One very large player figured only marginally in the scandals of the 1990s — the $7 trillion mutual fund industry. There has been relatively little exposure of wrongdoing and even less reform when it comes to mutual funds — because, in the immortal words of former New Republic editor Michael Kinsley, the scandal is what's legal. The more than six thousand mutual funds hold the assets of over 100 million small investors and pensioners.
The legal scandal comes in two parts.
The first is the exorbitant amount of money that flows to mutual fund managers at investors' expense. The Investment Company Act of 1940, which governs mutual funds, explicitly requires them to be operated in the interests of their shareholders "rather than in the interests of their managers and distributors." Yet the amount of money taken from investors by mutual fund company managers is outsized and little appreciated.
John Bogle, the retired founder of the [The] Vanguard Group [Inc. of Malvern, Pa.], has become a crusader for reform of his industry. Mr. Bogle calculates that between 1950 and 2004, the assets held in mutual funds increased more than a thousandfold, to more than $8 trillion from about $2 billion. One might have expected that as the amount of funds under management grew, economies of scale would reduce the expense ratio paid by investors to fund managers.
In fact, the expense ratio more than doubled. Because of the miracle of compounding, mutual fund transaction costs and other fees consume a far higher percentage of returns than most investors realize. According to Mr. Bogle, "Equity fund investors paid costs estimated at $72 billion in 2004 alone, and as much as $300 billion in the past five years."
The net return of the average mutual fund was substantially lower than the average return of the stock market, not because the funds' very expensive advisers were bad stock pickers — their gross returns just about matched that of the broad market — but because of the huge transaction costs and profits to managers.
Between 1985 and 2004, Mr. Bogle calculates, the average mutual fund annual return, not adjusted for inflation, was 10.4%. That sounds good until you realize that the comparable return from the stock market itself was 13.2%. The difference was the mutual fund fees. The ordinary investor would have been better off using a dartboard to select a random basket of stocks or investing in a broad-based, low-fee index fund.
Mr. Bogle reports that $10,000 invested randomly in the stock market in 1984 would have returned an average profit of $109,800 by 2004. The same money placed in the average mutual fund would have re-turned a far smaller profit of $62,900. He observes, "The investor put up 100% of the capital and assumed 100% of the risk, but collected only 57% of the profit. The mutual fund management and distribution system put up zero capital and assumed zero percent of the risk, but collected 43% of the return." Timing can make that split even worse. During the boom and bust of 1997-2002, mutual fund managers collected $250 billion, while millions of investors suffered a net loss.
The second part of the legal scandal helps explain the excesses of the first. Although mutual fund managers are perfectly positioned to be agents of small investors, they fail utterly to serve investors' interests in a more transparent system. When I served on the staff of the Senate Banking Committee, you could count on the mutual fund lobby, the Investment Company Institute [of Washington], to be on the wrong side of every consumer and regulatory issue.
Nothing has changed. Mr. Bogle reports that not a single mutual fund has ever sponsored a proxy resolution opposed by management, supported efforts to reform option compensation, or testified in favor of the Sarbanes-Oxley Act.
When the [Securities and Exchange Commission] in 2003 put out for comment a proposal requiring mutual funds to disclose to their owners how they had cast their proxy votes, the industry united in opposition to the idea. The regulation was adopted in 2004 over the industry's objection, and it has actually led to a modest increase in shareholder activism directed against excessive CEO compensation.
Current law requires a majority of mutual fund directors to be independent of the fund's managers. But the independent directors are among the best compensated, and most docile, on Wall Street and invariably do what management wants.
One study reported that the average compensation to mutual fund directors, for attending a few meetings a year, was $386,000. The super investor Warren Buffett once criticized the activity of independent mutual fund directors as "a zombie-like process that makes a mockery of stewardship — a monkey will type out Shakespeare before an 'independent' board will vote to replace management."
After the [Houston-based] Enron [Corp.] scandals, a reformer, William Donaldson, briefly served as SEC chairman. In 2003, the Donaldson SEC, by a 3-2 vote, issued a proposed regulation that would have required that 75% of mutual fund directors, including the chairman, be independent of the management company that organizes, markets, and profits from the fund and that the independent directors meet separately at least quarterly.
This was opposed by the mutual fund industry and the U.S. Chamber of Commerce, which represents large corporations and successfully sued to block the regulation. Mutual funds themselves have not been immune to corruption. In 2003, Eliot Spitzer brought civil charges against four major mutual management fund companies for "market timing" and other forms of late trading: executing trades after U.S. markets had closed, based on breaking news events that influenced foreign markets that were still open, which accurately predicted the direction of the next day's market in New York.
These illegal trades were primarily for the benefit of managers. Putnam Investments [of Boston], one of the industry's largest fund sponsors, paid a fine of $193 million. Bank of America [Corp. of Charlotte, N.C.] paid $600 million. All told, 24 mutual fund management companies paid a total of $2.5 billion in fines by mid-2004. One academic study estimated that market-timing abuses cost ordinary investors on the order of $4 billion and that the practice had been common for at least two decades before regulators were pushed to intervene. Fund managers have also taken bribes to promote favored funds to their retail customers.
Financial conglomerates that own mutual funds also frequently promote their own funds to retail customers, giving sales incentives to brokers. Morgan Stanley [of New York] paid $70 million in fines for such practices, and Merrill Lynch [& Co. Inc.] and Citigroup [Inc. have been] targets of class action suits.
The abuses of the mutual fund industry nicely illustrate how self-regulation and the premise of "agency" break down on Wall Street. In theory, mutual funds could solve the problem of the atomized shareholders failing to hold corporate management accountable. In practice, mutual fund managers are doing very nicely and don't want to rock the boat.
Mutual funds are a sleeping giant. If their own outside directors were to push them to become more active on behalf of corporate governance, it could shake up corporate America.
One awaits a set of "Bogle Principles," modeled on the Sullivan Principles of the late 1970s and the 1980s, in which activists and shareholders pressed American corporations to use their leverage to bring racial reform to South Africa. Under the Bogle Principles, in-vestors would put their money only into mutual funds that had genuinely independent directors and that used their political influence to lobby for, rather than against, systemic reforms.