We Were Wrong (About the Supreme Court)

By James Kwak

Last November, we criticized a decision by the Court of Appeals for the Seventh Circuit in Jones v. Harris Associates in which Judge Frank Easterbrook wrote that mutual fund companies can charge their mutual funds whatever they can get away with (assuming disclosure and absent fraud), because prices are set by The Market. The case was remarkable because of a dissent by Judge Richard Posner, part of his recent (partial) disavowal of his earlier free market views, arguing that markets could not be trusted to set mutual fund fees. However, we predicted that the Supreme Court would pass up the opportunity to strike a blow on behalf of mutual fund investors and against excessive mutual fund fees:

“It can take the easy way out and resolve the case on the sole question of what ‘fiduciary duty’ means. Or it could limit itself to deciding what standard should be used in reviewing mutual fund fees and then tell the 7th Circuit to hear the case again. Most likely it will either sign off on the efficient-markets myth or dodge the question in one of these ways.”

We were partially right; technically speaking, the Court (opinion here) simply clarified the standard to be used when assessing mutual fund fees. Substantively speaking, however, it went a bit further. As Jennifer Taub explains, not only did it strike down Easterbrook’s bit of outdated free market theory, it also held that courts should compare the fees that a mutual fund company charges its captive mutual funds and those it charges institutional clients who can negotiate fees directly. In Jones v. Harris Associates, Harris Associates was charging its captive mutual funds fees that were more than double those it charged institutional asset management clients.

It still doesn’t look that great for the plaintiffs–mutual fund investors who claim they were charged excessive fees. The district court that first heard the case found that, under the existing Gartenberg standard, the plaintiffs had no case. The Supreme Court in its opinion said that it was reaffirming Gartenberg, but as Taub and William Birdthistle have pointed out, it really was modifying Gartenberg slightly in a pro-plaintiff way. So what happens now is that the case goes back to the Seventh Circuit to deal with the case in a manner consistent with the Supreme Court ruling (and I think the Seventh Circuit could hand it back to the district court). But it’s still a small step.

17 responses to “We Were Wrong (About the Supreme Court)

  1. Well James, you take what you can get eh???

    I could ramble on about how if these judges didn’t have government retirement they’d take a different attitude on these things. I could ramble on how AFTER 15–20 years when it becomes obvious that everyone has been F__KED over by exorbitant mutual fund fees, F__KED over by low yielding, crappy asset allocation Target-date ETFs, and F__KED over by limited choice, low yield, high management fee 401Ks——THEN FINALLY thick-headed judges like Posner might get a effing clue…. But it’s just makes me tired.

  2. Does Taub have her own blog James??? Enquiring minds want to know. Taub sounds like a nice Ashkenazic name, so she must be sharp.

  3. The opinion is slightly refreshing but far from satisfying. By my reading, the 7th Circuit can come to the same result with different wording. Hardly a major advance for investors. However, if the Court is sending right wing code for “back off before we p— them all off over something that is not central to our system of dominance” a.k.a. “pigs get fat and hogs get slaughtered”, we should not take any comfort. To suggest that fund boards are independent, and thus capable of objectively reviewing fees paid to advisors, indicates how off the grid the Supremes, and the SEC, really are. We cannot survive on a diet of this kind of reasoning. While it may not be a win for advisors, it’s hardly a major advance for investors. “All the circumstances…”, give us a break.

  4. Perhaps someone can explain who these mutual fund investors haven’t voted with their feet?

    The MF industry is the one financial sector in which we do have competition. Why anyone pays more than half of one percent is simply a triumph of advertising. Most investors will fare better dollar averaging in index funds or throwing darts at the financial pages, and the literature proving it has been around for thirty years.

  5. who should obviously be WHY in the above comment. Sorry.

  6. It looks like the SCOTUS ruling is likely to cause the 7th Circuit to vacate the District Court’s Motion for Summary Judgment and remand to the District Court, where it is likely that the case will go to trial, since the scope of the facts that are relevant to the case have been widened sufficiently to make a motion for summary judgment very hard for a court to grant. The 7th Circuit in its appeal was charged with determining if there was a disputed issue of material fact present or not, under the correct legal standard, rather than with resolving the case on the merits.

    Faced with the prospect of a trial on the merits and a standard that sounds tough but is fuzzy, the mutual fund may be strongly inclined to settle and other mutual funds may look much more carefully at how they set their own fees.

  7. Perhaps mutual fund investors should consider what they are investing in and whether it is worth 1/2 percentage, 1 percentage or 2 percentage points. But that might lead to seeing through the whole mutual fund scam…….
    Personally, I bet it wouldn’t matter what mutual fund companies charged to the vast majority of the public, they would still buy into the propaganda about investing in mutual funds leading to a good retirement income!

  8. Simon Johnson isn’t it about time for a mea culpa? As a member of the IMF haven’t you helped destroy countries long before the crisis reached the 1st world. You, sir, are an intelecually deficient, dishonest well fed, MIT inbred.

    How many countries have gone bankrupt during your tennure at the IMF?

    Pleae elaborate on your wonderful time at the IMF.

    That would be a great book, wouldn’t it?

  9. Mutual fund scam? Really? Most people know nothing about saving for retirement and depend on professional management. If people don’t want to pay a certain management fee, they’re welcome to buy from any other company’s mutual funds, in an investment discipline that’s cheap to manage, like US large cap value. Management fees pay for shareholder services, sales operations, risk management/compliance, custody and settlements, performance measurement, trading, portfolio management and a host of IT and software needs.

    I realize everyone on the planet wants everything for free, but there is a veritable army of people who work to grow investors’ assets at mutual fund companies, and they generally aren’t interested in donating their labor five days a week to do so.

    Really, if you’re THAT lazy you can’t shop around for an acceptable management fee, manage your own damn portfolio.

  10. Here is a perfect example of the problem. You act as if people can just shop around and choose their mutual fund company, but you know that most people buy MFs in their companies 401ks, which rarely gives them a wide array of choice. You fail to mention the sales propaganda that regularly claims investors will get 8-10-even 12% returns, yet the data indicates actual investors get less than 4% returns [Dalbar studies, etc.]. You do not mention the fees that one can only find if they know where to look in the prospectus where they are buried.
    You do not mention the army of sales people hired that have no finance background and only tell their clients what the companies have cleverly decided to tell them. Do you really think all these people would buy MFs if you told them their portfolio would regularly lose 25% or more in a year????

    I sold all my mutual funds years ago and do manage my money [actually let Warren Buffett manage most of it]. And I wouldn’t expect anyone to work for free [that is a red herring if I have ever seen one].

    Let’s be clear, since the movement to 401ks from defined benefit pensions, we are seeing the failure of the populace to create sustainable retirement income. This is as much on the shoulders of MF companies as anyone else [although the government has their share of blame]. That is why I called it a scam. In any other industry, if the majority of your customers failed to achieve the stated goals with you products you would change the product or fail.

  11. Please. 401K benefits are part of the perks of a job. If you don’t like the funds available in the platform your company is providing, like with all things, either start an IRA or find another job — or just don’t roll over funds from a previous employer’s plan. Or the employee could actually go to the HR department and ask about adding more companies’ funds to the available platform. There ARE options here.

    Sales personnel have to be licensed, and investors need to be informed about the products they buy. It’s a two-way street here. If people don’t know how to read a prospectus, they can *call* their benefits provider and ask what the management fee is. They can even break out a calculator and do some multiplication. Or they could actually read the sales literature and look for it there.

    The problem is twofold: Increasingly, people have an insufficient level of financial education, despite choosing to enter into sophisticated retirement planning — and they’re not doing anything about that; and secondly, the lack of government regulation to create a universal standard investor information form that people can be taught to read and understand. Just like going to a funeral home, when they have to provide you an itemized list of associated costs, mutual fund companies should have to do the same thing, but with examples of a typical subscription amount for a 401K investor.

    Where are you getting this 25%/yr loss statistic? I’ve never heard of it. And I imagine if you said to people instead — especially those people who know jack sh!t about investing — that they should abandon mutual funds and try to manage their money on their own, they’d lose a lot more than that.

  12. “The problem is twofold: Increasingly, people have an insufficient level of financial education, despite choosing to enter into sophisticated retirement planning — and they’re not doing anything about that”

    Agreed

    “and secondly, the lack of government regulation to create a universal standard investor information form that people can be taught to read and understand.”

    Note the amount of disclosures and simplification for mortgage originations did not stop people from entering into predatory lending arrangements! So this is not going to work because of your first argument.

    You deny that on average every 7-10 years the market drops 25% or more? Or do you deny that most mutual funds, because of their size and their competitive needs mimic the market?

    “especially those people who know jack sh!t about investing — that they should abandon mutual funds and try to manage their money on their own, they’d lose a lot more than that.”

    No, I argue that they should not be investing in equity markets they don’t understand nor can handle the risk. There are many products that work better.

    I have sat through enough sales presentations by licensed individuals to understand the pitch. Seen the charts….just know they do not represent any reality seen in the financial markets. I also see the data on how much wealth people have in mutual funds. By any accounts mutual funds are not working to create sustainable retirement income for the masses. And that is a real problem for our country. You can “caveat emptor” all you want, but if your product is failing to do the thing it was designed to do, then you need to make changes or you should be relegated to the trash bin!
    No

  13. I still have no idea what this 25% statistic is that you keep quoting. Post a link to it so I know what index or group of indexes you’re referring to.

    “No, I argue that they should not be investing in equity markets they don’t understand nor can handle the risk. There are many products that work better.”

    No one should invest in an unsuitable product. As to which products work better, you can’t generalize about that, because every investor’s needs and portfolio is different.

    None of this is evidence that mutual funds are a scam. Mortgage loan documentation can actually be quite difficult to read. The kind of universal form I’m thinking of would be simpler.

  14. Here is a visual chart that should be easy to understand:

    http://www.ritholtz.com/blog/2009/02/bear-market-comparisons-1929-2009/

    It seems that you have had a strong reaction to my use of the word “scam.” That is my fault for using it, knowing it would create an emotional reaction that would make it impossible to move forward the conversation.

    “No one should invest in an unsuitable product. As to which products work better, you can’t generalize about that, because every investor’s needs and portfolio is different.”

    That is industry speak and means little. You admit that most people aren’t educated enough to enter into sophisticated retirement planning, yet you seem to be saying that the mutual fund industry is capable of making that decision for people. It isn’t and the proof is in how their customers react to bear markets.

    Once again, if the majority of folks fail to accumulate enough retirement funds to have a sufficient income in retirement, that speaks to the failure of the product and it’s sales people [financial planners] since a majority of people are using mutual funds for retirement planning.

  15. 1) That graph is from early 2009, before the Dow started to recover.
    2) It charts only years of bear markets. To properly know the return, you need data for every year.
    3) That’s just the Dow. There are a whole lot more domestic and international options for mutual fund investors than 35 stocks.

    I wouldn’t quote that 25% figure to people. It’s very misleading.

    Suitability means quite a lot, considering you can be fined or lose your licenses for knowingly, repeatedly selling inappropriate products to investors.

    I’m saying most people aren’t educated enough to invest in sophisticated products, but if they choose to, there is a wealth of information available to them on how to do so: google, library, magazines, non-profit investor education groups, family members, financial advisors, RIAs, etc.

    If a majority of people fail to accumulate enough retirement income to survive on, that could speak to the failure of a number of things, such as insufficient contributions, the rising cost of living and medical care respective to average savings/investment, poor investment choices, the dependence of people on home sale profit for retirement income. . . . It’s not a failure of the idea of a pooled investment vehicle.

  16. 30 stocks

  17. Ahh, I see how you play!
    There was no mention of overall return. You wanted to know about the 25% drops. I gave you a chart for that. You can easily find a listings of returns for other indexes, but I bet they would match in intensity and quantity.

    I totally disagree with you on your last statement. When you have been selling moderate monthly inputs that would turn into comfortable retirement income, and it fails, then you need to look into why. Telling people that they just made poor choices is at best disingenuous, at worst a “scam” [there’s that word again].