Strengthening Mutual Fund Corporate Governance: A Security Design Approach

Abstract

This work analyzes the relation between the design of mutual fund shares and incentive problems in the mutual fund industry. It then describes an alternative split design that alleviates the problems. The current design of the mutual fund claim leads to diffuse ownership and a customer focus on net return. Both effects remove incentives for fund investors to monitor and discipline the fund board, particularly with respect to fees. Competition based on net return does not provide incentives for managers to lower fees when the class of competing funds exhibits a high cross-sectional variation in total return. Splitting mutual fund shares into pairs of linked return and fee shares mitigates agency problems. A return share has all the characteristics of current mutual fund shares except it has guaranteed fees and no voting rights. A fee share receives the guaranteed fees and pays the actual fees of the specific return share to which it is linked. The fee share has voting rights. Proceeds from the sale of a fee share accrue to the linked return shareholder. Board discipline arises naturally from the fee shareholders. Monitoring is economically viable for large investors in fee shares. Fee shareholders, who are owners, pressure boards via their votes to govern effectively. Fee shareholders want low fees. Less obviously, they also want satisfied return shareholders, since a fee share expires when its linked return share is redeemed.