The legendary John Bogle, founder and former chief executive of The Vanguard Group, recently met with members of the Securities and Exchange Commission to urge the commission to propose a rule that would require anyone providing retail investment advice to act as a fiduciary. 

Bogle and two other representatives of The Institute for the Fiduciary Standard argued that investment advisors at large mutual fund companies and other financial institutions often operate with conflicts of interest and do what’s best for themselves rather than their shareholders. The Investment Company Act of 1940 requires that mutual funds be organized and managed in the interest of shareholders, rather than their managers or directors, but Bogle pointed out that the spirit of the law is violated in practice.

Fiduciary responsibility encompasses everything from how a fund is structured and managed to individual judgment calls by the fund’s sales representatives. Yet, in equity funds, there is an inherent conflict of interest that costs investors at least $10 billion annually. This number is much higher if you consider all mutual funds.

These costs are generated whenever someone buys or sells shares. The problem is exacerbated when short-term traders move in and out of funds. Portfolio brokerage commissions and market impact costs associated with buying and selling shares are borne by all shareholders, which means short-term shareholders are getting a free ride -- or at least a cheap ride -- at the expense of long-term shareholders.

Mutual fund companies are well aware that these hidden costs are being passed along to all shareholders, but they do not disclose them in prospectuses and they are not included in a fund’s expense ratio. 

Funds should either address this problem by charging trading costs to the buyers and sellers or by including a disclaimer in their prospectus that reads something like this:

New investors who purchase shares do not pay their portion of the portfolio trading commissions incurred to assemble their portion of the portfolio. Liquidating shareholders do not pay their portion of the portfolio trading commissions to liquidate their portion of the portfolio. These portfolio commissions are deducted from the assets of the fund, which mean all shareholders bear the costs generated by those buying and selling shares.

Several procedures have been used to reduce this wealth transfer from long-term investors to traders, including minimum holding periods, restrictions on the total number of transactions during a specific timeframe and redemption fees for a specific time period after purchase. Restrictions on minimum holding periods or the number of transactions may reduce in-and-out trading, but only minimally. Redemption fees do nothing to reduce liquidity costs created by inflows, which are substantial.

If none of these procedures are effective in reducing short-term trading costs, why do some mutual funds continue to use them? The reason appears to be the compensation pattern for management fees. Management fees are typically a percentage of assets under management, which gives fund managers an incentive to increase assets as much as possible.  This is where a key conflict of interest lies and fiduciary responsibility gets trampled. 

But it is time for mutual funds to put investors first by changing the way they charge shareholders for trading. Quite simply, a “pay as you go” system is needed so those who are buying or selling pay for their trades. 

In a research paper, Mutual Fund Liquidity and Fiduciary Conflicts of Interest, David Rakowski, associate professor of finance at the University of Southern Illinois, Carbondale, and I discuss the enormous costs of the current system and a new approach to correct the inequitable wealth transfer in mutual funds. Known as the Sacks Equalization Model (SEM), it is a patented algorithm developed by Seymour Sacks, a 50-year veteran of the securities industry. 

(Mr. Sacks recently filed a petition for a rulemaking request with the SEC requiring mutual funds to fully to disclose in their prospectuses that all shareholders are paying the costs of portfolio trading commissions generated by new investors buying shares and by current investors liquidating shares.)

With SEM, the portfolio brokerage commissions for purchasing shares are added to the purchase price and the revenue generated by this mark up is returned to the general revenues of the fund. The price paid to redeeming investors is the net asset value minus brokerage costs incurred to sell some of the fund's securities.

SEM can logically be extended to include the market impact costs of transactions caused by new inflows to the fund or redemptions. For example, if brokerage commissions and market impact costs result in a cost of $.04 to buy or sell a share with a net asset value of $10.00, a purchaser would pay $10.04 and a seller would receive $9.96.

This approach not only meets the standard of fiduciary responsibility, but it can easily be adopted by any open-end mutual fund and improve fund performance by up to one percent per annum. What’s more, the algorithm can improve performance for nontrading shareholders without unduly punishing short-term traders or dampening assets under management.

We now have a straightforward and efficient solution to a problem that has been with us as long as the mutual fund industry.  The question now is:  Will the industry -- or the SEC -- take action?

Miles Livingston, Ph.D., is Bank of America Professor of Finance at the University of Florida, Gainesville, and has studied mutual funds and the capital markets extensively. This article first appeared in The Financial Times Economists' Forum blog and is reprinted with permission of the author.