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Mutual Funds
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Watchdogs could end up biting fund investors
Shareholders have a new ally in consumer protection groups. I welcome their know-how in pushing for change -- and worry that they may naively squelch some good funds.
By Timothy Middleton
As fund companies scramble to address the abuses uncovered in the scandals sweeping their industry, they face a new and potent enemy: veterans of the consumer-protection movement. They're intent on subjecting fund companies to the same withering scrutiny that made Ralph Nader the bete noir of industries from automotives to toys.
Last week, a Naderite group calling itself Restore the Trust fired a broadside at the industry, throwing its support behind legislation that would slash some expenses but possibly create new ones. It joins a growing coalition of consumer groups that have seized fund reform as an issue, including the Consumer Federation of America, Consumers Union and the U.S. Public Interest Research Group.
We think . . . its very important for fund customers (to receive) better cost disclosure to make clearer how much they are spending, says Pamela Gilbert, co-founder of Restore the Trust and formerly executive director of the Consumer Product Safety Commission.
Until last September, the mutual fund industry had been largely unopposed in tailoring legislation and Securities and Exchange Commission rules to its own liking. Then New York Attorney General Eliot Spitzer revealed massive collusion between funds and rule-breaking rich investors.
Already several major fund firms have reached settlements with regulators, including Bank of America (BAC, news, msgs) and FleetBoston Financial (FBF, news, msgs), which are merging and together have agreed to pay $675 million to settle fund-fraud charges. That brings to $1.65 billion the total that fund companies have agreed to pay to settle the scandals allegations, the most serious charges against it in the industrys 64-year history. One crucial demand by Spitzer, not shared with the SEC, is that funds also cut their fees, which some, including Putnam Investments, have agreed to do.
New allies
Now Spitzer and fund shareholders have important new allies in consumer advocates, who are skilled at seizing hot issues and using their expertise in grass-roots organization and media manipulation to bend Congress to their will. In last years fight over the Sarbanes-Oxley bill to improve transparency in corporate governance, Restore the Trust claims to have mobilized 55,000 Americans to lobby for the bills passage, which succeeded.
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The peril for fund investors is that consumer advocates, who are new to investing advocacy, will unwittingly smother the industrys best performers in their zeal to rein in the worst.
Ideas like having compliance officers at every fund complex and more independent trustees, as well as the greater likelihood of (consumer) lawsuits -- all of these things are going to push costs up, notes Don Phillips, managing director of fund tracker Morningstar. That may make it more difficult for people to get started in this industry, and some of the higher-quality funds tend to be from these smaller and more entrepreneurial shops.
Many of the proposals backed by the consumer groups are long-overdue reforms that, thanks to their political savvy, finally stand some chance of adoption. Restore the Trust, which was created with the help of a grant from the Rockefeller Family Foundation, wants 12b-1 fees eliminated entirely.
Along with the other consumer groups, it also calls for an end to directed commissions and soft dollars. These are dodges whereby fund companies pay overly high trading commissions -- which come out of shareholders pockets -- in return for research and sales support from brokerage firms.
MFS, a Sun Life Financial (SLF, news, msgs) unit, earlier this month became the first fund company implicated in the scandals to eliminate soft dollars, and estimated the move would cost it as much $15 million annually. Market research firm Greenwich Associates estimates funds and other large investors paid brokerage commissions of nearly $13 billion in 2002, half of it in soft dollars.
An outright rip-off
As Ive said before, 12b-1 fees are an outright rip-off, used to pay such fund-company bills as brokers commissions. They, at least, are included in fund expense ratios. Directed commissions and soft dollars are no less a rip-off, and they arent even disclosed.
Virtually the entire consumer lobby has lined up in support of the Mutual Fund Reform Act, sponsored by Sen. Peter Fitzgerald, R-Ill. It would ban all of these practices and offers a number of other useful ideas, such as allowing 401(k) participants to buy funds at their 4 p.m. closing price even if their orders are received later because of delays at the plan administrator.
Abuse of the 4 p.m. rule was exposed in New Yorks investigation. So-called late trading allowed hedge funds and other investors to buy funds late into the evening. Thats why the SEC wants to eliminate exceptions.
But the SEC is opposed by the 401(k) industry, as well as consumer advocates. ICMA Retirement, which represents public employers, says in a statement that a deadline that doesnt accommodate retirement plans would reduce the fund options and increase the costs for investors in these plans.
The case for inside directors
Despite its strengths, Fitzgeralds bill has weaknesses, too, to which consumer advocates so far are blind. One is the requirement that at least three-quarters of fund trustees, including the chairman, be outsiders. That idea ignores reality: John Bogel, by far the most diligent advocate for fund reform as founder of Vanguard Group, was an inside chairman of Vanguard funds, and successfully so.
Three of the most investor-friendly fund complexes, Vanguard, Fidelity Investments and American Funds, have insider chairmen. One of the most egregious abusers of shareholders, Putnam Investments, has an outside director in nominal charge.
Similarly, the acts call for independent staff for outside trustees imposes a financial burden that could be crushing for a small operation. This column regularly profiles what I call outstanding undiscovered funds, such as Auxier Focus (AUXFX) just last week, with so few assets that the payroll for window-dressing staffers could throttle the aborning enterprise.
So while I welcome the sudden interest of consumer advocates in capitalisms kitchen, I dont like all their recipes. Requiring fund boards to retain their own compliance officers, for example, is more effective as a full-employment act for lawyers than as a remedy for abuse; fund companies already have them.
Unfortunately, the only organized counterbalance to the advocates is the fund industry itself, which has forfeited all semblance of public spiritedness in its tooth-and-nail defense of its own worst practices. Worse, the SECs investment-management division is notoriously cozy with the industry it's supposed to regulate; the recent fund scandals were uncovered by state authorities, not the agency, and the SEC remains at odds with Spitzer and his colleagues over such issues as fund fees, which the agency is loath to rein in.
So we shareholders are left in suspense. Our new best friends will do us enormous good if they can shoot dead 12b-1 fees, directed commissions and other flagrant fund abuses. But if they naively squelch the industrys most promising newcomers, they will shoot shareholders in the foot.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article. He is the author of a book on Gross, "The Bond King: Investment Secrets from Pimcos Bill Gross."
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