Marianne K. Smythe, a partner in the law firm of Wilmer, Cutler & Pickering of Washington, is chairperson of the Mutual Funds and Investment Management Conference sponsored by the Investment Company Institute and Federal Bar Association being held this week in Palm Desert, Calif. Smythe is a former director and associate director of the SEC's division of investment management. She recently spoke with Mutual Fund Market News reporter Mike Garrity. An edited account of their conversation follows.
MFMN: Do you think the SEC is going too far by subjecting the tone of fund ads to scrutiny?
Smythe: I think it's a tough balancing act. The SEC knows well that the First Amendment and the concept of commerce allow advertisers substantial rein in how they present their advertisements. On the other hand, the law is pretty clear that most advertisements fall under regulatory oversight.
The SEC is right to be concerned when mutual funds start to be hawked like the latest rock music fad. Have they gone too far? I don't think they've gone too far yet at all. But I think they have to be careful about how far they do go.
MFMN: Does the SEC need to provide more guidance on how far funds can go in advertising?
Smythe: I suspect the SEC is doing a lot of jawboning. When I was there, there were a series of ads by one company that shall remain nameless that I thought were just outrageous. The way I dealt with that was to call the company and say, Cut it out. We don't want to test this in the courts. But, if you keep it up, we will.' And they toned down their ads considerably. I suspect that's some of what's going on.
The real worry here is that to the extent that the ads these days tout spectacular performance over the last two or three years, they almost seem to imply that this is what you can expect, even though there is eight point type that says past performance is no guarantee of future returns. I think the SEC is absolutely right to be reminding folks that they don't want to create a whole bunch of investors who have expectations that can't be met.
MFMN: The danger of that being that when the market drops, you've got a big redemption problem and potentially suitability arbitrations?
Smythe: My view is that the danger is that you hurt people. It's not so much whether they'll sue or turn against the market. The mutual fund industry has been so responsible for so long in adding value, it really doesn't need to be taking the risk of hurting people or encouraging the raising of expectations in a way that could be harmful to the investors.
MFMN: Is there a zone in which it is safe to advertise?
Smythe: The SEC allows a lot of free rein in advertising. It's not a question of whether there's a zone. There's something as wide as a football field.
This is not a universal problem. You look in the newspapers, most of the ads are just fine. But occasionally somebody wants to try to gain more attention just the way kids do in a playground by running outside of the playground saying, Catch me.' Well, I hope they get caught.
MFMN: If the fund governance proposals for directors are adopted largely as is, do you see them having much practical effect on funds and how they operate?
Smythe: I don't know that the proposals will be adopted as proposed because I think the SEC has gotten a lot of comment about the complex tradeoff between requiring more disclosure and junking up the prospectus again, disclosure that in some respects seems maybe not all that helpful in enabling an investor to make an intelligent decision about his fund.
I think it's very important for the SEC to keep doing what it does so well and has done so well over the last five or six years. That is to be on the bully pulpit reminding fund management, reminding fund boards, that the directors are the directors of a stand-alone corporate entity that has its own investors.
They're not directors of the investment adviser and their role is not to be a cheerleader for the investment adviser. They don't have to be adversarial or nasty but they have to be independent.
I think that the SEC's proposals are really an attempt to encourage that kind of independence. Whether the proposals themselves are necessary, I think the [Report of the Advisory Group on the Best Practices of Fund Directors which the Investment Company Institute adopted last year] went about as far as one needed to go.
I'm not myself persuaded that the governance proposals will add that much. I think that there is not much of an indication that fund boards are not doing their jobs.
I don't know what the SEC is going to do but I don't really think that these governance proposals, even if adopted, will add a tremendous about to the independence that directors already have.
MFMN: Do you think the most troubling part of those proposals is the personal disclosure about directors and their family relationships? What do you think about the proposal that sets a standard of independence for lawyers who advise independent directors?
Smythe: I find that to be troubling in two respects. First, I really do think that's intrusive to a degree that's really not appropriate. And it doesn't get at the issue which is, Are these guys buddies?' At the end of the day, buddies are buddies. And I don't think all the disclosure in the world is going to address whether people are friends or cronies or like each other.
You can't regulate it and that's really the issue. Americans for the most part are people who are collegial and try to get along with each other. You can't have fund board meetings that degenerate into hostile, adversarial undertakings. So I think the disclosure is largely unnecessary.
And the independent counsel proposal is only useful in this respect. It's very important for fund directors to have somebody to talk to who isn't beholden to the fund adviser, who doesn't have a substantial business relationship with the fund adviser to such a degree that they really can't look the adviser in the eye and say, No, you can't do this,' or, This is not something I'll advise the fund board to agree to.'
But to have the degree of independence that's proposed, I think that's unrealistic.
MFMN: Are there any legislative proposals that make sense for changing the Investment Company Act, the prohibition on affiliated transactions in Section 17 of the Act or anything else?
Smythe: The revisions to Section 17 are long overdue. I represent companies that really want to see these revisions so I have to acknowledge that I have a client interest in this but I think you can tell from my other responses that I'm not too inhibited about saying what I believe. And I really do believe in this area that sensible changes can be made.
I don't know that they need to be made legislatively. I think the SEC has the authority to do it itself through rulemaking and exemptive applications. The issue is the protection of investors and making sure that mutual funds aren't stuffed with bad underwritings from affiliated underwriters or given egregiously bad prices from the affiliated dealer desk. There are ways to address that.
MFMN: Those concerns can be addressed without blanket prohibitions on affiliated transactions?
Smythe: A prohibition on stuffing and on gouging, you betcha. But a prohibition on the affiliated transactions per se, I really do think that's anachronistic in the year 2000.
It may have been appropriate in 1940 and probably was appropriate then. But it really isn't now when you have these large companies that have asset management units that are their own profit centers and are absolutely independent in terms of decision making from anything that goes on in the underwriting or brokerage side. To have them be handcuffed because there just happens to be an affiliated dealer - handcuffed from going after the best price - I think that's just anachronistic.
MFMN: Do you see anything else in the Act that is anachronistic?
Smythe: There is one thing the SEC is going to be doing next week (3/16). I wished I understood it better and I wished that I thought of it when I was still at the SEC. That's tax reporting. In my defense, when I was at the SEC I wasn't allowed to own mutual funds. I didn't own any. In fact, we had no money. We didn't own anything.
There are so many people with after-tax dollars in mutual funds. I think that after-tax reporting is necessary. I understand it's controversial and I can't imagine why because I think it's the sort of thing that the retail investor deserves to know.
MFMN: Is the role of fund directors overseeing valuation of fund portfolio securities out of date? Should the SEC explicitly permit delegation by fund boards on pricing issues to the fund adviser?
Smythe: I have mixed feelings on that. On the one hand, being out here now and seeing how impossible it is for a fund director realistically to have a real opportunity to second guess valuation, I would say yes, it's anachronistic. On the other hand, it's one of the places where I would think I want to have the protection of knowing that independent people had some idea where those valuations were coming from when open-end investment companies are putting their money into all kinds of places where the markets aren't exactly deep and liquid.
I think the directors ought not to be charged with any kind of legal accountability for mis-pricing and the like. I think that's absurd. How can they really know? But they still should have a responsibility to ask questions, especially when the funds are investing in the kinds of marketplaces where you can't just look at the closing price on the NASDAQ or the New York Stock Exchange or the AMEX everyday and say, Oh well, that's the price of the security. That's the last traded price.'
MFMN: So directors should serve as a check on what the advisor is doing?
Smythe: Exactly. They still should have some responsibility to ask questions. What is your methodology? Have you had any problems? What about this fund that invests in some abstruse kind of instrument in some far-off land?' I think they need to say, How do you know that's the price?'
MFMN: There seems to be more activism by funds recently. Is it still a relatively small piece of the big picture for mutual funds?
Smythe: I think it's still a relatively small piece. I don't see any trend to have mutual fund companies becoming involved in portfolio company management. I notice that there's some stirring right now that fund companies have to make greater disclosure about how they vote proxies. I just don't think any of that is really important to a shareholder. The shareholders of a fund figure, What we really want to do is know what you're investing in.' If you don't like it, get out.
MFMN: The SEC and the NASD differ on whether portfolio managers should be able to use their prior investment performance when they change jobs. The SEC permits it under certain circumstances. The NASD does not. What do you think the end result should be?
Smythe: From having been out in the public for a while and seeing how things work, I think the idea that a portfolio manager is like Ken Griffey, Jr. is just absurd. Even Ken Griffey Jr.'s ability to hit as he hits and when he hits is to some extent a function of his team.
One of the reasons that Babe Ruth did so well arguably was that he batted third and Lou Gehrig batted fourth. There was no point in trying to get by him and then pitch to the next guy.
People who are on a team are affected by the quality of the team. In the portfolio management area, the opportunities to be successful are so much a function of the team and the context in which a person works.
I've come to disagree with the SEC's approach here. I don't think that a portfolio manager who has been successful in one place should be allowed to go elsewhere and promote his or her record as if it were his or her own. The obverse of that is just laughable. Is the fund company that this person has just left now supposed to revise its performance because they no longer have the superstar?
It just doesn't work. I really don't think that we should encourage people, especially encourage the American public, to believe in the absolute star system for portfolio mangers. Most of them are good because they're part of a team.
MFMN: Some have suggested that there is very little correlation between past performance and future performance except for the poorest performing funds. Should past performance be excluded?
Smythe: Past performance can be misused and oversold but it's all we've got. When you have a good organization which has some funds that have done fairly well, it's fair to assume that at least the fund organization cares about its shareholders and cares about giving value. That's really all we have. What do you base your decisions on other than the integrity and quality of the fund company plus how have you done?
MFMN: A mutual fund is an intangible. To some extent the only thing you really have to sell is investment style and performance.
Smythe: The other thing you really have to sell is, Were you here yesterday? Are you going to be here tomorrow? Are you going to step up to the plate and do the right thing by your investors in times of difficulty?'
From having worked at the SEC, I've formed the distinct view that corporate culture is an important part of what one should care about in investing in a fund. Is the adviser going to be there trying to add value during difficult times?
MFMN: What do you think will be hot issues this year? Fund governance and advertising will be talked about a lot. Anything else?
Smythe: I think anything related either to information derived from or activities done through the Internet is going to be a hot topic.
And the question of the globalization of the asset management industry. I hope that's a hot topic because we really are becoming one world in that respect. Some of our parochial rules and laws are interfering with American investors having access to excellence overseas and vice versa.