Regulate Mutual Funds?

The fact that many funds failed tells me that the market is working. That’s part of what the market does, drive poor performers out of business. The best survive only to have to continue competing or be driven out of business as well. Over the long haul it makes us all better off.

Compare that with certain dismal public schools that are not allowed to fail. Their students would be far better off if the schools went out of business and the students were allowed to go elsewhere.

The market is working very well. Why is the answer always more regulation? People are not idiots. True, some make stupid choices, but I always wince when I hear about proposals to regulate mutual fund fees, etc. We don't tell car manufacturers how much they can sell their vehicles for. We don't tell airlines how much they can charge for tickets. We don't tell Starbucks how much it can charge for coffee. Why do we feel the need to tell mutual funds how much they can charge or how to run their business? There are plenty of low cost fund families out there. Consumers have a choice. Vanguard is a prime example and they are gaining assets very quickly. Some consumers will make poor choices, but this is something that has occured for centuries. John Bogle built a great company but he really needs to stop tooting his own horn and let those firms that deliver what consumers want succeed while those that don't fail.

Agree with Scott. Failure is part of the markets, and life.

Let's be clear about our terms here. Business failure ususally refers to a business folding shop, liquidating or going into bankruptcy. Mutual funds usually don't fail in this sense, the funds are plowed into other funds and given a new name while they usually maintain the same management.

What's troubling about the mutual fund industry is that both emperical evidence and economic theory show it is impossible to consistently enjoy risk adjusted returns in excess of the market. In other words, it's not really that mutual funds have bad managers...its that you can't manage a fund and beat the market. Yet I wonder why index funds have not driven other funds out of the market?

Two issues that come to mind:

1. There's a disconnect between the investor and his money. Often money goes into mutual funds through a 401K or pension fund & enjoys great tax advantages. Just like the tax advantages of employer provided health insurance, I wonder if that encourages laziness in shopping for the best investment strategy. Also you have agency problems. An employer provided 401K may have the incentive to 'showcase' managed funds even though they are not in the employees interest.

2. Has anyone explored the implications of index funds? What would happen if everyone did the 'rational' thing and invested only in index funds? Does the market need irrational investors to work or could a world of hyper-rational & logical Vulcans be able to support a stock market?

Well, if everyone invested in index funds, what little incentive exists now for stockholder controls on executives would go away. Not a good thing. (I'm not fully convinced that mutual funds are a good thing for corporate governance themselves. As a way into the market for the little guy, yes. But from the perspective of the long term health of the corporate system, no.)

What is the exact rationale for mutual funds? Is it a method for the little Investor to get involved in the market, or is it a desire of those with funds to invest to utilize greater expertise than they personally enjoy to invest their money? Many people would not set their own leg, if they broke it. Why expect a Construction foreman to invest his own money? There is a need for regulation of Mutual Funds, just as there is a need to regulate the banking system. Denial of this fact leads to the S&L bailout of the 1980s, and to the mutual fund failures of current years. lgl

Well, if everyone invested in index funds, what little incentive exists now for stockholder controls on executives would go away. Not a good thing.

My understanding of an index fund is as follows:

1. Take the market cap of each stock.
2. Figure out what % that represents of the whole market.
3. By stocks in that proportion.

So, in a three stock market:

Stock Market Cap %
Company A $1.5B 25%
Company B $1.5B 25%
Company C $3.0B 50%

Since the price of stocks changes, their market cap relative to the whole market will go up and down requiring the index fund to adjust accordingly.

If a company was poorly managed, its price would fall and so would its market cap. The index fund would end up reducing its weight in its portfolio thereby 'punishing' the managers.

My question is what happens in a world of nothing but index funds? Can the market even set prices in such a world? I'm not really sure.

I agree with the other assesments that failures are part of healthy markets. I think it ironic that Mr. Bogle talks about how asset-gathering has replaced prudent management when Vaguard has over half a trillion under management ($500,000,000,000 that's alot of assets gathered.) I also think that the prime beneficiaries of any type of regulation of fees would be the lowest cost operators such as Vangaurd, Fidelity, and American Funds (which have assets approaching 1.5 trillion dollars.) This seems to me as the powerful trying to secure their positions in the marketplace through legislation (Mr. Bogle, while an excellent money manager and businessman, has become nothing more than economic rent seeker.)
I also have a problem with this claim; "During the past decade, for example, while the stock market has returned an average of 11.1% per year, the average equity fund has delivered just 8.6% -- a 2.5 percentage-point shortfall roughly equivalent to the drain of the heavy sales charges, management fees and operating expenses, and portfolio turnover costs it incurred."
When Mr. Bogle talks about the average mutual fund he is not referring to their size, he simply taking the amount of companies out there and finding an average. The problem with this is that a vast majority of assets managed by mutual funds are managed by the 20 to 50 companies, this is out of some 12,000 (if not more) mutual funds and thousands of companies. This is at best a naive calculation and at worst a duplicitous argument meant to shift the debate to Mr. Bogle's point of view.
"Has anyone explored the implications of index funds?" In regards to this question, I have not formally analyzed this question (I'm a trader not an economist), but I have considered it. There will always be a group of investors/speculators that will want the outsized gains offered by stock picking. I believe even hyper-rational individuals would be willing to take the risks associated with individual stocks if the risk/reward is deemed acceptable. That being said, it's not easy.

I'm also a long-term Vanguard customer whose investing strategy has been influenced by Bogle's writings on indexing. I arrived at Vanguard after a lot of trial and error.

I agree with Arnold Kling that forcing other funds to adopt a Vanguard model is not a good public policy objective.

When I check out the selection of milk at the supermarket, I note that some labels cost considerably more than others. Why someone would pay extra for a gallon of milk with a different label puzzles me. I don't think the government needs to investigate this, though.

Is the fund market imperfect or unfair? Hardly. Mutual fund results are extraordinarily transparent - they are published daily in most American newspapers and are widely evaluated by several companies such as Morningstar. Costs of fees, hidden charges, and turnover are all net of published results. A fund can conceal the particulars of its costs, but it can't conceal results. What you see is exactly what you get.

Why, then, does the market seem inefficient? Or, more precisely, why do so many players seem to ignore the obvious? Boonton's first issue appears to be correct; most 401(k) investors have few choices. Still, most of these seem quite complacent about their lack of choice.

I've long been puzzled by this. My conclusion is that most investors don't trust their own judgement, and prefer to believe that their professional adviser possesses some sort of magic that is beyond their ability to understand. Sort of like paying extra for a special label. I also suspect that many investors believe that averages don't apply to themselves - that somehow they can beat the house. Regardless, any possible imperfections in the mutual fund market apparently reflect consumer demand.

As it stands today mutual funds, hedge funds, and program trading from large instituions (which would include mutual funds) control about 50 to 60 percent of the volume on the major exchanges. Despite the dominance by these large players there is still enough interest in idividual stocks (it is my understanding that the volume from ETFs, iShares, and index funds is rapidly growing.)
In regards to lgl's questions. Mutual funds, as they exist today, are an outgrowth of the regulations that were concoted in the early 1930's. They have been repeatedly regulated since then in order to do away with bad behavior, but that bad behavior has always returned. Short of shutting down the financial markets all together the same schemes that could be found in the Dutch bourses 400 years ago can be found today. You can not regulate away the bad actors, only the market can punish them (maybe I've been over at Mises.org too much.) For every regulation there will be a new scheme concoted and additional costs placed on the small investor. You also have to understand how most regulations are created. They are usually promulgated by the S.E.C. after the exchanges recommend them. The exchanges by the way are essentially owned by the large financial institutions who become the prime beneficiaries of the regulations (I am not trying to be too consipiratorial here, but ask most individual speculators and that is probably how they will explain it.)

"Has anyone explored the implications of index funds? What would happen if everyone did the 'rational' thing and invested only in index funds? Does the market need irrational investors to work or could a world of hyper-rational & logical Vulcans be able to support a stock market?"

I'm no economist, but I have given this question some thought, and I think I have a good answer. Investing in index funds is only rational because the market efficiently prices stocks. If everyone invested in index funds, the market would no longer be efficient because there would be no investors buying undervalued stocks and pushing the price up or selling overvalued stocks and pushing the price down. Then there would be obvious opportunities to profit from active trading, and it would no longer be rational for everyone to invest in index funds. That's the funny thing about the efficient markets theory: if everyone believes in it, it's no longer true.

It seems to me that passive investors are freeloading off the market signals generated by active traders. That's bad for investors in actively managed funds, but it may be good for the rest of us. I don't see why government intervention would be appropriate.

This seems to me as the powerful trying to secure their positions in the marketplace through legislation (Mr. Bogle, while an excellent money manager and businessman, has become nothing more than economic rent seeker.)

How does regulation of mutual fund fees create economic rent for a mutual fund manager? If nothing else I think fees should at least be regulation in terms of disclosure. It should be easy to determine what the fees are of a mutual fund, they should not be hidden in the fine print & should be consolidated so they are not hidden in churning costs or other schemes.

The problem with this is that a vast majority of assets managed by mutual funds are managed by the 20 to 50 companies, this is out of some 12,000 (if not more) mutual funds and thousands of companies. This is at best a naive calculation and at worst a duplicitous argument meant to shift the debate to Mr. Bogle's point of view.

It's hardly naive, numerous studies as well as theory tell us that managed funds cannot consistently beat the market (risk being held equal).

Why, then, does the market seem inefficient? Or, more precisely, why do so many players seem to ignore the obvious? Boonton's first issue appears to be correct; most 401(k) investors have few choices. Still, most of these seem quite complacent about their lack of choice.

Perhaps part of the solution should focus on removing tax favored status of 401K's. Why should the gov't subsidize one activity (saving for retirement) and tax another more heavily (not saving for retirement) if we are supposed to trust people to make decisions for themselves? Economic theory tells us when gov't grants subsidies to one type of activity, the market will respond by overindulging in that activity. Why should we be surprised a group of economic rent seekers (called advisors, consultants, fund managers etc.) have attached themselves to the 401K market?

If we are going to subsidize retirement accounts then shouldn't we demand a min. level of responsible management of them? At least some diversity (such as no more than 25% of the account in any particular company's stock) and some limit to fees (that would favor low cost index funds rather than speciality funds). Then allow people to put their after tax dollars in whatever they please. After all, I'm not allowed to buy lottery tickets or go to Atlantic City with my 401K!

How many mutual funds that would have otherwise failed are being propped up by 12b-1 fees?

It seems to me that passive investors are freeloading off the market signals generated by active traders. That's bad for investors in actively managed funds, but it may be good for the rest of us. I don't see why government intervention would be appropriate

A while ago Slate had an article pointing out that index fund investors are basically free riders. So it would seem like any commons there's only so many index fund investors (free riders) that can be supported. I wonder if any one has ever tried to explore this. Could the market work with 90% index fund investors and 10% 'other' types?

I know the studies and how the performance of fund managers breaks down (I also used to be on the sell side, although not for long.) I also agree that 401-k's and all the other tax advantaged accounts have drawn economic rent seekers in the form of advisors, accountants, etc. Fundamentally, however, I see any attempt to regulate fees as price controls (because that is what it is), price controls favor one group at the expense of everyone else. Some mutual funds are aggressive and make use of derivatives (whether these are futures or options does not really matter), these strategies have a higher cost. If the price a fund could charge were set by the government you eliminate an entire class of fund companies. Their assets will most likely be bought out (our simply assumed) by the larger, long only funds.
There is also a reason why most fund managers can't beat the "market" in the long-run; the can only own stocks. This means they can not short, they can not hedge, they often can not flip product. Funds have to declare a specific type strategy and are not allowed (by law) to switch there strategy when the market changes.
By the way, what is the "market"? Is it the Dow-30, S&P 500 (the normal benchmark), the Nasdaq 100, the Russell 2000 (1000, or 3000)? There is a problem with using specific benchmarks as well.

Larry,
That is an excellent question. I think it is almost impossible to answer, however. There are plenty of ways to mask such behavior. By the way, for all you mutual fund holders you can vote toget rid of 12b-1 fees. Most people do are not aware of that.

P.S. I own no mutual funds, although I have owned and sold American Funds. Fair disclosure, not required, but appropraite.

"A while ago Slate had an article pointing out that index fund investors are basically free riders. So it would seem like any commons there's only so many index fund investors (free riders) that can be supported. I wonder if any one has ever tried to explore this. Could the market work with 90% index fund investors and 10% 'other' types?"

Yes. Xavier got it right. The "free rider" analogy is inapt because price change occurs on the margin. For example, a small fraction of shares are traded each day, but the striking price changes the price of all shares.

Only a few non-index traders are needed to determine the correct price of shares, whether most shares are held by indexers or not.

I agree with Boonton that the government shouldn't subsidize retirement savings. I'll write my congressman about this as soon as Social Security shuts down and stops collecting "contributions" from me.

In the search for the first government regulation that has ever benefitted the economy, it is unlikely the regulation of financial markets will prove to be the mother lode. It is usually forgotten that even if things 'improve' after a government regulation is promulgated, the lack of knowledge as to what would have happened absent the regulation prevents us from claiming success.

Before debating whether (additional) mutual fund regulation would be beneficial, therefore, it is necessary to come up with some economic theory suggesting economic regulation of any kind (excepting the usual defense, externalities, etc.) would be beneficial.

While many have tried, we await the first success.

If we are going to subsidize retirement accounts then shouldn't we demand a min. level of responsible management of them?

This already happens, and the rsponsibilities of the plan fiduciaries is well defined. In fact, the plan fiduciaries can go to jail, as well as lose personal assets if things are not done responsibly. ERISA is the main framework of responsibility when dealing with qualified plans.

I find it ironic that Bogle would cite the cost to investors of poorly managed funds as evidence to support regulation, the cost of which would be borne by the the very investors he seems so worried about.

Scott answers Arnold's question as follows.

The fact that many funds failed tells me that the market is working. That’s part of what the market does, drive poor performers out of business. The best survive only to have to continue competing or be driven out of business as well. Over the long haul it makes us all better off.

That seems reasonable, but I wonder if the underlying assumptions are met. A mutual fund is not a manufacturing company. It exists, essentially, only on paper, and can easily be merged into another fund, renamed, etc. So "going out of business" does not quite imply the same thing that it does in other industries. The shoddy product may well still be out there.

Now of course investors have a responsibilty to look out for themeselves, but let's not get too huffy about this. Investing is not brain surgery, but it's not child's play either. There are things that need to be understood, and they are not trivial, especially when one considers the vast amount of misinformation floating around. Markets work well when participants are informed. I'm not sure that mutual fund investors are all that well-informed.

Where does that lead me? Well, first I think it's worth knowing what Bogle is suggesting before criticizing it. He knows more about mutual funds than I do. Maybe he has some good ideas.

I personally think investors could be better informed by the funds, and I think it would be appropriate for the SEC to require some changes. Yes, I know expense ratios and the like are given in the annual reports, but more could be done.

I would like to see the actual dollar fees paid by investors included on the quarterly statements. I think that would have an impact. I would like to see something done about selection bias in promotion. Start ten funds. Wait and see which one shows strong performance and push the hell out of it. And I would like to see better reporting of performance. Let funds define a benchmark and compare their performance against the benchmark on the quarterly statements also.

Too much regulation? Well, I'm mostly trying to improve information, not regulating fees or practices. I think my first and third item would be very easy to do, and the second could be accomplished with a little thought.

Bernard says:

'Too much regulation? Well, I'm mostly trying to improve information, not regulating fees or practices.'

I am reminded of a seminar I attended at the UofChicago when an audience member asked essentially the same question - can't government improve the financial markets by providing more information to the public?

Merton Miller replied, "I'm surprised the University allowed you to graduate."

His point, easily understood by everyone in the audience, including the questioner (albeit a hair too late), was that if there was value in providing the information, the free market would provide the information, and the government didn't need to worry about it.

I, for one, do not want to pay for the information Bernard wants, because it is of no value to me. I should have the right to buy a mutual fund which provides me only with what I want, not what Bernard wants, just as I am allowed to buy the shoes I prefer, and am not limited to buying shoes that Bernard thinks would look good on me.

Many of the regulations that the S.E.C. and Congress have imposed on the financial industry have been regulations that have been created in order to increase "transparency". The only problem is, as those regulations were imposed and promulgated hundreds of lawyers, accountants, and financial professionals were able to game the changes. They were able to do this because Congress, and even more so the S.E.C., turned to the biggest players on the Street and asked them to create the legislation and rules. This is the most significant issue when it comes to financial regulations, those who create them often come from or are going to the Street. This allows insiders to create a system that will not affect their distribution networks, but make it more difficult for new firms to rise and challenge them. It is not simple irony that most discount brokers were created in the days after the de-regualtion of the financial industry began.

if there was value in providing the information, the free market would provide the information, and the government didn't need to worry about it.

It is not without trepidation that I disagree with Miller, though I am encouraged by the thought that it is your interpretation and application I am disagreeing with.

First of all, the cost argument is phoney. The cost to mutual funds of providing the information I describe is, for practical purposes, zero. They know their expense ratio, they know the size of my account. They have powerful computers that can perform the multiplication in twinkling.

Second, the notion that "if there were value the market would provide it," does not wholly apply. I am suggesting that information be provided on the statements. I can't start a company that can put information on mutual fund account statements. It's the placement that I think is valuable.

I am not trying to tell anyone what fund to buy. Buy whatever you want. I am suggesting that increasing transparency would be a good idea, achievable at negligible cost.

What manager of a failed mutual fund has lost a penny in a fund that folded? They take their paychecks and move on. It is only the investors that lose. How is that a free market?

The previous poster must be unaware that some fund companies require their managers to invest in their funds, not the same why that hedge funds have amnager co-investment, but that is a market created advantage hedge funds have that help them market to clients, not a regulation.

Second, the index fund investing arguement is so twisted arround it is amazing that it is an arguemtn carried on by such intelligent people. (I am posting without reviewing notes so please excuse any mis-citations or estimated numbers)

The point of the arguement is not can you beat the index consistently, many people can, in fact about 25% of all mutual funds do beat their averages over considerable time periods, the arguement is can you determine in advance if your fund will beat the average. Some years more than 50% of the funds beat it, some years very few beat it. I believe that Vanguard 500 is below average for the past two years. If 1900 funds "failed" out of 10,000 some funds, then we can kind of see that about 25% of funds do significantly better than the average (which is tough to beat since it is not a random sample of stocks, but the 500 biggest, and proably most of the best companies in the world) and 25% or so do really bad, the other 50% are somewhere in the middle, kind of looks like a bell curve normal distribution (PS the best recognized tallent in the industry runs hedge funds, not mutual funds and the hedge funds average kills the S%P 500 over a long period of time). So we know that some people are great, most are kind of good and some are bad at their job.

It is pretty clear that active management can beat passive management, but not everyone can beat passive management.

Third, it makes perfect sense for Bogle to advocate for more indexing. Take this example: bad managers foolishly bid up the price of some key stocks in the S&P 500, generating interest in the market=more overly emotional (read all of the 'sopisticated active traders" on schwab, e*trade etc..) buying Bogle's index fund forcing his "manager" to buy more of those same stocks, bidding up the prices more and creating a feedback loop. More sophisticated managers at hedge funds go short key stocks or even the whole index via SPY or IVV. bad news and the stocks crater, led by the shorts, creating a round of reflexive selling by the same "sophisticated do-it-yourself investors" resulting in withdrawals from Vanguard, "managers" selling dropping the price more.

Basiscally Bogle is open to getting hit by speculation since his "managers" cannot manage the funds under their care (which you could see as a violation of the prudent man rule) and wants as even and predictable market as possible, which means a market driven by decisions at S&P, where Bogle can see and anticipate change.

Sorry for the long post.

TRB,

Not sure I follow your argument entirely, but a few points seem worth making.

First, the S&P500 is not an appropriate benchmark for all funds.

Second, the failure of 1900 funds does not mean there necessarily were an equal number that significantly beat the market. Even if fund peformance is symmetrical, and I'm not sure it is, the mean is likely to be lower than the performance of the market, if only because of the costs of operating a fund. My recall is that in any year about 15% of funds beat the market, but that there are few consistent outperformers.

Third, we have ignored risk. Evaluating returns without adjusting for risk is omitting half the picture. To the extent some mutual funds or hedge funds outperform this may be no more than a consequence of being willing to take on bigger risks. We need also to recognize that hedge fund managers earn much larger fees than mutual fund managers. This makes perfect sense, but it does mean that returns need to be compared net of fees.

Fourth, if I understand your claim about index funds correctly, I think it rests on questionable assumptions. Key stocks rise, you claim, because of foolish purchases, and this sets your cycle in motion. Day-traders now buy the index fund, forcing the fund into more buying, accelerating the process. Short sellers then pounce, reversing the cycle and causing losses to the fund.

But this presumes that it is clear which stock price increases are foolish and which are sensible. It also presumes that momentum day traders use the index funds for this purpose, and are big enoughto ave this effect. All this seems doubtful to me.

On the fourth point I agree with Bernard. Most day traders are looking for clear technical breakouts or breakdowns in whatever equity or etf they are tracking. By or selling an index fund and taking the opposite of that trade with specific stocks that are part of the index is an arbitrage strategy that requires lots of computer power, extremely fast executions, and a lot of capital. This is a type of strategy that many hedge funds employ, not one that daytraders would get invovlved with because they do not have the amount of capital necessary to implement this type of strategy, nor do they have the type of clout with their brokers to insure that their orders are executed fast enough (and stealthily enough) to implement such a strategy.

Sometimes the "dumb" money is right and stocks will go up regardless of the views of "experts". It is often difficult to determine which stocks are up for the "right" reasons. To paraphrase Keynes, the market can remain irrational longer than you can remain solvent.

I am reminded of a seminar I attended at the UofChicago when an audience member asked essentially the same question - can't government improve the financial markets by providing more information to the public?

Merton Miller replied, "I'm surprised the University allowed you to graduate."

I wonder...If I spend millions researching the information, discover something juicy, and then the WSJ publishes the bottom-line in a 50 cent print edition, and hundreds of bloggers pick it up for free, how do I recoup my investment? Consumer Reports tries harder than anybody I know to keep their results private to subscribers, and I believe they largely fail

Marco,

You just don't understand the magic of the market. It is god-like. There is nothing it can't accomplish.

My personal belief is that this form of market-worship doesn't differ much from Marxism in its psychology. Announce a few principles and then explain the world entirely in terms of those principles, allowing neither logic nor evidence to dissuade you.

on By to Marco: Consider the basic market exchange. Seller to buyer, both being people or persons; if the market is God, whose invisible hand lifts it up to all our benefit? If the elements of the market are fallible, whence comes perfection ? Addict to pusher -"And God said take this baggie and uuuuuuse!"