How can anyone serve two masters? It’s hard enough when the two want the same thing. But when the masters’ interests conflict, the servant’s position is untenable.

That’s the view of the mutual fund industry’s harshest critics. Fund managers, they say, cannot properly serve fund investors when they must also serve their own bosses, the management companies’ owners, public or private. Fund company owners make bigger profits when investors are charged high fees; investors get higher returns when fees are low.

“The question is: whom are they serving?” asks Wharton management professor Nicolaj Siggelkow. “Which boss are they serving more, and what influences this balance?”

Industry defenders have long rejected the critics’ charges, arguing that fund-company owners do best when their funds attract as many investors as possible. The need to compete puts a natural brake on the impulse to maximize fees, they contend.

Who’s right? New research by Siggelkow, reported in a paper titled, Caught Between Two Principals, supports the industry’s critics. After examining thousands of funds, Siggelkow concluded that fund managers do exploit opportunities to maximize fees, often using techniques that make fees virtually invisible to investors.

Legally, a fund is a corporation with a board of directors charged with looking after investors’ interests and hiring a firm to manage the fund. In practice, it is the management company that sets a fund up, appoints itself manager and selects the directors. Some management companies are publicly traded, others are held privately. The management company’s profits come from fees charged investors – primarily the “expense ratio” expressed as a percentage of assets and approved by the directors.

According to Siggelkow, securities regulations allow fund companies to shift research and distribution expenses from themselves to the fund investors. “I test whether fund providers take advantage of these opportunities … choose to maximize profits for their owners, rather than maximize the returns for their fund shareholders,” Siggelkow writes. “Moreover, I test whether better informed fund shareholders and fund shareholders with more buyer power, such as institutional investors, are able to reduce the ability for fund providers to shift expenses.”

In 1980, the Securities and Exchange Commission adopted Rule 12b-1, which allowed fund companies to charge investors a fee to pay for funds’ marketing and distribution. Previously, fund managers paid these expenses themselves out of revenue from the ordinary fee – the expense ratio. By 1983, about 24% of funds charged 12b-1 fees. The figure climbed to 61% by the end of 2002.

While lobbying for Rule 12b-1, fund companies said it would not harm investors financially because the marketing and distribution costs would be offset by reductions in other expenses from economies of scale, as marketing and advertising drew more investors, Siggelkow writes. If investors’ total fees remained the same, it would not matter whether the marketing and distribution costs came in a separate 12b-1 fee or were wrapped into the ordinary expense ratio, he said.

But that is not what happened. Funds that charge 12b-1 fees typically do not compensate by charging lower non-marketing expenses. The overall cost to the investor is thus higher if a 12b-1 fee is charged. Among “retail” funds sold to small investors, one with a 1% 12b-1 fee typically carries overall expenses that are 0.839 percentage points higher than those of funds that don’t have 12b-1 fees, Siggelkow found. In other words, about 84% of the 12b-1 fee represents a fee increase that benefits the fund manager.

For funds sold to big investors – “institutional funds” – this pass-through rate was slightly smaller. If a 1% 12b-1 fee was charged, overall expenses were 0.601 percentage points higher than for funds without the marketing and distribution fee. “Overall, these results indicate that 12b-1 fees are used to shift marketing and distribution expenses onto current fund shareholders, yet the degree to which this effect occurs is larger for retail funds than for institutional funds,” Siggelkow writes.

Since institutional investors are presumably better informed and carry more clout, they were better able to resist the pass through, he concludes.

But with both types of funds, the findings show that fund companies put their own interests ahead of investors’ interests by declining to reduce ordinary fees to match the 12b-1 fee, according to Siggelkow.

There was no evidence that funds that had more competitors had lower pass-through rates, he said. This suggests market forces alone cannot be expected to drive fees down, perhaps because it is so difficult for investors to get complete, detailed fee information that they cannot consider this factor when deciding whether to buy or sell.

Siggelkow also looked at whether fund managers shift research expenses to investors. While research can be funded through ordinary fees, many fund companies pay for it through so-called “soft dollars.” In this practice, which is legal, a brokerage company that executes trades for a fund manager provides research data in exchange for inflated trading commissions.

Commissions are paid out of fund assets and are not clearly reported to investors. Hence, shifting research expenses to soft dollars makes it harder for investors to determine research expenses. If expense ratios were lower as a result of fund managers’ use of soft dollars for research, it would not matter to investors that commissions are paid this way.

But, again, that is not the case. Retail funds that used soft dollars tended to charge higher fees overall than ones which did not, though the effect was slight.

Soft dollars seemed to have no effect on institutional funds’ fees. As with the 12b-1 fees, the institutional investors with more knowledge and clout could better resist the fund managers’ effort to shift research costs to investors’ shoulders. That suggests fund companies deliberately exploit the retail investor’s lack of knowledge and power.

According to Siggelkow, “no evidence can be found that excess payments of brokerage commissions (soft dollars) are used to lower the explicit research fees that fund providers charge. These results suggest that, at a minimum, soft dollar arrangements should be made more transparent.”

His research, he concludes, indicates fund providers are maximizing short-term profits by shifting expenses to investors. “Whether the practice of expense shifting is profit-maximizing in the long-run, however, is an open question,” he adds. “Given the current increased sensitivity of investors with respect to governance, accountability and disclosure, the practice of shifting expenses, either via soft dollars or 12b-1 fees, especially if it raises expenses to investors without their knowledge, could develop into a serious problem for mutual fund providers.”

Caught Between Two Principals