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?
Eric Zitzewitz, "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," Stanford Business, July 2002.
Diana B. Henriques, "He's the Go-to Guy for Fund Investigators," The New York Times, November 16, 2003, Section 3, p. 6.
John C. Bogle, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor (New York: John Wiley & Sons, 2000).