Part Three
WHAT’S WRONG WITH “MUTUAL” FUNDS
Part Three of Don’t Count on It! includes five chapters that trace the historical development of the mutual fund industry’s peculiar structure and how that structure shaped the industry’s development. As the late, great economist and author Peter Bernstein has written, “[W]hat happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets.” These chapters include colorful anecdotes regarding industry leaders and regulators during the industry’s formative years, which provide a powerful contrast between the structure of America’s first mutual fund and the very different structure that the industry subsequently adopted. Since the now-prevailing structure has failed to adequately serve fund shareholders, I offer a set of sound, long-term-oriented principles of stewardship to which I urge the industry to promptly return.
Chapter 12—“The Alpha and the Omega”—analyzes those changes in industry structure starting with America’s first mutual fund, which was created in 1924. As I explain in this essay, that original mutual fund used the Alpha model—under which trustees were employed by the fund itself, without the need to retain a separate investment advisory company to manage its affairs, and with share distribution provided by a separate and independent sales organization. This original Alpha model was almost immediately supplanted by a new, now-dominant Omega model, in which a separate advisory company, now usually publicly held, essentially controls the fund’s affairs and distributes its shares.
This chapter also contrasts the faltering investment returns and diminishing growth that occurred when, in 1969, the managers of that first fund abandoned its original “mutual” Alpha model based on stewardship. Instead, it adopted the prevailing industry model focused on salesmanship. The result: deteriorating fund performance and plummeting market share. Just a few years later, in 1974, another firm (which happened to be the newly created Vanguard) revived the original Alpha model in an innovative and unique manner. That bold step was accompanied by, yes, improved fund performance and soaring growth in market share. In 2010, it ranked as the largest mutual fund firm in the world, holding an unprecedented market share of 16 percent of the assets of all U.S. stock and bond mutual funds. Yet despite that accomplishment, this truly mutual structure has yet to be adopted by a single other firm.
“A New Order of Things—Bringing Mutuality to the ‘Mutual’ Fund,” is presented in Chapter 13. That essay was inspired by a 1968 speech by then-SEC Chairman Manuel Cohen. His speech, entitled “The ‘Mutual’ Fund,” was prescient to a fault—especially the quotation marks he placed around the word “mutual.” However, his warnings fell upon deaf ears. As he feared, the legal floodgates that had prevented fund management companies from “going public” or selling out to financial conglomerates had been thrown wide open by a California appellate court in 1958. As a result, fund managers, in Chairman Cohen’s words, “may be obligated to serve the business interests of the very companies in which they invest.” And that is what has happened.
In Chapter 14—“The Fiduciary Principle: No Man Can Serve Two Masters”—I discuss the cataclysmic stock market crash and economic crisis that began in 2007, and the role played by institutional investors in that failure. I cite 10 striking examples of how fund managers have violated their fiduciary duty to mutual fund investors. The principles that I advocate are age-old, clearly echoing the principles so beautifully enunciated by Supreme Court Justice Harlan Fiske Stone in 1934, in the wake of the stock market crash in 1929 and the Great Depression that followed. To reduce the chances of yet another crash, I recommend the establishment of a federal standard of fiduciary duty, a simple concept that would require fund managers to place the interest of their fund shareholders first, just as the preamble to the Investment Company Act of 1940 demands.
Chapters 15 and 16 also reflect my mission to return the mutual fund industry to its founding values. In “Fund Directors and Fund Myths,” I urge that fund independent directors stand up for the rights of the shareholders who elected them—an idea, alas, that has yet to gain much traction. To guide directors along the way, I offer Ten Commandments and a Golden Rule. The final chapter focuses on “Fair Dealing with Investors.” Here, I call for far better disclosure of relevant information to fund shareholders and prospective shareholders, so that the mutual fund industry can truly operate with “high standards of commercial honor and just equitable principles of trade.” We have a long way to go.