Quote of the Day: Agency Problem in the Mutual Fund Industry

From Investment guru David F. Swensen of Yale University

The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors…

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.

Read the rest here

This has been a dynamic which I have repeatedly been talking about, see here and here

I agree with Mr. Swensen that EDUCATION has to be in the forefront in the campaign to protect investors against such conflict of interests

But I strongly disagree with the suggestion that the SEC has to play a greater role in regulation and enforcement.

One of the reasons why investors have become vulnerable has been due to the complacency derived from the expectations that the nanny state will do the appropriate due diligence and provide protection in behalf of the investors.

Such smugness reduces individual responsibilities and increases the risk taking appetite. Yet for all the regulations and bureaucracy added over the years, why has Bernard Madoff been able to pull one off over Wall Street and the SEC?

Romanticizing the role of arbitrary regulations and bureaucrats won’t help.

Two, unquestionably putting clients ahead is an ideal goal. But this is more an abstraction in terms of implementation. The ultimate question is always how? The devil is always on the details. Has more regulations led to greater market efficiency or vice versa?

Or to be specific in terms of the industry's literature how should these be designed, should they encourage short term trades or long term investments? How does the regulators determine which is which?

Three, it would be wishful thinking to believe that regulators know better than the participants with regards to the latter’s interest. Yet giving too much power to regulators would translate to even market distortions, more conflict of interests, corruption, regulatory arbitrages and benefiting some sectors at the expense of the rest. For example, the shadow banking industry, which has played a crucial role in the 2008 crash, has been a collective byproduct of myriad regulatory arbitrages.

Lastly, since regulators are people too, conflict of interest with the regulated is also likely to occur. This means that the risk of the agency problem dynamic will not vanish but take shape in a different form; the difference is that conflict of interest will shift from the marketplace to the political realm. This is known as regulatory capture.