By Tim Middleton
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Mutual Funds
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The SEC takes a swing at sleaze -- and misses
Mutual fund regulators' new 'reform' proposals don't demand an end to the chiseling and double-dealing, only that the fund cheat you right out in the open.
By Timothy Middleton
While state attorneys general have been marching through mutual fund scandals like Marines on the road to Baghdad, the Securities and Exchange Commission has been waltzing with the girl it brought, the fund industry itself.
Rather than attacking the numerous conflicts of interest between funds and their investors that the scandals have revealed, the agencys Division of Investment Management is pushing more disclosure of the conflicts. The divisions stance is akin to requiring stables to leave barn doors open but report how many horses have fled.
That division of the SEC has been co-opted by the industry they are supposed to regulate, says James Cox, professor of corporate and securities law at Duke University. I think the commission and that division havent gotten the full message.
This week, for example, the agency is set to propose a new rule requiring that funds charge explicitly for marketing costs known as 12b-1 fees, rather than hiding them in expense ratios. It has also submitted for public comment a rule that brokers would have to disclose other kickbacks they receive for touting some funds over others, a practice known as revenue-sharing.
In neither case, however, does the agency propose to end these abuses, which take money directly from shareholders to pay management company expenses. Revenue-sharing agreements are stealth versions of 12b-1 fees, and both should be prohibited, says John Haslem, emeritus professor of finance at the University of Maryland and author of "Mutual Funds: Risk and Performance Analysis for Decision Making."
Fee abuses
Not even on the table is a rule to end soft dollars, which are overly high trading commissions -- paid by shareholders -- that earn fund managers free research and even computers. Indeed, while the SEC has proposed all manner of window dressing, it has ignored the most explosive issue facing the industry, which is trading costs that can more than double a funds published expense ratio.
Trading costs currently (are) hidden from investors. Most fund investors are completely unaware (of them), says Eddie ONeal, assistant professor of finance at Wake Forest University. He recently co-wrote an article that found that at medium-size, high-turnover funds, transaction costs subtracted an average of 1.67% of shareholder assets from total returns annually.
The SECs stance, as represented by a spokesman, is this: The SEC is making a thoughtful review and taking aggressive action to stop mutual fund abuses. The spokesman says many of the proposals are designed to give independent fund directors the tools they need, such as their own legal and consultative services, to do their job properly.
The fees called 12b-1 have been allowed by the SEC because, it argues, permitting fund companies to charge shareholders for the cost of selling their funds will ultimately benefit shareholders. As assets grow, the agency reasons, economies of scale allow funds to cut their management and other fees.
But as Ive reported over the last year, fund expenses have actually risen faster than assets. The 12b-1 fees have evolved from their original intent, such as paying for advertising, to cover such things as paying brokers to sell funds.
Learn more about the mutual fund scandal on MSN Money
A class structure
These fees express themselves in share classes. Typically, a load fund charges 0.25% annually on A shares and 1% on B and C shares. So the only difference in terms of annual expenses between load fund share classes is the 12b-1 fees they pay. They're reflected in the expense ratios of these share classes, which vary accordingly.
The SEC proposes that 12b-1 fees be charged for and paid separately, either in cash or redeemed fund shares. If you own $10,000 of the typical Class B shares of a fund, you now pay that fee as a lower total return of the fund. Under the proposed change, you would pay it explicitly, by writing out a check for $100 to your broker, or cashing in enough fund shares to pay that tab.
Obviously, the immediate effect on shareholders is nil: They're paying the fees either way. Equally obviously, 12b-1 fees haven't had their intended effect of bringing down shareholder costs. They simply enrich management companies and the brokers who sell their funds.
Instead of fiddling with the mechanism for paying these fees, the SEC should simply eliminate them.
SEC seeks only disclosure
Another reform the agency is considering is requiring that at least 75% of a funds board of trustees be independent of the management company that sponsors it, and that the chairman also be independent.
Abuses uncovered in the recent fund scandals all spring from illegal or unethical practices that trustees failed to identify and correct, so independent boards sound like a great idea. But fund boards at Putnam Investments, one of the most egregious offenders in the scandals, already meet the SECs proposed criteria.
Similarly, a proposed reform would improve prospectus disclosure of break points, or volume discounts from the front-end load of Class A shares. The proposal ignores the fact the disclosure is already made, though it's buried deep within the prospectus. The issue is enforcement, which is where the SEC has been so badly upstaged by the top security cops in New York and Massachusetts.
The biggest SEC failure
But the biggest hole in the SECs thinking involves fund transaction costs, primarily for securities trading. Currently, virtually nothing useful about this is disclosed because reports are often for multiple funds, meaning nothing can be learned about expenses at individual funds.
Sleazy practices abound in fund management, and none is sleazier than soft dollars. The system works like this: A portfolio manager pays inordinately high trading commissions in order to earn kickbacks from the broker, such as stock research and advanced technology, including computerized systems.
Costs like these are part of a fund companys overhead, paid by the management fee that is built into the expense ratio. Pushing them off on shareholders would fit the ordinary persons definition of the word fraud. The SEC has no proposal, even at what it calls the concept stage, to end this abuse.
Trading costs are the scandal-in-waiting. While the SEC dithers, individual investors should shop for funds with low portfolio turnover, which is disclosed. Less trading means lower commission and less room for abuse. Index funds tend to have the lowest turnover.
The SEC, on the other hand, would push fees up by requiring funds to hire separate staffs for outside trustees. They already have such staffs. Those staffs simply have been co-opted. The SECs solution translates into still higher fund expenses, which means it's a curious way to attack the issue of shareholders being ripped off.
The SEC is striking out on reform. The cure is action in Congress to force the SEC to reform itself, so it can truly reform the fund industry.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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