This paper suggests that the essence of these funds and their regulation lies not just in the nature of their investments, as is widely supposed, but also—and more importantly—in the nature of their organization.

Specifically, every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I am calling the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

I explain this pattern of organization and explore its costs and benefits. I argue, paradoxically, that the separation of investments and management benefits fund investors by limiting their control over managers and their exposure to managers’ profits and liabilities.

…continue reading: The Separation of Investments and Management

In our paper, Are Mutual Funds Active Voters?, which was recently made publicly available on SSRN, we document that mutual funds vary significantly in how they fulfill their fiduciary duty to vote their shares in shareholders’ interests. Approximately 25% of mutual funds vote with ISS on nearly all company agenda items throughout our five-year sample period. However, many other mutual funds disagree frequently with ISS, particularly on contentious votes. We find that certain types of funds are more likely to find it optimal to incur the costs of evaluating the necessary information to independently assess the items up for vote. For example, large funds and funds from top 5 families can spread the costs over a wider asset base, and low turnover funds are more likely to own the stocks long enough to realize the valuation effects of the vote outcome and any consequent changes in company governance. We would thus expect such funds to be more likely to actively vote. A summary measure of fund activism, which is based on six fund characteristics, highlights the extent to which variation in funds’ costs and benefits of actively voting translates into dramatically different voting patterns. Across a sample of contentious compensation and governance votes, we find that passive funds follow ISS in 86% of the compensation and 77% of the governance votes, compared to analogous rates of only 15% and 19% among actively voting funds. Similarly, across a sample of contentious director votes, passive funds are approximately three times more likely than active funds to follow ISS.

…continue reading: Are Mutual Funds Active Voters?

The Center for Political Accountability released on December 10, 2012 its annual survey of mutual fund support for corporate political disclosure. The analysis, which is available on CPA’s website, reviewed how 40 of the largest mutual fund families voted on shareholder resolutions that asked for disclosure of political spending based on the CPA model.

The review’s key findings include the following:

…continue reading: Survey of Mutual Fund Support for Corporate Political Disclosure

My recent article, Mutual Fund Sales Notice Fees: Are a Handful of States Unconstitutionally Exacting $200 Million Each Year?, forthcoming in the Hastings Constitutional Law Quarterly, describes the political compromise struck in 1996 between Congress and state securities regulators. That year, Congress enacted the National Securities Markets Improvement Act of 1996 (NSMIA), which effected multiple changes to the federal securities laws to promote efficiency and capital formation by eliminating overlapping federal and state securities regulations.

With respect to mutual funds, NSMIA resolved the problem of overlapping regulation by preempting state substantive regulation and registration requirements of mutual funds, thereby providing for exclusive federal jurisdiction over the contents of a mutual fund’s prospectus and operation of each fund. NSMIA was welcomed by the mutual fund industry because it eliminated the “crazy quilt” of regulation that had made registration of mutual fund shares unnecessarily cumbersome—in some cases leading mutual funds to restrict their fund offerings to residents of certain states.

However, in order to secure the acquiescence of the states and secure NSMIA’s enactment, NSMIA preserved state authority to require mutual funds to file sales reports and to pay state filing fees based on those sales in connection with the sales reports. A handful of states have taken unfair advantage of this fee loophole.

…continue reading: Mutual Fund Sales Notice Fees

In our paper, An Experiment on Mutual Fund Fees in Retirement Investing, we report the results of a new experiment studying the impact of mutual fund fees on consumer investment decisions. The importance of fees to overall investor returns, especially in the context of long-term investing like retirement accounts, is frequently overlooked. Morningstar’s Director of Mutual Fund Research recently observed, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision.” But there is evidence that many investors are paying high fees. One study estimates that in 2007 alone, retail investors paid $206 million more in S&P index fund expenses than they would have paid had all investments been in the lowest-fee funds.

Why are investors willing to pay high fees? Are existing fee levels the result of robust market competition or do market failures or investor biases limit market discipline? In his recent Jones v. Harris opinion, Judge Easterbrook took the efficient market position, concluding that market forces will lead investors to reject funds that charge excessive fees in favor of more fairly-priced alternatives. Under this view, investors will only pay higher fees when those fees are justified. Judge Posner countered, in dissent, with an empirical question: do high fees really affect investor behavior? A growing collection of evidence suggests that Judge Posner’s skepticism is well-founded; in the market for mutual funds, uninformed investors do not appear able or willing to distinguish between cheap and expensive funds.

…continue reading: An Experiment on Mutual Fund Fees in Retirement Investing

The balance of power among shareholders, management, and boards of directors has been a subject of debate for many years. One area of intense focus has been how institutional shareholders exercise their proxy votes, which Mary Schapiro, Chairman of the US Securities and Exchange Commission (SEC), described as “often the principal means for shareholders and public companies to communicate with one another, and for shareholders to weigh in on issues of importance to the corporation.” [1]

There is clear consensus on the importance and benefits of having institutions vote their shares in a responsible, well-informed way, but much less clarity on how the voting process works in practice. A particularly active area of the debate is over how investors use proxy advisers’ research, recommendations, and other services – alone or in conjunction with other internal and external sources – in making decisions about tens of thousands of unique agenda items each year. Convictions are strong on both sides, with those in one camp charging that institutional investors vote “in a lock-step manner” [2] with proxy firm recommendations, and their opponents insisting that proxy advisers’ research and recommendations are used “solely as a supplement to [most investors’] own evaluation of agenda items.” [3]

…continue reading: Voting Decisions at US Mutual Funds: How Investors Really Use Proxy Advisers

A major reason for the existence of conglomerates or business groups is to create internal capital markets to promote the efficiency of the group. One of many efficiency measures that internal capital markets can offer is an insurance pool, which provides temporary liquidity to the members of the group in the event of adverse shocks.  If mutual fund families, which are a collection of legally independent entities tied together by the sponsoring management company, are regarded as groups, it seems reasonable to assume that there would be a group interest. If so, it seems natural to ask whether insurance pools could exist in these families where cash-rich mutual funds direct capital to family funds that are facing large redemption requests, as these redemptions could lead to large fire sale losses. However, by law, they cannot. This is because, while the provision of such an insurance pool against temporary liquidity shocks benefits the family, the cost is borne by the shareholders of the fund providing this “free” insurance. A mutual fund owes a fiduciary responsibility only to its own shareholders, and not to its family.

In our paper, Conflicting Family Values in Mutual Fund Families, forthcoming in the Journal of Finance, we address whether such insurance pools exist in mutual fund families. We examine this by analyzing the investments of affiliated funds of mutual funds (AFoMFs). AFoMFs are mutual funds that only invest in other mutual funds within the family. Instead of the investors or their financial advisors choosing which mutual funds of the family to invest in, AFoMFs do that for the investors. Virtually non-existent in the 1990s, these funds have become very popular. In 2007, which is the last year of our sample.  Of the 30 large families that made up around 75% of the industry’s assets, 27 had AFoMFs.

…continue reading: Conflicting Family Values in Mutual Fund Families

I recently returned from a trip to Beijing, where I launched the Mandarin translation of a book that I co-authored with Theresa Hamacher entitled The Fund Industry: How Your Money is Managed.

The book was translated because the Chinese fund industry is expanding rapidly; Chinese mutual funds were introduced in 2001 yet held over $340bn in assets by the end of 2011.

However, the future development of the Chinese fund industry faces a stiff headwind. In China, most retail investors buy mutual funds hoping to score a quick short-term gain, rather than to generate long-term returns. The high turnover is usually costly to investors and stunts the development of the fund industry.

The short-term mentality of Chinese investors is reinforced by the fund industry, which spews forth an incredible number of new funds each year. Though fewer than 1,000 mutual funds exist in China, the industry launched 136 new funds in 2010 alone.

This flood of new funds is partly caused by large up-front commissions on fund sales paid to distributors, who also receive smaller fees on an annual basis. To collect these up-front commissions, distributors hype the new funds and investors rush to buy. But these investors hold for a relatively short time – until the next wave of new funds.

As a result, there are very few large funds in China that attract assets through long-term performance. One helpful reform would be to reduce up-front commissions on fund sales and put more emphasis on annual trailer fees that are collected only as long as shareholders remain in the fund.

…continue reading: Reform Needed in China’s Fund Business

In the paper Channeling Funds into the Group: IPO Pricing in Business Groups, which was recently made publicly available on SSRN, we demonstrate that business groups use financial intermediaries to boost the stock prices of affiliated firms in initial public offerings (IPO). This is done when mutual funds belonging to the group strategically participate in the IPO’s that originate from the group during the road show, and subsequently sell their holdings quickly after the IPO.

In the past decade there has been increasing interest in pyramidal business groups and in the ability of group owners to transfer assets from one firm in the pyramid to another. This phenomenon, dubbed “tunneling” by Kogut and Spicer (1998) and Johnson (2000), can take many forms such as transfer pricing, transfer of goods at nonmarket prices and inflated payments for intangibles. Much of the research examined the internal capital markets in these groups yet the theoretical possibility of transferring resources from external sources into the group’s internal capital markets, an activity we refer to in this paper as “channeling” was not previously addressed.

…continue reading: IPO Pricing in Business Groups

What is the critical factor for success in the U.S. mutual fund industry? Is it top-ranked investment performance, innovative products, or pervasive distribution? In our view, it is none of these factors, despite their obvious importance. Instead, the best predictors of success in the U.S. fund business are the focus and organization of the fund sponsor. We believe that the most successful managers over the next decade will be organizations with two characteristics: dedication primarily to asset management and control by investment professionals. Our view is based on research for the book The Fund Industry: How Your Money Is Managed (Pozen and Hamacher 2011).

Dedicated asset managers—firms deriving a majority of their revenues from investment management—dominate the industry, as shown in Table 1. The table ranks U.S. fund families by assets under management in 1990, 2000, and 2010 and shows dedicated asset managers in boldface. At the end of 2010, 8 of the top 10 firms were dedicated to investment management, as were 14 of the top 25 firms. Dedicated firms have held this dominant position for the past 20 years; in 1990, 13 of the top 25 firms were dedicated to asset management, only 1 fewer than in 2010.

…continue reading: Leadership in the Fund Industry