WASHINGTON- Excessive fees and inadequate disclosure represent far more serious threats to mutual fund shareholders than the trading abuses uncovered in recent months and will require more stringent legislation to remedy them. And it's time to take the bull by the horns.
That was the message resonating from Capitol Hill last week as industry professionals, government regulators and whistleblowers delivered testimony before the Senate Subcommittee on Financial Management, the Budget and International Security.
Legislators believe late trading and market timing are abuses that could have been effectively curtailed through stricter enforcement and compliance, but addressing excessive fees and a lack of transparency is a much more daunting task.
Different Strokes for Different Folks
Responding to a wave of industry criticism for forcing funds to cut fees, New York Attorney General Eliot Spitzer fiercely defended his position that any settlement reached between a tainted fund shop and his office must contain some sort of advisory fee reduction.
"Requiring mutual funds to return to investors money that should never have been taken from them is not rate-setting," he told members of the subcommittee. "It is what regulators across the country do every day when they uncover evidence that consumers have been ripped off, and is what I will continue to do as I uncover more evidence that mutual fund investors have been cheated."
The unflinching attorney general illustrated his point by presenting data provided by two of the fund companies slapped with civil fraud charges. In 2002, Putnam Investments of Boston charged its mutual fund shareholders 40% more in advisory fees than its institutional clients. That represents an additional $290 million for individual investors.
Alliance Capital's mutual fund customers paid twice as much as their institutional counterparts, ponying up an additional $200 million. Spitzer's settlement with Alliance requires the firm to reimburse investors through a five-year, 20% reduction in advisory fees.
"There are two different fee structures being imposed, and we could demonstrate that in litigation," Spitzer testified.
The argument originated when the Investment Company Institute issued a report that aimed to refute evidence that mutual funds pay more than institutional clients. The trade group stipulates that investment advisory fees paid by pension plans are primarily for portfolio management, whereas management fees imposed on fund shareholders carry not only portfolio management expenses, but also a variety of administrative costs associated with running the fund.
Spitzer argued that the ICI study was "misleading and false" primarily because it was based exclusively on data concerning the fees that sub-advisors charge management companies. Sub-advised funds represent a narrow slice of the industry, comprising a mere 7% of the mutual fund universe, according to a recent Business Week poll.
And those funds often impose additional costs on top of the sub-advisory fees, which the ICI report does not include. Spitzer said that the ICI report does not take into account that fees charged by sub-advisors are not the typical way fees at most mutual funds are approved. Rather, they are the product of arm's length negotiation between two disinterested parties.
Paul Schott Stevens, an attorney representing the ICI, testified that retail mutual funds have thinner profit margins than public pension plans. The average profit margin for a retail mutual fund is roughly 23.1%, while the average institutional holding yields a 29% profit margin, he noted. Stevens dismissed the notion that fund companies charge significantly different prices for nearly identical services, calling it an "apples to oranges" comparison.
"Price gouging over advisory fees is rampant, and the industry is in denial," said John Freeman, a law professor at the University of South Carolina and author of an academic paper on fund fees. "Overcharging for portfolio management has been the industry's dirty secret for years."
Freeman cited an instance where Alliance was charging 93 basis points, or $162.7 million a year, for managing the $17.5 billion Alliance Premier Growth Fund. At the same time, the company was managing the Vanguard U.S. Growth Fund for only 11 basis points - less than 1/8 of what it was charging its own shareholders.
Kicking Back
In addition to the advisory fee mess, Freeman spoke out against other shady practices including revenue sharing, soft dollars and directed brokerage arrangements. Broker/dealers have increasingly required mutual funds to make additional compensatory payments outside of sales loads and 12b-1 fees. These revenue sharing payments come straight from the adviser's bottom line and may supplement distribution costs from fund assets. Mutual funds pay brokers up to $2 billion annually in revenue sharing payments, according to the U.S. General Accounting Office.
Directed brokerage refers to the practice of funds paying brokers to encourage them to sell fund shares, a cost that is shouldered by fund shareholders. These under-the-table payments are used to bilk shareholders and generate income for the advisor without running up the fund's expense ratio. Soft dollars enable portfolio managers to pay for brokerage and research services with client commissions. These services may include third-party research, access to hot IPOs or even golf clubs for traders. Clearly, there is very little transparency in this area, Freeman noted.
"These types of secret commissions and arrangements mean investors aren't getting objective investment advice," said Sen. Carl Levin (D- MI). He argued that if a broker was paid $1 by a company for every share of its stock he sold and didn't disclose that information to the customer, the broker would be in violation of securities law. Based on that premise, he asked the panel if that was the same as pitching a certain brand name of funds in exchange for a fatter payout? "I don't think it is any different," Spitzer replied.
"In Chicago, we call these kickbacks," said Sen. Peter Fitzgerald (R- IL), chairman of the subcommittee, who has repeatedly called the fund industry "the world's largest skimming operation." He also pointed out that federal employees' retirement plan, the Thrift Savings Plan, charges only 11 cents per $100 invested compared to 63 cents per $100 for the average private sector S&P 500 index fund.
"Sad to say, retirement investing appears to be yet another instance in which federal employees get a great deal, but everyone else gets the shaft," he said. Fitzgerald is in the process of introducing sweeping legislation to reform the industry and make it easier for investors to understand the fees they're paying and compare them with other funds.
But not every lawmaker was keen on the idea. "It is a mistake to suggest that the mutual fund industry is the world's largest skimming operation," said Sen. John Sununu (R- NH). He cautioned that too much legislation could create an environment where good, qualified individuals don't want to take part in the process of protecting shareholder interests. Sununu also defended a brokers' right to earn a commission, reminding the panel that they are indeed salesmen.
He further stressed that the most important number to be concerned with from an investor standpoint is not the fees themselves but the return of a fund, net of all fees. This caused quite a sparring match between Freeman, Sununu and Stevens, one that prompted Fitzgerald to bang the gavel to restore order.
Freeman blasted the ICI for being part of the problem and not part of the solution, calling into question their willingness to protect shareholders. "The ICI epitomizes problems of conflict of interest," he shouted. He expressed complete disgust with the ICI's lobbying efforts in Washington, accusing them of using shareholder money to block the very reforms designed to protect them.
He also took a shot at former SEC chief Arthur Levitt for advising in his book that shareholders avoid funds that charge 12b-1 fees, yet during his tenure he did nothing to remedy the obviously flawed SEC rule. "The SEC's division of investment management represents a Chihuahua watchdog, not the Doberman shareholders need."
The ICI supports banning directed brokerage practices and the use of soft dollars for third-party research, but rule 12b-1 is a much more divisive issue. Junking the rule would not eliminate the costs for shareholders, ICI's Stevens argued, rather it would simply relocate them to another area.
Jeff Keil, vice president of Global Fiduciary Review at Lipper, proposed an overhaul of 12b-1 because it fails to serve its original intent, which is to pay for promotional and marketing activities. Ninety-five percent of 12b-1 plan expenditures went to commissions and administrative services, according to the ICI. Lipper advocates establishing guidelines that itemize acceptable and unacceptable uses of distribution expenditures in order to curb abuse. Still, eliminating it altogether would be a mistake, he cautioned. Another witness, Travis Plunkett, the legislative director for the Consumer Federation of America, proposed that 12b-1 fees be passed on to the distributor
The big picture is that fund companies are reaping big-time profits while small investors remain confused as to where their hard-earned dollars are being put to work. Since mutual fund fees are often opaque or hidden altogether, the appearance, if not the reality, of a conflict of interest is evident.
While trading abuses can be stamped out through beefed-up compliance procedures and stiffer penalties, the fee conundrum is one that may only be solved through comprehensive structural reform. As Congress works on drafting new legislation, a certain attorney general will continue to circle the wagons.
"We've seen people taken away in cuffs and there will be more of them," Spitzer vowed.
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