Exclusive FiduciaryNews.com Interview with Mutual Fund Fee Myth Busting Professor
Like many college students, D. Bruce Johnsen faced a summertime dilemma. Painting houses to earn money for school, a homeowner called him to do a difficult job. Johnsen looked at the house and realized it required stain – something he had never done before. He really needed the money, so he offered to do the job for $300. The owner looked at the young college student and frowned. Johnsen’s heart sank. But the customer countered, “How about if I pay you $450?” The incredulous scholar absentmindedly asked, “Why? That’s more than what I’m asking for.” The wily owner only smiled and replied, “Sure, but I want you to do a good job.”
Johnsen, now a professor at George Mason University School of Law, never forgot that story. The common sense “you get what you pay for” philosophy permeates his recent study “Myths About Mutual Fund Fees: Economic Insights on Jones v. Harris” (George Mason School of Law, Law & Economics Research Paper No. 09-49, posted October 7, 2009). [For a review of that paper, see the story “New Study Refutes 4 Mutual Fund Fee Myths,” Fiduciary News, October 12, 2009] Professor Johnsen was kind enough to consent to an exclusive interview with Fiduciary News. His conversation revealed not only how some have abused common economic sense, but how – just maybe – the issue of mutual fund fees raises fiduciary liability only when the 401k fiduciary circumvents market forces by actively trying to address the issue.
FN: Professor Johnsen, can you summarize the main point of your paper?
Johnsen: The paper addressed an issue currently facing the Supreme Court. Jones v Harris is concerned about the fees charged to mutual funds by the adviser managing the fund’s portfolio. Although you wouldn’t know this from reading the popular press, economic theory clearly suggests paying high fees is justified in a world where the average shareholder doesn’t have the wherewithal to monitor the adviser to assess the quality of services. This is known as the efficiency wage notion. In other words, reducing fees entails an added cost that can be more than the savings. The paper describes and refutes what I call the four myths associated with the Jones v Harris case.
FN:What is the greatest danger to 401k fiduciaries posed by the proliferation of these myths?
Johnsen: Fiduciaries are on the hook for higher fees only if they have some negotiating leverage to bargain. However, this is a calculus. As soon as a plan begins negotiating, the plan’s monitoring costs increase. Unlike mutual fund fees, monitoring costs may not be readily measurable – that’s one of the reasons why mutual fund fees get all the press but other 401k fees don’t. So, it becomes a business decision to determine whether, as a 401k fiduciary, you want to act as a benign fiduciary – i.e., allow market forces to determine fees – or act in an active manner by not only negotiating fees lower, but also incurring the costs of monitoring those lower fees beyond what the market would do. Now, here’s the cruel irony and the greatest danger posed by the myth of high mutual fund fees: by taking back some of the responsibility normally delegated to professional advisers, an active fiduciary may in reality take on a greater fiduciary liability. So, a 401k fiduciary might be better off just leaving well-enough alone and let the market decide the optimal fee for any mutual fund the plan invests in. Indeed, there’s no guarantee active fiduciaries will even meet their objective. For example, it’s quite possible, even in the hypothetical case of a large pension plan that commingled its assets with public investors who can come and go, that market forces will ensure normal risk-adjusted returns.
FN: Which myth is most prominent as it pertains to 401k plans?
Johnsen: As you can guess from the above, I feel the myth most relevant to 401k plans and their fiduciaries is the one that states mutual fund fees should match pension fund fees. High prices – in this case higher fees – might insure higher quality service, thereby relieving the fiduciary from incurring monitoring cost. In other words, higher fees “bond” the performance of the adviser. So, if you’re a small plan fiduciary, it might make more sense to pay higher “investment advisory” fees than to incur even higher monitoring costs elsewhere.
FN: What is the best thing 401k plan fiduciaries can do right now to address these myths?
Johnsen: Well, the first thing they can do is simply relax. No one can expect you to spend a dollar to save 50 cents – and this is precisely the pragmatic result of being too aggressive chasing lower fees. A fiduciary needs to optimize across various dimensions of costs and benefits. This is just not good economic calculus. It’s a simple business decision and should be protected by the business judgment rule absent some kind of demonstrable misconduct by the fiduciary such as self-dealing, gross negligence, or bad faith.
FN: What is the one thing you hope most to achieve by publishing this paper?
Johnsen: This goes right to what I do as a scholar. I’d like to see the law be more careful about embracing economic principles. For example, many critics of mutual fund fees assert there are “economies of scale” in fund management without any real understanding of what the term actually means. They say that with fixed costs that do not increase with assets under management, average cost must decline. Such a statement has nothing to do with economies of scale, which occur when the average cost of producing a good investors want declines as more of it is produced. Assets under management is not a good, and it is not what investment advisers produce. In fact, any investor would be better off if he or she could restrict the growth in assets from other investors. I explain all this in the paper. In the end, to say that fees should decline as assets under management increase you must have some kind of theory about adviser compensation and incentives to say anything intelligent. As a first approximation, my paper makes the point that fees are irrelevant because money can flow in and out of mutual funds to equalize expected returns adjusted for risk. To assume high fees reduce returns dollar-for-dollar is simply wrong. Lower fees are not necessarily better where you cannot observe quality. You just need to look at basic economic theory to understand there’s really nothing systemically malevolent going on here.
FN: Are there any final thoughts you’d like to leave with our readers?
Johnsen: There is something that has bothered me tangentially. For plan fiduciaries, legal risks arise under ERISA only if something bad happens and the lawyers have reason to start poking around. Success resulting from fund inflows breeds higher “total” fees, and ironically this leads to a more tempting target for excessive fee suits under Section 36(b) of the Investment Company Act (1940).
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So it seems the notion that somehow fees reduce returns may not necessarily be true at all. Lower fees may not necessarily be better where the cost to monitor quality exceeds any anticipated savings. Indeed, just as a homeowner in need of a paint job felt many years ago, when it comes to high fees, sometimes you get what you pay for. And that reality often leaves investors smiling.