competition among funds.”
Inappropriate metrics: “…the mutual fund industry and its regulators have constructed a system for preparing and disclosing expenses (and costs and fees), characterized by incorrect, incomplete, missing, and misleading expense data and information. This system reflects fund vagaries in the preparation and disclosure of expenses and the lack of sound practice in accounting for them.”
Conflicts of interest: “Soft dollars have no economic justification, but they do create inherent conflicts of interest between fund managers and fund shareholders…[as do] pay to play agreements between mutual fund managers and broker/dealers…”
“Large and Significant Differences”
So what are the “large and significant differences” between fund fees that indicate a lack of competition? The second half of this article explores the relationship between fees and various measures of fund success.
Unfortunately, the evidence is somewhat mixed. In some cases, mutual funds with relatively high fees (vs. their Morningstar category) have positive attributes:
“Analysis by Morningstar category overall across each of the four standard deviation classes finds that five-year annualized total returns have a consistent and increasingly positive association with management fees. Thus, total returns increase as management fees increase.”
But in other cases, the pictures was less clear:
“Jensen’s alpha has a very uneven association with management fees. Again, this is inconsistent with our expectations.”
And in further cases, higher fees were clearly negative:
“Analysis by Morningstar category overall across each of the four standard deviation classes finds that the Sharpe ratio has a consistently increasing negative association with expense ratios.”
“A potential implication of these results is that higher management fees may add value to active portfolio management and contribute to improved performance measures. These findings add fuel to the continuing debate over active versus passive portfolio management.”
Although they leave the door open to the possibility that managers may add adequate value, this does not necessarily mean that prices are actually set appropriately, say the authors. Based on fixed costs and an increasing scale, the authors still conclude that mutual fund fees are simply too high.
But managers (particularly hedge fund managers) often argue that their services are priced on value, not on underlying cost. The authors acknowledge this argument:
“While the evidence leads to the conclusion that mutual fund expenses are too high, one basic question remains. So what if expenses are too high? Investors apparently do not appear to find the cost issue a hindrance to fund investment to meet their financial needs and goals given that they have invested trillions of dollars in funds.”
But in the end, the proof is in the pudding. The authors say that huge and consistent profits seem to suggest at least some kind of market failure:
“Money management is one of the nation’s most profitable businesses, if not the most profitable.”