What Will it Take to Save the Managed Mutual Fund?
In this month's column, I purposely took what I assumed was an extreme position in asking if this was the twilight era for the managed mutual fund. The responses the column generated from individual investors, heads of organizations representing groups of investors, and from those in the U.S. and other countries—if at all representative—provide what is for me a rather sobering assessment of the future of these funds.
At one end of the spectrum are the feelings largely of investors. As Chris Lee put it, "As a small individual investor, I feel powerless to control or even understand how my mutual funds operate." Anupam Bordia comments, "the mutual fund scandal will shift public trust towards index funds."
There is also a suggestion that the job of the money manager may change. Remarking, "we have probably seen the beginning of the decline of the actively managed mutual fund," Charles Broming expressed the hope that "money management will become another technical job and compensation will reflect its real added value."
Part of the problem may be the perception created in press coverage of mutual fund management misdeeds. And part may be in the general ignorance about how funds are managed and investors charged for the services. Whatever the cause, according to William Donoghue, "The financial McCarthyism of the press coverage of anyone who ... proactively manages money as a vile 'market timer' is a sad commentary on how inflexibly the mutual fund industry is viewed by academics, regulators and distributors."
Richard Eckel suggests that both perceptions and real problems will be addressed when, among other things, interests of managers and investors are aligned. As he says, "Linking management fees/rewards to fund performance would be very attractive to investors: Who can argue with shared ambition?"
The importance of these questions lies in the heavy reliance that so many people deep into saving for retirement will place on others to manage their savings, particularly in a future in which Social Security will account for a smaller share of retirement income. How can their options best be preserved? Is the managed mutual fund worth saving? If so, what needs to be done? And how fast must the industry move to correct investor perceptions that appear to have been formed over a number of years? Or is all of this just an overreaction to phenomena that will recede in perceived importance to investors and money managers alike as other concerns crowd them out in our collective consciousness? What do you think?
Since their creation in the 1920s, mutual funds have progressively become the cornerstone of most individuals' investment portfolios, providing the diversity that is generally agreed to be an important element of any investment strategy. But in recent weeks, fund managers have increasingly come under fire, casting a shadow over the entire industry.
The alleged problems include managers of fund families who allocate investments among individual funds in which they may have a management or ownership stake. This allows some investors (particularly hedge funds) to trade in and out of funds quickly while prohibiting others from doing so, presumably in return for favors. Some favored international funds managers with investments spread across time zones who have a continuing stream of fresh investment information participate in after-hours "arbitrage" trading at prices set just once a day.
The net effect of much of this alleged activity is to tax long-term investors in order to reward short-term investors. In a two-year-old paper, "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," Eric Zitzewitz, assistant professor of strategic management at the Stanford Graduate School of Business, estimates that the total cost to long-term mutual fund investors of just the latter of these practices is about $5 billion per year.
John Bogle, founder of the Vanguard family of mutual funds, suggests that mutual fund investment management is just as problematic as fund governance. Some time ago he concluded that mutual fund investment managers: (1) through their investment decisions destroy as much value for investors as they create—a view for which there is a great deal of evidence—and (2) through their behaviors destroy value for investors by running up high management fees, in part for their own enrichment. As one might imagine, he is not popular with many of his peers in the mutual fund industry. To combat these practices, he has been perhaps the strongest advocate for indexed (vs. managed) funds as well as management incentives for minimizing costs to investors.
At a recent discussion of Professor Zitzewitz's ideas, one academic in the audience commented, "Why is this such a moralistic issue? Maybe the time of the mutual fund has simply passed, and we should just use other instruments."
What is the answer to allegedly poor mutual fund governance practices? Can mutual fund directors, often responsible for dozens of funds in a fund family, be expected to exercise adequate oversight? Or must practices be corrected through added regulation? Or is the problem, as Bogle suggests, deeper than this, extending to actual fund investment management? If so, what could be done to align managers' interests with those of investors? Or is this really the beginning of the twilight era of the managed (vs. the computer-administered indexed) mutual fund business? If so, does it present an opportunity for mutual fund entrepreneurs to devise new vehicles for investors seeking diversification? What do you think?