While it is premature to expect a Sarbanes-Oxley law for mutual funds, the recent scandals in the industry have caught the attention of Congress.
Bills have been introduced in both the House and Senate that focus largely on greater disclosure and enhanced independence of directors. Other measures being discussed include an independent oversight board for the industry.
But much of the focus is on fees.
Although the much-discussed collapse of Enron Corp. and other companies cost investors billions of dollars, critics say investors, perhaps unknowingly, are paying similar amounts year after year through fund investments. It’s estimated that funds paid more than $50 billion in advisory fees last year and $20 billion more in other management fees.
Critics say those fees can–and should–be far lower.
Calling the fund industry “the world’s largest skimming operation,” Sen. Peter Fitzgerald (R-Ill.) said fees swallow too big a chunk of Americans’ portfolios.
“Investors and consumers are being bled … drop by drop,” he said in an interview last week.
Fitzgerald has advanced one of the most potentially far-reaching ideas to lower fees: requiring funds to solicit competitive bids for advisers.
Although mutual funds typically are started by fund operators, they are owned by the shareholders, and the mutual fund’s board selects the adviser to manage the fund.
The fund’s board is often too intertwined with the adviser, critics say, and firing an adviser is all but unheard of. Usually an employee of the adviser serves as chairman of the fund’s board. That, they say, can be a conflict of interest that can lead to excessive fees.
“The directors are supposed to be the stewards of their shareholders’ investments but too often act at the behest of the advisory and management companies that run the funds’ day-to-day operations,” New York Atty. Gen. Eliot Spitzer, who has spearheaded probes of the industry, told the Senate Governmental Affairs Subcommittee on Financial Management, chaired by Fitzgerald.
With data from fund tracker Lipper showing an average expense ratio of 1.36 percent for all funds last year, Spitzer said carving off a mere 25 basis points would save investors more than $10 billion a year.
The mutual fund industry defends its system, saying fund boards actively assess what they’re paying, and that such fees, by law, must be reasonable.
The Investment Company Institute, the leading fund company trade group, has indicated it is willing to discuss various proposals in the wake of the scandals rocking the industry but defends the system as a whole.
“We do not believe it is fair to place blame upon directors or the fund governance system,” institute Chairman Paul Haaga told lawmakers last week.
“Overall, we continue to believe that the system of mutual fund corporate governance has served investors very well through the years.”
SEC on sidelines
But Gary Gensler, a former undersecretary of the Treasury and co-author of “The Great Mutual Fund Trap,” a 2002 book that identified many of the issues being debated on Capitol Hill, said regulators at the Securities and Exchange Commission need to step in.
“I think at its core, the SEC, possibly with the backing of the Congress, needs to address itself to a broken governance system,” he said in an interview.
He, too, is critical of the size of fund fees, saying some funds could be managed just as well for a fifth of what they’re paying advisers. That situation, he said, stems in large part from the close ties between fund boards and advisers.
Gensler said not all funds necessarily have to engage in competitive bidding for an adviser, but he points to the firms involved in the recent series of allegations over inappropriate and possibly illegal trading as an example of why it should happen more often.
“Shouldn’t the ones that have been dealing with such skullduggery be seeking a new manager, or at least use the threat of seeking a new manager to clean up the act of the current manager?” he asked.
When the idea was discussed at Fitzgerald’s subcommittee hearing, ICI President Matthew Fink balked, saying investors who purchase shares in a Fidelity fund expect it to be managed by Fidelity, not shifted in midcourse to, say, T. Rowe Price.
“I would say that doesn’t make the current behavior right,” Gensler said.
“You can easily address it by subcontracting it out or subadvising it,” he said, noting that Wellington Management Co., for example, has been a subadviser for many funds, including several from the Vanguard Group.
The mere threat of shifting advisers, Gensler said, could persuade them to lower fees.
Pension funds pay less
Gensler and Spitzer note that pension funds, which put contracts up for bid, typically pay far less for the same services than mutual funds; academic research has found fund fees are, on average, double the fees paid by public employee pension funds.
Fitzgerald points to the federal government employees’ Thrift Savings Plan, which bids out contracts for its index funds. It has an average expense ratio of 0.08 percent, below those at Vanguard, which is widely regarded as the low-fee leader.
“That’s not the management costs–that’s the whole expense ratio,” Fitzgerald said.
“You can bring these costs down. The point I’m trying to make is you have to bargain hard.”
Momentum on that issue may be building on Capitol Hill.
The ICI and SEC have suggested some measures, generally dealing with ways to prevent the behavior that has sparked the new furor. But experts say getting a more sweeping package passed may require the circumstances surrounding Sarbanes-Oxley: more scandals, loud complaints from investors and a sinking stock market.
Although the scandals have provided an opening, Fitzgerald said, the issues are more complex and more difficult to grasp than the corporate scandals, and the opposition will be fierce.
“In order to sell any kind of reform bill and get people calling their legislators … it will take some explaining,” he said.
“It will be very difficult to pass any reforms because of the strength of the industry.”
A look at some proposals to clean up the mutual fund industry
FEES AND DISCLOSURE
– A bill introduced by Rep. Richard Baker (R-La.) would require disclosure in dollars, not just percentages, of investor fees; disclosure of compensation to brokerages for distribution of fund shares; and disclosure of so-called soft-dollar arrangements, in which funds steer transactions to a broker in exchange for research and other services.
– Massachusetts Secretary of State William Galvin wants lawmakers to ban soft-dollar arrangements, which critics say increase investors’ transaction fees.
– A bill by Sens. Peter Fitzgerald (R-Ill.) and Daniel Akaka (D-Hawaii) advocates: disclosure of portfolio managers’ funds holdings; adding brokerage commissions to expenses; and providing written notice of brokers’ compensation for selling funds.
– New York Atty. Gen. Eliot Spitzer proposed a measure to ensure mutual funds don’t pay higher fees than pension funds for the same services.
DIRECTOR INDEPENDENCE
– Baker’s bill would mandate that at least two-thirds of fund directors be independent of the adviser, up from 40 percent; the Akaka-Fitzgerald bill puts it at 75 percent. Others have called for as few as one inside director.
– Both bills would tighten definitions of independence.
– The Senate bill would prevent board chairmen from being connected with advisers.
– Former Securities Exchange Commission Chairman Arthur Levitt advocates putting an investor representative in an ombudsman role on fund boards.
OTHER PROPOSALS
– To address claims that funds have allowed big investors to make trades after they are priced for the day, the leading mutual fund trade group urged rules that would require most transactions to be submitted earlier.
– Fund giant Fidelity Investments and others urged creation of a central clearinghouse with technology to prevent late trading.
– Mercer Bullard, founder of the Fund Democracy shareholder advocacy group, advocated creation of an independent oversight board. The Akaka-Fitzgerald bill would require the SEC to study the idea.
– Fitzgerald said the answer may lie within the SEC. “Not enough attention has been paid to the industry until now,” he said. “Now that it’s a $7 trillion industry, it merits perhaps a whole separate division within the SEC.”
–Andrew Countryman
