Are Mutual Fund Investment Advisory Fees Determined Competitively

Stewart L. Brown, Florida State University

Abstract

Investment advisors create and manage their sponsored mutual funds, giving rise to a potential conflict of interest. Prior research demonstrates that manager-advisors of open-end mutual funds charge their funds about 25 basis points more than they charge public pension funds with similar portfolios and investment objectives. The lower management fees associated with public pension funds may be attributed to arms-length pricing of pension fund contracts. The premium advisors charge captive funds is attributable to the absence of competitive pricing. The overcharging of investors exceeds $25 billion annually. The Investment Company Institute has sponsored studies concluding that investment advisory fees are determined competitively. They argue that the creation of mutual funds is characterized by relatively free entry. Furthermore, the large number mutual fund investors are free to choose funds according to their preferences, be they fee- or non-fee related. Largely on the basis of these premises, the studies conclude that sponsors’ fees cannot be excessive. A hallmark of competitive industries is that they earn “normal profits” and “normal rates of return” for their shareholders. Using Fama-French methodology, this paper demonstrates that shareholders of fund sponsors have earned profits and rates of return that are much higher than “normal” over the last 25 years and successively shorter periods. A $100 investment in 1985 in a capitalization-weighted index of fund sponsors would have grown to more than $21,000 by 2010. A similar investment in S&P 500 stocks would have been worth about $1,200 over the same time period. The paper suggests that there appears to have been a systematic violation of fiduciary standards by fund sponsors.