The Mutual Fund Board: A Failed Experiment in Regulatory Outsourcing

Mutual fund boards are a curious institution. Mandated by the Investment Company Act of 1940, they are tasked as “watchdog” supervisors of the management firms that organize, administer and market mutual funds. The fund board and its “independent” directors approve fund transactions with the management firm and ensure compliance with the 1940 Act and implementing SEC rules. Fund directors thus function as outsourced regulators, with their selection and compensation in the hands of the management firm they supervise. This essay argues that the outsourcing to mutual fund boards of key regulatory functions—principally the review and approval of management contracts—has not lived up to the hopes of the 1940 Act. Fund boards have been weak and even feckless protectors of fund investors, their deficiencies exacerbated as mutual funds have grown into the leading investment vehicle for private retirement savings in the United States. Gauged by the important metric of management fees—whose negotiation is delegated to fund boards—the experiment in regulatory outsourcing has failed As the mutual fund industry has grown in size and scope, the fund board has shown itself to be mostly ineffective in negotiating on behalf of fund investors to realize the value from improved information technologies and growing economies of scale. Study after study finds fund expense ratios growing over a period when fund assets have exploded. Just as significant as their poor performance in negotiating lower management fees, fund boards have also failed in their supervision of fund design and marketing. Fund boards, charged with the approval of fund mergers and dissolutions, have acquiesced in the strategy of many fund groups of creating a stable of “above average” funds by merging losers into winners. Fund groups then heavily market the resulting winners (also an activity subject to board supervision) by appealing to the “past is prologue” mentality of many fund investors. Fund boards have failed to respond to the “cognitive biases” of fund investors, a problem aggravated by the shift of