WASHINGTON - Congress will be going over mutual fund fee practices with a fine-tooth comb to ensure investors are getting a fair shake.
That was the message resonating from Capitol Hill last Wednesday as members of the House Committee on Financial Services heard testimony from a brain trust of industry leaders during a heated four-hour debate.
Among the key issues put forth for discussion were the rise in fund fees and expenses, the widespread use (and abuse) of soft-dollar commissions and the role of independent directors.
The panel of lawmakers was led by Rep. Richard Baker (R-La.), chairman of the subcommittee on capital markets, who opened the hearing by saying "not all is well" in the mutual fund industry, pointing to its "alarming" turnover rate and a troubling "roll em in, roll em out" mentality.
Chairman Michael Oxley (R-Ohio), co-author of the groundbreaking Sarbanes-Oxley Act, spoke about the lack of transparency in the way fees are disclosed and funds' failure to provide breakpoint discounts promised in prospectuses. "That is simply unacceptable," he said.
Oxley has been particularly vocal in his criticism of mutual funds in recent weeks, as evidenced by his commissioning of the General Accounting Office to examine trends in the industry with particular emphasis on fees and their disclosure. The GAO report found that fees on the biggest equity funds have increased 11% between 1999 and 2001, from 63 basis points to 70.
"Fees and expenses, in fact, are going up, and this despite the efficiencies created by these enormous economies of scale," Oxley said in his opening statement.
Bogle, Captain of Reform
Captaining the team of witnesses calling for further reform in the industry was Jack Bogle, founder of the low-cost Vanguard Group, whose Vanguard 500 index fund has trounced its peers by 76% over the last decade. The seasoned veteran provided statistical evidence that the rise in mutual fund fees over the last 20 years has had an adverse effect on annual rate of return. During that time frame, funds have lagged the equity market by 3.1%, nearly doubling the performance lag experienced between 1950 and 1970, Bogle said.
Bogle estimated the average annual impact of various fees levied by fund complexes to be 3.1%. That is far more than the average expense ratio, the benchmark for a fund's cost. While careful not to say that the performance lag was a direct result of those costs, he said it is not a coincidence the two numbers are similar. "Costs matter," he stressed.
Fund fees are more than just the expense ratios found in prospectuses and fund snapshots on Morningstar. They include a whole slew of management fees, out-of-pocket fees and transaction costs, just to name a few factors, he said. These costs are eating away at returns, yet investors remain largely unaware of what they are being charged, he said.
As a solution, Bogle recommended simplifying account statements to read like any gas or electric bill. He thinks that total costs should be spelled out as a percentage of net assets, including the expense ratio and the transaction ratio along with the dollar amount of costs incurred by the fund over the year.
Wayne Wagner, chairman of the Plexus Group, shared Bogle's criticism of fund fees, saying, "I personally believe that total transaction cost is the largest cost borne by investors over time. Yet these figures are never disclosed," He added that 75% of those costs are derived from performance.
Paul G. Haaga Jr., chairman of the Investment Company Institute, offered his rebuttal, maintaining, "Mutual fund fees and expenses are clearly and prominently disclosed in a standardized, easy-to-read fee table at the front of every prospectus." While Haaga stressed that mutual fund disclosures are more transparent than any other financial product, Congressman Baker scoffed at the notion, saying that despite good faith effort and expert advice, investors still can't make sense of where their dollars are being put to work.
Another point of contention was the use of soft-dollar commissions between Wall Street brokerages and investment advisors, an agreement in which brokers provide research, software or other resources to investment advisors in exchange for their business.
"The practice of soft-dollar commissions is one of the worst examples of undisclosed conflicts of interest in the mutual fund industry," testified John Montgomery, founder of Bridgeway Funds.
He said that soft dollars are really hard dollars except they belong to someone else.
The crux of the situation is that the advisor receives the immediate benefit from the broker, while the shareholder pays for it. Essentially, it is not in the best interest of investors because they're the ones shouldering the load. That is not to say that the SEC doesn't have its eye on the ball, however, as it has already documented abuses of soft dollars for vacations, cars, and other expensive amenities.
Several of the witnesses agreed that soft dollars should be banned altogether including Gary Gensler, former Undersecretary of the Department of the Treasury and co-author of The Great Mutual Fund Trap (see MFMN 10/14/03). "There is no excuse for it," he said.
Also at issue were matters of corporate governance including the role of board directors, who have been accused of turning a blind eye to the needs of investors. Bogle continually pushed his proposal that executives be prohibited from serving as chairman of the fund's board due to their inherent conflict of interest.
The ICI, already ticked off by the proxy disclosure provisions under Sarbanes-Oxley, immediately fired back at Bogle. "Independent directors make us all feel better, but it doesn't necessarily mean you're going to have a clean shop," Haaga said. "Some things are best left to best practices than legislation." The ICI is currently lobbying the executive branch's Office of Management and Budget to review the cost of proxy-voting disclosure (see MFMN 3/10/03).
Another issue was marketing hot funds. Several witnesses testified that funds prompting investors to chase past performance was an example of abuse. As the adage goes, past performance is no indication of future returns, so by pandering to the public taste, fund houses would be guilty of neglecting their fiduciary responsibility. "Mutual funds are not toothpaste, they're not soap. They're people's retirement savings," Bogle said.
Although the hearing is not likely to prompt immediate legislative action from the House any time soon. Congressman Baker concluded the session by saying he plans to send a bipartisan letter to the SEC next week urging it to examine soft-dollar arrangements, misleading fee information and the fiduciary responsibilities of fund directors.
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