[*PG391]RE-MUTUALIZING THE MUTUAL FUND INDUSTRY—THE ALPHA AND THE OMEGA
Abstract: The mutual fund industry began in 1924 with the formation of a truly mutual mutual fund: one organized, operated, and managed, not by a separate management company with its own commercial interests, but by its own trustees; compensated not on the basis of the trust’s principal, but, under traditional fiduciary standards, its income. This model of the mutual fund (the Alpha model) has been replaced by the mutual fund complex of 2004 (the Omega model). Although most mutual funds utilize this model, this Essay argues it is contrary to the intent and language of the Investment Company Act of 1940 as it benefits managers and directors as opposed to shareholders. This Essay compares the actual benefit to shareholders from funds utilizing the Omega model versus those using the Alpha model and proposes it is time to return to the Alpha model of 1924.
March 21, 2004 marked the eightieth anniversary of America’s first mutual fund. Organized in Boston, the Massachusetts Investors Trust (“MIT” or the “Trust”) was a Massachusetts trust managed by its own trustees, who held the power “in their uncontrolled discretion” to invest its assets.1 The trustees “were to be compensated at the current Boston rate for trustees,” 6% of the investment income earned by the trust.2
The mutual fund industry began, then, with the formation of a truly mutual mutual fund: one organized, operated, and managed, not by a separate management company with its own commercial interests, [*PG392]but by its own trustees; compensated not on the basis of the trust’s principal, but, under traditional fiduciary standards, its income.
We use the word “Alpha” to describe the first event in a series, and the word “Omega” to describe the last event, the end of the series, or its final development. To state what must be obvious, however, MIT’s Alpha was followed by the development of a very different mode of fund organization. Today, the industry’s almost universal modus operandi is not individual funds but fund complexes; they are managed not by their own trustees but by external corporations; they encompass not only investment management but also administration, operations, distribution, and marketing. The 1924 Alpha mutual fund, then, has been replaced by the 2004 Omega mutual fund complex—a term that, all those years ago, would have seemed somehow jarring or inappropriate.
But “the national public interest and the interest of investors”3—the focus of our industry’s guiding statute, the Investment Company Act of 19404 (the “1940 Act” or “Investment Company Act”)—precludes our acceptance of today’s almost universally accepted industry structure—today’s Omega model—as the end of mutual fund development. Why? Because the reality is that this structure has been shaped, increasingly and almost unremittingly, to serve the interest of fund managers, a disservice to the public interest and the interest of fund shareholders.
Sharply rising fund costs have widened the shortfall by which fund returns have lagged the returns earned in the financial markets; the age-old wisdom of long-term investing has been importantly crowded out by the folly of short-term speculation; and “product marketing” has superceded investment management as our highest value. The recent fund scandals provide tangible evidence of the triumph of managers’ capitalism over owners’ capitalism in mutual fund America, an unhappy parallel to what we have observed in corporate America itself.
These developments are indisputable, and they fly in the face of the very language of the Investment Company Act—mutual funds must be “organized, operated, [and] managed”5 in the interests of their shareowners rather than in the interests of their “investment advisers . . . [and] underwriters”6—a policy now honored more in the breach than in the observance. It is high time for a new Omega, an [*PG393]industry structure that would, paradoxically enough, parallel the Alpha structure under which MIT was created eighty years ago.
Almost from its inception, MIT was a remarkable success. Although in its first few years the going was slow, assets had soared to $3.3 million by the end of 1926. As the boom of the late 1920s continued, MIT flourished. It earned a return of 88% for its investors in 1926–1928, only to lose 63% of their capital in the bust that followed in 1929–1932. But as the market recovered, its assets grew apace—to $128 million by 1936 and to $277 million by 1949, the largest stock fund in the industry throughout that entire period. MIT would maintain that rank until 1975, when its assets reached a total of $1.15 billion—a truly amazing half-century of preeminence.
To its enviable status as both the oldest and largest mutual fund, MIT added the luster of consistently ranking as the lowest-cost fund. Its trustees soon reduced that original 6% fee to 5% of income and then, in 1949, to 3.5%. Measuring its costs as a percentage of fund assets (now the conventional way we report expenses), the Trust’s expense ratio fell from 0.50% in the early years to 0.39% in 1949, to a fairly steady 0.19% during 1960–1969. During that entire period MIT was offered publicly through stock brokers by an underwriter originally named Learoyd-Foster, later to become Vance, Sanders & Co. Managed by its own trustees and unaffiliated with its distributor, the truly mutual structure of the Trust played a major role in its sustained leadership of the industry.
As 1969 began, then, MIT was an industry maverick. It stood for trusteeship and did not engage in salesmanship. It kept its costs at rock-bottom levels. Its portfolio was broadly diversified and had little turnover. It invested for the long term and so did the shareholders who purchased its shares. Virtually every other fund in the industry operated under the conventional structure with an external “management company” that assumed full responsibility for its operations, investment advice, and share distribution in return for an asset-related—not income-related—fee paid by existing investors and a share of the sales loads paid by new investors. Yet MIT held to its own high standards and prospered—a success story, in its own way, for the idea that mutuality worked.
During 1969, however, the structure changed. The trustees solicited proxies from the shareholders of MIT (and its sister fund, Massachusetts Investors Growth Stock Fund—originally named “Massachusetts Investors Second Fund”) for approval to “demutualize” and adopt the conventional external management structure. When the shareholders approved the proposal, the Trust became a member of a fund family that adopted the name “Massachusetts Financial Services” (“MFS”). If MIT was a fund that had stood for something unique for nearly a half century, in 1969 it became one of the crowd.
Was that change from Alpha to Omega good or bad? We can say unequivocally that, in terms of the fees it generated for its managers, it was good. We can also say unequivocally that, in terms of the costs borne by its shareholders, it was bad. That 0.19% expense ratio in 1968 doubled to 0.39% in 1976, and doubled again to 0.75% in 1994, continuing to rise to 0.97% in 1998 and to 1.20% in 2003.
Figure 17">
[*PG395]And that old limit of 3.5% of income the trustees put into place in 1949? It was long gone. In 2002, in fact, MIT’s expenses consumed precisely 80.4% of the trust’s income.
But these ratios greatly understate the increase in the Trust’s costs. For even as its assets were growing, so were its fee rates, resulting in enormous increases in the dollar amounts of fees paid. With assets of $2.1 billion in 1969, MIT’s management fees (including some relatively small operating expenses) totaled $4.4 million.
Figure 28">
Even a decade later in 1979, although the Trust’s assets had declined by 50% to $1.1 billion after the 1973–1974 market crash and the troubled times faced by the fund industry, fees had actually risen to $5.2 million. In 1989, with assets at $1.4 billion, fees continued to rise to $6.3 million. And in 1999, when assets soared to $15.6 billion, fees totaled $158 million. While the Trust’s assets had grown seven fold since MIT demutualized in 1969, its fees had increased thirty-six times over.9
What effect did the new structure have on MIT’s shareholders? It is not difficult to measure. For MIT was the prototypical mutual fund, widely diversified among about 100 blue-chip stocks and, unsurprisingly, providing returns that closely paralleled those of the Standard & Poor’s 500 Stock Index10 (the “Index” or “S&P 500”), with an average correlation (R2) of 0.94 that has remained remarkably steady over its entire eighty-year history. Given the tautology that the gross return of the stock market, minus the costs of financial intermediation, equals the net return earned by market participants, it would be surprising if the rising costs that followed MIT’s demutualization were not accompanied by deterioration in the returns enjoyed by its shareowners.
Figure 311">
No surprise, then. The Trust’s relative returns declined. During its mutual era (1926–1969), the Trust’s average annual return of 8.4% [*PG397]lagged the Index return of 9.7% by 1.3% per year.12 But after demutualization (1969–2003), its average annual return of 9.7% lagged the Index return of 11.3% by 1.6% per year—a 0.3% reduction in relative return that exactly matches the increase in its average expense ratio from 0.3% in the 1925–1969 period to 0.6% in 1969–2003.13
This increase in the shortfall in MIT’s annual returns during the Trust’s thirty-four-year Omega period may seem trivial. But it is not.
Figure 414">
Thanks to the miracle of compounding returns, each $1 initially invested in the S&P 500 at the end of 1969 would have been valued at $38 at the end of 2003. Confronted by the tyranny of compounding costs over that long period, however, each $1 invested in MIT would have had a final value of just $23.60—in relative terms, a 38% loss of principal.
Even as MIT was abandoning its Alpha mutual structure in favor of an externally managed Omega structure in 1969, the stage was being set for another firm to take precisely the opposite action. Philadelphia’s Wellington Group (“Wellington” or “Wellington Group”)—eleven associated mutual funds with assets of some $2.4 billion (more than $1 billion behind the then-combined total of $3.5 billion for MIT and its sister growth fund)—was operated by Wellington Management Company (“Wellington Management”), then largely owned by its executives but with public shareholders as well. Its stock had recently sold at an all-time high of $50 per share, nearly three times its initial public offering price of $18 in 1960. Despite the travail that followed the demise of the go-go years, the stock market was again rallying, on the way to its then all-time high early in 1973, and the company was prospering.
With the so-called “currency” that its public stock had made available, Wellington Management had merged with the Boston investment counsel firm of Thorndike, Doran, Paine and Lewis, Inc. (“TDP&L”), in 1967. TDP&L was also the manager of Ivest Fund, a “go-go” fund that was one of the industry’s premier performers during that era of speculation, and it soon became a major generator of the Wellington Group’s capital inflows. And yet, even as MIT had just gone in the opposite direction, the Wellington CEO (who was also the Chairman and President of Wellington funds)15 was pondering whether this Omega structure was the optimal one for the funds’ shareholders, and whether a change to the recently vanished Alpha structure would improve both the lot of its fund shareholders as well as the firm’s competitive position in the industry.
In September 1971, he went public with his concerns. Speaking at the annual meeting of the firm’s partners, he talked about the possibility of mutualization, including in his remarks a 1934 quotation from Justice Harlan Fiske Stone:
“ [M]ost of the mistakes and . . . major faults [of the recent financial era] will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that ‘a man cannot serve two masters’ . . . . [T]hose who serve nominally as trustees, but . . . consider only last the interests [*PG399]of those whose funds they command, suggest how far we have ignored the necessary implications of that principle.”16
The Wellington CEO endorsed that point of view, and revealed what he described as
an ancient prejudice of mine: All things considered, . . . it is undesirable for professional enterprises to have public stockholders. . . . Indeed, it is possible to envision circumstances in which the pressure for earnings and earnings growth engendered by public ownership is antithetical to the responsible operation of a professional organization. Although the field of money management has elements of both, differences between a business and a profession must, finally, be reconciled in favor of the client.17
He then tranced on some ideas about how such a reconciliation might be achieved: (1) “‘mutualization’ whereby the funds acquire the management company”; (2) “‘internalization’ whereby the active executives own the management company, with contracts that are negotiated on some type of ‘cost-plus’ basis, providing incentives for both performance and efficiency, but without the ability to capitalize earnings through public sale”; and (3) limited internalization, with funds “made self-sustaining with respect to administration and distribution,” but with external investment mangers.18
Within three years, the CEO was put in a position in which he would not only talk the talk about mutualization, but would walk the walk. Even before the 1973–1974 bear market began, Wellington’s business had begun to deteriorate and the cash inflows of the Wellington funds, $280 million in 1967, had by 1973 turned to cash outflows of $300 million. The speculative funds created by the firm were suffering serious capital erosion and most would be merged out of existence before the decade was out. Assets of the conservative Wellington Fund (the “Fund”) flagship had tumbled from $2 billion in 1965 to less than [*PG400]$1 billion, on the way to $480 million in 1980. Wellington Management’s earnings of $2.52 per share in 1968 had dropped to $1.14 in 1974 and the stock price had fallen to $9.75 per share, on its way to a low of $4.87.
Figure 519">
This concatenation of dire events was enough to cause the happy partnership formed by the 1967 merger to fall apart, and Wellington Management Company’s CEO got the axe on January 23, 1974. But he remained as Chairman of the funds, with their largely separate (and independent) board of directors.
Shortly before the firing, the handwriting was on the wall, as it were, suggesting the nature of the change that might be in store. On January 12, 1974, the CEO had submitted a proposal to the mutual fund board of directors to mutualize the funds and operate under an internally managed structure. He wrote:
I propose that the Wellington Group of mutual funds acquire Wellington Management Company and its business assets . . . .
[*PG401] . . . Wellington Management Company would become a wholly-owned subsidiary of the several funds and would serve as investment advisor and national distributor for them on an “at cost” basis, resulting in estimated savings to the funds of $2 to $3 million per year in management fees. . . .
. . . .
. . . [T]he funds would pay an amount estimated to be in the $6 million range [the adjusted market capitalization of the company’s stock]20 . . . , and would receive in return liquid and fixed assets approximating $4 million with the remaining $2 million representing payment for the “going concern” value [or goodwill] of the enterprise.21
One need only understand the stunningly high profit margins of the investment management business to imagine a less-than-one-year(!) payback of the net acquisition cost of $2 million. While Wellington Management’s stock price had tumbled, and its fee revenues had declined, the firm’s pre-tax profit margin nonetheless remained at a healthy 33%.22 Although the fund Chairman openly acknowledged that such a conversion to mutual status was “unprecedented in the mutual fund industry,”23 the cautious fund board was interested enough to ask him to expand the scope of his proposal and undertake “a ‘comprehensive review of the best means by which the Funds could best obtain advisory, management and administrative services at the lowest reasonable cost to the shareholders of the Funds.’”24 The board also asked Wellington Management to produce a similar study.
By March 11, 1974, the Chairman’s first report was completed.25 Entitled “The Future Structure of the Wellington Group of Investment Companies,” the report offered seven structural options, of which the board decided to focus on these four:
[*PG402] 1.Status Quo—the continuation of the existing relationships.
2.Internal Administration—administration by the funds themselves; distribution and investment advice from Wellington Management.
3.Internal Administration and Distribution—with only investment advice from Wellington.
4.Mutualization—acquisition by the funds of all of Wellington’s fund-related activities.
The Future Structure study spelled out the ultimate objective: independence. One of the goals was to give the funds “[a]n appropriate amount of corporate, business and economic independence,”26 the Chairman wrote, noting that such a structure was clearly contemplated by the Investment Company Act. But such independence, his study added, had proved to be an illusion in the industry, with “fund structures [being] little more than corporate shells. . . . [with] no independent ability to conduct their own business affairs. . . . This structure has been the accepted norm for the mutual fund industry for [more than] fifty years.”27 He bluntly concluded:
The issue we face is whether a structure so traditional, so long accepted, so satisfactory for an infant industry as it grew, during a time of less stringent ethical and legal standards, is really the optimum structure for these times and for the future . . . . Or, [whether], . . . the Funds [should] seek the greater control over their own destiny so clearly implied by the word “independence.”28
Although the fund Chairman clearly preferred his original proposal of mutualization, he was prepared to begin with less, concluding the study with these words: “Perhaps, then, the issue is not ‘whether’, but only ‘when’, the Wellington Group of Investment Companies will become completely independent.”29
As it would soon turn out, he would have to be content with less than full mutualization. After much study, even more contention, and debate that sometimes seemed to be endless, the board made its decision on June 9, 1974. It chose the least disruptive option, number two, establishing the funds’ own administrative staff under the direction of [*PG403]its operating officers, who would also be responsible, as the board’s counsel, former Securities and Exchange Commission (“SEC” or the “Commission”) Commissioner Richard B. Smith wrote, for “monitoring and evaluating the external [investment advisory and distribution] services being provided” by Wellington Management.30 The decision, the counselor added, “was not envisaged as a ‘first step’ to internalize additional functions, but . . . to form a structure that will hopefully last into the future.”31
Late in the summer, to the Chairman’s amazement and disappointment, the board agreed that Wellington Management would retain its name. Although Wellington Fund would also retain its name, a new name would have to be found for the administrative company. In September, he proposed to call the new company “Vanguard” and, after more contention, the board approved the name. The Vanguard Group, Inc. (“Vanguard”) was incorporated on September 24, 1974. Early in 1975, the SEC cleared, without apparent difficulty, the funds’ proxy statements proposing the change; the fund shareholders approved it; and Vanguard, a wholly owned subsidiary of the funds operating on an at-cost basis, began operations on May 1, 1975.
But no sooner than the ink was dry on the various agreements, things began to change. With the funds controlling only one leg—and, arguably, the least important leg—of the operations/investment management/distribution tripod on which any fund complex rests, the Chairman began to have second thoughts. As he would later write:
It was a victory of sorts, but, I feared, a Pyrrhic victory.
Why? Because success in the fund field is not driven by how well the funds are administered. Though their affairs must be supervised and controlled with dedication, skill, and precision, success is determined by what kinds of funds are created, by whether superior investment returns are attained, and by how—and how effectively—the funds are marketed and distributed. We had been given one-third of the fund loaf, as it were, but it was the least important third. It was the other two-thirds that would make us or break us. . . .
. . . I had realized all along that the narrow mandate that precluded our engaging in portfolio management and distribution services would give Vanguard insufficient power to control its destiny.32
The next one-third of the loaf was seized quickly. The newly named Vanguard Group’s entry into the investment management arena came in a groundbreaking way. Only a few short months after the firm began operations, the board of the funds approved the creation of an index fund, modeled on the S&P 500. It was incorporated late in 1975. When its initial public offering was completed in August 1976, it had raised a disappointing $11 million. But the world’s first index mutual fund had come into existence. It is now the largest mutual fund in the world.
Only five years after that halting entry into what was, arguably, equity investment management, the firm assumed full responsibility for the management of Vanguard’s bond and money market funds. A decade later, Vanguard began also to manage equity funds that relied on quantitative techniques rather than fundamental analysis. A variety of external advisers continue to manage Vanguard’s actively managed equity and balanced funds, now constituting some $180 billion of the Group’s $700 billion of assets.33
The final one-third of the mutual fund loaf was acquired only five months after the index fund IPO had brought investment management under Vanguard’s aegis. On February 9, 1977, yet another unprecedented decision brought share distribution into the fold. After another contentious debate in a politically charged environment, and by the narrowest of margins, the fund board accepted the Chairman’s recommendation that the funds terminate their distribution agreements with Wellington Management, eliminate all sales charges, and abandon the broker-dealer distribution system that had distributed Wellington shares for nearly a half century. Overnight, Vanguard had eliminated its entire distribution system, and moved from the seller-driven, load-fund channel to the buyer-driven, no-load channel. Nar[*PG405]row as the mandate was, it set the fledgling organization on a new and unprecedented course.
What would the flourishing of Vanguard into a full-fledged Alpha complex—its full mutualization—mean to its fund investors? First, it would mean far lower fund operating expenses, with the group’s weighted expense ratio tumbling from an average of 0.67% in 1975 to 0.26% in 2002—a reduction of more than 60%. Second, it would mean that the earlier 8.5% front-end load—and the performance drag on shareholder returns inevitably entailed by that initial sales charge—would be removed forever. And because gross returns in the financial markets, minus costs, equal the net returns earned by investors, this slashing of costs was virtually certain to enhance shareholder returns.
And that is just what Vanguard’s change from Omega to Alpha did. What followed over the subsequent twenty-nine years was a major enhancement in the absolute returns (sheer good luck!) and the relative returns earned by Wellington Fund.
Figure 634">
[*PG406]Specifically, this balanced fund provided an annual return of 12.9% from 1974–2003, actually outpacing the 12.3% annual return of its unmanaged (and cost-free) benchmark—35% Lehman Aggregate Bond Index, 65% S&P 500, an allocation comparable to Wellington’s—and by an even wider margin the 11.1% rate of return earned by the average balanced fund. During the comparable prior period (1945–1974) under the Omega structure, the Fund’s return of just 5.7% had actually lagged the benchmark return of 7.6% by a full 1.9 percentage points per year.
Part of that near-miraculous 2.5 percentage point annual improvement in relative returns—a staggering margin—was related to lower costs. The Fund’s expense ratio, low enough in the earlier period at 0.56%, fell nearly 40% to 0.34%, and the sales charge drag was eliminated.
Figure 735">
But the largest part of the improvement arose from a 1978 change in the Fund’s investment strategy, in which the Fund’s management di[*PG407]rected its reluctant adviser to return to its traditional conservative, income-oriented policies from which it had strayed during the late 1960s and 1970s. Result: by the end of 2003, each $1 invested in Wellington Fund in 1974 would have grown to $33.60. The same investment in the balanced index benchmark, in comparison, would have grown to just $28.90.36 The lower chart, showing the relative cumulative returns of Wellington Fund vis-�-vis its benchmark, presents a stunning contrast with the lower chart on Figure 4.37
Other than the direct impact of costs, it is not easy to characterize “cause and effect” in the attribution of investment performance. Although Wellington Fund’s return to its conservative investment tradition was a major benefit, the new Alpha structure itself, under which Wellington Management became an external investment adviser that had to provide satisfactory performance in order to retain its independent client, could well have itself provided a major benefit. And, although we cannot be certain, the development of the arms-length relationship that is part of the Alpha model clearly did no harm.
Whatever the case, we do know that there is a powerful and pervasive relationship between expense ratios and fund net returns. We know, for example, that the correlation coefficient of the ten-year returns of individual equity funds and their costs is a remarkably impressive negative 0.60. We also know that during each of the past two decades the returns of the equity funds in the low-cost quartile have consistently outpaced the returns of funds in the high-cost quartile by an enormous margin of some 2.5% per year. The lower the cost, the higher the return. And it is crystal clear that the Alpha model of fund operations is, well, cheap, whereas the Omega model is dear.
The contrast in costs could hardly be sharper than in the two fund complexes we have just considered. Both were dominated by a single mutual fund until the 1960s before becoming more and more diversified fund complexes thereafter. Both had roughly comparable assets under management up until the 1980s—in the hundreds of millions in the 1950s, then the billions in the 1960s and 1970s, growing to the tens of billions in the 1980s. Then their paths diverged. While Massachusetts Financial Services enjoyed solid asset growth to some [*PG408]$94 billion at the market’s peak in 2000, Vanguard grew even faster, then overseeing some $560 billion of assets.
Late in their Alpha period, the asset-weighted expense ratio of the MFS funds averaged less than 0.25%. Under its new Omega model, the MFS ratio jumped to 0.67% in 1984, to 0.92% in 1988, to 1.20% in 1993, and to 1.25% in 2002, an increase of 421% for the full period.
Figure 838">
By way of contrast, late in their Omega period the Vanguard funds’ ratio averaged about 0.60%. Under its new Alpha structure, the Vanguard ratio tumbled to 0.54% in 1984, to 0.40% in 1988, and to 0.30% in 1993, continuing to drop in 2002 to just 0.26%, a reduction of 61% from the pre-Alpha rate.
These ratios may seem diminutive and trivial but they are not. They entail hundreds of millions, even billions, of dollars. In 2003, the assets of the Omega MFS funds totaled $78 billion, and their 1.25% expense ratios, including management fees, 12b-1 fees, and operating costs, produced expenses totaling $975 million. Had their [*PG409]earlier 0.25% ratio prevailed, those costs would have been just $195 million, an astonishing $780 million(!) saving.
Figure 939">
Again by way of contrast, assets of the Alpha Vanguard funds totaled $667 billion in 2003; with expenses of $1.7 billion, the expense ratio was 0.26%. Had the earlier 0.60% ratio under its Omega structure prevailed, Vanguard’s expenses would otherwise have been $4.0 billion, representing $2.3 billion of additional costs that would have been incurred by its fund shareholders.
Even as Vanguard, under its Alpha structure, did good in building value for its fund shareholders, it did well in implementing its business strategy. Assets under management have grown from $1.4 billion in 1974 to nearly $700 billion currently and its share of mutual fund industry assets has soared. Although a late entry into the money market business resulted in a plunge in its market share from 3.5% in 1974 to 1.7% in 1981, the rise since then has been unremitting, consistent, and powerful.
Figure 1040">
As 2004 begins, Vanguard’s share of industry assets stands at 9.2%—by far the largest market share increase achieved by any mutual fund firm.
The growth of MFS assets, too, has been awesome—from $3.3 billion in 1969, when it abandoned its original Alpha structure, to $78 billion currently. But its original 7.0% market share began to shrink within a few years after the change, falling to just 1.1% in 1982, where it remains today. To the extent that we can measure it, then, under the Omega strategy—which is of course the strategy that is pervasive in the industry—the MFS transition from its original roots has not only resulted in increased costs and reduced returns for its fund shareholders, but proved to be a losing strategy in the highly competitive mutual fund marketplace.
Nonetheless, the Omega strategy does have something very important going for it: it is immensely profitable for the funds’ managers. Immediately after its demutualization in 1969, MFS remained a private company, with its profits divided among its own executives and employees. But in 1981, in a curious twist, the firm sold itself to Sun Life [*PG411]of Canada (“Sun Life”), which remains its owner today.41 According to Sun Life’s financial statements, the pre-tax earnings of MFS during the five year period 1998–2002 totaled roughly $1,900,000,000 (Canadian), certainly a splendid return on their initial (but undisclosed) capital investment—a near $2 billion (Canadian) gold mine for the Sun Life shareholders.42
Both the Alpha fund model and the Omega fund model have been tested over almost the entire eighty-year history of the industry.43 The forty-five-year preeminence that MIT achieved from 1924 to 1969, to say nothing of the flourishing of Vanguard almost from the day it was created, hardly suggests major flaws in the Alpha model. Yet the economics of the business remain a major stumbling block to the creation of new Alpha organizations. If funds are run at cost, after all, there are no profits for the management company owners. It is hardly surprising, then, that Vanguard’s structure has yet to be copied, or even imitated.
It is a curious paradox that the transformation of MFS from the Alpha model to the Omega model was accomplished with apparent ease. Vanguard’s conversion from Omega to Alpha, however, was fraught not only with contention and debate, but with regulatory opposition. Whereas the internalization of the administration of the Wellington funds was straightforward, and even the internalization of the management of the index fund raised no regulatory eyebrows, the decision to internalize distribution was a bombshell. It was opposed by a Wellington Fund shareholder, who called for—and received—a formal SEC administrative hearing, which was said to be the longest hearing in the history of the Investment Company Act, lasting, if memory serves, something like ten full days in court, and a long period of examination by the regulators. Finally, in July 1978, after considering our application for the Vanguard funds to assume joint financial and administrative responsibility for the promotion and distribution of our [*PG412]shares, the administrative law judge who presided at the hearing made his decision: Rejection!44 We were back to square one.
At issue was a long history during which the SEC had successfully argued that funds could not spend their own assets on distribution.45 Shortly after we made the no-load decision in February 1977, we had asked for an exemption that would allow the funds to spend a limited amount (a maximum of 0.20% of net assets) on distribution. Although our argument in favor of this plan was somewhat technical, it came down to the fact that, while we would spend $1.3 million on distribution, we would simultaneously slash by $2.1 million the annual advisory fees paid to Wellington Management for that purpose: Assuming responsibility for distribution would result, not in a cost to the funds’ shareholders, but in a net savings of $800,000 per year.
Happily, the SEC had allowed us temporarily to pursue our distribution plan pending Commission and fund shareholder approval. So Vanguard had in fact been running the distribution system since 1977. Despite his rejection of our plan, the judge gave us the opportunity to amend it, and after making a few technical changes, we resubmitted it early in 1980. With this sword of Damocles suspended above us during this long period, we blithely pursued our distribution activities. The threatening sword was finally removed on February 25, 1981, when the Commission at last rendered its decision.46
The decision was a home run for Vanguard! Far better than any characterization I could use to describe the decision, the Commission’s words speak for themselves:
Applicants’ joint distribution arrangement is consistent with the provisions, policies and purposes of the Act. The proposed plan actually furthers the Act’s objectives by ensuring that the Funds’ directors, with more specific information at their disposal concerning the cost and performance of each service rendered to the Funds, are better able to evaluate the quality of those services. Moreover, applicants’ proposal will foster improved disclosure to shareholders, enabling them to make a more informed judgment as to the Funds’ operations. In addition, the plan clearly enhances the [*PG413]Funds’ independence, permitting them to change investment advisers more readily as conditions may dictate.
The proposed plan also benefits each fund within a reasonable range of fairness. Specifically, the plan promotes a healthy and viable mutual fund complex within which each fund can better prosper; enables the Funds to realize substantial savings from advisory fee reductions; promotes savings from economies of scale; and provides the Funds with direct and conflict-free control over distribution functions.
. . . .
Accordingly, we deem it appropriate to grant the application before us . . . .47
The decision was unanimous. We had at last formally completed our move from the original Omega model under which we had operated for nearly a half century, to a full-fledged Alpha mutual fund model. Our joy was profound and unrestrained, and our optimism about the future was boundless.
The Commission’s decision, in its own blunt words, was based on “[o]ne of the Act’s basic policies . . . that funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers, underwriters or others.”48 And that would also seem to be the most elementary principle of the common law as it relates to fiduciary duty and trusteeship.49 Yet it must have been obvious to the Commissioners that, although they had just approved our Alpha model, the entire rest of the industry was operating under an Omega model in which the advisers and underwriters—the funds’ management companies—were in the driver’s seat.
Fully fifteen years earlier, in fact, the SEC had vigorously recommended legislative changes designed to restore a better balance of interest between shareholders and managers. In Public Policy Implications of Investment Company Growth, a report to the House Committee on Interstate and Foreign Commerce dated December 2, 1966, the [*PG414]Commission pointedly noted that “internally managed companies, which employed their own advisory staffs, had significantly lower management costs than the externally managed funds, whose investment advisers were compensated by fees based, in most cases, on a fixed percentage of the fund’s net assets.”50
After considering the level of fund fees ($130 million a year seemed large in 1966, but by 2003 fees had soared to $32 billion); the far lower fee rates paid by pension plans and internally managed funds; the then-average 48%(!) pre-tax profit margin earned by publicly held management companies; and the effective control advisers held over their funds, as well as “[t]he absence of competitive pressures, the limitations of disclosure, the ineffectiveness of shareholder voting rights, and the obstacles to more effective action by the unaffiliated directors,”51 the SEC recommended the adoption of a “statutory standard of reasonableness.”52
The Commission described this standard as a “basic fiduciary standard [that] would make clear that those who derive benefits from their fiduciary relationships with investment companies cannot charge them more for services than if they were dealing with them on an arm’s-length basis.”53 The SEC described reasonableness as “a clearly expressed and readily enforceable standard that would measure the fairness of compensation paid by investment companies for services furnished by those who occupy a fiduciary relationship”54 to the mutual funds they manage:
[This standard] would not be measured merely by the cost of comparable services to individual investors or by the fees charged to other externally managed investment companies. . . . [but by the] costs of management services to internally managed investment companies and costs of investment management services provided to pension and profit-sharing plans and other large nonfund clients. . . . [and] their benefit to the investment company and its shareholders . . . . [including] sustained investment performance . . . . . . . .
[*PG415] The Commission is not prepared to recommend at this time the more drastic statutory requirement of compulsory internalization of the management function of all investment companies [and the performance of services at cost]. . . .
While internalization could produce significant savings in management costs for large investment companies . . . , for smaller ones it might be more costly. . . . [or] would be insufficient to provide an adequate full-time staff . . . . [and] might prove a deterrent to the promotion of new investment companies . . . .55
Accordingly, the Commission believed that, “an alternative to the more drastic solution of compulsory internalization . . . should be given a fair trial.”56 If the standard of reasonableness does not “resolve the problems that exist in the area of investment company management compensation. . . . then more sweeping steps might deserve to be considered.”57
Alas, the Commission’s “reasonableness” proposal was never put to the test. The industry fought hard, and lobbied Congress vigorously. Finally, five years later, in the Investment Company Amendments Act of 1970, the Commission had to settle for a weak provision in which the investment adviser was charged with “a fiduciary duty with respect to the receipt of compensation for services,”58 with damages limited to the actual compensation received, and with no definition of what might constitute reasonableness.59 And even thirty-three years later, “more sweeping steps” have yet to be considered.60
In its 1966 report, the SEC had also expressed concerns about the growing trend of sales of management companies to other firms at prices far above book value, transfers the Commission opined have “some elements of the sale of a fiduciary office [which is] strictly prohibited at common law.”61 It also expressed a concern about earlier “widespread ‘trafficking’ in advisory and underwriting contracts.”62 The Commission recommended that the sale of a management company could not take place if it came with “any express or implied understanding . . . likely to impose additional burdens on the investment [*PG416]company.”63 The implication that funds were already bearing heavy burdens would have been lost on few observers, and even the subsequent legislation diluted that protection.
Had the initial SEC recommendations prevailed, they may well have aborted the accelerating trend toward higher fund expense ratios that today seems endemic in the fund industry. The unweighted expense ratio of 0.87% for the average equity fund that concerned the Commission in 1965 has risen by 86%, to 1.62%.64
But we deceive ourselves when we look at fee rates instead of fee dollars. When applied to the burgeoning assets of equity funds ($26.3 billion in 1965 and $3.36 trillion in 2003), equity fund expenses have leaped from $134 million in 1965 to an estimated $31.9 billion in 2003.
Figure 1165">
[*PG417]Fund expenses have risen 238 fold(!) since 1965, nearly double the 128-fold increase in equity fund assets. In a field in which, as today’s lone Alpha fund complex demonstrates, the economies of scale in fund operations are truly staggering, it is a truly astonishing anomaly.
Further, the SEC’s 1966 concern about trafficking in advisory contracts could hardly have been more prescient. Although a number of fund management firms had gone public with IPOs by then, the large majority remained privately held. Today, only six(!) privately held firms remain (seven if we include Vanguard) among the largest fifty fund managers. Another seven are publicly held, and fully thirty-six are owned by giant financial conglomerates, from Sun Life and Marsh and McLennan, to Deutsche Bank and AXA, to Citigroup and J.P. Morgan. With these consummate business firms in control, it is small wonder that the idea of fund management as a profession is gradually receding. Using the words I used in my 1971 speech, these firms are “the financial heirs of the [original mutual fund] entrepreneurs . . . if it is a burden to [fund shareholders] to be served by a public enterprise, should this burden exist in perpetuity?”66
Apparently, the burden should. For such trafficking takes place with the tacit consent of fund directors, who seem all too willing to ignore the burdens imposed on funds that are part of giant conglomerates—firms whose overriding goal is a return on their capital, even at the expense of the returns on the fund shareholders’ capital. When such transfers are proposed, fund directors could easily insist on fee reductions—or even mutualization—but they apparently have never done so. In a recent sale (for $3.1 billion!) of a large fund manager to Lehman Brothers, the earlier fee structure remained intact.67 So far, at least, the directors seem disinclined to act even when a scandal-ridden firm is on the auction block (Strong Management) or is already part of a conglomerate (Putnam, which has delivered nearly $4 billion of pre-tax profits to Marsh and McLennan over the past five years.) The idea that “the burdens of public ownership should exist in perpetuity” has yet to be challenged.
It is time for change in the mutual fund industry. We need to rebalance the scale on which the respective interests of fund managers and fund shareholders are weighed. Despite the express language of the 1940 Act that arguably calls for all of the weight to be on the side of fund shareholders,68 it is the managers’ side of the scale that is virtually touching the ground. Even to get a preponderance of the weight on the shareholders’ side, we need Congress to mandate: (1) an independent fund board chairman; (2) no more than a single management company director; (3) a fund staff or independent consultant that provides objective information to the board; and (4) a federal standard that, using the 1940 Act’s present formulation, provides that directors have a fiduciary duty to assure that “[funds] are organized, operated, [and] managed . . . in the interest of [their] securities holders” rather than in the interests of their “advisers [and] distributors.”69
As I wrote five years ago, changes such as these would at long last allow independent directors to:
become ferocious advocates for the rights and interests of the mutual fund shareholders they represent. . . . [T]hey would negotiate aggressively with the mutual fund adviser . . . . They would demand performance-related fees that enrich managers only as fund investors are themselves enriched . . . . They would challenge the use of 12b-1 distribution fees. . . . [A]nd would no longer rubber-stamp gimmick funds that have been cooked up by marketing executives . . . . [They] would become the fiduciaries they are supposed to be under the law . . . .70
Alternatively, and perhaps even more desirably, I argued, the industry may require
[a] radical restructuring [which] would be the mutualization of at least part of the American mutual fund industry. Funds—or at least large fund families—would run themselves. . . . [A]nd the huge profits now earned by external [*PG419]managers would be diverted to the shareholders. They wouldn’t waste money on costly marketing campaigns designed to bring in new investors at the expense of existing investors. With lower costs, they would produce higher returns and/or assume lower risks. . . .
. . . .
[But] [r]egardless of the exact structure, mutual or conventional, an arrangement in which fund shareholders and their directors are in working control of a fund . . . will lead to . . . . [an] industry [that] will enhance economic value for fund shareholders.71
And it is in that direction that this industry must at last move.
During its forty-five years of existence, the Alpha operating model instituted by MIT eighty years ago worked well for its shareholders.72 Similarly, during Vanguard’s soon-to-be thirty years of existence, our Alpha model has resulted in amazingly low costs for shareholders, and generally superior returns compared to peer funds, to say nothing of a spectacular (and unmatched) record of asset growth and enhanced market share.73 As an illustration of a demonstrably winning strategy for fund shareholders, our Alpha model has met the test of time.
Of course, we have enjoyed an advantage some of our rivals have described as “unfair.” Because the fund shareholders own Vanguard—lock, stock, and barrel—none of their investment returns have had to be diverted to the owners of a management company—private, public, or financial conglomerate, whatever the case may be. Put another way, our structure has been an essential element in the returns that our shareholders have enjoyed. That shouldn’t surprise anyone, for as the economist Peter Bernstein has observed, “what happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets.”74
With MIT long since having abandoned the Alpha model, Vanguard alone has remained to test it. With this single exception, it is the Omega model that prevails. But I simply cannot accept that today’s [*PG420]model can be, as the word “Omega” suggests, the final stage of the mutual fund industry’s development. That this model has ill-served fund investors could hardly be more obvious. This industry’s present high level of operating and transaction costs have led—as they must—to a lag in the returns of the average equity fund of some three percentage points per year behind the stock market itself over the past two decades, with similar cost-related lags for the industry’s bond funds and money market funds. And our focus on asset-gathering and marketing has helped to create an even larger lag for the average equity fund shareholder—at least another six or eight percentage points behind the returns of the stock market itself, there for the taking.
I have no illusions that a return of the industry to its original Alpha model will be easy—not in the face of the powerful forces that are entrenched in this industry and whose economic interests are at stake. But I believe that this is the direction in which shareholders, competition, regulation, and legislation will move. Although we won’t get all the way to that goal in my lifetime, and maybe not even in the lifetimes of most readers of this Essay, I’m certain that investors will not ignore their own economic interests forever.
However, if Congress acts to impose on fund directors the responsibilities that so many of us believe they have always held but rarely exercised, I see no reason that full mutualization should be mandated by law. On the one hand, as long as advisory firms are owned by managers who act responsibly and put the interests of their fund shareholders first, and who make manifest their dedication to that proposition in their actions—self-imposed limits on fees and on marketing activities, focus on long-term investment strategies, and superior service to their shareholders—mutualization hardly need be required. On the other hand, when a fund complex reaches a certain size or age—when it has become more business than profession—it is high time to demand that mutualization—the Alpha model—be placed on the board agenda, and be honestly and objectively considered. It won’t be done easily, of course, and literally no one in this industry knows as well as I do the obstacles that may be faced in reaching that goal. But if there is a will, there will be a way.
Yet please understand me: although the Omega structure has caused many of the mutual fund industry’s serious shortcomings in serving our shareholders, the Alpha structure is hardly a panacea that will cure them. For a mutualization structure in which the interests of [*PG421]fund shareholders are placed front and center is, in and of itself, not enough. Without the proper strategy, such a structure will lead nowhere. In the ideal, the strategy of mutualization would emphasize low operating costs and more, well, Spartan operations, a minimization of the dead weight of marketing costs, and investment policies for stock, bond, and money market funds alike that focus on the wisdom of long-term investing rather than on the folly of short-term speculation.
Strategy, alas, does not necessarily follow structure. One need only look at the life insurance field to see how its sensible mutual structure, finally, came to fail. With their heavy emphasis on sales and their apparent lack of concern about costs, nearly all of the giant mutual life insurance companies relinquished the strategy of service to policyholders long before they abandoned their original Alpha structure. Partly as a result, this dominant industry of a half century ago has lost much of its earlier appeal to American families.
But even more than structure and strategy to get today’s Omega mutual fund industry back to its Alpha origins, we need the spirit of mutuality—a spirit of trusteeship, a spirit of fiduciary duty, an all-encompassing spirit of stewardship—a spirit of service to the ninety million shareholders who have entrusted the mutual fund industry with their hard-earned dollars. As the recent scandals show, we need regulation to curb our avarice. As our record since the publication of the SEC’s 1966 report has made clear, we need legislation to improve our governance structure, a major step towards the ideal Alpha structure whose development I have described in this Essay. But no regulation, no legislation, can mandate a spirit of trusting and being trusted. Trust must come from within the character of the organization—whether Omega or Alpha—and those firms that evince the spirit of trust will ultimately dominate the mutual fund field. Our industry’s future depends on the simple recognition that the management of other people’s money is a loyal duty and a solemn trust.