How can it be that an industry with hundreds of competitors and thousands of products is not competing on price? This is the question we asked ourselves as we began an 18 month study of the mutual fund business in September 2005. The most striking fact about the industry was the extraordinary size and variety of the fees and costs—together, as a percent of the fund’s assets, they are called the “expense ratio”—that investors are charged for the services and advice associated with their mutual fund investments. Using data from Morningstar, we found that for 811 ordinary equity funds there was a difference of 300 percent between the lowest and highest expense ratios, without any appreciable difference in the quality of performance or service.

Mutual funds matter: Americans have now put over $10 trillion into them, much of it for retirement. Because of the magic of compound interest, even small differences in expense ratios, when accumulated over many years, can have a major effect on the size of an investor’s portfolio at retirement.  

Today, all mutual funds are corporations, governed by boards of directors but managed under contracts by investment advisers. Under the Investment Company Act of 1940—an artifact of the New Deal—fund boards must approve the adviser’s fees and expenses, and thus the fund’s expense ratio. For at least 40 years, the SEC and industry critics have argued that mutual fund expense ratios are too high because there is an inherent conflict between the advisers’ desire for profit and the interests of fund shareholders. The SEC has sought to increase the independence of fund boards, so that they could negotiate fees and expenses more effectively with advisers. In 2005, the agency’s effort to require a supermajority of 75 percent and an independent chair for each fund’s board was struck down by the courts, and there are indications that the SEC may try again to restore the supermajority requirement.

The fact that advisers’ profits must be deemed reasonable in relation to their costs discourages advisers from reducing their costs.

But the SEC’s conflict of interest theory can’t be right. If investment advisers were competing on price, they would have every incentive to lower their fees and the funds’ expense ratios on their own, since this would attract more investors and increase their revenues and profits. There would be no need for independent boards to press them for lower fees. So the question is not whether the mutual fund boards are sufficiently independent, but why it is that an industry with a multitude of companies is not competing on price.

The answer, in our view, is rate-regulation by mutual fund boards of directors. Under existing law and SEC regulations, directors are required to determine whether advisers’ costs and profits are “reasonable.” Directors perform this task by reviewing the advisers’ actual costs of managing the funds. Yet the fact that advisers’ profits must be deemed reasonable in relation to their costs discourages advisers from reducing their costs in order to attract more investors, since this risks a loss of revenue and profits if additional investors don’t flow in. But even if the fund attracts new investors, the adviser does not fully benefit from the risk it takes, because mutual fund boards are expected to require lower fees in the future in order to “recapture” some of the benefits the adviser reaps from economies of scale. Faced with these adverse incentives, advisers understandably tend to stick with their existing costs, and not seek the efficiencies that companies fight to achieve in competitive markets. In short, this cost-plus process closely resembles the regulation of electricity rates by local utility commissions, which has been shown to stifle efficient operation.

If our theory is right, the key to obtaining lower costs for investors is to create an environment in which advisers will compete on price, by freeing them from board rate-regulation and allowing them to set their own fees. In virtually every case where rate regulation has been eliminated over the last quarter-century—including airlines, trucking, long-distance telephone service, and securities brokerage—competition has brought consumer prices down. There is no reason to believe that it won’t do so for mutual funds.

The way to test this theory is to look to the United Kingdom, where investment advisers can set their own fees without the approval of a board. The range of pricing in the UK is much narrower than in the United States—a difference of about 50 percent between the lowest and the highest expense ratios of 456 equity funds. In other words, the UK market shows a convergence in pricing that is characteristic of a competitive market, while the U.S. market does not.

The policy message for Congress and the SEC is clear. If they want to lower the costs of investing in mutual funds—as they should—then board independence is a distraction. The right policy is to eliminate rate-regulation by boards of directors and allow advisers to compete on price.

Peter J. Wallison is a senior fellow at the American Enterprise Institute. Robert E. Litan is a senior fellow at The Brookings Institution. They are the authors of “Competitive Equity: A Better Way to Organize Mutual Funds” (The AEI Press, 2007).