Paula A. Tkac
Economic Review, Vol. 89, No. 4, 2004

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The improprieties in the mutual fund industry that surfaced in the fall of 2003 prompted the passage and drafting of legislation and regulations that cover nearly every facet of mutual fund pricing and operations. While this regulatory flurry is clearly intended to protect shareholders' interests, the question remains: How will these scandals and regulatory changes ultimately affect mutual fund investors?

When considering the problems inherent in mutual fund management and the best ways to address them, it is important, the author stresses, to understand current business practices in the industry, who these benefit, and why they exist.

Mutual fund investors, the author explains, are legally considered owners of a company that pools the investment capital of many investors. In practice, however, investors are often viewed (and often view themselves) as customers of a management firm that acts as an investment adviser.

Regardless of which view is taken, inherent conflicts exist between investors and advisers because the two parties have differing objectives: Investors want to receive higher returns on their investment while minimizing risk, and advisers want to maximize their own profits without exerting undue efforts (costs).

The author reviews a number of possible solutions to these conflicts of interest, including compensation-based fee structures, a separation of functions, proposed regulatory and legislative changes, and monitoring and information disclosure.

By far the strongest weapon investors have in resolving these conflicts is their own demand, the author concludes. "When unfettered and free of frictions, a competitive marketplace will supply the products and services investors demand at the lowest possible price," she notes.

December 2004