Can We Trust the Mutual Fund Industry Yet, or Is Reform Illusory?Published: July 28, 2004 in Knowledge@Wharton
And, in recent months, several fund family executives have been forced to step down, companies have paid more than $2 billion in fines and a string of fund managers has faced civil and criminal charges.
Are the enforcement actions and new rules enough to stop the late trading, market-timing and other abuses revealed over the past year? Will governance reforms drive down the fees paid by investors? It has “been disciplined,” Wharton finance professor Jeremy Siegel says of the industry. Late trading and market-timing abuses are thus unlikely to continue, he notes, but then cautions: “Who knows what else can happen.”
Siegel is less confident that the disciplinary actions and governance reforms will drive down the high fees that undermine investor returns but do not violate securities regulations. The typical actively managed stock fund charges fees in excess of 1.5% a year, nearly 10 times the charges for passively managed index funds that merely try to match market returns, and which historically beat most active funds over long periods. “Honestly, I don’t think corporate governance changes are going to affect that,” he states. “The only thing that could affect that is continuing studies” underscoring the corrosive effect of high fees. “It’s a matter of education to the public.”
John Bogle, the retired founder of the Vanguard funds and a longtime industry gadfly, described the new governance rules as “a wonderful start” by “a very courageous commission and a very courageous chairman.” The SEC approved the rules on a 3-2 vote, with chairman William Donaldson siding with two Democrats against the two Republicans.
By the end of 2005, fund company chairmanships will be restricted to outside directors – men and women who do not work for the advisory companies that manage the funds. In addition, three-quarters of the directorships will be reserved for outsiders, up from a simple majority. The SEC also gave fund boards the right to hire their own staffs to help oversee the funds, and it ordered directors to keep records of their contract negotiations with fund advisors and to annually explain to shareholders why they use the advisors they do.
Further reforms are under consideration: a rule aimed at curbing “stale-price” trading abuses (in which prices no longer available to ordinary investors are offered to favored clients) by imposing strict deadlines for trades; another, intended to curb costs from quick in-and-out trading, that would impose a 2% fee when funds are sold within five days of being purchased.
But the new governance rules could well turn out to be the most sweeping changes ordered by the SEC. The independent-chairman rule was strongly opposed by the fund industry. Its trade group, the Investment Company Institute, said independent directors should decide among themselves whether the chairman should be independent. It supported the other changes.
Legally, every mutual fund is an independent corporate entity with a board elected by fund shareholders that is charged with hiring, firing and overseeing the advisory firm that buys and sells stocks and bonds for the fund. In practice, it is usually the advisors that establish new funds, and an estimated 80% of funds are chaired by an executive from the advisory company. Critics have long complained that fund directors are little more than window dressing. Directors, who at many large funds earn six-figure fees, often serve, in effect, at the pleasure of the chairman, and they rarely fire managers, regardless of how poorly a fund performs.
“Negotiation with yourself rarely produces a barroom brawl,” says Bogle, paraphrasing Berkshire Hathaway Chairman Warren Buffett.
Only “Fierce Watchdogs” Need Apply
The shareholders want the best performance they can get at the lowest cost; the advisory firm wants to keep its job and charge the highest fees it can. To tackle this conflict and reduce fees, another regulatory change is needed, Bogle says: a federal law giving fund directors a legally enforceable fiduciary duty to place the interest of investors above those of the fund advisors. That, combined with the recent changes, will encourage directors to act as fierce watchdogs, he argues. “I believe there’s still plenty of room for improvement.”
Thomas W. Dunfee, professor of social responsibility in business at Wharton, says investors should profit from greater independence of fund boards, just as citizens benefit from checks and balances in government. Even companies that have not been tainted are likely to benefit. “If you have independent people to whom you have to explain things, you’re going to get better results,” he suggests.
While fund chairmen who work for advisory firms may believe they are representing investor interests, it can be hard to balance that against the management company’s financial interest in preserving its role and maximizing its own profit, according to Dunfee. “You can always rationalize a little bit when the rationalization is in your own self-interest. But the key is you don’t really realize that you’re doing it … One way you can reduce that bias is if you have to explain yourself.”
Trading abuses might have been prevented had fund executives felt their directors were scrutinizing them more closely, Dunfee says. “Maybe if they had known they had somebody smart looking over their shoulder, they would have thought a little more carefully about these things.” Still, he added, structural changes imposed from outside can only go so far. “A company that hires a consultant to develop a code of ethics is not as likely to improve behavior as one that puts its own people to work examining its culture and values. Intuitively, that has always seemed a better approach.”
$90 Million Settlement
According to Wharton finance professor David K. Musto, fund performance could improve as a result of the reforms, but market forces eventually could neutralize the gains. If lower fees cause a fund’s returns to improve, investors will pour more money into the fund, making it harder and harder for managers to find enough under-priced securities to soak up the additional cash. It will then become more difficult for the actively managed fund to compete with the passively managed index fund charging lower fees.
If the reforms make fund directors more vigilant, fees may come down, he says, noting, however, that market forces are the real factor driving fees. In many other countries, investors pay much higher fees, simply because they have not been educated about the importance of minimizing costs. “If investors cared more about fees, then fees would come down.”
Investors and regulators will be able to assess the governance changes by observing the behavior of the boards at large fund complexes, where a single board often oversees dozens of funds, Musto says. In any given year, a board overseeing a single fund would not be expected to fire its advisory firm. But a board with 100 funds could well be expected to regularly find a few poorly performing advisors that need to be replaced.
The stale-price scandal began in September 2003 when regulators announced that funds run by Bank One Corp. had allowed a hedge fund to make trades at stale prices, draining money from the funds and undercutting the value of ordinary investors’ holdings. As the scandal unfolded, it turned out that many funds had given favored investors such preferential treatment, and in some cases fund company executives were trading for themselves at the expense of their shareholders.
In June, Bank One Corp agreed to pay $90 million to settle a market-timing case brought by the SEC and New York Attorney General Eliot Spitzer.
Though the stale-price scandal seems to be ebbing, the SEC announced early in July that it had begun to look at the massive 401(k) industry, seeking evidence of kickbacks paid by fund companies to get their funds included in 401(k) plans. If funds pay plan sponsors – employers or the plan-packaging firms they use – for “shelf space,” employees may not be getting the best fund choices. Nearly $1 trillion is invested in funds through 401(k)s. “I believe there’s a lot of, for want of a better expression, hanky panky going on in the 401(k) area,” Bogle says.
Regulators are also looking at “soft dollar” arrangements between funds and the brokerages that execute the funds’ trades. Instead of paying a penny a share to buy and sell, a fund might pay a nickel. In exchange the brokerage provides the fund with market research, stock analysis and other services. The question is whether these arrangements benefit fund investors or hurt them by adding to costs.
Though trading costs clearly hurt fund performance, they are not reported to investors. Investors may be attracted to a fund because the reported fees are low, not realizing actual expenses are much higher.