Three U.S. Senators introduced new legislation last week aimed at reforming the $7.4 trillion mutual fund industry. The Mutual Fund Reform Act of 2004 would not only stamp out abusive trading practices but also overhaul the hidden fee structure imposed on shareholders.
Sponsored by Sen. Peter Fitzgerald (R-IL), Sen. Carl Levin (D-MI) and Sen. Susan Collins (R-ME), chairman of the Senate Governmental Affairs Committee, the Mutual Fund Reform Act of 2004 would require a total fund expense ratio to include portfolio transaction costs and rationalize 12b-1 fees by treating broker compensation as a shareholder expense.
The bill would also require disclosure of actual individualized expenses and prohibit revenue sharing, soft dollars and directed-brokerage practices.
Collins said that the new legislation would "significantly overhaul the arcane and opaque structure of fees and expenses that has prevented meaningful price competition among the approximately 8,200 mutual funds that are offered to investors."
Some of the reforms outlined in the new bill mirror proposals already put forth by the SEC, such as a point-of-sale disclosure for brokers, revamping the boardroom, and establishing a code of ethics for fund executives. Last Wednesday, the SEC proposed banning mutual funds from directing brokerage business and from paying commissions to brokers to compensate them for marketing fund shares. The Commission voted unanimously to require that shareholder reports disclose the cost in dollars to each investor for an investment of $1,000 in the fund based on its actual expenses for the period.
Disclosing fees and expenses in individual account statements would make it easier for investors to understand what they're being charged and what service is being provided.
This would yield a total investment cost ratio and essentially spell out for investors the actual dollar costs.
The provision is modeled after the common checking account statements most people receive from their banks each month, whether received in the mail or accessed through the Web. Other disclosures include portfolio manager compensation and stakes money managers and executives hold in their own funds, broker compensation at the point of sale, portfolio turnover rates and proxy voting records.
The Senate bill also proposes a repeal of rule 12b-1, a statute first designed in 1980 to help shoulder the burden of marketing and advertising costs for fund managers. Currently, these fees are more often used to pay hidden sales charges or broker commissions. In fact, a mere 5% of 12b-1 fees are used for their original intent, while more than two-thirds of the fees go to directed brokerage arrangements, according to recent testimony before the Senate.
The knock on 12b-1 fees is that they have "degenerated into disguised sales loads," Fitzgerald told reporters at a press conference unveiling the initiative last Monday.
Indeed, some 12b-1 fees can range as high as 100 basis points per year. That being said, over the life of a retirement plan, that 1% annual 12b-1 fee may cost investors 35% to 40% of their retirement income, according to the Senate committee's findings.
"We're taking the brokerage community off the gravy train," Fitzgerald said. "There's nothing wrong with an honest load, but funds should call a load a load, make it account-based an not disguise it as a permanent asset-based distribution fee."
The SEC Wednesday put out for comment a proposal to ban directed brokerage.
The Investment Company Institute, along with many industry professionals, opposes doing away with 12b-1 fees, but agrees that using them to fund directed-brokerage arrangements should be prohibited. In the past, the industry's largest trade association has contended that all mutual fund fees and expenses are fully disclosed in a standardized fee table in a fund's prospectus and any additional disclosures would be costly.
That argument has been a major point of contention with industry critics because prospectuses are as thick as textbooks and often go unread by a fund's shareholders. Plus, the expenses are not spelled out in dollar terms, making it difficult for the average investor to make sense of it all.
"It's not going to cost the industry anything to standardize its disclosures and actually start telling investors how much the advisor is making, and where the money is flowing," said John Freeman, a finance professor at the University of South Carolina. Freeman has openly criticized the ICI for wielding its tremendous influence in Washington to shield its members from being regulated using shareholder dollars -- essentially protecting their bottom line.
ICI President Matthew Fink said he needs more time to evaluate the bill but expressed initial concerns that it contains many "ill-defined new legal standards . . . that could produce major dislocations and unintended consequences that would deter innovation, diminish competition, breed litigation and -- as a result -- harm current and future generations of mutual fund shareholders." However, the ICI did show support for the SEC's proposal to improve the quality and usefulness of semiannual shareholder reports.
With respect to the problems of late trading and inappropriate market timing at fund shops, the impetus of recent regulatory scrutiny, the Fitzgerald bill would require the SEC to issue new rules to prevent such egregious practices. Among them are a hard 4 p.m. cutoff for trade orders and the use of fair-value pricing. It would also call for a fund to disclose its market-timing policies in its prospectuses and make any trades that contradict that policy a violation of securities law.
Another tenet of the reform bill targets the makeup of the board of directors, in that it would require 75% of board members and the board chairman to be independent. Further, it would establish a more stringent definition of independence by barring them from being associated with the fund's management in the last 10 years, have no material business relationships with the fund, or close family ties with its management team.
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