by Chidem Kurdas
David Swensen, the chief investment officer of Yale University’s endowment, rightly criticizes the behavior of mutual fund companies. Then he wrongly attributes the problems to regulators’ hands-off approach and argues for additional regulation. In fact the companies’ behavior reflects comprehensive rules dating to the Franklin Roosevelt administration. Mutual funds, among the most regulated of financial services, would not be what they are without the regulatory system that spawned them. It is notable that no matter how much regulation exists, someone will want more.
To improve investment options for most Americans, the rules need to be changed and simplified to allow flexibility, not made even more cumbersome.
This would be consistent with the “Yale model” of investment pioneered by Mr. Swensen and adopted by other endowments. His approach is to invest in a wide variety of markets and strategies, from natural resources to private equity and hedge funds. The latter are not meant for middle-class investors, who typically depend on mutual funds and exchange-traded funds.
But there is one way to bring retail investments closer to the Yale model—-by reducing regulation, not by adding to it, in particular regarding fees. Mutual funds are paid a management fee assessed as a percentage of capital. By contrast hedge funds, often described as lightly regulated in comparison to the heavy-duty regulation of their mass-market cousins, charge a performance fee from profits. Certain successful hedge funds charge only a performance fee, no management fee—that is, they get paid only if they make money.
Regulation prevents mutual funds from taking performance fees. The result is that their focus is on getting more capital so as to increase their management fee revenue. As Mr. Swensen writes in the NYT: “In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets— and invest poorly.” So why not give them an incentive to invest better by allowing them to be paid from profits? The Securities and Exchange Commission could permit a group of actively managed mutual funds to charge a performance fee instead of a management fee.
A manager who relies on performance fee revenue has to, well, perform in order to stay in business. Hedge funds do go out of business, whereas mutual funds that made large losses have survived on client assets. Only managers confident that their strategy has a good chance of showing a profit will agree to performance fee compensation.
Of course, anyone can be sideswiped by markets. Even Mr. Swensen—-in the 2008 crisis Yale and similar endowment portfolios did not do well because investments that were supposed to be diversified fell into lockstep. He has argued that the diversified approach shows its benefits in the long run. Individual investors, too, are generally better off investing long-term. And they’d have a better chance of diversifying if mutual fund rules allowed greater diversity.
The additional rules Mr. Swensen prescribes won’t do this. To encourage investors to pick low-cost index funds instead of high-cost, actively managed funds, he suggests that the SEC require every actively managed mutual fund offering to be accompanied by an index fund alternative, with a comparison of the two options.
The problem is that investors generally don’t read fund offering documents. Prepared according to SEC rules, fund documents are so tedious that almost nobody reads them except lawyers, who parse them word by word when there is litigation. Mr. Swensen wants investors to educate themselves, but laudable as that wish is, people are unlikely to devote more time to this purpose. Some have an interest in the topic; most don’t.
The SEC now allows summaries or short versions of fund descriptions that investors might actually read. As a mutual fund client, I’d like to see a crisp one-pager for a fund that charges fees if it makes money.