An equitable solution

With an overwhelming number of mutual fund products offered by hundreds of companies and money managers, price competition should be stiff and prices low. But critics contend the opposite is true; that it's a fee-laden industry horribly over-priced. 12b-1 fees are the latest to fall under SEC scrutiny, and players on all sides are anxiously awaiting the outcome.

Peter Wallison, senior fellow at the American Enterprise Institute, says it never should have come to this. His latest book -- Competitive Equity , co-authored by Robert Litan -- offers specific solutions to the fee and pricing issues companies now face; solutions that resonate well with boomer advisors and their clients.

Wallison previously served as general counsel of the United States Treasury Department and, more impressively, he was White House counsel to President Ronald Reagan. He sat down with Boomer Market Advisor to talk about his ideas and their potential impact on the financial advisor business.

Boomer Market Advisor: The number of available mutual fund products is high, and barriers to entry for new firms and funds are low. This type of environment should lead to stiff price competition. But the opposite is true, and the fund industry instead reflects something closer to monopolistic competition. Why is this happening?

Peter Wallison: It was exactly this question that led me to explore how mutual funds are regulated. The huge disparity in pricing for mutual funds -- the fact that there is a 300 percent difference between the expense ratios of the lowest and highest cost equity funds -- strongly suggests that there is little or no price competition. This seemed strange, since the industry has a very competitive structure. In the rest of our economy, if there are 500 competitors and ease of entry, competition would be driving down prices. In the mutual fund business, the prices are the expense ratios and they are simply not competitive with one another.

BMA: But isn't it paying for performance?

PW: One can argue, of course, that it's performance, but we see price disparities of almost the same size among S&P; index funds, where performance is not a factor.

BMA: So what did you conclude?

PW: Ultimately, it's the way mutual funds are regulated that's responsible for the lack of price competition. Mutual funds are corporations, each with a board of directors, but they are managed by investment advisors under a contract with the fund. Under the Investment Company Act of 1940, the directors must approve these contracts, including the fees of the advisor and the expenses that the advisor charges to the fund. This turns out to be a form of cost-plus rate regulation, not unlike the way commissions regulate electric utilities. Economists have shown that cost-plus rate regulation reduces or eliminates any incentive to cut costs and operate efficiently. If an advisor cuts his costs, the profit that he earns on the revenue from fund management goes up, and the directors then insist that he cut his fee in order to reduce his profit. This creates a strong incentive on the part of investment advisors not to cut their costs. In this environment, price competition will not occur, no matter how competitive the industry appears to be from the outside.

BMA: What's to be done?

PW: We recommended the elimination of any role for boards of directors in approving advisory fees and expenses. With advisors then free to cut their costs, competition will ensue and expense ratios will fall.

BMA: The controversy over 12B-1 fees is heating up. They were originally instituted to cover necessary costs when industry margins were low. But it's tough to make that case today. Is there a valid argument for the continued imposition of 12b-1 fees, or should they be done away with altogether?

PW: I don't see any problem in principle with 12b-1 fees. To the extent that they make it possible to have no-load funds, or reduced-load funds, I see them simply as deferred sales costs. Someone has to pay for sales costs. Front-end loads tend to restrict investors' options; if they redeem within a short time after making the investment, they could suffer substantial losses. Back end loads have the same effect. A better system would be to have investment advisors pay the sales charges out of their advisory fees, but then -- in the current regulatory environment -- the question arises whether the fees are excessive because the advisors have money available to pay for marketing and sales costs. In a truly competitive market, this would not be issues. Advisors would develop different approaches. Some would develop all-in fees that included enough profit to pay marketing and sales expenses and their funds would be no-load; others might continue to charge front or back-end loads. Investors would have choices.

BMA: Other countries, such as Japan, the U.K. and Canada, have a structure similar to UITs. What are the advantages of setting the fee structure in this manner, and how well is it working in these foreign markets?

PW: It's very difficult to compare foreign markets to the U.S. market. None of them comes close to the our market size, and they are all subject to various regulatory and cost differences that affect the pricing of collective investment structures. We did look at the U.K. market because that one seemed the closest to the U.S. structure. In the U.K., there is no board of directors that approves mutual fund fees and expenses. Advisors are free to charge whatever they want. The result is what appears to be a much more price-competitive market, with the expense ratios of equity funds differing by 90 percent instead of the 300 percent that we found in the U.S. Interestingly, we found six U.S. advisors offering funds in the U.K. Their pricing in the U.K. did not differ by more than 10 basis points, although their U.S. pricing differed by as much as 55 basis points.

BMA: More independent financial advisors are realizing the value of charging a fee for their services. This business model removes the inherent conflict-of-interest associated with "selling" commission-based products. Do the solutions in your book complement this movement towards the fee-based or fee-only advisor business model?

PW: Sure. If the market continues to move in this direction, investment advisors will -- under our proposed system -- have the opportunity to offer at least two different investment formats. In the first, the investment advisor will pay the intermediary financial advisor out of their all-in fee that is charged to the fund. That does not entirely eliminate the conflict of interest, because one can contend that the size of the fee paid by the investment advisor to the financial advisor will affect what the financial advisor sells to his client. However, price competition will force advisors to advertise their prices, making the public aware of the differences between them. This in turn will force financial advisors to pay attention to these costs on behalf of their clients. In addition, the investment advisor could offer a lower fee option in which the investor pays the financial advisor directly. That would eliminate the conflict, and could become the most popular way for mutual funds to be marketed and sold.

BMA: With the advent of 24-hour cable news and the Internet, investors have a higher level of financial education that ever before. Baby boomers, in particular, want financial advisors and investment management companies to "sit on their side of the table" and be their advocates. Is this part of what's driving the call for change in the way the fund industry conducts business?

PW: Frankly, I don't see many calls for change in the way the fund industry conducts business. The SEC should be the source of calls for change -- given the needlessly high cost of investing in mutual funds -- but they seem caught in their old and fallacious view that the key issue in pricing is to give boards of directors more power and independence to negotiate with investment advisers. Thus, they are still talking about requiring all mutual fund boards of directors to have at 75 percent independent directors and an independent chair. This is exactly the wrong thing to do, because it reduces even further the incentives of investment advisors to cut costs and compete on price.

BMA: What can independent financial advisors do?

PW: Responsible financial advisors should be looking for the funds with the lowest expense ratios. They should inform their clients of an important fact -- that over the long term all funds regress to the mean in performance. No one can beat the market over the long term because no one, even the best portfolio manager, has as much information as the market as a whole. So the best investment strategy is to find the lowest cost fund -- maybe even an index fund -- and stick with it. Clients should remember the old Wall Street expression that "bulls make money, bears make money, but pigs don't make money."