Academic

The 7^th Circuit decision in Jones v. Harris, as well as the Supreme Court case that followed, generated a renewed interest in the regulation of the mutual-fund industry, as well as a great Masters Forum on this blog.   

One background issue the case implicated was the role of the fund board in policing mutual-fund fees.  Although I?m not convinced by Easterbrook?s free market analysis of the pricing of mutual funds, I?m also unsure that a board of directors is a useful regulatory mechanism for monitoring fees.

Mutual funds typically have a rather odd structure.  A mutual fund has a board of directors, but the fund itself is essentially a shell, whose sole asset is its portfolio of securities.  The fund?s affairs are handled by its investment adviser, and the board?s main role is to make sure that the adviser isn?t charging fund shareholders an exorbitant fee for its services.

But the board is ill-positioned to serve shareholders in this regard.  In the corporate context, board governance benefits shareholders as a response to collective action problems.  The board can make high-level corporate decisions more efficiently than a diffuse shareholder body.  It can also oversee management better than shareholders, each of whom may be unwilling to bear the costs of management oversight because of the public-goods nature of a well-run company.

Neither of these rationales for board governance applies in the fund context, however.  The board isn?t there to make big policy decisions.  Mutual-fund shareholders choose a fund based on, among other things, the investment strategy that the manager is bound to comply with.  It would be out of place for the board to question this strategy.  Nor is there a public-goods problem with respect to policing fees.  Shareholders are adequately incentivized to monitor fees on their own.

Perhaps, however, investors aren?t paying as much attention to fees as they should, even though it?s in their own best interest.  The board, therefore, can be justified as a mechanism to help protect them from themselves.  This logic, however, is dubious.  The structure of the industry makes it highly likely that board members will be captured by the investment adviser.  Because shareholders are quite apathetic when it comes to board governance, it is really the investment adviser who controls the appointment and tenure of fund boards.  That being the case, the board?s devotion to low shareholder fees may be questionable.

If we are concerned about fund fees, rather than impose an intermediary with dubious incentives, we should take steps to improve the operation of the fund marketplace.  As I have argued elsewhere, this would include, among other things, steps such as requiring better disclosure of fund fees and other aspects of fund investing.