Sen. Peter Fitzgerald has two wishes this year.
One is that Congress passes sweeping legislation to reform the $7.5 trillion mutual fund business, an industry that hasn't seen new legislation since the FDR administration. The other wish is for the Chicago Cubs to finally win another World Series title, a feat that has eluded them since 1908. In both cases, the odds seem stacked against him. But following a year in which bulldog Attorney General Eliot Spitzer knocked the cover off a widespread trading scandal and the Florida Marlins shocked the mighty New York Yankees in the October classic, surely anything can happen.
During the last nine months, a wave of inappropriate market timing and illegal late trading has opened a Pandora's box of problems for the fund industry. Spouting from it has been the misuse of 12b-1 fees and soft dollars, broker kickbacks, lax corporate governance, hidden or excessive fees and an overall dereliction of fiduciary duty.
Fitzgerald, a former attorney and lifelong Cubbies fan armed with extensive knowledge of the banking industry, has been going to bat for the small investor. He believes that despite a good-faith effort and expert advice, investors still remain in the dark about where their hard-earned dollars are being put to work. After hearing testimony at a series of hearings on Capitol Hill in recent months, Fitzgerald drew up the Mutual Fund Reform Act of 2004, a bi-partisan bill designed to curb fund abuses and fix its flawed fee structure.
Money Management Executive Associate Editor Kevin Burke caught up with the Republican senator from Illinois in his Washington office to discuss his proposed reforms and what he hopes to accomplish before his retirement at the end of the year.
MME: You have called the mutual fund industry, quite famously, "the world's largest skimming operation." Explain why you believe this to be true and why you think legislative reform is necessary.
Fitzgerald: The mutual fund industry has enjoyed incredible growth in the last 24 years, rising from $115 billion in assets in 1980 to $7.5 trillion today. A lot of that growth has been promoted by the government by virtue of its promotion of tax-sheltered accounts such as 401(k)s and IRAs. Really, the only way to offer those accounts is through a mutual fund. But I'm afraid that fee disclosure is inadequate and that free market forces need to be liberated so they work better in the mutual fund industry to allow more cost-comparison shopping for investors. By not having full disclosure of fees and a poor understanding of their impact on investors over time, we have made the mutual fund market less cost-sensitive than it should be.
Approximately $400 billion in fees is being collected each year, according to Vanguard Group founder John Bogle. If free market forces were more liberated by greater disclosure, the fees would be squeezed down quite a bit and investors would have much more available to them at return. One percentage point of fees over 40 years of investment will cut somebody's retirement nest egg by 45%. That's a lot of money. The government has created tax-sheltered accounts, but a lot of the benefits of tax sheltering have been captured by the brokers, advisers and other industry insiders and not by the clients. I'm concerned about that. So I think there's a role for government here.
MME: In the hearings on mutual fund practices in the past few months, what testimony has surprised you most?
Fitzgerald: The enormous amount of fees that are paid, how high fees have a more corrosive effect on people's retirement savings over time than even the market timing and late trading.
MME: What about directed brokerage and revenue-sharing arrangements?
Fitzgerald: Certainly, I find objectionable a lot of the shadow transactions that take place in the industry. I'm encouraged, though, that even the Investment Company Institute seems to be headed in the direction that they, too, would like to end revenue sharing and directed brokerage. The SEC has already moved on that front with its point-of-sale disclosure rule.
Mutual funds are almost being shaken down by the brokers, who tell funds, "We won't distribute your shares unless you give us payola." That's what we would call in Chicago a "shakedown." The brokers seem to be extorting, for the lack of a better word, what in Chicago politics they call a "kickback."
Brokers should be giving investment advice based on what's best for the customer, instead of thinking of their own revenue. It may have been commonplace for a long time, but it sounds to me like an unsavory practice that has gone on far too long. I doubt many customers whose broker tells them to go into a particular fund realize that their broker is being paid by the fund advisor to steer them into that fund.
MME: You've called for a ban on soft dollars. What about instances where small independent research firms add real value and boost competition, and where brokerage is not intertwined?
Fitzgerald: The research firm that's producing duplicative, low-quality junk will be hurt by it and lose business. Right now, there's a subsidy for bad research out there, so the market is not allocating the money very well. Good research firms will not be affected at all, and, certainly, my bill still allows brokers or advisors to buy research, except they'll use hard dollars and the cost will show up in the expense ratio.
The SEC can't eliminate the safe harbor. That's another reason why there's a need for Congress. In an expense ratio, you need only disclose non-transaction-related expenses. That loophole has resulted in fund advisors trying to convert their own overhead into transaction costs without disclosing it to the investor, which borders on unethical. It certainly is a very brazen use of fund assets.
MME: Critics of your bill argue that commission costs are dissimilar to total expense ratios because one is an operational cost while the other is investment-related. Why do you propose combining the two?
Fitzgerald: Mutual funds have under-performed the market by nearly 2% from 1982 to 2002. The difference in market return is fees, and that includes all fees, not just whether it's in the expense ratio or not. We're just pretending that a part of the fees don't exist. So if an investor owns a fund that somehow manages to keep its expense ratio low, but still has a very high transaction cost, the investor's returns will be less over time. That needs to be disclosed. And standardization would likely squeeze costs downward, similar to what is happening in the healthcare industry.
MME: Rule 12b-1 was created to ease the burden of marketing and distribution costs for funds so that they could achieve economies of scale, but its initial intention has become obscured. Why is repealing rule 12b-1 the best solution?
Fitzgerald: Since that rule was put into effect, fund assets have grown 60 times, while fees have gone up 90 times. Clearly, the rule did not achieve its original purpose. The equivalent in the banking world would be if your local bank put an ad in the newspaper, and in order to pay for that ad they debited everybody's bank account. But on top of it, they didn't tell anyone that they were taking that money out of their account. To that end, fund shareholders are not explicitly notified when 12b-1 fees are paid.
Fund advisors also use rule 12b-1 to pay hidden or disguised loads, essentially kickbacks, to brokers for distributing the funds. When 12b-1 was put in place back in 1980, investors were starting to realize it was unwise to pay a front-end load or a back-end load because it was deemed a dead-weight cost. So the fund industry then began looking for ways to disguise loads. It would be one thing if shareholders were told they were paying a load, but if the fund shareholder is charged less than 25 basis points, he's not even told it is a disguised load. Yet the fund can continue to call itself a "no-load" fund.
A fund can have a 12b-1 that's as high as 1% and still identify itself as a no-load fund. Congress needs to repeal the 12b-1 rule so advisors use their own money to promote distribution and serve as an incentive to keep costs as low as possible.
MME: Do you believe a 75% independent board truly will guarantee more rigorous oversight?
Fitzgerald: Under the 40 Act, the definition of a "disinterested" party is very loose. You could have your uncle running the fund, and he would be considered disinterested. Independent boards would be less likely to rubber stamp the fee agreements that asset management companies put forward. In fact, a recent study shows that non-bank mutual funds with independent chairs perform better and have lower costs than funds that have interested chairmen. No fund has ever fired the asset manager no matter how egregious its behavior was. That shows that boards are not really independent.
MME: Fidelity CEO Ned Johnson opposes that funds be required to have an independent chairman, arguing that there is no proof that companies with independent chairmen perform better and that a number of the fund shops involved in the scandal had independent chairmen. Does his argument hold any weight?
Fitzgerald: His argument is that the rule would require having two captains aboard the same ship. The trouble with his argument is that a mutual fund company is not one ship, but rather two separate ships, the mutual fund itself and the asset manager. Each ship needs its own captain. Oddly enough, Mr. Johnson wrote the article in such a way that he encouraged the perception his family owned not only FMR Corp., the fund advisor for Fidelity funds, but also the mutual funds themselves. The Johnson family does not, in fact, own the funds. They're owned by the shareholders. He seems to be confusing shareholders' money with his money. That in itself causes some alarm.
My question for Mr. Johnson is, if you're chairman of the outside asset manager and you owe a fiduciary duty to the shareholders of that asset management company, how can you possibly be the chairman of a mutual fund and fulfill the fiduciary duty to the mutual fund shareholders, especially when the only contract that the mutual fund enters into is with the asset manager? And who negotiates that contract? Does he wear both hats and sit at both ends of the table? Mr. Johnson's interests are not aligned with Fidelity shareholders. It's a flagrant conflict of interest. We need to ensure that there be an independent chairman for a fund board. It's a very important point and one that is worth fighting for.
MME: Do you believe that fund boards have the information they need to make informed decisions?
Fitzgerald: Right now, it doesn't look like they do. Any information they get is coming from the outside asset manager. The fund boards have no staff and they're dependent on their largest outside supplier. I would like to see fund boards have their own staff, a compliance officer and be in a better position to evaluate what they're being told by the advisor.
MME: What about amending the definition of fiduciary duty?
Fitzgerald: The 40 Act recites a fiduciary duty, but it doesn't provide any content for that fiduciary duty or any means of enforcing it. And furthermore, state law is involved because mutual funds are either trusts or companies that are chartered under the laws of their states. Only Congress can strengthen the fiduciary duties of fund directors and the directors of asset managers. Legally, there's never been a case where they have found a breach of fiduciary duty on behalf of the directors of the fund advisor. At one time, Congress considered putting in a provision requiring that fees must be "reasonable," but the ICI was successful in killing that.
MME: Attorney General Eliot Spitzer has publicly criticized the SEC for being behind the eight ball on the mutual fund scandal. How would you rate the SEC's performance prior to the scandal, particularly Paul Roye and the division of investment management?
Fitzgerald: Well, I think the division of investment management has not heretofore been given the resources by the SEC it should have had to do its job. Unfortunately, it's taken the scandal to facilitate the realization that the SEC overall needs to be putting more attention and more money into protecting the shareholders in mutual funds. I don't think it is fair to say that it is Paul Roye's fault. The SEC and perhaps Congress didn't realize that mutual funds needed to be more of a priority. After all, 20 years ago, the mutual fund industry was much, much smaller and did not merit the kind of attention it now needs to be given.
One thing I do worry about in general, not at the high level of a Paul Roye or a Bill Donaldson, but down in the trenches at the SEC, there is quite a bit of a revolving door. A lot of the enforcement people, after working for the SEC for a few years, wind up being employees of mutual funds. That is a government-wide concern.
MME: Should lower fees be a part of fund settlements?
Fitzgerald: I don't favor regulating fees, but I think the most important thing we can do for investors is to have better fee disclosure and more cost-comparison shopping. Attorney General Spitzer has awesome power under the Martin Act in New York. The other state attorneys don't have that power. When foregoing the pursuit of a criminal case, you can negotiate whatever plea bargain you want. The fund companies could take their chances at trial. If they think the market should set their fees, then they shouldn't settle with the attorney general's office but roll the dice and go to trial.
MME: How would you characterize the amount of support you've received for your bill? And what is its current status?
Fitzgerald: We have a number of sponsors, starting with Susan Collins, Carl Levin and myself, and we've since added a number of co-sponsors from both parties. Many of my colleagues who are not on the Banking Committee have given support for Congress getting involved.
While I think we have some support from the Banking Committee, the biggest issue is working on Sen. Richard Shelby. At one time, he seemed open to passing a mutual fund reform bill this year, but it appears he may be rethinking that. He's a critical player in this, and we'd certainly like to have him on board. He has a legitimate concern that we don't want to step on what the SEC is doing. I hope to work on his soft underbelly [laughs].
I think the least we can do is pass a bill out of the Senate, get it into conference with the House-passed bill and let it sit there until the end of the session when we have a clearer picture of what the SEC rules are. That way, our bill does not conflict with any of the new SEC rules. But I would give the SEC less leeway than other of my colleagues who are aligned with the ICI. The ICI does not want Congress to act. They're very cozy with the SEC staff and hope reforms are left up to them.
MME: Does the ICI have clients' best interest at heart?
Fitzgerald: The ICI encourages the perception that it's a lobbying group for mutual fund shareholders, but in fact, it represents asset managers. ICI dues are paid out of shareholder money, which is perverse because the ICI then uses that money to lobby against the shareholders. Put another way, the king compels the cook to buy the food to fatten the king. That's an imbalance that needs to be remedied. The difficulty is there's no lobbying group for shareholders. So it's up to guys like me to work on that.
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