by Melissa Klein
As more and more investors pour their money into mutual funds - some 95 million people hold funds in their portfolios - concerns have been raised over fund fee disclosures and, as a result, regulators, trade groups and lawmakers are weighing in on the debate.
The outcome of their discussions could drastically alter what financial planning clients know about the funds in which they invest, as well as the way in which funds are run.
On the heels of a report on fund disclosures issued by the General Accounting Office, Rep. Richard Baker, R-La., introduced H.R. 2420, a bill that would direct the Securities and Exchange Commission to adopt rules that would, among other things, require funds to provide investors with greater disclosure of portfolio transaction costs, soft-dollar arrangements and operating expenses that are incurred by shareholders in dollar amounts.
Regulators hope that increased disclosures will increase competition among funds and ultimately result in lower fees.
Currently, mutual funds disclose information about the fees and expenses that investors pay as percentages of fund assets, rather than in dollar terms. Funds also incur brokerage commissions and other trading costs when they buy or sell securities, but those costs aren’t prominently disclosed to investors.
“The idea is that fund companies will seek opportunities to reduce fees to remain competitive,” said Richard J. Hillman, General Accounting Office director of financial markets and community investments. “Right now, without full disclosure, fees can, and do, vary considerably, and some investors may be unwittingly and unwillingly investing in very inefficient funds.”
“We came out in favor of additional disclosures related to fees in the quarterly account statement, because we found in an ICI study that the quarterly statement is the one that investors rely on the most,” Hillman said. “If you want to influence investors’ perception of what it’s costing them to be in a fund, you have to have disclosures in that statement.”
In its report, the GAO advised the SEC to consider three measures to increase investor awareness and competition among mutual funds on the basis of fees.
The GAO recommended that the commission consider the benefits of additional disclosure relating to fund fees, including requiring more information in quarterly account statements about the fees.
The GAO also recommended that the SEC look at ways to provide more information to investors that would allow them to evaluate possible conflicts of interest that arise from revenue-sharing arrangements, payments funds made to broker/dealers to promote the sale of shares, and so-called “soft dollar” arrangements - a portion of the commission charged to funds (and other investors) for the execution of portfolio trades, which is then directed by the investment manager to brokers who provide services such as investment research and to reward brokers for their sale of fund shares.
H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003, would also require that two-thirds of a fund’s board be independent (compared to the 40 percent required now), and that the board’s chair be independent.
It would also require investment advisors to provide the fund’s board annually with a report on revenue sharing arrangements, directed brokerage arrangements - services provided to the fund or paid for by brokers executing securities transactions for the fund or its affiliates, and “soft dollar” arrangements.
The commission lent its support to the bill. “We particularly support the goals of enhancing disclosure and the expanded authority that the bill would provide the commission to define which directors can be considered independent,” Paul F. Roye, director of the SEC’s Division of Investment Management, testified before a House Financial Services Subcommittee.
However, Roye noted, “With respect to some other provisions, while supporting the goals, the commission believes that the bill should preserve the commission’s flexibility to determine appropriate standards through the notice and comment rulemaking process.”
The bill would also direct the SEC to conduct a study of the use of soft dollars and to report its findings to the Committee on Financial Services and the Senate Committee on Banking, Housing and Urban Affairs no later than 18 months after enactment.
It would also make the audit committee, rather than the board of directors, responsible for the selection of the auditor, and would make the audit committee responsible for the appointment, compensation and oversight of auditors, and would require auditors to report directly to the committee.
In addition, the bill would establish a fiduciary duty on the part of the board to supervise the advisor’s direction of brokerage transactions and to determine that the direction of fund brokerage is in the best interests of shareholders, and would require the board to determine that revenue sharing payments are not disguised payments from fund assets.
The Investment Company Institute, the national association of the mutual fund industry, came out in favor of the provisions to clarify the roles of fund advisors and fund directors concerning soft dollar and directed brokerage arrangements.
“This is a good idea, and the SEC does not need to wait for legislation to take this step,” ICI chairman Paul G. Haaga said, in his testimony before the House subcommittee. He said that the group also supports the provision calling for the review of soft-dollar practices. “We believe this is one of the most important issues addressed by the bill,” Haaga said.
He urged the SEC to adopt rules that it had already proposed requiring fund shareholder reports to disclose the cost in dollars of a $10,000 investment in the fund, based on the fund’s actual expenses and return for the period of the report.
However, he said that the ICI disagreed with other measures, such as the provision to require mutual funds to have an independent chairman of the board. The ICI contended that existing fund industry practices, such as having lead directors and regular meetings of independent directors in executive session, make it unnecessary. “Not only is it unnecessary, but having an independent chairman could actually result in a less effective board,” Haaga said.
In addition, he said that it would be a mistake for legislation, rather than the SEC, to dictate how certain items are disclosed, and in which document they should appear. He recommended that once the SEC adopts new rules on expense disclosure, Congress should study their effectiveness before mandating additional disclosures, such as requiring disclosure of individualized operating expenses, which he said would be costly and inhibit comparisons among funds.
Haaga added that the industry supports H.R. 2420’s provision to apply to mutual funds the standards for audit committees established in the Sarbanes-Oxley Act, and said that he will recommend to the institute’s board of governors that the standards be adopted as an industry best practice.
The father of index funds, Vanguard Group founder John C. Bogle, gave his nod to the bill’s provisions, and added that he’d like to see the legislation go further. In testimony before the House subcommittee, Bogle praised provisions calling for disclosure of the dollar amount of annual operating expenses and an increase in the number of independent fund directors, as well the proposal that the fund chairman be an independent director.
“In my personal experience, the economies of scale in this industry are staggering, and it would be simply incredible to argue that they have been adequately shared with fund owners,” Bogle testified.
Bogle called for an addition to the Investment Company Act of 1940 that would call for “an express standard of fiduciary duty on the part of directors to act precisely in the manner called for in the preamble: a fiduciary duty to place the interests of fund holders ahead of the interests of fund managers and underwriters.”
Bogle also urged the committee to require funds to report their estimated portfolio transaction costs to investors.
