Testimony on Mutual Fund Reform
Committee on Banking, Housing & Urban Affairs
United States Senate
February 25, 2004
Chairman Shelby, Ranking member Sarbanes, members of the committee, thank you for the opportunity to testify today on how to better align the mutual fund industry with the interests of investors. Since I last appeared here during my tenure as Under Secretary of the Treasury, I co-authored a book, The Great Mutual Fund Trap, to present common sense investing advice to middle income Americans.
The recent mutual fund scandals have shaken the confidence of these very investors. They are now asking, what went wrong? How do they best protect their savings? What can their government do to better protect investors in the future?
I believe that, at its core, the scandals have revealed the need for substantive reform regarding how mutual funds are governed and operated in America.
In today's global economy we simply have no choice but to ensure that America has the fairest and most efficient capital markets in the world. Mutual funds are a dominant factor for a majority of American families trying to save for retirement. They are amongst the largest sources of capital for corporate America. If mutual funds were to truly operate in the best interest of investors it would increase investors' returns, increase retirement savings, and lower the cost of capital for the overall economy. This is ever more critical as we prepare for the retirement of the baby boom generation.
Congress long ago recognized the inherent conflicts of interest that exist between investors and those who mange investors' money. Responding to an earlier era's financial scandals, Congress passed the Investment Company Act of 1940 (the "1940 Act"). The 1940 Act set up a system of mutual fund governance whereby non-interested mutual fund directors ("independent directors") must independently review and approve all of the contractual relationships with the management company and the financial community. Congress understood that these relationships presented unavoidable conflicts and could significantly affect investors' overall returns.
It is largely that system - independent mutual fund directors acting as gatekeepers for the benefit of investors - which we have in place today. It is that system that I believe deserves serious review and reconsideration.
Only Congress can adequately address these issues through reform legislation. While the Securities and Exchange Commission (the "SEC") is pursuing an active agenda of reform, it can not act alone on all of the necessary reforms to best align the interests of mutual funds with those of the investors they are supposed to serve.
The whole idea of a mutual fund is, as the name suggests, mutuality. Funds allow investors to share the costs of professional money management, in the nature of a cooperative. Mutual funds offer investors a chance at the superior long-term performance of equity investing, and a convenient way to buy bonds. They offer risk reduction through diversification as most funds own a broad spectrum of the market. Lastly, when compared with the full-service brokerage commissions of the time, at first mutual funds' costs were relatively attractive.
Legally, investors actually have collective control over their mutual funds. The company managing the assets is distinct from - and legally simply a contractor hired by - a mutual fund. Investors are represented by a board of directors which has a fiduciary duty to oversee their investments and hire the money management company (known as an "adviser") to invest it. In theory, the adviser works for investors to get the best returns for the lowest costs and risks. That is, at least in theory.
Mutual fund companies, as distinct from the funds themselves, however, have their own shareholders and profits to consider. They have a primary responsibility to their shareholders above any duties to the investors in the many funds they manage. They charge high management fees even though those fees come directly from investors' returns. They generally are willing to take added risks in an effort to attract assets in rising markets. And they trade frequently, even if that increases trading costs and investors' short-term capital gains taxes.
In practice, mutual fund investors have very little power over "their" company. Mutual funds are set up by advisers, not by individual investors. Funds have no employees of their own. All of the research, trading, money management and customer support staff actually work for the adviser.
Mutual fund directors serve part-time and rely on the adviser for information. The adviser initially selects directors for new funds and often recruits new directors for established funds. Approximately 80% of mutual fund boards are even chaired by someone affiliated with the adviser. Furthermore, fund companies generally set up a pooled structure, whereby fund directors serve on groups of boards for a fund family. The Investment Company Institute (the "ICI") recommends use of such 'unitary boards' or similar 'cluster boards' in the name of efficiency. Not surprisingly, mutual fund boards fire their advisers with about the same frequency that race horses fire their jockeys.
The Role of Fund Directors
The 1940 Act establishes specific roles for mutual fund directors. In particular, section 36 of the 1940 Act imposes a fiduciary duty on directors with respect to fees paid to advisers. Section 15 of the 1940 Act requires that the independent directors annually review and approve the contracts with the investment adviser and the principal underwriters. Rule 12b-1 requires a similar review of distribution contracts. According to the late Supreme Court Justice William Brennan, the 1940 Act was designed to place unaffiliated fund directors in the role of independent watchdogs, to furnish an 'independent check upon the management of investment companies.' (1)
In speaking to the inherent conflicts and potential for abuse and overreaching, SEC chairman Donaldson said just two weeks ago:
"This problem is nowhere more in evidence than in the negotiations over the advisory contract between the manager and the fund. The money manager wants to maximize its profits through the fees the fund pays. The fund's shareholders want to maximize their profits by paying as little as they can for the highest level of service. The fund's board of directors serves as the shareholders' representative in this negotiation." (2)
This duty, however, has never been interpreted very stringently. In the landmark case on the matter, the second circuit court of appeals ruled in 1982 that:
"To be found excessive, the trustee's fee must be so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." (3)
Over the subsequent years, the Gartenberg standard has proved to be insurmountable. No shareholder has subsequently proved a violation of the Gartenberg standard. And while it was initially found with regard to the fiduciary duty of the adviser (under section 36(b)) courts have allowed its use as the standard for directors as well. The SEC also has never sued a fund director for failing to review adequately an advisory agreement.
In practice, fund directors have a difficult time striking a proper balance between working with the adviser and vigorously pursuing investors' interests. Directors, in essence, are recruited by the fund companies. Directors generally serve on a multitude of the fund family's boards. They naturally serve only part time and rely solely on the management company for all of their information. There are not even any direct employees of the fund or the board. The directors also have been informed of the legal standards and that until recently there has been only limited actions by the SEC and the courts. How many well meaning directors would wish to make waves in this environment?
Why Governance Matters - Excess Costs Lower Retirement Savings
High mutual fund costs take a serious bite out of Americans' retirement savings. The SEC noted the potential effects on retirement savings when they stated: "a 1% increase in a fund's annual expenses can reduce an investor's ending account balance in that fund by 18% after twenty years." (4)
Over a lifetime, results can be even more dramatic when compared with low cost passive index investing. Investing in low cost index funds can lead to nearly twice as much savings by retirement than with the same amount actively invested (based upon just 2 percent more earnings per year.) (5)
In total, investors can expect costs totaling close to 3 percent to disappear each year in an actively managed stock fund. Those investors who invest in a fund with sales loads (close to one half of all investors) can expect costs averaging over 4 percent per year. While fees for bond funds are modestly lower, they still overwhelm the expected returns on bonds, particular in today's low interest rate environment.
Mutual fund companies impose costs on investors approaching $100 billion annually. These mutual fund costs are disclosed to investors:
· Monthly management, administrative, and distribution fees averaging well over 1 percent per year. A review of the 2,297 actively managed stock funds in the Morningstar database shows an average expense ratio of 1.49 percent. (6)
· Sales loads, charged by half of all actively managed mutual funds, averaging 3.9 percent. (7) With an average holding period of just over three years, investors can pay an additional 1.2 percent per year.
While investors may not pay particular attention to these costs, at least they are disclosed. Also, fund directors are legally required to pay attention to them.
There are some very important costs, though, which go undisclosed. They are hard for investors to measure and they do not show up on any statement. Mutual fund directors also have a more limited legal role in these costs. As investors' representatives, however, I believe, they actually should be very engaged in these costs.
· Portfolio trading costs - the typical active equity fund manager turns over their entire portfolio once every 18 months, incurring brokerage costs and bid/ask spreads approximating 1/2 to 3/4 percent of assets each year.
· Excess capital gains taxes - adding costs of 1 to 2 percent of assets per year - are incurred as portfolios are rapidly traded. While helpful to the US Treasury, this pervasive triggering of short term capital gains tax is particularly costly for investors in the new 15% long term capital gains rate environment.
· The opportunity cost of holding idle cash lowers returns about 0.4 percent each year, on average, during the last ten years. (Though even more during the strong market of last year.)
Why Governance Matters - Soft Dollars
Hidden within portfolio trading costs is something Wall Street calls "soft dollars." This is where an adviser, with the acquiescence of the funds' directors, benefits itself at investors' expense.
The mutual fund industry's educational material on the role of directors has this to say about "soft dollars." (Emphasis added):
Directors also review a fund's use of "soft dollars," a practice by which some money managers, including mutual fund advisers, use brokerage commissions generated by their clients' securities transactions to obtain research and related services from broker-dealers for the clients' benefit. Directors review their fund adviser's soft-dollar practices as part of their review of the advisory contract. They do this because services received from soft-dollar arrangements might otherwise have to be paid for by the adviser. (8)
What's hard to figure out is how soft dollar payments can ever be "for the clients' benefits" when they "might otherwise have to be paid for by the adviser." A portion of every commission will be retained by the broker as payment for research advice or other services normally paid for by the fund company. Basically, any expense that the fund company can direct to the fund's broker adds to the fund companies' profits at the expense of individual funds and their investors.
Why Governance Matters - The Sad Averages
All of these costs have their effect. Looking at the results over the last ten years, Morningstar data shows that the average actively managed diversified US equity mutual fund fell short of the market by 1.4 percent annually. Annual fund returns of 9.2 percent compared to the overall market return of 10.6 percent annually, as measured by the Wilshire 5000.
Furthermore, currently reported performance results include only those funds that survived the entire period. The many funds which have been routinely merged or liquidated are not still included in industry statistics. Looking at ten-year returns of currently active funds in 2004 will by definition exclude all the unfit funds that closed up shop during the last ten years.
This phenomenon is known as survivorship bias. It is like judging the contestants on a reality TV show simply by looking at the last few people left on the island. If someone asked a viewer how interesting the contestants were, they would probably forget the ones who were voted off in the first few weeks. What were their names again?