Mutual Fund Advisory Fees: Sponsors Game the System as Watchdogs Slumber

Abstract

Mutual funds are captives of the investment management firms, also known as fund sponsors, that bring them into existence and provide for their day-to-day operations. Because fund sponsors exercise complete control over the operations of their funds, the possibility arises that a fund sponsor will use its position of control to obtain advisory fees that are greater than those that would have been established by arm’s length bargaining. A fundamental responsibility of independent mutual fund directors, which serve as watchdogs over the interests of mutual fund shareholders, is to ensure that advisory fees are reasonable in light of, among other factors, economies of scale and profitability realized by a fund sponsor. Yet, despite oversight by independent directors, this paper shows that many mutual fund sponsors have been able to maintain high advisory fees, and have realized increasing levels of economies of scale and profitability, as industry assets increased more than 600% between 1995 and 2018. The nub of the issue is that the methodologies used to calculate profitability have largely evaded meaningful scrutiny by fund boards, which are typically advised that there is no “right answer” when it comes to a methodology. Yet, sponsors are keenly aware that litigation risk arising from excessive profitability could force advisory fee decreases on large and highly profitable funds, and therefore are incentivized to use inappropriate cost allocation methods to understate profit margin. Vigilant fund directors should recognize this potential conflict and rectify the situation, but this has not happened. This paper explores profit margins, scale economies, cost allocation methodology and case law in depth. It identifies two large fund complexes with unambiguously inappropriate cost allocation methodologies and presents circumstantial evidence of widespread use of such practices in the industry.