Improved Performance Guarantees

Abstract

Many mutual fund shareholders invest in funds with supra-competitive fees that reduce their expected return even though lower cost alternatives are available. While financial arbitrage could address this problem, conventional arbitrage is difficult to implement in the mutual fund market. This article proposes legal reform to our system of mutual fund regulation that responds to the problem of high-cost funds by providing the investors who are making the most substantial mistakes with salient and transparent market information about the existence of superior investment alternatives. We first consider ways that regulation could be reformed to facilitate what we call redemption, the mutual fund analog to of securities. A vibrant market for short redemptions would allow smart money to arbitrage fee differences by selling (redeeming) short high fee funds while buying comparable low-fee funds. But because of predictable resistance from the shorted funds and the difficulty of obtaining shares to borrow, we conclude that the short redemption is unlikely to be sufficient arbitrage discipline of inefficient high fee funds. Instead, we propose regulatory reform that would encourage low fee funds to offer performance guarantees. An improved performance guarantee promises that the consumer will achieve a better net financial outcome if she switches from a current provider to a competitor product. The core notion is to guarantee to the consumer an improvement in relative performance. The guarantee functions as an arbitrage of high fee funds that would improve price competition in the mutual fund market. Our central claim is that lawmakers and regulators can enhance competition in mutual funds by enabling sophisticated investors to arbitrage supra-competitive fees.