Taking Exit Rights Seriously: Why Governance and Fee Litigation Don't Work in Mutual Funds

Abstract

Unlike shareholders of ordinary companies, mutual fund shareholders do not sell their shares ? they redeem them from the issuing funds for cash. We argue that this unique form of exit almost completely eliminates mutual fund investors' incentives to use voting, boards, and fee liability. Investors will almost never become active in their funds even if the investors are large and sophisticated and even if most of the mutual fund market is not competitive. We also catalogue a number of unintended and harmful ways in which exit distorts voting, boards, and fee liability. Exit interacts with voting, for example, to make firing managers impossible and to prevent investors from receiving notice of fee increases. Exit also interacts with fee liability to cause recoveries to go to the wrong investors and to discourage investors from moving to lower-fee funds. Though exit gives investors a powerful tool to protect their interests, the net effect of exit on many investors is ambiguous, because investors who do not use their rights to leave underperforming funds cannot expect activism by other investors to improve the funds. Ultimately, exit causes mutual funds to look more like products than like ordinary companies. Voting, boards, and fee liability therefore have limited value, and whatever benefits they now achieve could be achieved more effectively and at lower cost by product-style regulation that applies automatically without investor action or that prompts investors to use exit rights effectively.