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Saturday, October 31, 2009

The Mutual Fund Industry Is Afraid That Lower Fees Might Be Bad For You

The mutual fund industry is replete with conflicts of interest. One that is being challenged in a case that is going to the supreme court is the issue of the independence of the fund board of directors who are supposed to represent investors in negotiating management fees with the fund managers. As can be seen in this legal case it seems that there is great potential for conflicts of interest.

from the wsj: my bolds and italics

Fees Case Strikes at Heart of Mutual Funds
Supreme Court to Weigh How Much Money-Management Firms Can Charge; Defining Fiduciary Duty

The money-management fees that drive the mutual-fund industry are at stake Monday when the Supreme Court hears a case that asks how much is too much.
A ruling for shareholders could push down fees that last year approached $100 billion by some estimates in the $10 trillion industry. That could reduce the multimillion-dollar paydays of some fund advisers. The industry warns that its defeat could invite a wave of lawsuits challenging advisory fees, rewarding plaintiff lawyers more than investors and driving talented managers from the mutual-fund business.

Supreme Court: Hears arguments Nov. 2; decision expected by June.
The case, Jones v. Harris Associates, strikes at the heart of the workings of the mutual-fund industry, whose products are owned by more than 50 million American households. Typically, the investment-advisory company that manages a mutual fund takes a percentage of the assets, say 1%. That fee is negotiated with the mutual-fund board, which is set up to represent investors.

Doing Their Duty?
In 1970, Congress imposed on investment advisers "a fiduciary duty with respect to ... compensation for services." Advisers said that means they should disclose fees, costs and profits to the mutual-fund board, which can then strike a deal on behalf of investors. The existence of nearly 8,000 mutual funds gives investors plenty of alternatives if they believe fees are too high, the mutual-fund industry said.
The shareholder plaintiffs, backed by the Securities and Exchange Commission, argue that fund boards often are too closely tied to the advisers to drive hard bargains. They have a different definition of fiduciary duty, saying in their brief that Congress meant the fees "must be fair" to investors and "comparable to an arms-length deal."

"The law, as it stands now, just went down the wrong road and let management fees get totally out of hand," said John Bogle, founder of mutual-fund company Vanguard Group Inc., which sells mostly low-fee index funds. Mr. Bogle filed a friend-of-the-court brief backing

The case was filed in 2004 by three shareholders in the Oakmark Funds, which were developed and run by Harris Associates LP, a Chicago firm that said it oversees about $48 billion in assets. The plaintiffs said Harris charged Oakmark an effective rate of 0.88% on $6.3 billion in assets, nearly twice the 0.45% rate for an unrelated institutional client like a pension fund.

The fee for independent clients, plaintiffs argue, should be a benchmark for what an arm's-length transaction would look like. Harris responds that servicing the Oakmark Funds is more demanding than work for independent clients.
According to the plaintiffs' data, Oakmark's manager, William C. Nygren, took home $12 million in 2002, compared with the average portfolio manager's pay of $800,000. Mr. Nygren couldn't be reached to comment. A Harris Associates spokesman had no comment.
The dispute divided two influential judges, Frank Easterbrook and Richard Posner, who are both known for their market-based views of the law but differed on whether the market works well in this case.
Judge Easterbrook wrote the opinion for the Seventh U.S. Circuit Court of Appeals in Chicago rejecting the shareholder suit.
"Holding costs down is vital" for mutual funds, he wrote, because "management fees are a substantial component" of the costs and even small differences in rates can have a big impact on returns. He said that gives fund boards a reason to keep fees low, or investment advisers an incentive to deliver net returns that justify extraordinary pay.
"It won't do to reply that most investors are unsophisticated and don't compare prices," Judge Easterbrook said. "The sophisticated investors who do shop create a competitive pressure that protects the rest."

The plaintiffs asked the full Seventh Circuit to reconsider the ruling, but fell a vote short. Writing for five dissenters, Judge Posner delivered a critique of the free-market theory.
The Easterbrook opinion rests "mainly on an economic analysis that is ripe for re-examination," Judge Posner wrote, citing evidence that company boards have done little to rein in executive compensation. "Mutual funds are a component of the financial services industry, where abuses have been rampant," he wrote.
He argued that the existence of thousands of mutual funds was no barrier to excessive management fees because virtually all funds shared a structure riddled with conflicts of interest: The investment adviser creates the fund and its board of directors, which then is "captive" to its adviser.
Conflicts Alleged
The plaintiffs allege several "conflicting business and personal relationships among the trustees and Harris personnel." The Oakmark board's chairman, despite being classified as an "independent" director, was a former Harris partner who continued to earn six-figure sums in deferred compensation from the firm.
Judge Easterbrook dismissed allegations regarding the board chairman's independence, ridiculing arguments that he "possessed some Svengali-like sway over the other trustees" who approved Harris's fees unanimously.
Harvard law professor Jesse Fried, a corporate-governance specialist, said a shareholder win would encourage plaintiff lawyers, "for their own selfish reasons, [to] monitor compensation structures in these firms," filing suits when pay looks out of line. "That will keep the compensation down," he said.

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