If I could assign every politician running for office this year one book to read, it would be Professor William Birdthistle’s Empire of the Funds, the story the avalanche of money poured into mutual funds and the staggering inadequacy of the results as the baby boomers approach retirement. He calls it “the richest and riskiest experiment in our financial history.”
The consequences of this failed experiment affect every aspect of the US economy, as investor funds are diverted to pay costly hidden fees, capital is inefficiently allocated, and critical elements of accountability between the investor and the money manager and the money manager and the companies in the investment portfolio have all but disappeared.
The book is witty and accessible, citing sources from Jane Austen to Angry Birds and Ronco infomercials. But it is a comprehensive and powerful indictment of a system that has been distorted to look like pure capitalism when it is really subsidizing an increasingly ineffective financial services industry.
In an interview, Professor Birdthistle discussed some of his findings and conclusions.
At the end of the last session in Congress, the Democrats’ sit-in over gun control legislation was interrupted by a proposal to reduce the effect of the fiduciary standard for money managers. Why is that important? What is the difference between a fiduciary standard and a suitability standard?
The proposal on the fiduciary standard is one of the most important legislative efforts on personal finance in decades. The rule it would overturn may appear to be just a minor legal change to how financial advice can be given, but the definition of fiduciary is more dramatic than it appears — and the tumult around the rule is a vivid illustration of how challenging our new system of saving is for ordinary investors.
Under the new rule, all those who offer retirement financial advice will be deemed “fiduciaries” and must act in the best interests of their clients. A large group of financial professionals have been fiduciaries for years and long abided by the fiduciary standard; the new rule would broaden that obligation to groups, like brokers, that have given retirement advice for years without falling under the old definition of fiduciaries. Brokers traditionally gave their advice subject instead to a suitability standard, which required only that they had a reasonable belief that an investment was “suitable” for a client.
The difference between those standards may not be obvious, but here is the key: fiduciaries cannot offer conflicted advice, non-fiduciaries can. So brokers and other non-fiduciaries could recommend a mutual fund with higher fees than equivalent investments, for instance, because the fund gave it money for doing so. In less polite company, we’d call those arrangements kick-backs, but the suitability standard did not prohibit them, and many financial professionals regularly pocketed such payments. A White House study calculated the economic cost of conflicted advice to investors at $17 billion each year.
So the real curiosity about the new fiduciary rule is not why are we imposing this rule now, but why have we allowed conflicted advice for so long and why does the new rule apply only to retirement investing and not all investing? The answer to the first question is that the financial firms that pay and receive those sweeteners have fought vigorously to oppose the rule — they still are, at midnight on the floor of the House and in lawsuits all across the nation. And, let’s give them some credit: it takes an impressive amount of cheek to declare that a rule putting the best interests of investors over side-payments to investment firms is bad for American investors.
The answer to the second question is that these new rules come from the Department of Labor, which oversees ERISA and retirement rules. The SEC, which would have jurisdiction to impose a much broader fiduciary standard, has failed to pass a fiduciary rule so far.
How has the switch from defined benefit pension plans (with the employer making investment decisions and guaranteeing a particular level of retirement benefits) to defined contribution plans (with individuals making investment decisions and receiving whatever results, gain or loss) impacted investors? Is it fair to expect individuals with busy lives and no expertise to be responsible for making investment decisions and how can we make it easier for them to be more effective investors?
The bigger picture of the fiduciary fight is what it tells us about the way we save now. Over the past few decades, we have launched massive financial experiment: millions of Americans have lost pensions and received defined contribution plans like 401(k)s and 403(b)s, whether they like it or not. The hypothesis is that millions of investing amateurs with jobs, families, but little training can successfully manage their life savings for decades in a system dominated by investment firms, like those that so vigorously oppose the fiduciary rule.
But the evidence so far says we’re not doing well with this project: one-third of all Americans have zero savings for retirement, and even those on the cusp of retirement have nest eggs that will provide an average of just about $7000 a year.
So we’ve seen this massive cultural shift in just a single generation with almost no corresponding change in the way we train people to manage their own life savings or provide them with a structure that encourages their success. Attempts to ease enrollment in 401(k)s plans, to lower fees in those plans, and to stamp out conflicts of interest routinely become pitched battles with years of legislative and judicial conflict.
To assume we’re all going to thrive in this brave new world of financial autonomy is willfully obtuse — or financially cynical. Humans are pretty good at learning how to do things with practice, but as Richard Thaler notes, “barring reincarnation,” we only get one chance to succeed at saving for our future.
I think we need to embrace as many complementary ways to improve this process as possible. So, yes, we definitely need more auto-enrollment and auto-escalation, so that people begin this project as early as possible. But we also need to copy the lessons of America’s most successful companies, such as Wal-Mart and Amazon, by harnessing the bargaining power of millions of individual investors to enjoy economies of scale. If we invested as a massive group, such as through the Thrift Savings Plan, then we could demand the quality of the best investment firms, working for the lowest possible fees, and delivering the most scrupulous performance.
How can investors find the hidden fees in their mutual fund investments?
The problem with finding fees in a mutual fund investment is that there are so many of them. The obvious fees — such as those for management, distribution, 12b-1 plans, administration, and so on — are set forth in the fee and expense tables of fund prospectuses. With a little Googling, those tables are relatively easy to find. But they’re not very easy to read.
First, the disclosure for many funds is often consolidated into a single prospectus, which means an investor will have to know the specific name and share class of their investment in order to find and interpret the correct table. In my book, I include a single prospectus that covers 17 different funds with at least 4 different share classes each. Second, the tables are less easy to read than one might think — they can include waivers that may apply for unknown periods. The presence of several footnotes on those charts is a pretty good clue that they’re not simple.
The less obvious fees — such as those for the fund portfolio’s brokerage commissions, for soft dollar arrangements, and other arcane operations — can be buried in Statements of Additional Information, which are impenetrably thick documents often found only online. And there’s no easy trick to figure those out.
How should fund managers who overcharge their customers or give preferential treatment to insiders be punished? How often does that happen?
I would like to see the SEC bring just one or two high-profile enforcement action against the funds with the most outlandish fees. By now, almost everyone has heard how critically important fees are on mutual fund investing, but the SEC has only ever brought one or two such cases in its history, and almost nobody has heard anything about them.
The regulation governing mutual funds — the Investment Company Act of 1940 — gives both the SEC and private plaintiffs a cause of action against fund advisers that charge compensation inconsistent with their fiduciary duty. Private plaintiffs regularly bring and settle such cases, but they do so against the wrong defendants: large funds with deep pockets but relatively reasonable fees. Law firms don’t want to bring cases that won’t pay their bills.
What we need is a public-spirited plaintiff willing to bring principled cases without regard for their profitability — we have one: the SEC. The SEC should bring a case against a fund charging the most indefensible fees, even if just a small fund, to police the outer bounds of mutual fund fees.
Will the new IEX exchange limit the front-running abuses giving special treatment and higher returns to some investors over others that you describe in your book?
Yes, the IEX looks like a promising trading venue for mutual funds and their trillions of dollars of our savings. Just like we, as individuals, need to harness our bargaining power to demand better investments, mutual funds need to wield their own clout, in a market haunted by hedge funds and high-frequency traders, to improve their own investing. And, of course, if funds can avoid losing value by being front-run in the market, they should be able to pass those savings down to their shareholders: us.
What special advantages are given to hedge funds and how can investors take advantage of them?
As private funds largely exempt from the Investment Company Act, hedge funds are able to invest in far more risky securities and derivatives, with far less diversification than mutual funds, all while using far greater leverage. That volatile mix may sound appealing to those of us confined to steerage in mutual funds but we might be reassured by a few points: first, hedge funds generally have done very poorly in recent years and rarely ever beat the market over long-term horizons, though they always charge much higher fees; second, mutual funds may be comparative jalopies, but they are meant to be so — they are intended to protect valuable family assets and to convey us safely along our investment journey. So rather than attempting to emulate hedge funds or to reach for outsized returns (which may not exist even in hedge funds), long-term investors should focus on getting the best mutual fund performance through low-cost index funds. The larger project for lawmakers, of course, is to protect ordinary mutual fund investors from any systemic risk generated by hedge funds — or investment banks or insurance companies or other financial institutions — that act irresponsibly in the capital markets we all share.
Why don’t fund managers represent their investors’ interests in voting proxies on issues like excessive CEO pay or conflicted boards of directors?
I don’t know. I’d really like to hear a good answer to that question from the head of a mutual fund investment adviser. With the trillions of dollars they control, mutual funds certainly have the market clout to impact matters up for a vote at major American corporations. One answer might be that they simply don’t want to expend the resources to track the voting issues at so many different companies, though of course they could (and some already do) hire advisers to digest that information for them. Another might be that they provide — or want to provide — 401(k) services to those companies and therefore don’t want to antagonize the executives who decide whether to retain them. A third is that they might think their fund shareholders hold views that are too heterogeneous to represent fairly with active votes. Of course, each of these positions is empirically testable, so fund managers should be willing to defend their behavior and to support it with evidence. Investors might then have more information and could make a more meaningful choice about where to put their money.
Does it benefit investors to keep index fund fees low by permitting the lending of the securities? What about lending them over the record date so that the borrower can vote shares for stock it does not plan to keep?
An index fund certainly could benefit its investors by lending securities. Like any other loans, loans of securities generate revenue — and if that revenue were directed into the fund, then it would clearly benefit the shareholders in that fund financially by keeping the fees low. I’m not certain about what the industry practice is, but my sense is that lending securities is widespread, though I’ve seen instances in which the fund managers have not given those proceeds to the fund. And it seems unfair to use investors’ assets to generate profits not shared with those investors — even if the manager discloses that fact deep in the bowels of a musty disclosure document that nobody receives or reads.
Are you advocating a pension equivalent of the “public option” many people want for healthcare?
I’m advocating opening the Thrift Savings Plan to all Americans, so that everyone — even the self-employed, the unemployed, and those employed at small businesses — can benefit from an excellent plan with a concise menu of prudent funds managed by a sophisticated adviser, BlackRock, at astonishingly low fees (less than 3 basis points or 0.03%).
Now, depending on who we’d like to please or offend, we can describe that proposal as either (a) a “public option” that makes a great government plan available more broadly or (b) a way to make individual investing more successful using bargaining power, economies of scale, and other tools of capitalism. Obviously, (a) might appeal more to the stereotypical Democrat, but candidate Clinton focuses on expanding Social Security; and (b) might appeal to the stereotypical Republican (Marco Rubio did once endorse the idea), but I’m not sure what candidate Trump’s retirement policy is. Perhaps we can take some comfort, in this bizarre presidential campaign, from an idea that might offend both sides.