Understanding the ownership structure of a garden-variety mutual fund can give anyone a headache.
We start by recognizing that there are two distinct entities that make up a mutual fund complex. First, there is the mutual fund itself, with a board of directors, that is responsible for holding our money. This board represents our interests as investors.
Second, there is a management company that is not a mutual fund but that does all the work required of the fund, such as administration, record keeping, sales and -- most importantly for us as investors -- stock picking. Whenever we are considering a mutual fund investment, the "public face" of the fund is not the fund itself but the management company.
The board of directors of the mutual fund represents us investors. In theory, it has the power to change management companies at any time. It would never do this, however, because that board has been hand-picked by the management company. It's an empty promise. In other words, the management company (with its own board and stockholders) controls the board of our mutual fund and makes an enormous profit at our expense.
Fund management companies are often huge companies that are publicly owned. Management companies charge us money through our annual fund expense ratio, and that costs us a portion of what could otherwise have been part of our annual earnings.
The mutual fund industry made up of these management companies was once said by Forbes magazine to be the world's most profitable business, with a pre-tax profit of more than 30 percent per year. They get away with it, largely because investors are not price sensitive. Fund investors' costs are deducted automatically every day. They never receive a bill or have to write a check.
Technically, the directors of our mutual fund should be protecting our interests and negotiating with the management company for the lowest costs for services. But in practice, the management company tells the fund directors what it wants want to charge investors for operating the fund, and those fund directors, representing you and me, rubber stamp the request.
Not all mutual fund companies operate under this conflict of interest. At Vanguard, for example, there is no management company making money at the expense of investors. Instead, the mutual fund itself owns the management company and operates the latter as a nonprofit entity providing services to the funds on an "at-cost" basis. That's why Vanguard funds tend to have lower fees than other funds.
When it comes to mutual fund organizations that operate in the sole interests of their investment clients, Vanguard isn't alone. TIAA-CREF is a similar nonprofit financial institution originally formed to offer college professors a retirement savings opportunity. Then, there's USAA, the United Services Automobile Association -- now a Fortune 500 company owned by its active and retired military members.
The 30 percent industry profit applies to the industry overall and includes its cost of handling small retail accounts with as little as $1,000 each. On retirement plan money alone, however, profits can be as much as 90 percent, because the entire retirement plan is treated as a single investor. Accounting for each employee's money is handled by seamless electronic databases, and the cost is usually paid for as an expense of the employer.
Fund board members with a fiduciary obligation should have pressed their management companies for cut-rate share classes for retirement accounts 20 years ago, but meanwhile, those investors who haven't wanted to wait have voted with their feet. Vanguard and TIAA-CREF have eclipsed firms like Fidelity and American funds and now dominate the industry. It's called "just desserts."
Steve Butler is CEO of Pension Dynamics. Contact him at email@example.com or 925-956-0505, ext. 228.