The New York Times reports on executive pay and mutual fund management fees, topics which are getting fairly significant interest in the courts. On one side are the econs, who argue that the market will solve outsized fees by shifting money to the best performing options (e.g., fund managers with an optimal mix of risk, return and fees). For example, a lawsuit brought by investors in a set of mutual funds claimed those funds had overpaid their investment advisor. A multi-judge panel in the US Court of Appeals for the Seventh Circuit in Chicago dismissed that case. As quoted in the Times, Chief Justice Frank Easterbrook summed up their argument as follows:

“Mutual funds rarely fire their advisers,” Judge Easterbrook acknowledged. But, he continued, “investors can and do ‘fire’ advisers cheaply and easily by moving their money elsewhere.”

In a 2003 letter to shareholders, Warren Buffet focused hard on the hesitation of mutual fund directors to axe poorly performing advisers:

“Year after year, at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessly approved fees that in many cases far exceeded those that could have been negotiated.”

Setting aside political philosophy, who’s right? If average Joe investors “can and do” fire advisors “cheaply and easily” by voting with their investment dollars, why aren’t the mutual funds that rely on poor or overly expensive advice penalized with decreasing investment in those funds? Maybe Easterbrook et al are half right: although investors *can* move their money, few actually *do*.

CCEC advisory board member Ian Ayres along with two colleagues apply behavioral economics to make just that case in a “friends of the court” brief filed with the Supreme Court. They argue:

Problems such as “misperceptions of chance,” “sample-size neglect,” “loss aversion,” and “mental accounting” render the assessment of mutual fund performance extremely difficult for investors. Accordingly, the proposition that mutual fund investors will simply “fire” their advisers by “redeeming their shares and investing their assets elsewhere” ignores these natural impediments to competition.

And to this I would add hyperbolic discounting, which drives procrastination. Judge Easterbrook (and any cool-headed, rational observer) might conclude that moving money from one mutual fund to another is easy to do, but psychologically that’s not the case. The investor must actively decide to do something, find a suitable alternative, and (at a minimum) make a phone call or visit a website (the password for which s/he may or may not recall). All of these little hassles occur in the present, and therefore loom large relative to the benefits, which are all downstream.

It sure does feel that all of these cognitive shortfalls – especially loss aversion and hyperbolic discounting – could create significant stickiness that would inhibit the movement of money between investments. If so, the argument that the market will take care of the problem of excessive management fees is questionable. One solution is greater regulation to do what the market apparently cannot (or in the case of this lawsuit, suing advisors over outsized fees).

But another approach is a new type of caveat emptor – let’s call it “Caveat Emptor 2.0″ – in which the buyer isn’t just aware that the goods might not be what they seem, but that her own behavior and thought processes might not be in her long-term self interest. If we know, for example, that we are inclined to leave our money in a sub-performing mutual fund, how surprised should we be that investment advisors’ fees are poorly correlated with performance?

Stay tuned.  My bet is that as the science underlying behavioral economics becomes more compelling, the discussion will shift to the role of government versus the individual in addressing how to overcome these shortcomings.