The mutual-fund industry has been having a torrid time for several years and there is little sign that life is going to get any easier for it in the near future. At the heart of its woes are the linked issues of competition, or the alleged lack of it, and the level of management fees that companies charge the ordinary investors who pay into them.
Already there has been testimony to the US Congress that fund-management fees are too high, and the office of at least one state attorney general, that for New York, has agreed. Investors have, on occasion, filed lawsuits alleging that they have been charged excessive fees.
Inevitably, as will come as no surprise to anyone in any kind of customer-facing business, this has led to talk of more regulation in the interests of investor protection. Specifically, regulation of fees has been suggested along with the associated issue of further mandatory disclosure of charges that are borne, one way or another, by the investor.
A new perspective through the prism of market share
We decided to take a fresh look at the whole issue, using as our prism the changes in market share over time of different “families” or groups of mutual funds offered by different investment companies. Why? Quite simply, it seemed to us to be the best measure, being the ultimate outcome of both the decisions made by the fund families and the reaction of investors to them.
Our finding is that market share responds positively to competition on both price and on product differentiation, the latter covering both past performance and product innovation. In other words, the mutual-fund market is competitive and, we assert, that calls for further regulation of fees are premature.
These findings, we suggest, are of interest not only to those in the industry and to regulators, but to individual investors and to all business people who face demands for more supervision and regulation in their own line of work, demands that may be based on misconceptions.
More on our conclusions in a moment. First, it is important to see how the industry reached its present state and why the manner in which it has developed may have led some to believe that management fees are too high and ought to be reduced.
Between 1976 and 2009, mutual-fund assets in the United States grew by a factor of 200, from $51 billion to $11.1 trillion, and the number of active fund families quadrupled. The average market share of each family of funds declined over that period, by four-fifths. This was a time of intensifying competition and one in which there were winners and losers. For example, from roughly equal market shares in 1976 of less than six per cent each, Fidelity and Dreyfus had, by 2009, respectively 12 per cent and 2.5 per cent of the market.
Yet despite investing their money in what would appear to be a fiercely competitive marketplace, investors found that the total costs charged in return for fund-management services have, on average, not only not fallen but have actually increased, from a ratio of 1.06 per cent of assets in 1976 to 1.36 per cent in 2009.
Is competition working?
To the industry’s critics, this is evidence that competition is not working, either in terms of price competition or of competition on the basis of product differentiation. This is why, using market share as our yardstick, we decided to investigate the state of play with regard to both these varieties of competition.
On price, we found that competition in this area is effective and has real “bite”. Families of funds that charged higher fees and failed to pass on to their investors the potential benefits of economies of scale had a lower market share, just as one would expect in any other business.
But not all fees had an equal impact in this regard. Those fees levied to pay for the marketing and distribution of the funds concerned had a positive rather than negative impact on market share, suggesting the promotional efforts on which they are spent tend to be effective.
Furthermore, investors in low-cost families of funds show little or no sensitivity to fee levels. Provided any increase was not excessive, such funds could raise their fees towards the industry average without loss of assets under management. By contrast, high-cost fund families risk loss of market share from fee increases, while they would benefit more than lower-charge fund families from reductions in their fee levels.
Product differentiation as a driver of competition was of special interest to us because we were aware that it could provide part of the answer to the puzzle of why expense ratios had failed to decline despite competition. Perhaps the fund families had been able to keep prices high by “customising” their offerings, softening the impact of competition by shutting out rivals from bespoke products.
Funds that innovate attract a larger market share
We looked at the two key expressions of product differentiation: past performance and product innovation. On the first, we found a very definite relationship between performance and market share, while fund families that innovate more than others also tend to attract a larger share of the market.
But a word of warning here: such innovation must be “real”. It must feature a genuinely differentiated product away from the more crowded segments of the market. Investors pay attention to the types of assets held in new funds and are quite capable of noticing when such a fund is merely a re-packaged version of existing funds. As a result, the impact on market share is much diminished.
We therefore urge investors always to scrutinise the fees that they are being asked to pay, in particular to ask themselves whether the fees in question are in line with their individual needs for investment-management services.
As stated earlier, we do not see a requirement for more regulation and legislation in this area without additional evidence. We do however see a need for fees always to be kept under careful and constant review. The difference between us and some of the industry’s fiercer critics is that we see a provably competitive marketplace of sophisticated investors as providing the best mechanism for such scrutiny.