Mutual funds hold a large share of America's public companies and are the largest category of household financial assets. As pensions give way to 401(k)s and IRAs, more Americans' retirements depend on how well their funds perform. Yet most investors know little about how a mutual fund is actually built, and that structure explains much of how funds are governed and regulated.
In this TalksOnLaw interview, Joel Cohen sits down with Professor John Morley of Yale Law School, a leading scholar of investment fund law, to take apart the mutual fund. Morley explains the "divided structure" that separates investors from managers, why redemption rights change everything, how the Investment Company Act handles conflicts of interest and fees, and why the rise of index funds and ETFs is reshaping the industry.
Why Mutual Funds Matter
The industry began in the 1920s, when ordinary Americans first started investing in faraway companies. It grew explosively from the mid-1990s on. Morley explains that funds hold not only stock but vast amounts of debt. Money market funds are so large a holder of short-term corporate debt that their troubles in 2008 threatened the broader financial system.
The Divided Structure
Using the Fidelity 500 Index Fund as an example, Morley describes what he calls a divided structure. The fund's investments sit in one legal entity, owned by its shareholders. The people, offices, and expertise sit in another, the adviser, owned by someone else. The adviser creates the fund and has it sign an advisory contract, drafted by the adviser, that hands over almost complete control of investments, marketing, and staffing in exchange for an annual fee. Fund shareholders own the fund, not Fidelity. Mutual fund fees are almost always a percentage of assets rather than a share of profits, partly because the Investment Company Act restricts performance fees.
Redemption Rights: Getting Off the Titanic
The key feature, Morley says, is the daily right to redeem shares at net asset value. A stockholder who sells Apple shares passes them to another investor, and Apple keeps its assets. A fund investor who redeems takes a pro rata share of the fund's assets with them. As Morley puts it, selling your Titanic ticket to someone else isn't worth much. What matters is being able to get yourself and your luggage off the ship.
Exit Instead of Voice
Because investors can simply leave, they almost never use their legal right to vote. Like parents choosing between two neighboring schools instead of joining the PTA, they switch rather than fix. That puts responsibility on each investor. In an ordinary company, market prices build in expected performance, and activist investors can step in to improve a struggling business. In a mutual fund, a fund run by a genius and a fund run by an incompetent can have the same share price today, and no activist will ever show up. Morley says the fund market works more like a product market than a securities market. As with car tires, if you don't do your research you can overpay.
Regulating Fees
Two statutes of 1940 govern the industry: the Investment Company Act, which regulates funds heavily, and the lighter Investment Advisers Act. Beyond requiring fee disclosure, the Investment Company Act lets shareholders sue an adviser on the theory that its fee is excessive, even when fully disclosed. The Supreme Court's standard asks whether a fee bears a reasonable relationship to the services rendered. Morley notes that courts have never settled whether "excessive" means a high price to investors or a high profit to the manager.
Conflicts of Interest Among Funds
A single adviser may run a hundred funds, so it constantly has to choose among them: which fund gets a scarce allocation of IPO shares, which gets the star portfolio manager, even which gets computer time. Those conflicts would be intolerable for the CEO of an ordinary company. Mutual funds tolerate them because investors can exit, and the law adds limits. Funds generally cannot trade with affiliated funds, and advisers cannot use funds as dumping grounds for securities they are underwriting, an abuse of the 1920s that the Investment Company Act was written to stop. Morley compares this to a law firm deciding which client gets its best associate. Some favoritism is unavoidable, and the main check is that a fund treated badly will lose its investors.
Separating the Risks
The divided structure also walls off financial risk. When Lehman Brothers collapsed, its separately organized funds were not part of its bankruptcy, and Lehman's creditors could not reach their assets. Bear Stearns' failing hedge funds did not drag down its other funds. The flip side is the risk that a manager will disregard the separation and walk off with investors' money, which the SEC has authority to police. Morley is skeptical of the Act's limits on fund borrowing, which he finds poorly designed.
Index Funds and the ETF Boom
Morley identifies two trends: the steady shift to index investing, as fewer investors pay for active management, and the rapid growth of exchange-traded funds. ETFs trade throughout the day on an exchange, while large institutions create and redeem shares in big blocks. That makes them a hybrid of an ordinary company and a mutual fund.
What to Know Now
Both of Morley's trends have accelerated. Index funds now hold more assets than actively managed funds in the United States, and average fund fees have kept falling. ETF assets have grown many times over, and ETFs have become the default vehicle for many new fund launches. The SEC answered his point about regulation with Rule 6c-11, the 2019 "ETF Rule," which lets most ETFs operate under a single standardized framework instead of individual exemptive orders. The line between the two products is blurring: after a key Vanguard patent expired, many managers sought permission to offer ETF share classes of existing mutual funds, and the SEC has begun to allow that structure.
Regulators have also revisited the risk issues Morley raised. After money market funds again came under severe stress in March 2020 and needed Federal Reserve support, the SEC in 2023 raised their liquidity requirements, eliminated redemption gates, and required some funds to charge liquidity fees during heavy outflows. Rule 18f-4 (2020) replaced the old patchwork of limits on derivatives and leverage with a risk-based framework. Excessive-fee suits remain available, but plaintiffs have rarely succeeded under the Supreme Court's standard. The concentration of voting power in a few large index fund managers has become a live debate, and those firms have responded by letting some investors choose how their shares are voted. Meanwhile, policymakers are pressing to open private-market investments to retail and retirement investors. Supporters see broader access to returns. Critics warn about fees, liquidity, and valuation. The core lesson of the interview still holds: because fund prices do not reflect expected performance, investors still need to look at costs and management before they buy.
