WASHINGTON -- Despite the enormous weight of proposed regulations bearing down on the financial services industry, mutual funds are taking the issue in stride, focusing on their core strengths of transparency, diversity and customer service.

"History has shown that events of this magnitude have a significant impact on investors, on markets and on policymakers," said Mark Fetting, chairman and CEO of Legg Mason Inc. and chairman of the Investment Company Institute's General Membership Meeting, held here last week. "Investors increasingly are not just looking for access to asset classes; they want solutions to problems."

ICI President and CEO Paul Schott Stevens said the emphasis of the proposed financial reform legislation is on controlling systemic risks and has not been aimed at mutual funds or other registered investment companies.

"We have made the case that mutual funds do not pose broad risks for the financial system at large," Stevens said. "As a result, our comprehensive system of regulation and oversight will remain largely unchanged."

Stevens said the ICI is focused on stopping proposals that could have unintended consequences and potentially harmful effects on funds and their shareholders.

"The sell-off in the markets in the last two years accelerated how people think about retirement," said Greg Johnson, president and CEO of Franklin Resources Inc. "There are more allocations towards global equities and global bonds. I'm surprised that retail investors haven't come back to equities, though. I don't think it's a healthy balance."

Johnson said the industry will start to see money coming back to equities if advisers can get investors to step back and look at the big picture, such as expected returns over the next decade.

"If you ask most individual investors what they want from their portfolios, they think in terms of outcomes," said Bridget Macaskill, president and CEO of First Eagle Investment Management. "They want capital preservation, and they want their assets to grow."

There is an increasing demand for "outcome-oriented products" such as absolute-return funds, Johnson said, but managers must be diligent that the underlying assets are an appropriate fit for the fund.

"You have to be careful because markets don't always do what you want them to," he said.

"Stressful times begin to reveal gaps between what we practice and what we preach," Macaskill said.

"We lost sight of the basics," Macaskill said of the industry at large. "We didn't really understand what we owned, and we didn't really understand risk. We lost sight of the difference between recognizing risk and managing risk."

Macaskill said that as an industry, mutual funds systematically removed the flexibility and control portfolio managers have by putting funds into style boxes and requiring them to focus on narrow mandates.

"I'm afraid we have taken responsibility away from the people who are supposed to manage these funds and delegated it to individual investors and their advisers," she said. "Most people don't have the time or the temperament to adjust their portfolios on their own."

"As an industry, we always tend to be fighting the last battle, when we should be preparing for where the next problems will be," said John Walters, president and chief operations officer of Hartford Life.

Fund companies need to go back and rethink the downside of their risk measurements, consider how deep their stress scenarios go and whether they are really diversified, Walters said.

"In many cases, the protection we thought we were getting wasn't really there," he said.

Walters said that most money managers might prefer that no regulatory changes are made, but if pressed, they acknowledge that some things clearly need to be tightened up, such as derivatives and trading.

"We need to emphasize stewardship over salesmanship," Macaskill said. "Mutual funds have always tried to align ourselves with Main Street over Wall Street, and we should continue to do so. I believe that if you do the right job for the investor, the firm will benefit as well."

Former Republican Senate Majority Leader Trent Lott said he is worried that Congress will overreact on its plans for sweeping financial reforms.

"It's typical of Congress that when somebody breaks the law, the first thing Congress thinks it needs to do is change the law. Can we at least figure out what happened first?"

If Congress can pass well-structured, comprehensive reforms, there should be political benefits for everybody, Lott said, but "just getting it done isn't good enough. We need to get it done right."

While he no longer serves as a Congressman, Lott is still very involved in politics, lobbying on behalf of the Washington-based Breaux Lott Leadership Group.

He said there are many problematic areas of the proposed bill, such as the details for a Consumer Protection Agency, rules for proxy access, derivatives and the "Volcker Rule" for new banking regulations.

The main reason the proposed financial reform bill is struggling is because Republicans and Democrats are not working together, he said.

Acrimony

"The acrimony in Congress is as tough as I've ever seen it," said Lott, who represented Mississippi in Congress for 35 years before retiring in 2007. "We have a lack of leaders who will step up and work together. We've got to have a facilitator who can cross the aisle and get people to listen to each other. In politics, as in many things, you have to give a little to get a little."

Without this across-the-aisle cooperation, Lott said it's unlikely Congress will pass financial reform legislation this year, but perhaps that's a good thing.

"The biggest mistakes tend to be made when one party controls the House, the Senate and the White House," he said. The party in power typically becomes arrogant and tries to force its agenda through, irrespective of the needs of the minority.

The result is often a political roadblock, followed by an electoral backlash. Lott said he thinks Republicans could gain 30 to 40 seats in the House in the November election, if not more, and possibly four or five seats in the Senate.

(c) Copyright 2010 Money Management Executive and SourceMedia Inc. All rights reserved.

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