Mutual Funds: Time To Clean House

What's wrong with mutual funds? Investors are putting fewer dollars into them despite boffo stock market gains. Money flows into equity funds in 1999 were 30% below those of two years ago.

Certainly, poor performance counts for much of the disenchantment. Even though many fund managers outperformed last year's total return of 21% by the S&P 500-stock index, most have missed the boat over the last five years. Tied to their old models, many managers didn't "get" the New Economy of high technology and globalization that favored big-cap stocks and altered views on valuation. It's time these managers learned the basics of the information era or got out of the business.

But there are also problems that go to the core of the mutual-fund industry. Most managers are compensated on the basis of the size of the assets they control. Shareholders, however, want to maximize performance, not size. Indeed, size can often prove detrimental to boosting total return. Tying management fees to benchmark performance, as many Fidelity and Vanguard Funds do, is one way to go.

Lowering expenses is another. The benefits of huge economies of scale that come with electronic trading are not being passed on to investors. The average expense ratio for equity funds is actually up to 1.55% from 1.45% a decade ago, according to Morningstar Inc. And higher fees aren't always associated with higher returns. Some fund families with lower than average expenses have better returns. Cutting expenses could raise returns and attract investors.

It might also surprise people to know that there are supposed to be independent directors on the boards. But few of the actual directors represent the interests of shareholders. Crony boards have no place in the mutual-fund industry. It's long past time to get rid of them.

Before it's here, it's on the Bloomberg Terminal.