[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]




                   MUTUAL FUND INDUSTRY PRACTICES AND

                  THEIR EFFECT ON INDIVIDUAL INVESTORS

=======================================================================

                                HEARING

                               BEFORE THE

                            SUBCOMMITTEE ON
                    CAPITAL MARKETS, INSURANCE, AND
                    GOVERNMENT SPONSORED ENTERPRISES

                                 OF THE

                              COMMITTEE ON
                           FINANCIAL SERVICES

                     U.S. HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                             MARCH 12, 2003

                               __________

       Printed for the use of the Committee on Financial Services

                           Serial No. 108-11


87-798              U.S. GOVERNMENT PRINTING OFFICE
                            WASHINGTON : 2003
____________________________________________________________________________
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                 HOUSE COMMITTEE ON FINANCIAL SERVICES

                    MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa                 BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska              PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana          MAXINE WATERS, California
SPENCER BACHUS, Alabama              CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware          LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York              NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California          MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma             GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio                  DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice         JULIA CARSON, Indiana
    Chairman                         BRAD SHERMAN, California
RON PAUL, Texas                      GREGORY W. MEEKS, New York
PAUL E. GILLMOR, Ohio                BARBARA LEE, California
JIM RYUN, Kansas                     JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio           DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois         CHARLES A. GONZALEZ, Texas
WALTER B. JONES, Jr., North          MICHAEL E. CAPUANO, Massachusetts
    Carolina                         HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California                 RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois               KEN LUCAS, Kentucky
MARK GREEN, Wisconsin                JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania      WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut       STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona             MIKE ROSS, Arkansas
VITO FOSELLA, New York               CAROLYN McCARTHY, New York
GARY G. MILLER, California           JOE BACA, California
MELISSA A. HART, Pennsylvania        JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia  STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio              BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota           RAHM EMANUEL, Illinois
TOM FEENEY, Florida                  DAVID SCOTT, Georgia
JEB HENSARLING, Texas                ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey             
TIM MURPHY, Pennsylvania             BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona

                 Robert U. Foster, III, Staff Director
            Subcommittee on Capital Markets, Insurance, and 
                    Government Sponsored Enterprises

                 RICHARD H. BAKER, Louisiana, Chairman

DOUG OSE, California, Vice Chairman  PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut       GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio                DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama              BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware          GREGORY W. MEEKS, New York
PETER T. KING, New York              JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma             DENNIS MOORE, Kansas
EDWARD R. ROYCE, California          CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois         MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York               HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio                  RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona             KEN LUCAS, Kentucky
JIM RYUN, Kansas                     JOSEPH CROWLEY, New York
VITO FOSSELLA, New York              STEVE ISRAEL, New York
JUDY BIGGERT, Illinois               MIKE ROSS, Arkansas
MARK GREEN, Wisconsin                WM. LACY CLAY, Missouri
GARY G. MILLER, California           CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania      JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia  JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania        STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota           BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio              RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida           DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona


                            C O N T E N T S

                              ----------                              
                                                                   Page
Hearing held on:
    March 12, 2003...............................................     1
Appendix:
    March 12, 2003...............................................    59

                               WITNESSES
                       Wednesday, March 12, 2003

Bogle, John C., Founder, The Vanguard Group......................     7
Bradley, Harold S., Senior Vice President, American Century 
  Investments....................................................    13
Gensler, Hon. Gary, Co-author The Great Mutual Fund Trap, former 
  Under Secretary for Domestic Finance, Department of the 
  Treasury.......................................................    18
Haaga, Paul Jr., Executive Vice President, Capital Research and 
  Management Company.............................................    16
Montgomery, John, Founder and President, Bridgeway Funds.........    11
Riepe, James S., Chairman, T. Rowe Price Associates, Inc.........    20
Wagner, Wayne H., Chairman Plexus Group, Inc.....................    10

                                APPENDIX

Prepared statements:
    Oxley, Hon. Michael G........................................    60
    Clay, Hon. Wm. Lacy..........................................    62
    Emanuel, Hon. Rahm...........................................    63
    Gillmor, Hon. Paul E.........................................    65
    Hinojosa, Hon. Ruben.........................................    67
    Kanjorski, Hon. Paul E.......................................    68
    Ney, Hon. Robert W...........................................    70
    Bogle, John C. (with attachments)............................    72
    Bradley, Harold (with attachments)...........................   134
    Gensler, Hon. Gary...........................................   155
    Haaga, Paul G. Jr., (with attachments).......................   168
    Montgomery, John.............................................   193
    Wagner, Wayne H. (with attachments)..........................   202

              Additional Material Submitted for the Record

Fidelity Investments, prepared statement, March 12, 2003.........   210
United States General Accounting Office, prepared statement, 
  March 12, 2003.................................................   216

 
                   MUTUAL FUND INDUSTRY PRACTICES AND
                  THEIR EFFECT ON INDIVIDUAL INVESTORS

                              ----------                              


                       Wednesday, March 12, 2003

             U.S. House of Representatives,
    Subcommittee on Capital Markets, Insurance and,
                   Government Sponsored Enterprises
                           Committee on Financial Services,
                                                   Washington, D.C.
    The subcommittee met, pursuant to call, at 10:07 a.m., in 
Room 2128, Rayburn House Office Building, Hon. Richard Baker 
[chairman of the subcommittee] presiding.
    Present: Representatives Baker, Ose, Gillmor, Castle, 
Royce, Manzullo, Oxley, Kelly, Ney, Fossella, Biggert, Kennedy, 
Tiberi, Harris, Kanjorski, Sherman, Meeks, Inslee, Frank, Lucas 
of Kentucky, Ross, Clay, Baca, Matheson, Lynch and Scott.
    Chairman Baker. [Presiding.] I would like to call this 
meeting of the Subcommittee on Capital Markets to order, and 
welcome those who are here in attendance today.
    Today, the subcommittee will examine mutual fund industry 
practices and the potential effects on individual investors. 
This hearing is a next step in the committee's continuing 
efforts to protect America's investors and help in the 
restoration of public confidence in the performance of the 
capital markets. This effort began some time ago in the last 
Congress, with hearings in this subcommittee on the conduct of 
securities analysts and a series of others, culminating in the 
passage of the Sarbanes-Oxley legislation. The statute once 
adopted addressed not only analysts' conduct, but strengthened 
oversight and the responsibilities of accountants, attorneys 
and corporate officers. It was a very important beginning.
    Last month, we examined the collection and investor 
restitution efforts by the SEC. I am personally anxiously 
awaiting the outcome of the global settlement, hoping that it 
will make significant provision for investor restitution. The 
committee will continue this work. For example, it is my hope 
in the near term to visit the credit rating agencies and 
determine how their performance fared during the disappointing 
market periods.
    These actions are not without justification. Ninety-five 
million Americans are now investors in mutual funds, with many 
depending on long-term performance for their retirement. The 
point needs to be made clearly. The responsible performance of 
the markets and the equitable treatment of all investors is 
essential for the economic vitality of the country. This 
committee, and I hope this Congress, will take all appropriate 
steps to restore efficient performance and ensure fair 
functioning of the capital market allocations.
    Today, we turn our attention to the mutual funds, a sector 
of the market which during the 1990s experienced unprecedented 
growth. We should examine whether investors really get what 
they pay for, and determine whether investors know what fees 
and costs they are paying, and then examine how the current 
regulatory system either succeeds or fails in investor 
protection. It is not, at least with my current understanding, 
clear to me that all is well. The recent GAO report, which was 
by the way initiated by request of this committee many months 
ago, has reached a conclusion only yesterday that fees are up. 
More troubling, investors are paying higher fees while 
suffering from troubling fund performances.
    According to the information reviewed in the last few days, 
in the last 15 years the S&P index has outperformed almost 60 
percent of the diversified equity funds. Another trend in the 
industry which is alarming is the turnover rates in portfolios. 
Currently, the average portfolio turnover for a fund is 110 
percent, with average fund holding periods of 11 months. 
Obviously, these are not investments made for the long haul. 
This continual churning increases cost to the investor and 
potentially generates additional tax liabilities. This short-
term, roll-them-in and roll-them-out strategy, as I call it, 
certainly does not enhance the building of corporate wealth or 
shareholder return, but appears to generate significant cash 
flow in fees for somebody.
    As troubling as the facts appear today, really they are not 
that easy to get at. So I am, just like everyone else, hoping 
to learn today about how to better understand how the market 
functions. This lack of transparency certainly leaves the 
average investor without an ability to determine what action is 
in his own best interest.
    Current disclosure in the prospectus that shows fees as a 
percentage of assets, which is based on a hypothetical dollar 
amount, may be somewhat instructional. But I am very hopeful 
that the SEC will soon move forward on an enhanced disclosure 
requirement and also give final approval to the pending proxy 
voting disclosure rule. I think such changes will provide the 
initial and necessary steps to strengthen the position of 
individuals and certainly help build confidence in market 
performance. But know from my perspective that these two steps 
are really very rudimentary. They are only small steps down 
what is, I think, going to be a long road.
    I hope we can turn to the industry leaders to assist in 
this effort. At the end of the day, everyone from the director 
of a large fund to the smallest investor will benefit from a 
market structure which is transparent, efficient and fair. We 
must have a platform in which investors are willing to return 
to the market with their dollars. Our economy and our nation, 
will benefit from such enhancements. I, for one, will not 
conclude my efforts until we have attained that goal.
    Mr. Kanjorski, do you have an opening statement?
    Mr. Kanjorski. Mr. Chairman, thank you for the opportunity 
to offer my initial thoughts about mutual funds before we hear 
from our witnesses. I want each of them, and you, to know that 
I approach today's hearing and future discussions on mutual 
fund issues with an open mind.
    As we begin our examination of mutual funds in the 108th 
Congress, I feel it is important to review some of the basic 
facts about this dynamic industry. According to the Securities 
and Exchange Commission, at the end of fiscal year 2002 mutual 
funds managed $6.1 trillion dollars in investments, 
significantly more than the $3.7 trillion deposited at 
commercial banks. Additionally, the SEC calculated that 93 
million investors living in 54 million households owned mutual 
funds. The mutual fund industry has also evolved dramatically 
in the last several decades. The number of mutual funds has 
grown from 564 in 1980 to nearly 8,300 today. In addition, the 
assets in mutual funds portfolios totaled just $56 billion in 
1978. By 1990, this figure increased to $1.1 trillion, and by 
the turn of the century mutual fund assets had expanded another 
six-fold.
    Today, mutual funds also represent about 20 percent of our 
nation's equities market. Without question, we can therefore 
conclude that mutual funds constitute a major sector of our 
nation's economy.
    As the mutual fund industry has grown, it has worked to 
bring the benefits of securities ownership to millions of hard-
working Americans. Many securities experts have noted that the 
typical investor would find it expensive and difficult to 
construct a portfolio as diverse as that of a mutual fund. I 
wholeheartedly agree. Mutual funds have clearly provided an 
economical way for middle-class Americans to obtain the same 
kind of professional management and investment diversification 
that was previously available only to large-scale institutions 
and wealthy investors. In short, mutual funds have worked to 
democratize investing.
    Despite this tremendous success, securities experts 
continue to examine how we can improve the performance of the 
mutual fund industry and advance the interests of U.S. 
investors. Some recent public policy debates in this area have 
focused on disclosing proxy votes to mutual fund shareholders, 
modifying industry oversight through the creation of self-
regulatory organizations, and increasing the frequency of 
mutual fund holdings disclosures. Although each of these issues 
is important, today we will generally focus our examinations on 
the cost of mutual fund ownership--an issue that many consider 
is the most consequential.
    As you know, Mr. Chairman, I have made investor protection 
one of my top priorities for work on this committee. 
Understanding the cost of operating a mutual fund and learning 
how such expenditures affect investing is, in my view, 
therefore very important. These fees and loads will, after all, 
have a significant effect on investors' returns. A recent story 
in USA Today, for example, determined that for government 
securities mutual funds, the group with the lowest expense 
ratios averaged a 43 percent gain over five years, while those 
with the highest expense ratios grew by 34 percent during the 
same time frame. Small differences in annual fees will 
ultimately result in major differences in long-term returns.
    During our deliberations today, I expect we will hear many 
conflicting views on the issue of mutual fund fees. Some of our 
witnesses will cite studies showing that these expenses have 
increased in recent years, while other panelists will refer to 
analyses demonstrating a gradual decrease in such fees. 
Although each side in this debate will seek to use statistics 
to its advantage, our job should be to learn more about the 
industry today so that we can work to improve public policy in 
the future.
    For my part, I hope that these experts will answer a number 
of questions that I have about mutual fund fees. I would like 
to determine whether investors have obtained the benefits of 
economies of scale as the size and scope of the mutual industry 
has grown. I also want to learn more about the calculation of 
12(b)(1) fees, the use of soft dollar arrangements, and the 
effects of portfolio transaction expenses.
    In closing, Mr. Chairman, I look forward to hearing from 
our expert witnesses on these important issues. Mutual funds 
have successfully worked to help middle-income American 
families to save for an early retirement, higher education and 
a new home. We need to ensure that this success continues. I 
therefore look forward to working with you to examine these and 
other matters related to the mutual fund industry in the weeks 
and months ahead.
    Thank you, Mr. Chairman.
    [The prepared statement of Hon. Paul E. Kanjorski can be 
found on page 68 in the appendix.]
    Chairman Baker. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. Oxley. Thank you, Chairman Baker, for holding this 
important and timely hearing. This morning, we will discuss the 
state of the mutual fund business. Our inquiry is simple: Are 
investors getting a fair shake? At last count, there were 95 
million mutual fund investors in the United States. For most 
Americans, mutual funds are the primary vehicle for accessing 
the capital markets and building wealth. The rapid growth in 
fund ownership over the past 20 years is unquestionably a 
positive development. Mutual funds provide the opportunity to 
invest small sums of money in return for a diversified 
investment in stocks, bonds, and other securities. Selecting a 
suitable fund can be a challenge for many investors. Some funds 
buy large capitalization stocks; others buy small or mid-caps. 
Some buy foreign companies or corporate or municipal bonds. 
Still other funds invest entirely in one sector of the economy. 
There are multiples classes of shares, different investment 
styles and so on. Add to this the fact that there are now 
almost 5,000 stock mutual funds.
    All these funds are competing for investor dollars. While 
there is clearly competition in the fund industry, some 
question whether it is working the way it does in other 
industries. That is to say, are costs going down for investors? 
Recent data indicate that the answer is no. Fees and expenses 
in fact are going up, and this despite the efficiencies created 
by these enormous economies of scale. While investors have 
become sensitive to certain fees like sales loads, other fees 
are either hidden or opaque, escaping the attention of even 
savvy fund investors. This precludes them from comparison 
shopping--a strong market influence that would encourage fee-
based competition and would likely bring down costs.
    What are investors getting in return for these increasing 
costs? The evidence is troubling. Noted financial commentator 
Jim Glassman has said, what is truly remarkable is that 
hundreds of funds do worse than the rules of chance would seem 
to allow. He adds that the low-cost Vanguard 500 index fund has 
beaten 76 percent of its managed fund peers over the past 10 
years, according to Morningstar. Even worse, the NASD and the 
SEC have recently discovered widespread evidence that fund 
investors are not even receiving the discounts on sales loads 
that funds promised in their prospectuses. While preliminary 
reports indicate this failure to provide break-point discounts 
does not appear to be the result of fraudulent behavior, one 
commentator is reported as attributing the problem to laziness 
or sloppiness. That is simply unacceptable. I am pleased that 
the regulators are acting quickly, and I urge them and fund 
directors to take steps immediately to repair this breakdown 
and to make investors whole.
    Along with rising fees that are often hidden or not easily 
understood, and chronic under-performance, this committee 
intends to examine the role of mutual funds in corporate 
governance. Last year, Congress passed the Sarbanes-Oxley Act 
in an effort to help rebuild investor confidence in public 
companies. New and mostly sensible regulations have been 
enacted for accountants, corporate executives and directors, 
investment bankers, research analysts, and attorneys. Until 
very recently, though, mutual funds have not been the focus of 
regulators and lawmakers, despite the fact that funds own about 
20 percent of U.S. equities. The voting power represented by 
these securities carriers carries great potential to influence 
U.S. corporate governance. Whether mutual funds have used their 
powerful position to do so is an important question that merits 
attention.
    Another important issue to this committee concerns the role 
of independent fund directors. Are they looking out for the 
best interests of shareholders in the fund, as is their 
fiduciary duty? At least one prominent investor emphatically 
says no. In his recent letter to Berkshire Hathaway 
shareholders, Warren Buffett said that fund directors had an 
absolutely pathetic record, particularly with regard to 
removing under-performing portfolio managers and lowering fees 
charged to investors. Some have asked, where were directors 
during the frenzied creation of a multitude of tech funds 
during the bubble of the 1990s that left so many investors 
holding the bag? An article in yesterdays Wall Street Journal 
observed that during the tech bubble, stewardship often gave 
way to salesmanship. Borrowing a phrase from one of our 
distinguished witnesses here today, Vanguard founder, Jack 
Bogle.
    In recent months, the SEC has acted on a number of 
important mutual fund initiatives, often in the face of fierce 
industry opposition, I might add. Last December, the commission 
issued a proposed rule that would enhance portfolio disclosure 
and help clarify fund fees. The commission also recently 
required funds to disclose both their proxy voting policies and 
procedures and their actual proxy votes. These are good steps, 
but more needs to be done. I have the utmost confidence that we 
can count on Chairman Donaldson to continue Harvey Pitt's fine 
work on behalf of fund investors.
    Mr. Chairman, I look forward to hearing the testimony of 
this distinguished panel, and I yield back the balance of my 
time.
    Chairman Baker. Thank you, Mr. Chairman, for your statement 
and your participation today.
    [The prepared statement of Hon. Michael G. Oxley can be 
found on page 60 in the appendix.]
    Mr. Scott?
    Mr. Scott. Thank you very much, Chairman Baker. I want to 
thank you and the ranking member, Mr. Kanjorski, for holding 
this hearing today regarding the mutual funds industry. I also 
want to thank this distinguished panel of witnesses today for 
their testimony.
    Given that more than half of all households in the United 
States now hold shares in mutual funds, any discussion today 
will have an enormous impact on millions of investors and 
billions of dollars. I firmly believe that the individual 
investor is empowered when given the tools to compare varying 
investment funds. Hopefully, this hearing will help us 
understand whether mutual funds investors are receiving fair 
value in return for the fees that they pay.
    There are some serious issues and some troubling questions 
that the American people certainly want answers to. For 
example, how can mutual funds empower individual investors to 
make the best decision about their money today? Some funds are 
able to get away with overly high fees because investors do not 
understand how fees can reduce their returns. We need to find 
answers and make recommendations to clearly explain the 
potential cost of fees to investors up front.
    Another troubling issue is sloppy recordkeeping at 
brokerage firms. What cost is that for mutual fund customers? 
There is a cost that is estimated at more than $600,000 in 
overcharges in one year alone. How can we get the mutual fund 
industry to ensure that they have the capacity to charge 
customers the right amount? These are questions I think that 
the American people certainly want answers to, and I would hope 
with our deliberations today that we can get some of those 
answers.
    Again, I look forward to this very important discussion. 
Mr. Chairman, I yield back the balance of my time.
    Chairman Baker. Thank you, Mr. Scott.
    Mrs. Kelly?
    Mrs. Kelly. Thank you, Mr. Chairman.
    For many years, the public looked at the stock market as a 
sophisticated, obscure type of crap shoot. When mutual funds 
came into existence, the mutuals gave some investors the sense 
that there was stability somehow, and that in unity they would 
make out better. And they invested, and that was a good thing. 
Those were the vehicles that brought a lot of investors into 
the market. But recently, the public has been painting the 
mutual funds with the same kind of distrust that they are 
painting corporations and the stock market. I think that they 
are looking at things like hyperactive turnover. They are 
looking at sales techniques that are producing increases in 
fees.
    Personally, I think that if we can get some transparency 
into some of these things, it will help investors make 
intelligent decisions and it will bring people back into the 
market. So I applaud you, Mr. Chairman, for having this 
hearing. I look forward to the witnesses' testimony today.
    Chairman Baker. Thank you, Mrs. Kelly.
    Mr. Castle, do you have a statement? Ms. Biggert? Does any 
other Member have an opening statement? Ms. Harris?
    Ms. Harris. Thank you, Mr. Chairman.
    I wish to express my appreciation for this panel today and 
for the panel's testimony that is going to contribute greatly, 
I am certain, to helping us understand and secure investor 
confidence in the mutual fund industry.
    Mutual funds have become a vital tool that millions of 
Americans rely upon to ensure the safety of their investments 
in U.S. capital markets. In fact, nearly half of all U.S. 
households hold a stake in some type of mutual funds. 
Reflecting on that dramatic shift in recent decades towards 
investment alternatives, mutual fund industry assets raised 
dramatically from $56 billion in 1978 to $6.4 trillion in 2002.
    So as our nation confronts an array of daunting challenges 
to restore and safeguard the economic security of every 
American, that has to stay at the top of our priorities. We 
cannot achieve this goal without examining the basic practices 
of the mutual fund industry and the affect upon individual 
investors. So in particular, we must verify the legitimacy of 
the various charges that the industry levies, guaranteeing 
their relation to the substantial overhead costs that mutual 
funds encounter. Moreover, we must determine what action, if 
any, is necessary to guarantee an adequate level of disclosure 
and transparency so investors can make informed choices.
    I look forward to your testimony this morning. Thank you.
    Chairman Baker. Thank you, Ms. Harris.
    I have been informed that we might expect a series of votes 
about 11 o'clock. Certainly, any other member would be 
recognized for a statement if you choose to make it, but let me 
request you to do it briefly so we can give our panelists an 
opportunity before the committee's work is interrupted.
    Mr. Ney?
    Mr. Ney. I am going to submit for the record.
    Chairman Baker. Thank you, Mr. Ney.
    [The prepared statement of Hon. Robert W. Ney can be found 
on page 70 in the appendix.]
    All other Members' statements will be submitted for the 
record.
    Without any other requests, I would move now to our 
witnesses this morning, and call first Mr. John C. Bogle, 
Founder of the Vanguard Group. Welcome, Mr. Bogle.

    STATEMENT OF JOHN C. BOGLE, FOUNDER, THE VANGUARD GROUP

    Mr. Bogle. Thank you very much, Chairman Baker, and good 
morning. Thank you, Chairman Oxley. Thank you, Ranking Member 
Kanjorski and thank you Members of the committee for coming 
out.
    I hope that my long experience in the mutual fund industry 
will be of some help to you in considering the issues that lie 
before you today.
    Vanguard operates under a mutual structure in which our 
management company is owned by the shareholders of our mutual 
funds and operates on an at-cost basis. This is a unique form 
of shareholder-oriented organization and has enabled us to 
emerge as the lowest cost provider of services in our field. As 
you see in the chart, the expenses of the average Vanguard fund 
today come to just 26 hundredths of 1 percent of assets, a 
reduction of 65 percent since we began in 1974, while the 
expense ratio of the average mutual fund was 1.36 percent last 
year, up almost 50 percent in that period.
    Does this difference matter? Our cost advantage of 1.10 
percentage points applied to our fund assets, presently at $550 
billion, now results in annual savings for our fund 
shareholders of $6 billion. Lower costs mean higher returns, 
for what investors must earn and do earn is whatever returns 
the financial markets are generous enough to provide, minus the 
cost of financial intermediation. It is not very complicated. 
The returns therefore earned by mutual funds as a group 
inevitably equal the market returns, less the costs funds 
incur, most obviously in money market funds.
    Over the past five years, the money market funds with the 
lowest costs earned a gross return of 4.8 percent, costs of 
0.37 percent, net yield a little over 4.4 percent. The highest 
cost funds earned 4.7 percent--not very different from the 
lowest cost group--deducted cost of more than 1.7 percentage 
points and provided a net yield of just 2.9 percent. Result? 
Just by owning the lowest cost group, fund investors could have 
increased their income by 51 percent, without any increase in 
risk whatsoever.
    While less obvious, the same relationship prevails in 
equity mutual funds. Over the 10 years ended June 30, the risk-
adjusted annual return for the lowest cost quartile of equity 
funds was 13.8 percent--three full percentage points higher 
than the highest-cost quartile. This relationship, as you see 
in the chart, appears to be universal, prevailing in each one 
of the nine Morningstar so-called "style" boxes--large-cap 
growth funds, small-cap value funds and so on. Great 
consistency of advantage around the 3 percentage point level by 
each of the nine style boxes.
    In the long run, Mr. Chairman and members of the committee, 
costs make the difference between investment failure and 
investment success. Over the past two decades, and even after 
the recent decline, the stock market provided an annual return 
of 13.1 percent compared to a 10.0 percent return reported by 
the average equity fund. For the full period, therefore, 
$10,000 invested in the market itself grew by $105,000, while 
the same $10,000 invested in the average equity fund grew by 
$57,000--just half as much. That 3.1 percentage point 
difference is largely a reflection of the costs that investors 
incur. So yes, costs matter.
    In the interest of time, I am going to skip chart five and 
go to looking at costs in dollars rather than expense ratio 
terms. That is a very important thing the committee ought to 
consider. In 2000, for example, the actual cost of providing 
portfolio management services for all of Vanguard's money 
market funds, as shown in chart number six, came to $15 
million. That is our known cost. Yet in another firm's money 
market funds with the same $65 billion in assets, the funds 
paid the investment manager for investment management services 
only, $257 million. It is high time we looked into these issues 
and had a government-sponsored economic study that follows the 
money in the mutual fund industry.
    That such a fee was approved by that fund's directors 
suggests a monumental shortfall in the shareholder protections 
sought by the Investment Company Act of 1940, which clearly 
states that funds should be operated and managed in the 
interests of their shareholders, rather than the interest of 
their investment advisers, and subjected to adequate 
independent scrutiny.
    What is the case? Well, fund directors have two important 
responsibilities: obtaining the best possible manager and 
negotiating for the lowest possible fee. Yet their record has 
been absolutely pathetic. They follow a zombie-like process 
that makes a mockery of stewardship. Able but greedy managers 
have overreached and tried to dip too deeply into the 
shareholders' pockets and the directors have failed to slap 
their hands. Independent directors over more than six decades 
have failed miserably. I would not have the temerity, Mr. 
Chairman, to use those words, so they are all a direct 
quotation from Warren Buffett in his recent annual report.
    One reason for the failure of directors is that the head of 
the fund's management company is typically the chairman of the 
fund's board as well. As Mr. Buffett has observed, negotiating 
with oneself seldom produces a barroom brawl. So we need to 
require that the fund chairman be an independent director. 
Would it matter? Let me give you one example. That is the way 
we operate at Vanguard, and since we began in 1974, the fee 
rates that our Wellington Fund has negotiated at arms length 
with its external investment adviser, Wellington Management, 
have been reduced six times. Last year's management fee in this 
$22 billion fund was 0.04 percent--four one-hundredths of one 
percent of assets or $8.5 million. Without those reductions 
over the years, that fee would have otherwise been $92.2 
million. Active fee negotiations therefore saved the fund's 
shareholders $85 million for that one fund, and enabled the 
fund to catapult its returns over 90 percent of its balanced 
fund peers. Yes, again, costs matter.
    We need to awaken investors to the critical importance of 
lower costs. We need information that encompasses all of the 
costs of fund ownership, presented forthrightly in fund 
prospectuses and annual reports, and we need to show each 
shareholder the dollar costs that he or she is incurring in 
their statements.
    At the same time, we have got to empower independent 
directors to live up to the standards of the law of the land 
and protect the interest of the fund shareholders that they are 
honor-bound to represent.
    Thank you, Mr. Chairman.
    [The prepared statement of John C. Bogle can be found on 
page 72 in the appendix.]
    Chairman Baker. Thank you very much, Mr. Bogle, for your 
appearance and your testimony.
    I failed to say it at the outset, but all witnesses' formal 
statements will be incorporated into the official record, and 
to the extent possible, if you can keep your prepared remarks 
to five minutes, it would be helpful in getting to our question 
and answer period. We appreciate your courtesy in being here.
    Our next witness is Mr. Wayne H. Wagner, Chairman of the 
Plexus Group, Inc. Welcome, Mr. Wagner.

   STATEMENT OF WAYNE H. WAGNER, CHAIRMAN, PLEXUS GROUP, INC.

    Mr. Wagner. Thank you, Mr. Chairman and Committee Members.
    I want to talk about the transaction costs associated with 
the management of mutual funds here. Several points--Are these 
costs significant? How should they be evaluated? Should they be 
disclosed to fund participants? And are the markets--a little 
farther afield--are the markets optimally organized to keep 
these costs low?
    Bottom line, as Jack has said, costs hurt performance here. 
They immediately reduce investor assets. They do not stay in 
the portfolio to continue to perform. They impede the ability 
to capture the benefit of research. They reduce liquidity and 
interfere with capital formation. Congress and the SEC have 
repeatedly attacked these issues here to make these better in 
general here.
    To me, it is impossible to argue that uninformed investors 
are better investors. More information is better, as 
Congressman Scott said. It is empowering for investors to know 
the correct information here. As long as that information is 
not misleading, of course, and when we are talking about 
transaction costs, in particular, that can be a little bit 
problematic here.
    How important are these transaction costs? Very. I believe 
they account for the difference as to why active managers have 
such difficulty in maintaining performance to Mr. Bogle's fund 
here. We have measured those on a regular basis for 17 years. 
We measure them for 2002 as 1.5 percent, one-way transaction 
costs. Multiply that by a buy and sell, multiply that by 110 
percent turnover, and you can see we are talking about a great 
deal of money.
    I personally believe that these are the largest costs which 
are borne by investors over time. Now, that may sound like a 
very large number to you, and it is surprisingly large. To the 
retail investor, the market looks like a vending machine. You 
put your coins in, you push the button, and out comes your 
selection. That is not true for institutional trading. It is 
not true for mutual funds trading.
    Could I have my first slide please? Thank you. We took a 
look at our universal, which represents about 25 percent of 
exchange volume. We divided it into five groups, where each of 
the groups was sorted on the size of the trade. So the first 
line on there is the smallest trades. There are three groups 
omitted, and the last line is the largest trades that were put 
out by mutual funds in their investing process. Each of these 
is of equal importance to investors because each of them 
represents the same amount of dollars being invested.
    The top group is the smallest trades, and they are really 
not that different from the retail market here. They are the 
vast bulk of every trade, representing 11 out of every 12, 
averaging 2000 shares, $53,000 in principal and less than half 
of 1 percent of the daily volume. They cost about a quarter of 
1 percent, but they are only one-fifth of the trading.
    Concentrate for a moment on the largest trades here. This 
is only one out of every 400 trades, yet it makes the same 
impact on the performance of the funds here. They average two 
million shares apiece, $77 million in principal, and over half 
a day's volume. They cost in excess of 1 percent here.
    Clearly, the vending machine analogy does not work for 
these large trades. These are not trading events. They are a 
trading process that links the portfolio manager and his 
decisions to the trader, to the broker, and to the exchange. 
They are really orchestrated into the market, and because of 
their size they may take many days to complete. This stretched-
out process leads to delay in opportunity costs.
    If I may have the other slide please? We have measured 
these on a regular basis. This iceberg shows that not only the 
costs are very obvious, the commission on the top of the 
iceberg is very obvious and we all see what that is. The impact 
cost is the cost of hitting in the marketplace. The delay in 
opportunity costs down below stem from this orchestration 
process where it is difficult to get the size through the 
marketplace.
    To our mind, this total cost is what investors need to 
know, because you cannot ignore that 75 to 80 percent of the 
cost, which is coming out of performance, and yet is really not 
available in something simple like the commissions here.
    Saying that, revealing the commission is sufficient to 
reflect the cost, I do think is not enough. It is only 10 
percent of the cost. It sends the wrong message that costs are 
trivial, and that costs are comprised of broker payments, 
rather than a measure of overall management effectiveness here.
    Investors need to know basically which firms are efficient; 
which ones are doing a good job of using their resources here. 
This was the conclusion of the AIMR trade management 
guidelines. I have a thousand copies coming. I will send copies 
for the committee here. It defines best execution as the 
trading process firms apply to maximize the value of client 
portfolios. Rather than focus on costs in isolation, the 
definition focuses on a cost-to-benefit ratio of trading. May I 
suggest that this is a useful definition for the committee to 
keep in mind.
    With that in mind, I have overrun my time and I will cede 
the mike.
    [The prepared statement of Wayne H. Wagner can be found on 
page 202 in the appendix.]
    Chairman Baker. Thank you, Mr. Wagner. We appreciate your 
participation today.
    Our next witness is Mr. John Montgomery, Founder and 
President of Bridgeway Funds. Welcome, Mr. Montgomery.

STATEMENT OF JOHN MONTGOMERY, FOUNDER AND PRESIDENT, BRIDGEWAY 
                             FUNDS

    Mr. Montgomery. Chairman Baker, Ranking Member Kanjorski, 
and Members of the Subcommittee, from a recent news article, I 
quote, "Mutual funds exist in a culture that thrives on hype 
and withholds important information in a cutthroat business 
that regularly misleads investors."
    While I hardly think that this reflects the environment at 
Bridgeway Funds, and while I believe that the mutual fund 
industry is on the cleaner end of the spectrum in the 
investment community, major criticism is well-deserved. As an 
industry, we must do better if we are to serve the long-term 
needs of this country's smallest investors.
    After the most extended bear market since before World War 
II, investors are starting to look under the hood of their 
mutual funds, and they do not like some of what they see, 
especially some of what they do not see and cannot find. Access 
to key information is crucial to fair competition on which our 
free enterprise system is based.
    To be sure, progress has been made with the plain English 
prospectus, simple and standardized fee tables, better 
standards of performance evaluation, disclosure of the effect 
of taxes on returns, and much more detailed information 
available through the Internet. Soon, we will have disclosure 
of proxy voting and more frequent disclosure of mutual fund 
holdings.
    My written testimony outlines better disclosure in 13 
areas, but I would like to comment now on just four of these: 
soft-dollar commissions, standardized industry operating 
information, manager salaries, and board decisions on 
management contract approvals.
    First, disclosure of soft-dollar commissions. Apart from 
the affiliated brokerage and directed brokerage, the practice 
of soft-dollar commissions is one of the worst examples of 
undisclosed conflicts of interest in the mutual fund industry. 
The term "soft-dollar commissions" refers to an agreement 
between a broker and investment adviser by which the broker 
supplies a variety of products or services from research to 
software, hardware, data or other services, in return for a 
certain volume of business to the broker. The problem with this 
legal arrangement is that the adviser receives the immediate 
benefit, while the shareholder pays. There is inadequate 
incentive for the adviser to keep soft-dollar commissions low.
    A confirmation of this situation is the response of vendors 
when we tell them that Bridgeway will be paying with our own 
hard dollars. One salesman, a software salesman, looked at me 
incredulously and asked, why on earth would you pay with your 
own money when you could pay for it in soft dollars? The 
problem with soft dollars, then, is that they are really hard 
dollars. They just belong to somebody else. As a fellow Texan 
said, if you see a snake, just kill it; do not appoint a 
committee on snakes.
    [Laughter.]
    This would be one snake we should not disclose. We should 
just kill.
    Second, standardized industry operating information. When I 
worked in the urban mass transit industry, there was uniform 
data on system expenses, passengers and other very helpful 
operating data, with enough detail to establish some best 
industry practices. Twenty years later, there is no similar, 
easily accessible database for the mutual fund industry. Some 
information is in the SEC-EDGAR system, but it is not down-
loadable, expense categories are not standardized, and it is 
terribly time-intensive to access information across fund 
families. While this level of detail is not generally sought by 
individual investors, use and analysis by academia, authors 
such as Mr. Gensler, media, consultants and fund boards of 
directors could greatly spur industry competition and 
efficiency. The federal government is in the best position to 
take the lead on this disclosure.
    Third, disclosure of manager salaries. When we invest in 
individual companies, we have the right to know the 
compensation of the company leaders. When we invest in mutual 
funds, we are in the dark. To the best of my knowledge, 
Bridgeway is the only mutual fund company that voluntarily 
discloses portfolio manager pay in its statement of additional 
information. Compensation level, and especially structure, do 
affect portfolio manager incentives and fund decisions. Our 
industry's refusal to disclose it contributes to the aura of 
withholding important information and misleading shareholders, 
that some shareholders perceive in the current environment. 
This disclosure would be easy and costless.
    Finally, number four--board disclosure. Over the years, I 
have examined the record of some of the consistently worst-
performing mutual funds and wondered, "where are their boards 
of directors?" Unlike the boards of privately held firms, 
nonprofit organizations and even publicly traded companies with 
multiple constituencies, a mutual fund board exists only to 
protect shareholder interests. Studying the worst-performing 
funds over the last five years, for example, I identified some 
funds that were poor performers for some years before. Their 
average costs exceeded the entire average historical return on 
the stock market. How can these funds hope to make any return 
for their shareholders? Why doesn't somebody put them out of 
their misery?
    Each year, the independent members of the fund's board must 
actively consider a number of factors before approving a 
management contract. Why not disclose to shareholders the basis 
for their decision? Here is an even more radical, but serious 
idea: Require fund boards to consider alternative bids for 
service when both fund under-performance versus a market 
benchmark, and fund expenses, exceed extreme levels.
    In conclusion, if mutual funds are going to address 
increasing public distrust in the environment of a bear market 
and if we are going to continue to play a major role in giving 
access to the wealth of this nation through the fund structure, 
we are going to have to earn it. We need to pursue the 
interests of shareholders relentlessly, and we need to ensure 
that adequate information is available for shareholders and 
their advisers to make informed decisions.
    Finally, I want to thank the committee for the opportunity 
to testify this morning.
    [The prepared statement of John Montgomery can be found on 
page 193 in the appendix.]
    Chairman Baker. Thank you, Mr. Montgomery.
    Our next witness is Mr. Harold S. Bradley, Senior Vice 
President, American Century Investments. Welcome, sir.

STATEMENT OF HAROLD S. BRADLEY, SENIOR VICE PRESIDENT, AMERICAN 
                      CENTURY INVESTMENTS

    Mr. Bradley. Thank you. Chairman Oxley, Chairman Baker, 
Ranking Member Kanjorski, and all the Members of the 
Subcommittee, I appreciate the opportunity to be here today and 
talk. Some of my remarks, limited to soft-dollars, mostly, and 
the use of commission dollars by investors, have been taken by 
my colleague to the right of me. So what I would like to do is 
walk through how it looks, but to say first that I am proud to 
be associated with the fund industry and its strong record as 
an effectively regulated and affordable place for investors. I 
have been a trader and a portfolio manager and virtually all of 
my investments are in a mutual fund, none of which are index 
funds. The three-year bear market has been hard on all of us. 
Me, too.
    I represent American Century Investment Management. Along 
with our industry, we are now looking in the mirror to see what 
things we might do better. We have a long record of working 
with the staff at the SEC of advocating more transparency 
regarding market structure and trading practices, specifically 
in the area of soft-dollar disclosures. We think Congress 
should work to understand how its law, section 28(e) of the 
1975 amendments to the Securities Exchange Act actually 
encourages investment managers, through expansive 
interpretation by the SEC, to use commissions paid by investors 
as a source of unreported income to pay unreported expenses of 
the managers. I would like to try and explain.
    This is a picture of the typical five-cent-a-share 
commission paid by the typical investor. That rate is 
negotiated by the investment manager. The blue bar represents 
our best guess, based on our experience, of what commissions 
pay for in execution-only services, based on fees charged by 
electronic venues, such as Archipelago or Instinct. The red bar 
on top represents what is called paying up, or the value of 
soft dollars in the commission's pot. It includes things like 
broker research, fund expenses, access to IPOs, and in some 
cases normal and customary business expenses, as in the 
expansive definition now allowed by the SEC.
    I am guessing when I estimate the size of these practices. 
Some have called these largely undocumented practices the 
frequent flyer program of the money management industry. Both 
the number of miles, which equates to trading volume, and the 
premium prices paid create cash-back rebates, or the free 
travel equivalent for the investment manager. We need to better 
understand the tangible benefit for the investors. I am told 
there is far less documentation of soft dollar use and utility 
since the 1997 SEC soft dollar sweep in this area. Furthermore, 
I am told by our accountants that our auditors have told us 
that if soft dollar deals were documented, it would likely 
trigger accounting treatment on the investment adviser's books. 
We do need some notion of fair value assessment here.
    I will restrict my remarks specifically to third-party 
payment of soft dollars and to the use of soft dollars to 
obtain IPOs. Chart two, is a picture that shows the long-term 
average commission rate paid by investment managers on behalf 
of investors. It goes back 12 years. You can see on the top 
line, the average commission rate paid by managers per share 
traded that there has been little movement in a decade. It 
looks a little bit like a flat line on a cardiac patient. It 
does not move because of the embedded economics--it is not in 
the investment managers economic interest to negotiate lower 
rates. In other industry surveys, the average commission rate 
remains above five cents per share traded. Meanwhile travel--
trading volume--is the chart that is increasing six-fold during 
the past decade. The current situation is not unlike fixed 
commissions that existed prior to 1975. The value of the 
unreported and mostly uncategorized or un-catalogued "research" 
services obtained by money managers, provides strong incentive 
to keep per-share charges high.
    Chart three. This is a busy chart that requires study. It 
takes a simplistic example and shows the strong positive effect 
of soft dollars on an investment manager's profits. They are a 
powerful form of economic incentive. Furthermore, since fund 
boards can only benchmark a fund's negotiated rates against 
industry averages, there is little competition. If you are 
paying a lot of soft dollars, you just do not want to be too 
far under the industry average or too far above.
    I think that there is a list of about 1,200 vendors in your 
attachment, called third-party vendors, where commissions can 
be used to pay for services through the commissions stream--
1,200. If you look at them, they include telephone companies. 
It includes hardware vendors like Dell Computer, quote vendors, 
the New York Stock Exchange. I would think that most investors 
believe the management fee they say should be sufficient to pay 
for stock quotes--a basic requirement to be in the business. We 
think there is a problem, and it is a transparency problem. We 
think specifically that commissions should be negotiated and 
disclosed as a percent of principal, as it is done in markets 
across the world. This will create more competition and 
transparency, and meaningful measurement of trading costs.
    Fund managers should identify and disclose the execution 
only rate for each broker they use, to make explicit the 
perceived value of services provided. The little blue bar on 
that first slide, that is the real execution rate. We must make 
explicit money manager use of commissions to pay third parties 
for goods and services available to the public for cash, like 
my Wall Street Journal.
    Now, of course, these things that are paid for cash like 
the Wall Street Journal, if in fact these were explicit 
contractual commitments on paper as agreements for soft 
dollars, they would show up as expense items already. They are 
just not "real" today because they are not recorded.
    We also think Congress should look at considering a new law 
or rulemaking that removes the structural incentives based on 
commission flows that have contributed, we believe, to the IPO 
pricing and allocation scandals. We also believe that 
underwriters should publish the size and identity of the 50 
largest IPO allocations so that our investors can be assured 
when they are told that by paying more, we get access to those 
IPO allocations, that we really do. There is no transparency 
there. We need transparency and we need accountability in these 
poorly understood areas.
    I really do believe that if we start to make progress a 
little bit at a time, we will more quickly restore investor 
confidence across all of our markets.
    Thank you very much.
    [The prepared statement of Harold S. Bradley can be found 
on page 134 in the appendix.]
    Chairman Baker. Thank you, Mr. Bradley.
    Our next participant is Mr. Paul Haaga, Jr., Executive Vice 
President, Capital Research and Management Company. Welcome, 
Mr. Haaga.

STATEMENT OF PAUL HAAGA, JR., EXECUTIVE VICE PRESIDENT, CAPITAL 
                RESEARCH AND MANAGEMENT COMPANY

    Mr. Haaga. Thank you, Chairman Baker, Chairman Oxley, 
Ranking Member Kanjorski, Members of the Subcommittee, I am 
pleased to be here.
    I am Chairman of the Investment Company Institute's Board 
of Governors, and I am a member of the executive committee, and 
I am here testifying on behalf of the institute. My own firm is 
the investment adviser to the American Fund, which manages $350 
billion on behalf of about 12 million mutual fund investors. We 
are the third largest mutual fund family in the United States 
and the largest that sells exclusively through financial 
intermediaries.
    I appreciate the opportunity to continue to work with 
Chairman Oxley, who first chaired a hearing on the fund 
industry in 1998, as well as Chairman Baker and their staffs, 
as the committee examines additional ways to bolster investor 
confidence in our financial markets. With half of all Americans 
owning mutual funds, fund companies can play a key role in 
helping millions of middle-American investors to gain 
confidence in long-term investing. Following today's hearing, 
the ICI and the fund industry look forward to addressing any 
questions or concerns members of the committee may have as we 
continue to reinforce our commitment to meeting the needs of 
the 95 million fund investors.
    You have asked how the fund industry is serving individual 
Americans who invest in our funds. We believe the answer is 
very clear. At a particularly difficult and challenging time in 
the history of our financial markets, we are serving 95 million 
investors very well. We provide useful information, multiple 
investment options, and valuable services to our shareholders, 
and at much lower cost than ever before. We believe the cost of 
mutual funds and the services they provide to investors are 
lower than any other alternative financial services used by 
investors.
    I was at a press briefing this morning, and I was asked the 
question, do you think that the hearings today will destroy 
confidence in mutual funds? My answer would be a resounding no. 
I think they will increase confidence in mutual funds. We 
welcome them. We welcome regulation and we think investor 
confidence will increase as they know that people are watching. 
So thank you again for having this hearing.
    We view strict federal regulation as an asset, not a 
liability. Under the SEC's watchful eye and the effective 
oversight of our independent directors, mutual funds have 
remained free of major scandal for more than 60 years. We do 
not think that it is an accident that historically mutual funds 
have enjoyed unusually high levels of trust and support from 
fund investors.
    The hearing occurs as we approach the 37th month of one of 
the worst bear markets in modern history. Our memory of costly 
accounting scandals and corporate abuses is also still vivid. 
Most individual investors holding stocks and stock mutual funds 
have lost money over the last few years. Some have also lost 
confidence. While stock mutual funds are not the cause of the 
scandals or abuses, our responsibility to serve and protect the 
millions of individual investors makes it imperative that we 
work to devise and support solutions.
    For this reason, we strongly supported the Sarbanes-Oxley 
Act and many other reforms to our financial reporting and 
oversight system, and in fact many of the corporate governance 
reforms that were in the Sarbanes-Oxley Act and the follow-up 
regulations came directly from mutual fund's longstanding 
practices.
    Let me turn to the issue of mutual fund fees. It is 
frequently reported that the average stock mutual fund charges 
fees at an annual rate of about 1.6 percent of assets. By 
itself, that statistic is essentially true. But by itself, that 
statistic is also very misleading. Although the average stock 
mutual fund charges 1.6 percent in fees, an overwhelming 
majority of stock mutual fund investors pay far less. At the 
end of 2001, the average investors stock mutual fund had annual 
fees of .99 percent, just under 1 percent. As illustrated in 
the chart we brought with us, 79 percent of all mutual fund 
accounts are in lower-cost stock funds. These lower costs hold 
87 percent of all stock fund assets.
    At first, it may not seem apparent that the average 
investor could pay less than the average fund charges. But 
consider a business that has two cars for sale--one for $20,000 
and the other for $40,000. The average selling price of the 
cars is obviously $30,000. But if 80 people buy the less 
expensive car, and only 20 choose the more expensive car, the 
typical buyer clearly does not pay the average price charged by 
the seller. The typical buyer pays $24,000. This is 20 percent 
less than the $30,000 average price charged by the seller.
    Now, what do cars cost, I ask? Industry critics would say 
$30,000, and they would point the finger at the cars that cost 
$40,000. We would say they cost $24,000, and so would the GAO 
and the SEC in their studies, which are asset-weighted, because 
that is what the majority or the average of what shareholders 
are paying. If you walk down the street and find somebody who 
owns a car, the likelihood is that they will tell you that 
their car cost $20,000, because that is what they paid.
    The committee also expressed interest in the trend in 
mutual fund fees and expenses. Since 1998, major fee studies 
have been completed by the ICI, the General Accounting Office 
and the Securities Exchange Commission. My written testimony 
points out that these studies share many common attributes and 
conclusions. Perhaps the single most important conclusion is 
the finding that as mutual funds grow, their fees generally 
decline, with the sharpest reductions apparent at the funds 
that grew the most. The ICI study found that 74 percent of the 
497 funds that they reviewed lowered their fees as they grew. 
The average reduction amounted to 28 percent. The GAO study of 
46 large funds found that 85 percent reduced their fee levels 
and the average reduction was 20 percent. The SEC study found 
that 76 of the 100 funds they looked at had contracts that 
automatically reduced fee levels. They also found that stock 
funds that had grown to exceed $1 billion in assets had fee 
levels substantially lower than smaller funds. In fact, the SEC 
found specifically that as fund assets increased, the operating 
expense ratio declined.
    We are pleased that all three studies on this subject--the 
ICI, the GAO and the SEC--recognized that cost savings from 
mutual fund asset growth can only be realized by individual 
funds, not by industries.
    It is equally important to understand that mutual fund fees 
schedules cannot be increased without three separate actions 
being taken. First, the fund's board must approve the increase. 
Second, the board's independent directors must separately 
approve the increase. And third, the fund's shareholders must 
vote to approve it.
    This positive news hardly means that our job is complete. 
This is especially true in the wake of the corporate scandals 
and abuses that have been revealed over the last 18 months. The 
challenge of educating investors about diversification, asset 
allocation, various types of risk and the impact of fees and 
taxes, the need for realistic expectations and a long-term 
focus is our constant responsibility and an essential element 
in reinforcing confidence in our markets.
    Thank you very much for helping us to ensure that we will 
do that.
    [The prepared statement of Paul Haaga, Jr., can be found on 
page 168 in the appendix.]
    Chairman Baker. Thank you, Mr. Haaga.
    Our next witness is Mr. Gary Gensler, no stranger to the 
committee as former Under Secretary for Domestic Finance, 
Department of the Treasury, and the author of The Great Mutual 
Fund Trap. Welcome.

 STATEMENT OF GARY GENSLER, CO-AUTHOR, "THE GREAT MUTUAL FUND 
TRAP," FORMER UNDER SECRETARY FOR DOMESTIC FINANCE, DEPARTMENT 
                        OF THE TREASURY

    Mr. Gensler. Thank you, Chairman Baker, Chairman Oxley, 
Ranking Member Kanjorski. Thank you for having me here today. 
It is a great honor to be back with you. It looks like there 
are more seats, though, here in the front since I was last 
here.
    Needless to say, as the author of The Great Mutual Fund 
Trap, I applaud this committee's willingness to look at the 
mutual fund industry closely. There are great statistics that 
have been named, but in each of your congressional districts 
there are 125,000 households that own mutual funds. Middle 
income, generally married, median age 46--sounds like I might 
be a pollster, but I am not--but 125,000 households in each of 
your districts. It counts to middle-income Americans what this 
committee is talking about here today.
    By any objective measure, however, mutual funds have been 
failing millions of those investors, or hundreds of thousands 
in each of your districts. That is understandable given $70 
billion of annual costs--$70 billion--not small amounts of 
money. In any other industry, we would take a close look at 
that, and I think Congress would, and I am glad you are today.
    Investors can expect costs totaling about 3 percent of 
their money each year for investing in mutual funds. I actually 
agree with the testimony to my right. It is about 1 percent a 
year on average for the management fee. Where is the other 2 
percent, you might ask? Well, it also comes in what is called 
sales loads. About half of mutual funds are sold today with a 
commission up front or at the back end, which is 4 percent. 
Given our American nature of turning things over so often, 
which is once every two and a half or three years, that adds 
about 1 percent to 1.5 percent more cost.
    Then there is the undisclosed cost, and those are dramatic. 
Portfolio trading costs add about .05 percent of your money a 
year, because these portfolios turn over on average pretty 
quickly. I would use the median, and they on a median turn over 
once every 15 months. That is pretty fast trading, and that 
fast trading runs up short-term capital gains taxes--good for 
the budget deficit, good for Treasury where I once served, but 
not good for Americans. Better to go back to a buy and hold 
strategy. Short-term capital gains taxes when markets are at 
least modestly going up add 1 to 2 percent of your money every 
year.
    Take out 3 percent of your money each year, what happens 
after 40 years of savings? You give up 42 percent of your 
savings. We wonder about savings in America, and the retirement 
of the baby boom generation, and the mutual fund industry has 
done a tremendous job, but can do better if costs are lower.
    I would also note that many Americans complain about their 
$1.50 ATM charges, because they see it. It is direct. Mutual 
fund charges, it is a wonderful thing--we do not see it. It is 
just taken out and we do not have to write a check like we do 
to our plumber or our mortgages.
    What happens to the average? As you heard Mr. Bogle's 
averages, I will not repeat them, but over the last 10 years, 
Morningstar reports the average diversified fund is behind by 
2.2 percent the S&P. But that does not count all the funds that 
went out of business. About 5 percent of funds go out of 
business every year. Add them, you are about 3.5 percent 
behind, similar to the cost structure, as we have just noted.
    Many Americans think, well, if I just buy yesterday's hot 
fund, I will be able to do well in the future. The mutual fund 
industry has figured out to advertise yesterday's hot fund in 
all those January and February Money magazines, and Smart Money 
magazine advertisements of the hot fund of yesterday. But 
yesterday's hot fund usually does not do well in the future--
just a little bit better than random chads.
    You have heard a lot about fund directors. Whose fund is it 
anyway? It is the investors' fund, and the Investment Company 
Act of 1940 set up a structure whereby investors actually have 
a board of directors control that fund, and can fire the fund 
manager--at least in theory, that is. In practice, when does it 
ever happen? In fact, fund governance leads to the problem you 
have heard about today--soft dollars. While I too am 
recommending that you ban soft dollars, I am not suggesting 
that you once again take up McCain-Feingold. This is not that 
type of soft dollars.
    These soft dollars are saying that fund companies, which 
are distinct from funds, make profits, because the fund 
companies ask Wall Street to pick up their expenses and then 
charge them through higher commissions, as was earlier shown, 
that nickel a share, the higher commissions, directly to the 
fund companies. In fact, many fund companies who get the 
benefit and have higher profits, direct commissions to Wall 
Street's biggest houses. I would say ban soft dollars. I think 
there is no room for it, no excuses for it.
    The other recommendations that I outline in the testimony, 
I would say start with the belief that Americans really have a 
choice. I wrote a book for Americans to choose. If Americans 
wish to choose the high-cost funds, that is their choice. But I 
think transparency would add something. While I say six 
recommendations in the testimony, let me just highlight a few.
    One is to disclose portfolio trading costs. A hard job to 
do, but important costs. Two, I think survivorship buys, as 
tough as it is--all those funds that go out of business--it 
would be helpful if fund companies put on their Web sites the 
ones that went out of business and report their averages 
including the failed funds. It would be sort of like asking 
about those reality TV shows and forgetting about all the ones 
that are kicked off the island. I think we need to know a 
little bit about those as well. Thirdly, I think disclosure 
with regard to all the revenue sharing arrangements, all the 
conflicts that are inherent in the market, would do us well. 
That is with brokers, as well as with corporations around 
401(k) plans.
    I too think that the SEC and Congress should consider 
taking a close look as to why funds do not go out and try to 
hire new fund managers. Seven thousand funds in America, and 
can we name one that in 2002 fired their fund company? Can we 
name one that went out to competitive bid? That is 7,000 
companies. Would not we think that there would be five, ten, 
fifty of them that might have, if fund directors actually were 
fulfilling their fiduciary responsibilities?
    Lastly, as you consider new 401(k) legislation, I know that 
many in Congress think that there is a need for investment 
advisers to be giving advice--that, too, raises new conflicts 
of interest. As you grapple with that, you might want to 
consider I would suggest adding that all 401(k)s and 403(b)s 
have at least an alternative which Congress has for federal 
workers--an index fund to add to the choice of investors so 
that if they get this new investment advice, at least they have 
one low-cost alternative in their portfolio.
    I thank you for considering my thoughts.
    [The prepared statement of Gary Gensler can be found on 
page 155 in the appendix.]
    Chairman Baker. Thank you for your participation, Mr. 
Gensler. We are glad to have you here.
    Our next witness is James S. Riepe, Chairman, T. Rowe Price 
Associates.
    Just by way of announcement, we do have a series of votes 
on the floor. It would be my intent after Mr. Riepe concludes 
his remarks that the committee would recess for about 15 
minutes to go make the votes and come back.
    Mr. Riepe?

     STATEMENT OF JAMES S. RIEPE, CHAIRMAN, T. ROWE PRICE 
                        ASSOCIATES, INC.

    Mr. Riepe. Thank you, Chairman Baker, Chairman Oxley, 
Ranking Member Kanjorski, and all the other Members of the 
Subcommittee.
    T. Rowe Price is a Baltimore-based investment management 
firm. We manage over $140 billion of assets. About $90 billion 
of that is in mutual funds, and we have been at it for about 70 
years. Personally, I have been in the fund management business 
for about 34 years, and I am happy to be here with you all 
today to talk about this important subject.
    Before I start, I want to note that as you conduct your 
review of the fund industry, it is important to remember that 
stock funds, although they get all the headlines--particularly 
after three years of a severe bear market, represent less than 
one half of the mutual fund industry assets, about 41 percent 
specifically. The balance are in fixed income funds and money 
market funds. Even when we look at just the equity fund portion 
of the industry, less than one-fifth of those assets are in 
aggressive growth funds--again the ones that get the most 
headlines. So that means when we look at the mutual fund 
industry assets, only about 6 to 7 percent of the entire 
industry is in this aggressive end, which enjoyed the upward 
volatility of the late 1990s and now suffered the downward 
volatility of the last three years. I think just putting that 
in context, that this is much more than just a growth stock 
business. It also means that the vast majority of investors 
have benefited from mutual funds in a very substantial way, 
when one considers all the other kinds of funds in which they 
are invested.
    Individual investors do not typically trust all their 
assets to just one fund or even one manager. The average T. 
Rowe Price investor, for example, owns at least three of our 
funds, and they also own funds offered by two or three other 
managers as well. So clearly, investors understand the idea 
that diversification is important, not only diversification 
among funds and within funds, but among managers as well.
    That has come across in the defined-contribution side of 
the business. Again using our example, our typical 401(k) 
investor has seven different investment accounts and about 50 
percent of the assets are in equities, and then some more in 
company stock, and then fixed income options. So as a result, 
the 401(k) investor has done relatively well in terms of his or 
her risk-adjusted performance during this recent down period, 
and did well during the later years of the bull market as well.
    Our panel has covered a range of subjects today, and I just 
want to touch on a few of them. Several issues we are a bit 
uncertain about, and others we view with some certainty. With 
respect to disclosure, I do not know if mandating more 
disclosure is the answer. I think we need to work harder in 
determining what disclosure is illuminating to the investor and 
what disclosure is obfuscating. As an industry, we are 
committed to educating investors, and I think the evidence is 
very clear that we have done that, both collectively and as 
individual firms. We have done it quite frankly, because it is 
in our self-interest to have investors who understand their 
investment.
    But disclosure for the sake of disclosure is not good. I 
would use the example of owners manuals. Studies show that 
people do not read owners manuals. One of their problems is 
that the first 10 pages tend to be filled with disclaimers and 
warnings, and then the book is too thick. If we do the same to 
mutual funds, then we are going to turn away the average mutual 
fund investor. So we need good, useful, focused disclosure; we 
do not need simply more disclosure.
    When we get into the world of trading cost evaluations, you 
can tell from listening to a couple of the comments here, it is 
incredibly complex, and very difficult to measure. There are 
multiple ways to measure transaction costs, but there is no 
consensus on which is best. And all the measurement models are 
at their base speculative. I think we can be comforted in the 
fund industry that however such costs are measured, we know 
that the fund investor's return is net of all costs. I think 
that is very, very important.
    Some things we do know. The fundamental qualities of mutual 
funds--diversification, professional management, relatively low 
cost--have proven their merit during this bear market. Being 
able to gain access to a diversified portfolio is critically 
important for investors. When they invest individually in 
individual stocks, they do not have such diversification. 
Morningstar and all the critics have pointed out the value of 
fund investments from a diversification perspective.
    Mutual funds also provide better and much more useful and 
more transparent disclosure than any other financial product we 
service. As Mr. Gensler suggested, the disclosure always could 
be better in mutual funds. But let's compare mutual funds to 
other financial services. If I buy a certificate of deposit at 
my bank, they tell me I am going to get 3 percent. They do not 
tell me that they are going to lend that money out at 8 
percent, use 400 basis points to cover their expenses, and keep 
100 basis points of profit. That is the reason, ironically, 
that you could not have hearings on the expenses of those 
products in the way you can have hearings on mutual funds. 
Because funds spell out all the expenses that investors incur, 
and they spell out the bottom line, which is the net return the 
investor receives after these expenses.
    I think, too, there is an impression being left that mutual 
fund investors panic easily, that they are skittish, et cetera. 
One has to look under the aggregate redemption numbers, to find 
that most fund investors are long-term investors. There are 
certainly those investors who follow trends. There are 
investors who think they can out-guess the market. They are not 
the majority. They are not even in many cases a significant 
minority, but they trade often enough that they affect the 
overall redemption numbers. So I think it is misleading, 
frankly, to look at aggregate numbers and try and draw 
conclusion about 95 million investors. Mutual fund investors 
are intelligent when they make their investments, and they hold 
their investments longer than aggregate redemption ratios might 
indicate.
    Unlike many other financial relationships, and in contrast 
to Mr. Bogle's suggestion, the interests of fund companies and 
mutual fund investors are, in my view, very well aligned. 
Investors and fund managers, they want good performance. We all 
want good performance. That is how we thrive. That is how as 
mangers we thrive and prosper. We want good service. We have to 
have good service to be competitive and we are an incredibly 
competitive industry. We also need to provide helpful guidance. 
Investors select us on the basis of the kind of guidance and 
intelligent advice we can give them. And they want all of that 
at a reasonable cost.
    As to the suggestion that almost no one beats "the index," 
nearly 80 percent of T. Rowe Price equity funds beat the 
competitor Lipper Group and the S&P 500 over the last five 
years. Almost two-thirds have beaten the market index over the 
last 10 years. So the fact is, there are many funds out there 
that have been successful in beating the indices. There are 
many investors who would rather bet on health care or on 
financial services, or on technology, than buy an index fund 
that is going to provide them with the overall market 
performance.
    Having said that, T. Rowe Price manages billions of dollars 
of index funds, along with our actively managed products. This 
is not about religion. This is a matter of choice. Selection 
depends on an investor's objectives and how he or she believes 
they can best achieve them. Index funds are out there for all 
those investors who want them.
    Let me just say very quickly a word on governance. 
Sarbanes-Oxley adopted governance practices that have existed 
for mutual funds for many, many years. So we feel the corporate 
world is coming closer to where we are now, and not vice versa. 
Fund investors do not invest in boards of directors. They 
invest in a fund manager--a company they know, a company they 
have read about, a company they have talked to their friends 
about, a company they have read in Morningstar or Lipper or 
Money magazine. They do not expect directors whom they do not 
know, and who do not necessarily have an investment expertise, 
to decide to replace the manager they have picked. What they do 
expect those directors to do is to monitor the funds's results 
and make sure the managers act in a prudent way. If there are 
funds that they believe have not performed up to reasonable 
standard, they should urge the management to make appropriate 
changes. But the idea that independent directors should start 
replacing managers and putting out to bid contracts, when the 
investor has already made the decision to invest with that 
company, I think is neither appropriate nor expected.
    In closing, when you ask about the effects that funds have 
had on investors, the answer is that the mutual fund as an 
investment vehicle for individual investors has been arguably 
the most successful financial service in the 20th century.
    Chairman Baker. Mr. Riepe, I hate to interrupt you, but we 
are down to two minutes left on this vote, and members are 
going to have to excuse themselves. We will pick up your train 
of thought when we get back in probably 15 or 20 minutes.
    Mr. Riepe. Great. Thank you.
    [RECESS]
    Chairman Baker. If I can ask everyone to take seats, we 
will reconvene our hearing.
    Before we took our recess, Mr. Riepe was concluding his 
remarks. Members will be returning momentarily. I expedited my 
trip. So Mr. Riepe, if you would, please?
    Mr. Riepe. I appreciate the opportunity, and I will just 
give you my closing remarks, Mr. Chairman.
    When you ask about the effects funds have had on investors, 
the answer is that the mutual fund--as an investment vehicle 
for individual investors--has been arguably the most successful 
financial service of the 20th Century. It has succeeded because 
investors see value in it as an investment vehicle. Funds have 
provided tens of millions of investors with diversified and 
professionally managed access to stock, bond and money market 
securities invested around the globe in every way, shape and 
form that investors could want. Mutual funds have succeeded 
without incurring major scandals or frauds during their long 
history--a statement that not many industries could make, and 
certainly not any other financial services.
    That success, in my view, is attributable to a number of 
factors, including the intensive regulatory scheme under which 
funds operate. But most important to their success is the 
transparency which our panel has talked about and which is 
inherent in funds. And that transparency has been critical in 
creating trust between tens of millions of investors and the 
managers responsible for investing their hard-earned dollars in 
these funds. It is a trust that all of us in the business know 
could be lost very easily if we do not continue to earn it 
every single day.
    What you see is what you get in a mutual fund. The net 
return on a fund is just that, return net of all the expenses--
whether they are in fact, the measurable ones or the more 
difficult ones to measure. Our fund is measured every single 
day. The results are posted in the paper, and are seen by 
everyone. The evidence clearly indicates that investors value 
this combination of transparency, diversification, and 
professional management--all at a relatively low cost.
    Thanks very much for the opportunity to express my views. I 
appreciate it.
    Chairman Baker. Thank you, Mr. Riepe. We also appreciate 
your participation here today.
    I will start off with questions to you, Mr. Haaga, and you, 
Mr. Riepe, centered around a comment which you made about 
performance of funds generally as contrasted with the S&P. When 
we passed Sarbanes-Oxley, we had what I called--and this is a 
congressional term--a coloring book requirement which posted 
the individual stocks that an analyst would cover against his 
upgrades, downgrades and price targets. That is required to be 
prepared by the firm for whom he is employed on an annual basis 
so that a shareholder interested in that analyst's performance 
can look back at that coloring book illustration and understand 
how his recommendations fared against the actual performance. 
That leads me to conclude this, that current disclosure 
requirements are not necessarily crystal clear. They are not 
opaque. They are somewhere in the translucent range, in order 
to help facilitate an individual investor's understanding of 
fund performance. Also with the disclaimer, past performance is 
not an indication of future, blah, blah, blah.
    Would either of you object to a requirement on an annual 
basis to have a disclosure of individual funds' performance as 
cast against either the Wilshire, the S&P--you pick out the 
standard index against the fund, so you could make a judgment 
of that sort from the graph, without having to dig through 
numbers and post it yourself. Is that an unreasonable request?
    Mr. Haaga. Actually, we already have it. There is an SEC 
requirement that our annual reports include our results in 
comparison, and of course net of fees, in comparison with a 
recognized stock index of our choice--Wilshire, S&P--
    Chairman Baker. But is there an industry standard that 
everybody does it against the Wilshire?
    Mr. Haaga. All the funds do not seek to mimic the Wilshire. 
There are many balanced funds, funds with--
    Chairman Baker. Well, do we require multiple--
    Mr. Haaga. Nearly all of them use the S&P--nearly all the 
large, broad-based equity funds use it. We also can in those 
disclosures compare against the Lipper averages, the averages 
of other funds, and many funds do. So they will say, we were up 
X amount; the Lipper average for our type of fund was up Y 
amount, and the S&P was up Z amount. I think bringing it down 
to a single comparative number would probably be misleading for 
some of the funds. There really is a vast range of funds and 
there is a vast range of what they do. Having said that, there 
are only three or four recognized indexes that we use. So we 
are almost there.
    Chairman Baker Do either of you think there is any 
additional disclosure standard required from your perspective 
at this time, based on what you have heard from other folks 
this morning?
    Mr. Riepe. With respect to performance?
    Chairman Baker. Fees, performance--you pick. We have about 
five or six different topics that others have elicited comment 
on. But generally from the read of your remarks, and do not let 
me mischaracterize it, you feel generally the industry on 
balance is performing well, and that investors have access to 
the information they need to make informed judgments. If that 
is your position, then do you think any additional standards or 
disclosures are required, based on what you have heard this 
morning?
    Mr. Haaga. Yes, and in fact we have got that in writing, 
because there are two SEC proposals out there. One is a 
requirement that any mutual fund advertising or anything you 
see in the paper include a cross-reference directing the 
shareholder to go to the prospectus to find the fees and 
expenses. That has not been there in the past, and we support 
that. The other is an additional fee table. There is, as you 
know, and several have mentioned, there is a fee table in the 
prospectus that takes all the fees and combines them and puts 
them in a standardized dollar amount. The SEC has proposed that 
that be extended to the shareholder reports, and that in the 
shareholder reports, unlike the fee table in the prospectus, 
the actual investment results of the fund be used against a 
standardized dollar amount to give the total. We support that 
as well, so there are two additional changes we would like to 
see.
    Chairman Baker. And my last point, because I am going to 
run out of time.
    Yes, quickly.
    Mr. Riepe. Mr. Chairman, I think the problem is not 
additional disclosure, as much as it is getting people--it is 
my owners manual analysis. It is getting people to look at what 
is there, and having a better understanding of what the 
characteristics of that particular investment are.
    Chairman Baker. I liken it to the privacy disclosure 
statement by financial institutions. By the time you read it, 
you do not know what bank you are doing business with, much 
less what your rights are.
    Mr. Riepe. And after the first couple, you just throw the 
envelope right out.
    Chairman Baker. And what you are looking for is something 
that says, if you give it to us, we are not going to do 
anything bad with it, but lawyers will not let you do that. But 
there ought to be some good faith disclosure which I do not 
think, frankly--I do not any longer invest in mutual funds or 
have any holdings in the stock market for a lot of reasons--but 
I have looked at my son's.
    I have got to tell you--I know I am a Congressman and that 
puts me on the low end of the food chain--but I could not make 
much out of his mutual fund statement to tell him really where 
he was. That is what is troubling. I do not think people can, 
despite good faith effort and a lot of expert counsel, on their 
own take their information and determine what their actual 
costs are, not to allege that the costs are inappropriate or 
that you are not getting good service for the fees you pay. 
Those are different issues. Right now, I think the question is, 
can the average investor understand where he is with his piece 
of paper and the holdings he has? T. Rowe Price is a great 
firm, does a good job, makes money for people. I have no 
complaint. But there are a lot of funds out there that do not 
exactly have your model, and that is the troubling part.
    I know I am over my time, but I am at least going to get 
Mr. Bogle and Mr. Wagner in, because the representations made 
on the other side are that your calculations of costs are not 
exactly on target, and that somebody here is not--from my view 
of the representations at the table, there are two pretty clear 
distinct representations about fees and charges. I am leaning 
toward writing my own letter. I have not had a chance to talk 
to Mr. Kanjorski to see if he would sign onto it, but at least 
from my own initiative, and we will ask other members if they 
choose to do so, to sign onto a letter to the SEC outlining the 
points made here today, and asking them for professional 
guidance in sorting this out, and maybe reporting back to the 
committee in some length of time to give us a real insight into 
the issues raised.
    If you were in our position, give me some good investment 
advice. Where do we go to get this resolved in an impartial 
courtroom?
    Mr. Bogle. I think going to the SEC or an independent 
consulting firm to look into the cost issue is a perfectly good 
thing to do, a perfectly intelligent thing to do. I would 
definitely tend to lean toward the SEC. They have a very good 
staff. Although I have had a lot of trouble trying over the 
years to get the SEC to do an economic study of this industry 
that is really on thing that ought to be central to the work of 
your committee. We need to follow the money in the mutual fund 
industry. Not only these ratios, which we have probably bored 
you to tears with, but the total dollars involved. This is an 
immensely profitable industry. Mutual fund managers get paid 
not only through their expense ratios, but through their use of 
brokerage commissions for their own benefit.
    Chairman Baker. Let me hit that point. I am really way 
over, but let's just take simple examples. Let's assume it is a 
$100 million fund; I am the investor; you are the portfolio 
manager and you are getting instructions from your director to 
do certain things. Let's assume, based on last year's 
performance, the fund is down 25 percent from the date on which 
I signed in. But you also assume we have had our 110 percent 
turnover rate that has been elicited earlier in the comments, 
and let's just use the average that they have used, the .99 
percent transaction cost. Is there a way for you as a portfolio 
manager in the current scheme of things, even when the fund is 
down, to generate a profit for you or the directors from the 
turnover in those fees?
    Mr. Bogle. Can you as the portfolio manager or the 
management company make a profit on turnover when markets are 
down?
    Chairman Baker. Based on the generation of the fees that 
you are talking about. Where does the fee money go, even in a 
down market? When you are rolling over my stocks at the rate of 
110 percent, and assume the stock valuation has gone down from 
the time I got in, but there has been a lot of turnover, a lot 
of transaction costs, and it is not going to research and 
market data. Where does that money go? You are saying, follow 
the money, tell me where it is going.
    Mr. Bogle. Okay. Let me just give you a simple example. 
Take a $10 billion fund and the market drops--
    Chairman Baker. I like your definition of "simple." Yes, go 
ahead.
    Mr. Bogle. Well, I want to make sure the numbers come out 
in a decent way. I will start with it simple. Let's assume the 
market goes down 20 percent. The fund is now $8 billion. 
Annualizing that number, the total management fee at 1 percent 
would drop from $100 million to $80 million. The manager at the 
beginning of the year is making about $50 million. The pre-tax 
profit margins in this business have been, at least at the high 
market levels, very close to 50 percent. So his profit is going 
to go down from $50 million of that $100 million of revenues, 
to--I have got to make sure I have got my decimal points 
right--from $50 million to $40 million. He will be making $40 
million, assuming his costs, which are the other $50 million of 
the original $100 million remain unchanged. So he makes less 
money, but it is still 40 million even though the shareholders 
have lost $2 billion--
    Chairman Baker. That is my point. Is that I as the investor 
have lost equity in my fund because of the market under-
performance, but the fellow with whom I am doing business is 
only going to make $40 million as opposed to $50 million. My 
heart goes out to him.
    Mr. Bogle. Yes, mine does, too, sir.
    Chairman Baker. I do not think we have focused on that 
enough this morning. I have got to quit, because I am way over 
my time.
    Mr. Lucas?
    Mr. Lucas of Kentucky. Thank you, Mr. Chairman.
    I come at this from a couple of angles--32 years in the 
financial planning business, so I was a supplier of these 
services and also a consumer. But I think one of the things, 
and I think it is healthy to have this hearing, and I think 
that there can be some good come out of it. I would just hope 
that we as a committee do not overreact to this, because it has 
been my experience that people who have stayed in functional 
allocation and in great diversification in mutual funds have 
been far better off. I think you need to look at the end 
result. Would the consumer be better off if he or she were 
involved in function allocation and spread all around the 
board? Would they be better off in the end paying these fees? 
The net bottom line is, in my view, the vast majority of 
consumers who were involved in functional allocation funds have 
far more in their 401(k)s and profit-sharing plans and 
individual portfolios today than some of those people who 
thought they knew all the answers and were in individual 
stocks.
    So I do not think we should, although I think it is 
important, as the Chairman said, to be able to know and 
understand this, the information is there for those who want to 
ferret it out. I think that competition works that one fund 
wants to be more open and more competitive than any other. I 
think those factors are there as well.
    So I really do not have a question, other than I very much 
am an advocate of this functional allocation. As I would tell 
my clients through the years, we may not hit any home runs for 
you, but we are also not going to strike out. Worst case, maybe 
we will do some singles and doubles, once in a while a triple 
maybe, in baseball parlance, but I think we have to look at the 
performance of the funds as measured against the marketplace. I 
know as a consumer who has a considerable amount of my net 
worth in the market, even though it is way down, it is much 
less down than people who are investing in individual stocks.
    So I would just say, let's do not throw the baby out with 
the bath water here, and let's not overreact. I am for more 
disclosure as well, but there are two sides to this coin.
    Thank you.
    Mr. Bogle. May I comment, Mr. Chairman?
    Chairman Baker. Certainly.
    Mr. Bogle. I would just like to say, we have talked a lot 
about the return of the average fund in these markets. We have 
talked very little about the return of the average fund 
investor. This industry, Mr. Congressman, has moved a long way 
from being an industry selling diversified stock funds, to 
selling specialty funds. In the recent bubble, technology funds 
were very big. Internet funds were very big. Telecommunications 
funds and aggressive growth funds owning those stocks actually, 
believe it or not, sir, took in $500 billion in the couple of 
years going up to the market peak, while fund investors were 
taking $40 billion out of value funds at just the wrong time. 
Investors had 75 percent of their money in stock funds at the 
peak, and in round numbers just 50 percent in stock funds now 
that the market is down--again too much risk at just the wrong 
time.
    So if we look at the returns of the average investor, not 
the average mutual fund, we see something very different. A 
study in one of my exhibits that is in your report shows that 
in the last 20 years, one of the great bull markets of all 
time, even after the decline, the stock market went up at a 13 
percent rate. You saw that a little bit earlier. The average 
mutual fund went up 10 percent, primarily because of that 3 
percent are points of costs. But the average fund investor, as 
far as the data we can find tells, and it is going to be very 
good data, but not precise, made 2 percent annually in that 20-
year bull market. The average investor in equity mutual funds 
earned 2 percent. That means if you started at the beginning 
with a dollar and owned the market, you ended up with a profit 
of $10.70. Starting in the beginning with an equity mutual fund 
on average, you ended up with $5.70--just about half as much. 
And if you earned that 2 percent that the average fund investor 
appears to have received, you ended up with a 50 cent profit. 
That just is not good enough. That is not one of the great 
success stories of the 20th century. It may not be a scandal, 
but I think it is close to one.
    Chairman Baker. Let me offer time to the other side here. 
Mr. Haaga did you want to make a comment?
    Mr. Haaga. I sure did. I will not refute all those numbers, 
but I will just say I do not agree with them. I guess if we 
were giving people 50 cents over 10 years, I do not know how we 
got to be $6.3 trillion in assets.
    I wanted to thank Mr. Lucas for his comments, and buttress 
them with some figures from Morningstar that really show the 
value of diversification. Twenty percent of the stocks in their 
database--that is 6,500 stocks they cover--20 percent of them 
lost 60 percent or more in value in the year 2002. One-tenth of 
1 percent of all equity mutual funds lost that much. So I think 
that shows the value of diversification.
    One other thing I would like to just set straight. The 110 
percent turnover rate, I do not know where that came from. We 
would like to check. It may be another one of those statistics 
that is an average that is not what anybody is doing. Our 
turnover numbers are way below that, but they are higher than 
they used to be. When I asked our portfolio counselors how come 
there is more turnover--our turnover is in the 20 to 30 percent 
range, but it is up from below 20 percent--their answer is that 
the market is so much more volatile.
    I was reading in Business Week, that said how two out of 
every five days on the NASDAQ, the market moves by 2 percent or 
more, and one out of every five days I think it is the S&P 
moves by 2 percent or more. Those numbers were unheard of. 
There is just volatility. There were no 2 percent days in the 
past. I think that is what is happening. I do not want to 
defend 110 percent turnover number, because I do not agree with 
it, and we do not have that kind of turnover, but I think we 
need to know what the real number is and we need to have it in 
context.
    Mr. Gensler. As I do find that Paul and I might differ on 
policy, we tend to agree on numbers. Turnover in the industry 
is reported by Morningstar from their database. The median is 
76 percent. The average is over 100 percent because there are 
some funds that I do not even know, have 6,000, 7,000 turnover 
that skew an average. Large diversified funds are probably 
closer to 60 percent turnover. That is still selling all their 
stocks every one and a half years. I do share your view that 
financial planners have a great service to Americans in asset 
allocation. All the studies that I have looked at show that 
about 80 percent of American returns come from how you allocate 
your assets. Do you buy stocks or bonds, and hopefully if you 
diversify. If you are, as Mr. Bogle said, picking just a sector 
fund, a technology fund, well then you are in for a wild ride.
    Chairman Baker. Mr. Lucas yields back all of his time.
    [Laughter.]
    Chairman Baker. Chairman Oxley?
    Mr. Oxley. Thank you, Mr. Chairman. It has been a most 
enlightening hearing and we appreciate all of your 
participation.
    Mr. Riepe, you indicated at the end of your statement that 
in your business what you see is what you get. That would seem 
to indicate that the average mutual fund participant and owner 
really understands and has all the information available to him 
in understandable form. Is that really true? Do you think that 
your customers really do have all of that information in front 
of them in understandable form?
    Mr. Riepe. I think, Congressman Oxley, that you perhaps 
were not in the room when I answered Chairman Baker's comment 
before, but those are two quite different things--having all 
the information one needs, and understanding it. I believe that 
investors get all the information they need to make an 
intelligent decision about a fund. The challenge for us is to 
get those investors to spend the time looking for that 
information, if you will. Understanding it is the bigger 
challenge. Finding it is not the big challenge.
    Mr. Oxley. Do you think the SEC is on the right track, 
then, with their proposal to take the proverbial $10,000 
account and try to put some numbers to it?
    Mr. Riepe. I will tell you two things on that. One, we as 
an industry have supported that. Personally, I honestly have 
some reservations about it because my experience over three 
decades with investors is that they understand things they can 
compare. Returns on mutual funds, returns on investments are 
expressed in percentages. That is why the expense ratio has 
always been the most simple and easily understood way to 
express a cost. So if I am going to earn 10 percent in this 
fund and it is going to cost me 1 percent, I can understand 
that. If you tell me every quarter that it cost me $322 last 
quarter, and this quarter it is $275, I do not know how to 
compare that. I do not know whether I put more money in, I did 
not put more money in, my asset value went up, my asset value 
went down. I cannot compare it to another fund as easily as I 
can in simple percentages. So I hope we will not lose the 
percentages.
    Mr. Oxley. If that is the case, let me ask you then, the 
GAO study indicated an 11 percent increase in that ratio. Those 
are relatively easy numbers to understand. Mr. Bogle, do you 
have any comments on that? You heard Mr. Riepe say that the 
more accurate definition would be the expense ratio, and yet--
    Mr. Riepe. I did not say accurate. They are both accurate.
    Mr. Oxley. They are both accurate?
    Mr. Riepe. They are both accurate. The question is 
understandable; which will be more useful to an investor?
    Mr. Oxley. All right. Is it useful to an investor, Mr. 
Bogle, to understand based on the GAO report that expense ratio 
has gone up 11 percent?
    Mr. Bogle. Yes, it is useful, and we ought to show 
investors the dollar amount of their costs. I do not think we 
should ever think of these things as mutually exclusive. In my 
testimony, I recommend that each mutual fund shareholder 
statement at year end, an annual statement, include a footnote, 
printed in the statement, showing that the annual expense ratio 
of this fund is 1.4 percent, say, and where he says the year-
end value is $11,000, just let that little computer multiply 
1.4 percent times $11,000, and say on that basis your cost 
would be $154 or whatever it comes out to. I do not see any 
harm in that. You still have the expense ratio, and at least 
the person can look at his direct mutual fund costs, previously 
hidden, and compare them with his electric bill or his rent or 
anything else he wants to compare them. He has the right to 
ignore it.
    Mr. Oxley. Or with other mutual funds, too, in terms of 
cost.
    Mr. Bogle. Absolutely.
    Mr. Oxley. Mr. Haaga, is that a good idea?
    Mr. Haaga. No, that is just the problem. He cannot compare 
it with other mutual funds. He can only compare it with his 
rent, if it is a non-standardized number. That is what we are 
talking about. We are all interested in including all the 
costs, reducing them both to a percentage and to a dollar 
amount. The argument is only whether you should use a 
standardized dollar amount or the actual dollar amount that the 
person paid. The comparison you were looking for at the end of 
your remarks, which is with other funds, can only be made if 
you use a standardized amount, not the actual amount that Jack 
Bogle is talking about.
    You can translate that. If you really want to know that, 
you could translate that yourself, but you would have to 
remember if you have made purchases during the period, you have 
to adjust for that. So we think it is much better to look at 
standardized amounts, not actual individual amounts. It is all 
about comparison.
    Mr. Bogle. It does not take a mathematical genius to apply 
the standardized expense ratio to the amount the investor has 
in the fund and show the dollar amount of costs he would 
expect. I do not see how that can even be controversial.
    Mr. Oxley. Mr. Haaga, when you sent out the investor 
account balance, that is net after fees, right?
    Mr. Haaga. Yes, it is.
    Mr. Oxley. You are able to calculate how much to take out 
of my account at that point, to determine the fees and the net, 
but can it also tell me how much in dollars it took out of my 
account?
    Mr. Haaga. We actually do not take it out of the account. 
The fees are paid by the fund itself, rather than by the 
shareholder. So we are not calculating that at the shareholder 
level, nor are we deducting them from shareholder accounts. So 
when the shareholder gets a statement, that is the net amount 
they own, which is the net amount the fund earned after the 
fund paid fees.
    Chairman Baker. Would the gentleman yield?
    Mr. Oxley. Yes.
    Chairman Baker. I just wanted to ask, if somebody else is 
paying the fee, where do they get the money from in the first 
place?
    Mr. Oxley. Yes. Those fees are obviously coming out of 
somewhere.
    Mr. Gensler. It really is a wonderful system they have, is 
it not? It really is. It works well.
    [Laughter.]
    Mr. Haaga. The fund is paying the fee, and the investor's 
account, the investor's earnings, the value of the investor's 
shares are net of that. But the fund does pay the fee.
    Chairman Baker. Mr. Chairman, if I may interrupt again, let 
me understand. I put money up. You manage it for me. In the 
course of managing that account, you are going to tell me I 
have this percent of fees that deduct from my net check. Before 
you get to that check, you have operating expenses that the 
fund assumes on my behalf. But that offset of operating 
expenses comes off the top of the distribution that comes back 
to the investor. Even though it is not allocable to me 
individually, it is allocable to the fund.
    Mr. Haaga. That is precisely what we are disclosing.
    Chairman Baker. Okay. I have got it. I yield back.
    Mr. Oxley. Mr. Montgomery, do you have any comments in that 
regard?
    Mr. Montgomery. I guess I am in favor of some kind of 
disclosure. I do agree with Mr. Haaga that the timing of 
purchases and sales of a fund complicate it, unless you have 
this footnote that Mr. Bogle refers to at the bottom of the 
statement that says, assuming you held your fund for the entire 
quarter, let's say, without any purchases and sales, it would 
be this. If you made that assumption, then it is very easy to 
calculate and I do not see why we cannot do it. If, however, 
you want to be accurate, if you are telling shareholders that 
this is the actual fee that you paid from your fund ownership, 
then you do have to account for purchases and sales. It gets 
very complicated. Bridgeway actually used to do this level of 
account disclosure for returns. One of the criticisms of our 
industry is that, yes, this is the return of the fund, but how 
has my investment since I made it actually performed? That is 
what I want to know.
    So when we created our first account statement eight and a 
half years ago, we actually told investors what that was. It is 
a much more complicated calculation if you include the effects 
of redemptions and purchases. So I am somewhere in between what 
you have heard today. But if you make the simplifying 
assumptions, it is a dollar amount, then people can compare it 
with the ATM fees that Mr. Gensler talks about.
    Mr. Oxley. Let Mr. Gensler respond. He looks a little 
skeptical to me.
    Mr. Gensler. The nature of the mutual fund industry is to 
promote profits for mutual fund companies. Many of them are 
public companies. The nature of Las Vegas is to promote profits 
for the casino. I would make a note, and I find myself probably 
agreeing with Mr. Riepe, who by the way is my twin brother's 
boss.
    [Laughter.]
    Mr. Oxley. He brought the wrong twin.
    [Laughter.]
    Mr. Gensler. But I would note that if there is some genetic 
flaw, then he must have it, too.
    [Laughter.]
    Mr. Gensler. Somewhat like Vegas, we Americans do not 
really pick our funds on cost. So if we put more disclosure out 
there, there is probably still going to be 85 or 90 percent of 
Americans investing in actively traded mutual funds. It is 
relying on experts. It is a sense of the buzz. It is a sense of 
in my work-a-day life, maybe I, too, can get an excess return. 
There are a lot of good things mutual funds do as well--the 
service, the diversification that has been referred to. So I am 
a little skeptical that added disclosures will help a lot. I 
think there are some areas that disclosure should be 
considered. I think, to comment on Chairman Baker's point 
earlier, just like with analysts and Wall Street firms, it 
would be helpful to know what the whole fund family has done, 
even including all those dead funds. As Mr. Riepe has said, 
many people pick by the fund family--by Fidelity or T. Rowe 
Price. It would be helpful to see how that whole fund does, and 
just put it on the Web site. Let the financial planners know 
that information is on a Web site. It does not have to go out 
in some thick owner's manual.
    I do think at the core there is an issue about governance 
in the mutual fund business, and all of these fund directors 
sort of passively going along with the status quo. In many 
funds, that is all right--probably the funds represented at 
this table. But we all know with 7,000 or 8,000 funds out 
there, there are a lot of really poor performers and high 
churn, high turnover and high fee funds, and if none of them 
ever change their managers--well now somebody in the press or 
somebody will find one that did--but so few do. It seems 
something is out of balance to me in that regard.
    Mr. Oxley. Well, let me just complete this. That really 
gets at the core of the whole issue. Why in the world would an 
investor stay with an under-performing fund that you just 
described, unless they had no idea what was going on? Why would 
they do that time after time, when they have the ability to 
take their money and run, or to vote with their feet and go 
with somebody else?
    Mr. Gensler. At the core, I think it is human nature. I 
think I could quote various studies, and in this case not 
financial studies, but the psychology of finance, that often we 
Americans hang with our losers. We sell our winners and hang 
with our losers, and all sorts of studies have shown this. It 
is a little like the deer caught in the headlights.
    Mr. Oxley. I could understand that with individual stocks. 
It is hard for me to believe in a mutual fund concept, which is 
just the opposite of individual stocks. You are buying a 
marketplace of stocks. It is almost like staying in a bad 
marriage, I guess.
    Mr. Gensler. It is. Fortunately, I have a good marriage. 
But it is like picking stocks. A lot of Americans will stay 
with a bad mutual fund, hopefully not represented at this 
table, and just stay and not open the monthly or quarterly 
statements.
    Mr. Haaga. Mr. Oxley, I have a good marriage, too, by the 
way.
    [Laughter.]
    Mr. Oxley. This was not meant to be a quiz. This is not 
Phil Donohue or even Jerry Springer, for that matter.
    Mr. Haaga. Since he said it, my wife is on the Web cast and 
I thought I'd better say it.
    [Laughter.]
    The truth is, the shareholders do move. We have talked 
about the lowest cost funds getting the most assets. There is 
kind of a circle of causality there. And we have also talked 
about the lowest cost funds performing the best. Those are all 
related consequences because the funds that do perform better 
get more people, and then as the GAO and SEC said, they reduce 
their fees. So they all cycle together. I do not want to leave 
it on the record that shareholders do not move when their funds 
do poorly. They move and they move quickly.
    I also do not want to leave it on the record that they do 
not go for the lower expense funds. I think as our slides show, 
there has been a million man march in the direction of the low 
cost funds. I think one of the reasons for that is because they 
perform better. Another reason for that is because they are 
lower cost and the people understand it. So I just wanted to 
add that. Thanks.
    Mr. Riepe. I would also add a specific example. We have a 
growth fund that under-performed both the market index as well 
as its competitive group in 1997, 1998, and 1999. It then out-
performed those same benchmarks in 2000, 2001 and 2002, and for 
the six-year period it is in the top decile of all other funds, 
and beat the market index as well as the competitors. So it is 
in the top 10 percent. But that tells you that people are not 
always confident they know when they should move, and too often 
they move at the wrong time. Human nature is such that people 
tend to give up at the bottom, and they tend not to have the 
courage to go into something at the bottom. I think that is the 
reason that we, and it was alluded to earlier, went out of our 
way both as an industry and individually to try and highlight 
during that bubble to investors the risks of moving into the 
top performing stocks. But you cannot overcome human nature and 
greed. They are powerful influences on people's behavior.
    Mr. Oxley. My time has expired. I yield back.
    Chairman Baker. Just barely, Mr. Chairman.
    Mr. Kanjorski?
    Mr. Kanjorski. Thank you, Mr. Chairman.
    The comment was made that some have bad marriages. My 
question is, should the government be involved in selecting 
spouses?
    [Laughter.]
    Is not that what we are talking about here? I guess I am 
interested in, one, I think the mutual fund industry represents 
risk. It invests in risk. By definition, there are going to be 
successes and there are going to be failures. I am more 
interested to know from the panel, maybe particularly Mr. Bogle 
and Mr. Gensler, is there any fraud or abuse that you see in 
the mutual fund industry that we should be attending to? Or are 
we just talking about poor judgment and boards of director that 
are not necessarily actively involved in what someone thinks is 
a standard of selecting new managers or new advisers? I am 
curious whether you see actual fraud or abuse out here, to the 
extent that it warrants government intrusion.
    Mr. Bogle. Well, I am not sure we need additional 
government intrusion, but let me answer categorically yes, 
there is fraud, and yes there is abuse. Let me give you a 
couple of examples of fraud by large managers with a great deal 
of power in the IPO market because they are clients of the 
brokers. They take those initial public offerings that they get 
because they pay large brokerage commissions to those firms. 
They direct all those IPOs into a new small fund, and the fund 
goes up, say, 100 percent in a year, or even 100 percent in a 
month, and they advertise that and put it out to the public. 
That is what I would call fraud. I am not sure anybody else 
would call it that, but I would call it categorically fraud.
    Mr. Kanjorski. You mean they get the advantage of the IPO 
because they are handling a larger fund, and then that is sort 
of a backward payoff?
    Mr. Bogle. They put the IPO's in the smaller fund where it 
has a huge impact, and they do it over and over again.
    Mr. Kanjorski. Should not it go into the same fund that 
created the incentive?
    Mr. Bogle. It is a curious thing. Of course, it is the 
large fund's buying power that gets this free ride--a term that 
will probably vanish after this great bubble--but of course it 
should go there from the economic standpoint. But I am sure 
that the manager argues that the big fund is a very 
conservative blue chip fund, and I have this little speculative 
fund over here, so I will put it there. That is a specious 
argument, because the real idea is to pump up that return to 
the fund, and then sell it to the unsuspecting public. We have 
two documented cases where the SEC has taken them to 
conclusion. Without the SEC having criminal powers, the 
managers were fined. So this is right there in the record.
    We have something else very close to that kind of fraud or 
over reaching. If you open up the March, 2000 issue of Money 
magazine, right at the market high, there were 44 mutual funds 
that advertised their past returns. The public did not know 
about these funds, so we advertised them and sold them to 
investors. We created the funds. The average return for the 
previous year of those 44 funds that were advertised in Money 
magazine, the average annual return was 85.6 percent. Our ads 
are saying, come and get your 85.6 percent. Oh, sure, there is 
a hedge clause saying past performance may not be repeated in 
the future. They should have said "will not" in this case, but 
it is in tiny type, barely readable. We know that high returns 
are what attract the public. Those ads, as it happens, produced 
business, and that is fraud or abuse.
    Other abuses is this pandering to the public taste by fund 
managers, bringing out 496 new Internet funds, technology 
funds, and aggressive growth funds in the midst of the bubble. 
I do not know that anybody in the investment departments of the 
fund firms wanted to do that, but I know the people in the 
marketing departments did. I have been in this business for a 
long time. I know what causes what. The great firm of Merrill 
Lynch brought out two such funds at the peak of the market. 
They sold $2.2 billion of these funds to their customers. One 
was an Internet strategies fund. One was a Focus-20 fund. Both 
funds went down about 95 percent in the market decline, and so 
did customers' money. One fund has been put out of business so 
its record will no longer be visible. Is that an abuse? Yes, 
sir. I would argue that is a serious abuse.
    Mr. Kanjorski. Of course, the NASDAQ itself went down 75 
percent, Mr. Bogle. Is 20 percent a greater loss than that?
    Mr. Bogle. You know, if you had started--it is a very good 
question--if you had started, out of your marketing 
opportunism, a NASDAQ fund when the index was at 5,048, and you 
said, well of course the index went down 75 percent, and so did 
the index fund. But, if you want to do that, and people did, 
the reason you are doing it is not to help people invest 
better. It is to bring money into the business. This business, 
as everybody has observed, has become an asset-gathering 
business, more than an investment management business. Just 
read what people that are doing all these mergers of management 
companies and acquisitions of management companies are saying. 
The first thing they say is, here is the asset-gathering 
capacity of the firm. I have never seen a word in one of those 
investment banker's reports that say anything about mutual fund 
performance.
    Mr. Kanjorski. Should the government then get into the 
business of maybe regulating how they advertise?
    Mr. Gensler. Mr. Kanjorski, the government is in the 
business. Sixty-three years ago Congress addressed itself to 
the inherent conflict in the Investment Company Act of 1940. 
Subsequently, the SEC has promulgated numerous rules and 
Congress has come back. I think this hearing is just part of 
the ever-going sort of finding the appropriate balance.
    On the issue that Mr. Bogle raised, yes those very things 
occurred, where large fund companies start up with what is 
called incubator funds and by the roulette wheel some of them 
will do well and some of them will do poorly. The one's that do 
well, you advertise. Sometimes they try to help the roulette 
wheel by putting in hot IPOs. Now, the SEC has addressed that 
with some final rules on IPOs. We could debate whether it has 
worked, but they have addressed that.
    To your question, I grappled with it. I wrote a book for 
investors. I did not write a book for Congress. I did not even 
envision that there would be such hearings. But when I was 
asked to testify, I sort of thought, Congress has grappled with 
this for 60 years and the SEC has grappled with it. By and 
large, I think there should be individual choice, freedom of 
American choice. This industry, like other industries, has the 
right to advertise its products. But I think on the margin, 
some additional disclosures could be helpful and warranted, and 
on the margin some addressing to governance, particularly 
around these soft dollars where I do not think that is fraud. I 
think it is well known. It has been going on for 10 or 15 
years, but it seems out of kilter with what the funds really 
ought to be doing.
    Mr. Kanjorski. Can that be handled by the present 
regulations in the SEC, or do we need additional statutory 
authority?
    Mr. Gensler. That is a very thoughtful question, one that I 
have not thoroughly researched. It may well be that the SEC has 
authority to address that, and if they did, I would hope that 
they would, but it may well be the Congress giving them a 
little added nudge along the way would help as well.
    Mr. Bradley. Can I speak to that one?
    Mr. Kanjorski. Yes.
    Mr. Bradley. As I understand, if 28(e) was originally 
interpreted by the SEC in a far more limited fashion. Managers 
could not pay for services otherwise and customarily available 
for cash to the public. The SEC has broadened that through 
interpretive releases over time. There has been no rulemaking. 
My concern would be, maybe it is time for rulemaking to say 
what exactly constitutes paying up, and what exactly is the 
value of those goods and services to investors.
    Mr. Kanjorski. Tighten it up.
    Mr. Bogle. I would like to add one other thing, sir, if I 
may. I think the government is going to have to look into, 
number one, a more express statutory standard of fiduciary duty 
for fund directors. Number two, is building up even further the 
independent majority of the board, for the present independent 
director structure clearly have let investors down. And number 
three, as I mentioned in my testimony, is to have the chairman 
of the board, not the same person as the chairman of the 
management company. The Investment Company Act of 1940 was 
right when it said that investment companies are affected by a 
national public interest, and all this talk about what buyers 
do and what buyers choose is fine, but our law says, more is 
required. It says, in effect, that mutual funds are not 
toothpaste and mutual funds are not soap, and mutual funds are 
not beer. They are people's retirement savings, children's 
college education savings. It is not just a consumer issue, it 
is a legal and governance issue that requires the boards of 
directors of mutual funds to see that funds are operated 
primarily in the interest of shareholders, and not in the 
interest of managers. I believe that balance has been badly 
distorted. The system that the law established isn't working.
    Mr. Kanjorski. So that is something statutorily that we 
could do.
    Mr. Bogle. Yes, sir.
    Mr. Kanjorski. The other thing that I am worried about in 
terms of the evidence is no manager has been fired among 7,000 
or 8,000 funds--that does raise a question. But it is sort of 
our shining example of independence. I am just worried about 
how many people we are going to put in charge of watching over 
the board of directors, and then who is going to watch over the 
watcher of the board of directors and how far can we go. Is not 
this structure sort of the same structure, and there are 
independent board members. Their job is to have a fiduciary 
relationship. If they violate that fiduciary relationship, are 
not they subject to class action lawsuits?
    Mr. Bogle. We have had class action lawsuits and they have 
been notoriously a failure for reasons that I think are in many 
respects too bad, because the courts have judged the level of 
one funds' fees by the level of other funds' fees. So if you 
look at a management company with, say, a 1.5 percent fee, and 
the range of fees is 1 to 2 percent, the court says, in effect, 
" we are not going to interfere with that." As far as it goes, 
that is okay, but it is almost the same issue as executive 
compensation that has gotten so out of hand in this country. If 
everybody is doing it, then I can do it too. But that is a new 
standard, and not the standard established by the 1940 Act. The 
standard of the 1940 Act is fairness to shareholders. Yet even 
as fees go up, plaintiffs have not been successful.
    Mr. Kanjorski. Mr. Bogle, I tend to agree with that, but 
then does not it go contrary to our system? I mean, if we are 
going to have the SEC approving salaries and activities, where 
does it end? I mean, if I needed brain surgery, I would not 
advertise as to who can give me the cheapest brain surgery. I 
would want to hire the best brain surgeon in the country. I 
assume that these funds are interested in growing and 
attracting more investment money. So is not the natural market 
incentive there to have the best managers and the best advisers 
in the country?
    Mr. Bogle. Yes, sir, and that is a wonderful question. 
There are, say, 500 different management firms and 10,000 
mutual funds, each of which is trying to be the best. But, it 
is inevitable, given the mathematics of the marketplace, that 
before costs are deducted, they are all average. When they 
trade stocks, they trade with one another. I will use the 
entire institutional community, not just the mutual fund 
industry because most firms are doing both. So they are all 
average before costs, but after cost, they are all losers to 
the market itself. Beating the market, is, must be, and always 
will be, a loser's game.
    So what happens in this industry? Well, we will have 
managers who look very good in the short term. The top 20 
managers in the two years coming up to the boom, the peak of 
the boom, were the bottom 20 managers in the two years that 
followed, metaphorically speaking. Actually, they were not 
exactly the bottom 20, but they were in the bottom 50 out of 
5,000 funds. They looked like good managers, but they were just 
speculators. So we have a system that is shaped the wrong way--
an opportunistic system.
    Mr. Kanjorski. How do we correct that?
    Mr. Bogle. Yes, that is a very good question. We need 
education. Investors should know that the first rule of 
investing is uncertainty. That the second rule of investing is 
gross return minus cost equals net return. The third rule of 
investing is, for God's sake, do not put all your money in the 
stock market unless you are 20 years old and it is your first 
$100 in a 401(k) plan, in which case it is fine. We need more 
education like that. But above all, we need a structure in 
which the people govern the fund, the directors, the 
fiduciaries, the stewards of the fund--are called to task to 
live up to their responsibilities.
    Mr. Kanjorski. The funds that you show in your chart--the 
Wellington Fund--you own your adviser group, so that is part of 
the fund itself?
    Mr. Bogle. No, let me explain that for a moment. Vanguard 
is a mutual company owned by our shareholders. It is a unique 
structure in the industry. We manage about 75 percent of our 
money inside Vanguard. The index funds and our bond and money 
market funds are pretty much all managed at Vanguard on an at-
cost basis. That was the main example. For the remaining 
approximately 25 percent of our assets, we use external 
investment advisers. We use Wellington Management, for one. 
Actually, I think we use about 18 different outside advisers. 
We go out and negotiate fees with those advisers. Believe me, 
if you are legitimately negotiating, you can get a fee of four 
basis points if the fund is large enough--and admittedly 
Wellington Fund is large enough--just four one-hundredths of 
one percent. Our Ginnie Mae fund, which I did not comment on 
earlier, pays a fee on that is only nine-tenths of a basis 
point. It is fractional, while other Ginnie Mae funds pay 50 
basis points, 100 basis points--sometimes 100 times as much or 
more. In the Ginne Mae case, it is very much of a commodity 
fund, so we were of course the best performing Ginnie Mae fund 
over time. We cannot do it otherwise. We cannot beat the Ginnie 
Mae index, but we can beat almost everybody else just because 
of one low cost. There is where our extra return comes from. We 
have got to educate investors about the importance of cost in 
shaping what they earn.
    Mr. Kanjorski. Why is it that through either the mutual 
funds themselves or the association or a cooperative formed 
under that group, why can't you buy seats and trade yourself 
and set your own cost? Would not that save a great deal, rather 
than going through the established brokerage business?
    Mr. Bogle. Well, we do not. I am not sure I fully 
understand the question, but at Vanguard we do not do any 
business with affiliated.
    Mr. Kanjorski. How do you make your purchases on the 
exchange?
    Mr. Bogle. First of all, index funds do very little 
transaction activity, but most is done on the New York Stock 
Exchange. Counting all index funds together, they account for 
maybe one-third of one percent of all exchange transactions. 
Our 18 outside advisers do business largely with brokers. We 
like advisers with low turnover, but they pretty much have to 
do business with brokers.
    Mr. Kanjorski. You have a significantly lower cost. What do 
you attribute that to?
    Mr. Bogle. I attribute that cost to--
    Mr. Kanjorski. Other than your brains.
    Mr. Bogle. Well, it is thriftiness, but it begins with 
having a mutual company. Think about it this way. If the mutual 
fund has a 1 percent fee and the pre-tax profit margin has been 
about 50 percent, that means if we eliminate that pre-tax 
profit margin by being mutual in nature and operate at cost, we 
are already down from 1 percent to one-half of one percent. The 
second thing is, we negotiate fees. We do not say to the 
adviser, these fees are just fine. I have done a lot of these 
negotiations and they are not entirely fun, but sooner or 
later, you get a better fee, and we've done them five or six 
times over 20 years for each fund. It pays off for the 
shareholder and then we are cheap in how we spend our 
shareholders money. That is the third part of the advantage we 
provide.
    Mr. Kanjorski. Do you think we should separate the 
investment houses from starting the fund, and that may be an 
internal conflict that has to be broken?
    Mr. Bogle. I would love to do that, but I do not see how it 
is practicable, honestly.
    Mr. Kanjorski. I see I am shaking up a lot of folks here.
    Mr. Gensler. I do not see how one would do that, but I 
would mention your brain surgery analogy is a very good one. 
Where it falls down, if I might say, is if you take the best 
brain surgeons, next year you presume they are still going to 
be very good brain surgeons. If you take the top 50 percent of 
performers, next year 45 percent of them are in the bottom 
half--close to what you would say is random chance. It is a 
little better than random chance.
    In terms of negotiating fees, just to give a little sense, 
the best academic study in the last year done on fees showed 
that pension plans, the big state pension plans, whether it is 
Pennsylvania's or Louisiana's and so forth--the state pension 
plans go out and negotiate fees. Their fees for advisory 
services are one level, and mutual fund fees are 2.5 times that 
level before considering all the administrative costs. So it is 
not the servicing or the envelopes that there are plenty of. 
Why is that? Many of the companies at this table and in the 
industry actually provide both services. I would imagine that 
many of them--if $1 billion from the Pennsylvania state pension 
plan came in would probably manage that in the equity market 
for 25 or 30 basis points, or if they had a good day, 40 basis 
points. But the standard in the industry might even go down to 
20 basis points. The mutual funds, if you take the standard $1 
billion large diversified fund is 2 to 2.5 times that. There 
just is not the competition. There is not the tension in our 
commercial environment.
    Mr. Kanjorski. How would we get it there?
    Mr. Gensler. I think it is the hardest challenge--much 
harder than disclosure. It may well be in fund governance. It 
may well be. I do not have a specific recommendation that this 
Congress and the SEC put more pressure on the deciders of these 
fees; that the fund directors act in their fiduciary 
responsibility that was first embedded in the Investment 
Company Act of 1940.
    Mr. Kanjorski. But is not that going to mean that it would 
force them to a level of mediocrity for safety purposes?
    Mr. Gensler. No, I do not think so. I do not think that the 
public pension plans in America--by the way, if you take all 
state pension plans in America, 57 percent of their U.S. equity 
dollars are indexed. That is still 43 percent that are not.
    Mr. Haaga. Maybe that is why their fees are lower.
    Mr. Gensler. No, I am not talking about the index side, 
because indexing for $1 billion you can get on a single-digit 
basis points.
    Mr. Kanjorski. Do you think out of the seven witnesses 
here, we could come up with recommendations that the seven 
witnesses could agree upon?
    Mr. Gensler. I suspect not, sir, because I think the 
industry group, as many industry groups in many industries, 
will be more likely not to wish to embrace reform and change. I 
would hope that they would, but it is not the customary way of 
America.
    Mr. Bradley. Could I speak to that quickly?
    Mr. Kanjorski. Yes.
    Mr. Bradley. I have a concern about the framing. Behavioral 
finance teaches us a lot about how people frame the problem and 
it actually frames the answers. When you think about the 
purpose of markets, it is not to make investment companies 
rich. It is to fund new ideas in America. It is to underwrite 
small ideas that Bill Gates had in a garage out in California; 
fund it with an investor's risk capital because the bank will 
not do it; grow the company up so it becomes a mid-cap company 
or middle-size company; then it gets large and then it gets in 
the S&P 500. Even the S&P 500 in 1999 and 2000 added major 
high-tech volatile companies at the top. So the idea that 
capital formation is only about investor returns is too narrow 
a perspective; it is a risk-return equation. I would argue that 
mutual funds are a way for little people to help fund capital 
formation in businesses in America and, in return be rewarded 
over time.
    Mr. Wagner. I would like to add to that. Sitting here 
listening to this, I hear "governance" coming up all the time 
over here. Most mutual fund boards that I have ever encountered 
are toothless tigers. They are selected by the investment 
manager and they do not report independently to the fund 
holders, I believe in most situations. We have independent 
directors for corporations that are really independent and do 
represent the shareholders--
    Mr. Kanjorski. At Enron.
    Mr. Wagner. and I do not see a similar thing in the mutual 
fund industry.
    Mr. Kanjorski. But how far do you want the government to 
get involved in what is a private decision, it seems to me, of 
selecting or classifying or categorizing board members? I mean, 
people have a right to be stupid. Is not that a principle--
caveat emptor?
    Mr. Gensler. There is most certainly that in a free market, 
and I very much believe in free markets. That is the burden of 
all of us and the benefit of our system. But I think as 
Congress saw 60-some years ago, there is an inherent conflict, 
and at times it may be worthwhile addressing that balance and 
just saying on the margin whether there are things to help the 
system out.
    Mr. Haaga. If I can jump in here, a couple of things--one 
is my colleague Mr. Gensler says that it is not the American 
way to reform yourself. I would say it is the mutual fund way. 
You can just look back at history and look at our participation 
in regulatory initiatives. I might also add that although the 
1940 Act requires for most funds only 50 percent independent 
directors, our best practices, which have been adopted by 
virtually every mutual fund, call for two-thirds. So we are 
almost at the point that Jack Bogle would have us go.
    Lastly, I just cannot leave un-commented upon the 
suggestion that has been made that the only way that you can 
measure the independence and effectiveness of a board is by 
counting how many times they fired the management organization. 
That is a very unusual step. A few years back, we merged with, 
actually bought, a management company and took over management 
of its funds. Their board had told them that they needed to go 
find a good home for the funds. They were tired of their 
management. That shows up not as a firing that everybody is 
looking for, but it shows up in the merger statistics that for 
some reason Jack Bogle finds objections to. Let me tell you, 
that was a firing and I think a lot of the other mergers that 
have taken place are prodded if not ordered by directors.
    Furthermore, we have talked about not firing advisory 
organizations. Advisory organizations do not manage the 
individual funds, but portfolio counselors manage the 
individual funds, and plenty of those have been fired. Finally, 
even without firing, as someone who has spent a lot of time in 
boardrooms with a lot of boards, we get a lot of pressure to 
fix things that are not going right. The boards, do it the 
right way, they say--give us a special meeting about this fund; 
we want to discuss its results and what you are doing about it. 
And they listen to our answers. If they do not like them, and 
sometimes they do not, we have another meeting and we come up 
with different answers, until they are satisfied and until 
things have turned around. Those will not show up in your 
firing statistics, but they were a case of an active board 
taking responsibility and putting pressure on the management to 
make things better on behalf of the shareholders. It goes on 
all the time in our industry.
    Chairman Baker. Thank you, Mr. Kanjorski.
    Mr. Fossella?
    Mr. Gensler. I would just say that I stand corrected. I am 
delighted that the head of the Investment Company Institute has 
that constructive approach to reform. So I stand corrected.
    Chairman Baker. Mr. Fossella?
    Mr. Fossella. Thank you, Mr. Chairman. Thank you, all of 
you for this healthy dialogue.
    It seems to me in looking at more than 200 years of 
experience in the industry, I would believe that all of you 
have an interest to see the future of this industry and a 
future of getting more Americans to become investors, you have 
an interest in seeing that it flourishes. It also seems to me 
that you are all looking at the same situation with varying 
degrees of criticisms and applause. Some have written books 
about it; others have made a lot of money in it.
    It was alluded to before as to what can you all agree on. I 
am not suggesting that you all have to agree on everything. But 
is it not in everybody's interest that you establish a common 
platform for just the industry, and then allow each of you to 
compete--in my opinion, the American way more so--but on an 
honest basis, with a sense of providing integrity and truth to 
your owners? Mr. Bogle has been among, it seems, the most vocal 
in his, I do not want to say criticisms, but what he thinks 
would be a healthier future, where others feel that some of 
those criticisms are unwarranted.
    So I am curious to hear from the rest of the panel. For 
example, Mr. Bogle just alluded to some possible, I am not 
saying it is the right thing or the wrong thing, but some 
possible statutory provisions regarding fund directors or 
independent directors on the board, and the issue of whether 
the chairman should be, or the title of the chairman, should he 
be the head of the fund as well. I am curious as to what you 
all think about that suggestion.
    Mr. Wagner. Sounds like a good one to me.
    Mr. Montgomery. I guess I could support that one, too. I 
am, by the way, both president of the advisory firm and 
chairman of the board of our board of directors of our fund.
    Mr. Fossella. Mr. Bradley?
    Mr. Bradley. I will yield to my colleagues.
    Mr. Fossella. Okay. You mean you do not have an opinion?
    Mr. Haaga. I am the chairman of our fixed income funds. If 
they asked me to step aside, I would. I think that specifically 
separating the role, making the chairman an outside director, 
would not do much and I think it would be a problem in some 
organizations, so I will not embrace that. But as I said about 
the 80 percent thing, we are almost there, and we got there on 
our own. So I think some things are best left to best practices 
and industry developments, rather than legislated.
    Mr. Fossella. Okay.
    Mr. Gensler. Specifically to having the chair of the fund 
be independent, I think on the margin that could be helpful. I 
think at the core, it is questionable. At these funds, it is 
not just whether they hire or fire, but also how they look at 
fees and why they customarily would pay 2.5 times for advice 
what the same service providers, the same T. Rowe Price's or 
American Century's provide to institutional pension money. So 
the same advice going to the state of Pennsylvania somehow, if 
I am the Magellan Fund or I am T. Rowe Price's big, large 
diversified fund has a higher fee--to ask those questions and 
find some way to ask those questions and get satisfactory 
answers.
    Mr. Riepe. Let me just say that when I worked with Mr. 
Bogle and he was chairman of the funds, he never held that 
attitude.
    Mr. Bogle. That is quite correct, by the way.
    Mr. Riepe. Clearly, he has had a revelation.
    Mr. Fossella. When did this revelation take place, Mr. 
Bogle?
    Mr. Bogle. May I just say that just because you have been 
mistaken for most of your life does not mean you have to be 
mistaken all of your life.
    [Laughter.]
    Mr. Riepe. Can I make my comment? If he starts again--
    Mr. Fossella. I have been mistaken most of my life, or one 
has been mistaken?
    Mr. Bogle. Many--
    Mr. Riepe. Let me just say that I think I would agree with 
what both Mr. Gensler and Mr. Haaga said in the sense that it 
could do something, but it is certainly not a silver bullet in 
any way, shape or form. If we learned anything in this latest 
corporate abuse experience that we have gone through, it is 
that just putting independent directors in a room does not 
guarantee that you are going to have a clean shop. Independent 
directors can be duped; independent directors can fall asleep 
and not do a good job. Either way, it simply is not an 
assurance. I think it makes us all feel better and it seems to 
make intuitive sense to have a majority of independent 
directors overlooking management, but it certainly does not 
protect one by itself.
    I think in the case of investment companies, the job is 
easier in the sense that one does not have to worry about 
accounting frauds and things like that because they do not 
happen in investment companies. So I think that the role of the 
independent director is more narrow and can be more forceful. I 
think this stuff about toothless tigers is a lot of malarkey, 
when you are talking about the middle 75 percent of the bell 
curve. I think as Mr. Gensler suggested, there are I am sure 
smaller groups where a couple of directors are luncheon buddies 
or something of the chairman. I do not know how one legislates 
that. I think the SEC has to do it through rules.
    Let me just comment very quickly on the pension question 
that Mr. Gensler brought up, because we manage money for 
institutions as well. I do not know where his statistic came 
from, but I can only hope that our mutual funds were 2.5 times 
what they are. Our experience is that they are higher than the 
pension fees that we charge, but I will also tell you that we 
could operate our company with about 80 percent fewer employees 
if all we were in was the pension business. Although everybody 
does not have 35 percent margins, as Mr. Bogle suggested, I 
will tell you the pension managers have the highest margins 
because they do not have all the other service requirements and 
all the other people requirements that are associated with 
taking care of an investment company. So there is a reason 
there is a spread between those fees. If someone is getting 2.5 
times in their mutual fund what they are managing their private 
accounts for, then I think they have a very tough explanation 
to make to their directors. I might add, that fee information 
goes to our independent directors; and I think most every year 
it is required as part of the annual contract review.
    Mr. Gensler. Just to answer the question that was had, the 
study, since it is not my work, it was two professors--one of 
business and one of law--Stuart Brown and John Friedman. It is 
called Mutual Fund Advisory Fees: The Cost of Conflicts of 
Interest, published August, 2001, University of Iowa Journal of 
Corporate Law. They excluded all of the amounts of money that 
went to service the account and just looked at advisory fees. I 
say that just in my conversations with the industry, generally 
pension funds will shoot for 20 to 25 basis points, often will 
pay 30, 35 basis points. That is about one-third of a percent 
of their money for let's say $1 billion or greater large 
capitalization, diversified, actively managed fund. If you look 
at the management fees, advisory portion in the mutual fund 
industry--somebody could check this with Morningstar--it is 
going to probably be roughly in the 60, 70 basis points. But 
again, if I am wrong, statistics will prove out what the real 
situation is.
    Mr. Bogle. Mr. Chairman, could I just respond to the 
Congressman's question about when my conversion took place?
    Chairman Baker. Certainly.
    Mr. Bogle. My conversion actually took place in 1974 when I 
was fired by Wellington Management Company, and started 
Vanguard as a mutual company. As such, I was chairman of the 
funds, and the chairman of the board of the adviser had no role 
in the firm whatsoever. You saw the chart that showed in 1974, 
our costs are down 60 percent and the industry's costs are up 
60 percent, so maybe that is not such a bad idea to have that 
separation. It has been a conversion that's lasted 28 years, 
and I feel real good about the new Bogle as compared to the old 
one.
    Chairman Baker. Okay. Anything further, Mr. Fossella?
    Mr. Fossella. If I may, and I know you have other speakers, 
but I am just curious as to maybe not the focus of this, but to 
what extent in all of these numbers and statistics does our 
current tax system affect all of these numbers about movement 
in and out of funds, or the decisions? I heard different 
theories--behavioral, market analysis, all this other wonderful 
stuff. But to what extent do you think the tax code and our 
policies today affect individual decision making?
    Mr. Bogle. I would like to just say one very interesting 
thing which should be brought up at this point, and that is the 
mutual fund is from an income standpoint the most tax-efficient 
investment ever devised by the mind of man, because mutual 
funds that happen to earn dividend income of about 1.8 percent 
on their portfolios. Taxes take away about 1.5 percent, and 
leave only 0.3 percent for the Federal Government to get its 
hands on. From that standpoint, tax policy, even the 
elimination of so-called double taxation, simply does not 
matter to the average mutual fund investor. Half of the 
shareholders pay no tax on their 401(k)s and so on, and the 
other half are paying taxes on a dividend yield of over three-
tenths of one percent.
    On that point, I want to add another comment about our 
ability to look so favorably on fees when someone says, well, 
it is only 1.5 percent of assets. That is the lowest number you 
can possibly get when you look at mutual fund costs. You say, 
what percentage is it of the market return? The 1.5 percent 
cost is 15 percent of a 10 percent stock market return. What 
percent is it of the mutual fund's income? While capital gains 
come and capital gains go, income and expenses go on and on.
    I want to give you an interesting example. It is in one of 
my exhibits here. I got involved in this industry in 1949 when 
I read an article in Fortune magazine called "Big Money in 
Boston." The industry was a $2 billion industry then. The 
article was about a firm called Massachusetts Investors Trust--
the oldest, the largest, and the lowest cost of all mutual 
funds. That article reported that the independent trustees of 
that fund had just reduced the management fee from 5 percent of 
income to 3.2 percent of income. They did not calculate it on 
the basis of assets. They calculated on the basis of income--5 
percent to 3.2 percent. Last year, that same old Massachusetts 
Investment Trust took not 3.2 percent of income and not 5 
percent of the fund's income, but 87.5 percent of that fund's 
income--87.5 percent of income was consumed by management fees.
    One of the big concerns this industry has about putting the 
dollar amount of fees in the shareholders' statement is that 
shareholders can see that my fund's income last year was $40, 
or was in effect $240 gross; the manager took $200 and only 
left me with $40. That will be easily calculable in that 
statement when you look at income.
    Chairman Baker. Mr. Fossella, are you done? I want to 
recognize Mr. Sherman for a couple of hours.
    Mr. Sherman. Thank you, Mr. Chairman. I have so many 
questions and so many ideas, I will try to get them in within 
the two hours allotted.
    One idea that has come out of these hearings, and I think 
it is a good one, is that in addition to whatever basic 
prospectus you mail out, there ought to be a required 
supplementary prospectus posted on a Web page. Does anyone 
disagree with that, knowing that we have to argue what would be 
in the supplementary prospectus?
    Mr. Riepe. No, sir. We put a great deal of information out 
on the Web.
    Mr. Sherman. It would just be good to standardize that, and 
then of course you would have your non-standardized 
information--the glossy thing with your picture on the cover, 
which would attract a lot of investors.
    Mr. Riepe. Our pictures are not in the prospectuses.
    Mr. Sherman. Oh.
    [Laughter.]
    One thing I would like to focus on, because I think I have 
been affected by it a bit, is what I call the lock-in effect or 
the bait and switch. It goes something like this. You start an 
index fund or a bond fund, with, say, a management fee of 
around 20 basis points. You go out and market it effectively. 
You get $100 billion. And then you raise the fee to 50 or 60 
basis points. Now, with a certain amount of inertia, you can be 
collecting the 50 or 60 basis points on the $100 billion of 
assets because people thought it was a good idea when they 
originally invested, and they do not bother to check that the 
fees are doubled or tripled. But there is another lock-in 
effect, and that is, if this is a bond fund or an index fund 
and the value has gone up, then no sane investor, unless they 
view themselves as immortal, is going to recognize a huge 
amount of capital gain income just so that they can invest in 
one of the fine funds represented here, and get out of this 
bait-and-switch fund. That is because you are going to be 
paying a huge fund just to avoid paying an extra 20 or 30 basis 
points a year until that great step up in basis that occurs at 
the termination of all of us.
    So is there anything that--and I have oversimplified what I 
think has happened to a small part of my personal portfolio--is 
there anything that prevents this ruse from happening--
marketing a fund at 20 basis points, and then after you have 
got a whole lot of cash in the fund, doubling or tripling the 
fee?
    Mr. Haaga. I think what you are referring to--well, the 
truth is, there are two ways the fees could go up. One is, as I 
discussed in my oral testimony--
    Mr. Sherman. Let me add one more element to this. The way 
they marketed the fund is they said, because the manager is 
currently waiving so much of the fee, the fund in its first 
year only paid a fee of 20 basis points.
    Mr. Haaga. And they had to tell you what the return would 
have been had they not waived the fee.
    Mr. Sherman. Right. That is a bit of a warning to anyone 
who has been through this process at least once.
    Mr. Haaga. Right. And as I told you, if you bought our tax 
exempt fund of California, it would not have happened.
    Mr. Sherman. But is there any rule that says you cannot 
wake up one day, having marketed a fund as the low-cost 
California tax exempt bond fund, and change it to the 70 basis 
point a year California tax exempt bond fund.
    Mr. Bogle. There is no such law. It is cast in the light of 
the marketing spirit of this great business, and that is, we 
are going to do a nice thing; we have a 1 percent fee, and we 
are going to waive three-quarters of it for you. Money market 
funds have done this. I think over half of the money market 
funds will move to wave fees when their yields go down. They do 
not tell you when they do it. They do not tell you when they 
put the fee back on. It is just wrong.
    Mr. Sherman. What if you did not even do the fee waiver. 
What if the official fee for 2003 is 20 basis points, and then 
in 2005, the official fee goes up to 50 basis points?
    Mr. Haaga. That would require a vote of the board and a 
vote of shareholders, so you would have gotten a proxy saying, 
do you want to do this or not, and some fee increases have been 
turned down by shareholders and many by boards.
    Mr. Sherman. So an increase in the management fee requires 
a vote of the shareholders.
    Mr. Haaga. Correct.
    Mr. Sherman. So this fee being waived, that is a bit of a 
warning that that fee may not be waived in the future.
    Mr. Haaga. Correct.
    Mr. Riepe. There is a table right in the front of the 
prospectus that the SEC requires. If you have waived a portion 
of the fees, and usually what gets waived first is the advisory 
fee, there is a cap on expenses. Over one-third of the mutual 
funds now tracked by Lipper have expense caps on them in one 
way or another. This speaks really to the competitiveness of 
costs.
    Mr. Sherman. I would like to go on to the next question. 
The other thing that you folks have brought up is the idea of 
the roulette wheel and the incubator fund. It would go 
something like this. Let's say you were going to start a low 
cap fund. You do not start one small low cap fund; you start 
three. One invests exclusively in corporations whose name 
begins with A. Another one invests exclusively in companies 
named with B; the third exclusively in companies with names 
starting with C. You do not even have to identify it. You just 
have that as a policy. Then at the end of a year, the A fund is 
in the tank; the B fund is under-performing; and the C fund 
tripled its money--not because of any brilliant idea; it just 
happened that low cap companies with the C beginning their name 
did very well. And then of course you advertise the hell out of 
the C fund.
    Would we benefit from a rule that said that when you go out 
and advertise that C fund and its 300 percent rate of return, 
that you also have to disclose the rate of return on a weighted 
average basis of all funds in the same category managed by the 
same company and its affiliates, so that you would disclose not 
only the 300 percent rate of return of the Hasbro C fund, but 
you would disclose the negative 2 percent rate of return of all 
low cap funds administered by Hasbro.
    Mr. Gensler. Mr. Sherman, you hit upon a very interesting 
problem, not only incubator funds, which are legal and will 
continue to be legal--that is the roulette wheel.
    Mr. Sherman. And as you pointed out, you could enhance the 
C fund by getting a good IPO into it.
    Mr. Gensler. That may be a little bit beyond what is good, 
healthy competition. But I think it does come back--your 
suggestion is a variation, maybe it is a stronger one--of my 
suggestion. It is just simply so that fund families can be seen 
in their full glory. Some will do better than others, but that 
they do not ignore the closed-down fund or that so many funds, 
about 5 percent a year go out of business. They aggregate all 
that performance data and at least have it on their Web sites 
so financial planners can get that information.
    Mr. Sherman. But if I want to invest in a low cap fund, I 
do not care that Paul has done very well with bonds. I want to 
know how well his company has done with low cap funds. It does 
not do me any good to find out that all of the funds he has 
managed have a rate of return of 6.2 percent. I mean, he could 
be a euro-bond fund for which he is responsible.
    Mr. Gensler. You raise a very good observation, and it may 
well be helpful to have it broken down by major categories. I 
do not know.
    Mr. Sherman. Because otherwise this works perfectly well. 
If I start 10 incubator funds, I guarantee one will do very 
well.
    Mr. Haaga. It works perfectly well, but the one you 
described involving the IPOs that I think Jack Bogle said was a 
fraud was the subject of an SEC enforcement action. That is why 
we know about it. So I think the egregious case is taken care 
of.
    There is a great deal of analysis and information out there 
in the Lipper and Morningstar and other things about fund 
families investment results. So there is a lot to know, plus of 
course the results of all our other funds are fully disclosed 
and fully advertised. So I think there is a lot to know there 
that even if it is, you know, you are hypothesizing that these 
funds could get buried, they are out there in the fund family 
data and they are out there in the historical data.
    Mr. Sherman. I think it might be helpful, though, to have--
I mean, it is nice to say that if you just know where to go in 
some Lipper chart somewhere on the Web, that the investor is 
protected. We need to explore what things should be in the 
prospectus, and perhaps the rate of return of all funds in the 
same sector administered by the same management team ought to 
be disclosed. Otherwise, the system I just--I realize enhancing 
the system I just described by throwing in IPOs, that gets you 
investigated by the SEC. But just starting three incubator 
funds and then advertising the one that does well, while the 
other two do poorly, it is not enough to just say "aha, " but 
those who look at the Lipper report are going to be saved from 
being misled.
    Mr. Haaga. You also ought to remember that funds close for 
a number of reasons. We started our first global investing fund 
and the interest equalization tax came in and we closed it. So 
there are changes.
    Mr. Sherman. I think my first hour has expired.
    Chairman Baker. I just learned that we may be having some 
votes here in a bit, and there are other members who have been 
here for a while. If we can, I will come back for a second 
round.
    Mr. Sherman. I just want to bring up one other thing, and 
that is I think it is important to disclose this whole soft 
dollar thing, but I am not sure that those advocating such a 
disclosure have been able to tell us how to do it in a way that 
is not avoided. What I have seen in another arena trying to 
prevent or quash or disclose soft dollars is sometimes you just 
drive things underground. One of the things--maybe you can 
reply in writing to this, because we do need to go on to other 
members--is the fact that you are dealing not with brokers, but 
with broker-dealers. Thus, if we say you have to disclose 
commissions, what about markups? I would hope that the 
advocates for the disclosure of either what you are paying in 
brokerage fees or what you are getting in free services beyond 
execution, that those advocates would tell us exactly not only 
how we are going to disclose this, but how does it get 
disclosed if firms react to the disclosure rules, and for 
example, instead of buying bonds on the market that have 
already been out there with a brokerage fee, simply buy new 
issues and can report a zero brokerage fee. There is a spread 
for some, a brokerage fee for others, and I look forward to 
seeing in writing your response to that.
    I yield back.
    Chairman Baker. Thank you, Mr. Sherman.
    Mr. Tiberi?
    Mr. Tiberi. Thank you, Mr. Baker.
    Over the weekend, Mr. Haaga, I received a couple of things 
that you might be familiar with. I got this little lovely piece 
in the mail. I do not know if you can see it or not. You 
probably can see this one a little bit better. You might 
recognize that.
    Mr. Haaga. Yes.
    Mr. Tiberi. It is an Investment Company of America, but 
this weekend I did. My question to you is this--
congratulations, by the way, on your election to the board. I 
think I voted for you.
    Mr. Haaga. Thank you.
    Mrs. Kelly. Would the gentleman yield?
    Mr. Tiberi. Yes.
    Mrs. Kelly. What is going on here between the two of you? 
Is he a constituent of yours, sir?
    Mr. Tiberi. No. The chairman of the board issue came up 
earlier, and the chairman of the board for Investment Company 
of America is a gentleman by the name of Michael Shanahan, who 
is also the chairman of the management company. As a 
shareholder, can you tell me why that is an okay thing or a 
good thing?
    Mr. Haaga. I think if you look at the rest of the list, you 
will see that we have over two-thirds of the directors are 
outside directors. The act of chairing the board involves 
putting together the agenda; it involves putting together the 
materials, et cetera. I do not think, in fact I know in his 
case, and it is certainly not in my case, it does not involve 
dominating the meeting.
    I would also add, and I did not get to add it before, so I 
would like to add it now, that we have separate meetings of 
only the independent directors in connection with reviewing our 
performance and our contracts. We even have executive sessions 
there. In those cases, the chair of the contracts committee 
chairs those meetings. So we do have a chairing role and a 
chairing function being performed by the outside directors.
    Mr. Tiberi. So you would argue that we would not--as a 
shareholder I should not be concerned about that potential.
    Mr. Haaga. I would argue that the specific designation of 
Mr. Shanahan as chairman of the board does not impede in any 
way the independent activity and operation of our outside 
directors.
    Mr. Tiberi. Just following up on the question Mr. Sherman 
had with respect to broker-dealers, there is something called 
revenue payments that are sometimes paid to broker-dealers. Do 
you believe that fund managers like yourselves should disclose 
to investors what those payments are?
    Mr. Haaga. The short answer is yes. The longer answer is, 
where and how much and to whom. I do not call them revenue 
sharing. I call them expense sharing.
    Mr. Tiberi. Okay.
    Mr. Haaga. Because that is a lot of what is going on. For 
example, we have computers on the desks of broker-dealers that 
they use to forward trades to us. They have information systems 
that we put out information to them, and educational sessions, 
and we split the cost with them. I do not know whether that is 
revenue. It looks a lot like expense to me. So the question is 
disclose what and to whom. We have worked hard at the ICI, and 
when I chaired the NASD investment companies committee, on 
finding ways to do that.
    I think the issue would arise with what is called revenue 
sharing if a substantial amount of the payments actually made 
it to the selling broker, the one who was making the 
recommendation to choose one fund versus the other. They 
generally do not. They do not get out to the selling broker. 
They are made to the management company.
    I also think it is important to note that a lot of them are 
not based on assets or sales. They are actually fixed-dollar 
amounts, where we are paying for some service or the cost of 
some facility that in effect both of us share. So I would like 
to find a way to disclose it. The devil is in the details of 
figuring out how to do it. I think if there were concerns, the 
fraud would be if there were huge amounts of money paid to 
sellers, either the firms or the individuals, to favor one fund 
over another, and that was how they were selecting the funds to 
be included in their group of sales. What happens is that they 
request fees at a certain level for all funds, and then all 
funds participate in paying them, so there is no skewing of the 
recommendations based on the amounts that are being paid.
    Mr. Tiberi. One of the devils in the detail is also 
directed commissions that a lot of these revenue sharing 
agreements have, that the brokerage has. It says that we will 
give you good shelf space in our supermarket if you also have 
the funds direct commissions--20, 25 percent of your total 
commission dollars back to our trading floors. Those 
arrangements I think are one of the devils in the detail that 
hopefully could be added to this.
    Mr. Haaga. What he described is prohibited by an NASD rule, 
in plain English.
    Mr. Wagner. I would like to point out the AIMR has 
approached this four or five years ago and come up with soft 
dollar standards that probably need to be updated, but at least 
form a starting point.
    Mr. Tiberi. Thank you, Mr. Chairman.
    Chairman Baker. The gentleman yields back.
    Mr. Bachus?
    Mr. Bachus. Thank you, Mr. Chairman.
    First of all, I want to commend you for holding this 
hearing. Ninety-five million Americans hold mutual funds, and I 
think it is important that these retirees or investors do not 
pay excessive mutual fees, and that if they pay hidden costs 
associated--well, that they really should not pay hidden costs 
associated with those mutual funds without knowing it.
    As you know, U.S. fund fees appear to be lower than the 
vast majority of the funds in other nations, and there is 
strong evidence recently that there has been more fee-based 
competition. This being said, unfortunately academic studies 
have shown that many funds have experienced an economy of 
scale, and that they are not passing those savings on to the 
shareholders. In addition, these same studies have noted that 
shareholder insensitivity to costs may rest with widespread 
investor ignorance about the various shareholder charges. In 
other words, they are not opposed to them because they do not 
know about them, and that is despite a request by the 
Securities Exchange Commission to get the mutual fund industry 
to properly disclose their fees.
    With that background, I would like to start with Mr. 
Gensler, and I would like to pose this question to you. Mr. 
Montgomery states that the practice of soft dollar commissions 
is one of the worst examples of undisclosed conflicts of 
interest in the mutual fund industry. What is the conflict and 
how does it affect fund shareholders?
    Mr. Gensler. There is a conflict, and I think it is a good 
question. Think of three parties--the investor, for this case 
it could be me; the fund company, if that is all right, if that 
is the chairman, just for a moment; and if you, sir, could be 
the brokerage house. What happens in soft dollars is that I pay 
you a commission--five cents a share, as Mr. Montgomery showed 
earlier--and part of that is a barter transaction. Part of it 
is that you are going to provide some services for Mr. Baker's 
fund company. In providing those services, it could be real 
estate; it could be data services; it could be a host of 
those--was it 1,200 services that was on that list. Barter is 
fine and it goes on in America. It is part of our commercial 
world.
    But here in this situation, there are three parties. I am 
paying you, the investor or fund company is paying you, the 
broker, five cents a share and you are picking up Chairman 
Baker's real estate or some other expenditures. That is where 
the conflict is, because it is not either disclosed to me in my 
fees. I do not see it in that management fee, so the shortest 
thing would be just add it to management fees. You could say 
that barter arrangement should be added to management fees, or 
go further and actually ban it because there is this inherent 
conflict that Chairman Baker is going to make more profits, and 
I am going to make less due to our barter arrangement.
    Mr. Bachus. All right. Let me go to Mr. Montgomery and ask 
you the same question. We are talking about soft dollar 
commissions. What is the conflict and how does it affect fund 
shareholders?
    Mr. Montgomery. The conflict is that I have a choice as a 
participant in the mutual fund industry or in the larger 
investment community, when I have clients who do pay 
commissions and all people working through a brokerage house 
are going to pay commissions, so that is fine. But I have a 
choice when I go to pay for my Bloomberg terminal for the 
services of Mr. Wagner here, for many things, of paying out of 
our own advisory fee and profit--and by the way, research is 
one of the biggest ones of those--so I can pay for it out of 
our own profits, which you could say come from the management 
fee. Or I can pay for it with soft dollar commissions, which 
means it is a cost borne by the fund, but does not affect my 
own advisory fee expense structure.
    So which am I going to do? One flows directly through to my 
bottom line, and a dollar of expense there comes directly out 
of my profit. Or I can pay for it with commissions, which does 
affect our overall performance of the fund, but does not--
    Mr. Bachus. And not even reveal that you had to spend that.
    Mr. Montgomery. And that is key, and not even have to 
reveal it. Nobody is going to see it; nobody is going to ask 
about it. There are rules. The SEC in their examination when 
they come in are going to be all over it. So it is not like no 
one is looking. I promise you, during the examination the SEC 
is all over this issue.
    However, what are the incentives on my part to control 
those costs? They are not good. The incentive is very clearly--
even if I have a 25 percent profit margin, I have four times 
the incentive to push it off on my shareholders as opposed to 
eat it myself. The only reason we do not do it at Bridgeway is 
it is a conflict of interest you cannot take care of, and we 
argue even by disclosure. It is too great a conflict of 
interest. Just do away with it.
    Mr. Bachus. Let me ask Mr. Bogle.
    Mr. Bogle. The same question?
    Mr. Bachus. Same question.
    Mr. Bogle. I could not give an answer any better than John 
Montgomery's. There is a definite conflict there, and I am not 
sure disclosure vitiates it, but an awful lot of research is 
paid for, and particular research is paid for through these 
soft dollars. It is interesting that mutual funds themselves, 
out of this $75 billion of revenues that I estimate that they 
got last year--it is very fair estimate--probably spend about 
$4 billion on their own research. All the rest of it is paid 
for by the soft dollars with which they could otherwise improve 
the returns of their clients. So it is a definite conflict.
    Mr. Bachus. Okay. Let me move to a second question, and 
this is for the whole panel. Should soft dollar commissions be 
banned in the mutual fund industry? Or short of banning the 
practice, what should regulators do to better protect the 
interest of fund investors? We will just start with Mr. Bogle.
    Mr. Bogle. I would say soft dollars create great problems, 
but I would suggest that we should do away with them in the 
entire system, and not just with respect to the mutual fund 
industry. The abuse, believe it or not, may be worse outside of 
the mutual fund industry than it is within it. We should be 
when we execute a transaction, we should pay for the execution. 
As one of the charts you saw earlier, we are paying for three 
or four times that with other people's money.
    Mr. Bachus. So you say prohibit it.
    Mr. Bogle. Prohibit it.
    Mr. Bachus. Okay.
    Mr. Wagner. The miner's commission in the UK actually 
recommended this, and that is certainly being experimented with 
over there, so we will have some evidence on that fairly 
quickly here. I think that, yes, they could go underground, as 
Mr. Sherman suggested earlier, that they could go into unbilled 
category of services that are available from the brokerage 
firms. So it may not solve the problem. I would opt for 
disclosure--what is being spent, to whom and what is being 
received for that payment.
    Mr. Bachus. Mr. Montgomery?
    Mr. Montgomery. I am in the banning category, and I think 
it is just an awful lot more efficient just to kill it. The 
costs that go into, as a mutual fund company, whether it is the 
adviser or the fund itself, of the regulators coming into look 
over the shoulders of it. It is kind of like the worst part of 
the tax system, with layer upon layer upon layer of loophole 
and exceptions. We spend a tremendous amount of money just 
trying to measure it and make sure that it is fair. Even if we 
were absolutely honorable, have integrity and want to do a good 
job, and maybe even disclose it--maybe somebody voluntarily 
discloses it--it is still a tremendous effort and cost that 
somebody has to pay to measure it, and I think that is 
inappropriate.
    Mr. Bachus. Mr. Bradley?
    Mr. Bradley. I have a couple of comments that I would like 
to frame. One would be that it is already underground. So the 
fear that this would go underground, it is there. The reason it 
is there is that in 1997, the SEC did a soft dollar sweep and 
investigation of broker-dealers and looked at these bills they 
pay, because that is the only audit trial. Two-thirds of the 
documents at that time were unreported, undocumented. In my 
earlier testimony, I stated that what we heard from our 
accountants is, if they were documented it would create an 
income and expense item on a fund management company's income 
statement, potentially.
    I think that I would be more in favor though, and I 
answered a similar question earlier, that we should really go 
back and revisit your law, section 28(e), and through 
rulemaking define specifically what "paying up" means; gather 
the execution-only rate from firms so that we can quantify what 
they pay above that execution-only rate; and then put the 
burden on fund companies to show their management company 
through quantifiable results, the value returned to investors.
    Mr. Bachus. Mr. Bogle?
    Mr. Bogle. I apologize, Mr. Bachus, for interrupting you. I 
was trying to make the following point. We are talking about 
abuses. I think it is important to note that when the SEC did 
their sweep a couple of years ago and found abuses, the only 
people that they found doing that were investment advisers, not 
the mutual funds. No mutual fund managers were caught up in 
that. We are throwing the term around back and forth about 
investment advisers doing that. Those were investment advisers 
to individuals who were being caught with the abuses.
    I guess in terms of what to do about--you asked the 
specific question of should we ban soft dollars--and some 
people answered we should ban it. I think you need to define it 
first. I will not get into it here, but soft dollars includes a 
lot of things that may not be wrong. The kinds of abuses that 
Harold is talking about should be curtailed either through SEC 
regulation or legislation--probably SEC regulation.
    Mr. Bachus. And what are some of the areas that you think 
are particularly abusive?
    Mr. Bogle. In Harold's case, I think that the ones he 
mentioned--that long list of things you could pay for. When I 
was in private practice before 1985, I used to advise some 
companies about interpretations of section 28(e). I once had a 
portfolio manager assert to me that if a light bulb shined on a 
guy doing research, that light bulb should be paid for out of 
soft dollars because it was research. You can imagine where 
that extends. There is just no stop to it.
    Mr. Bachus. So research is an area of abuse?
    Mr. Bogle. Research ought to have some intellectual 
content. That is what is permitted under 28(e), and the abuse 
is that people have taken research--you and I know what 
research is; it has an intellectual content to it; it is a 
study--and they extended it out to the light bulbs and the club 
membership for the guys who do the research because they need 
to relax after they have studied their prospectuses and things 
like that. That is where the abuses are. I would not mind 
getting rid of those abuses, but simply calling it soft dollars 
or simply repealing 28(e) would not do it. There is something 
going on that should not be going on, I will agree with that.
    Mr. Bachus. And Mr. Gensler, I think you made--
    Mr. Gensler. Even if that is at the risk of Chairman Baker 
losing the soft dollars in my earlier example, I would probably 
be on the side of banning it, or short of that, significantly 
curtailing it and disclosing the remaining portion.
    Mr. Bachus. Okay.
    Mr. Riepe. Let me just say three things. One, I want to be 
on the record as agreeing with Mr. Bogle on something. 
Specifically, as Chairman Baker pointed out at the beginning in 
his opening remarks, mutual funds represent only about 20 
percent of the equity market. As Jack pointed out, the soft 
dollar issue is not unique to funds. Some of the major pension 
plans in the country use commissions that are generated from 
their business, and direct advisers like us to pay certain 
expenses that those pension plan sponsors have incurred, 
presumably for the benefits of the participants in those plans. 
So this is not a mutual fund-specific problem.
    Secondly, I think, as Paul Haaga noted, the fund industry 
and the SEC have been doing a good job of managing it by 
examination and disclosure; but I do not think that is 
adequate, obviously, in terms of some of the abuses.
    And thirdly, a specific recommendation is that I think the 
SEC could be asked to go back and answer that question and have 
the time and the resources to delve into some of the nuances of 
it that Mr. Haaga was referring to, and come back with a 
recommendation on it. I will tell you that we can live with 
whatever that recommendation is, and if it is a complete ban of 
directed commissions, then fine. If it is something else, then 
that is fine as well.
    Chairman Baker. Mr. Bachus, it is my intent, based on what 
has preceded us here today, to have a letter to the SEC 
probably next week, outlining a series of issues for 
resolution, one of which would include the soft money question. 
I just make the announcement for members' interest. If they 
want to sign onto that letter, just let us know. But I have 
spoken to Mr. Kanjorski and he wishes to participate in the 
letter as well. So it is bipartisan and it is merely to get 
some factual determinations and also some definition in the 
case of soft money, and in a recommendation with regard to that 
definition. So we will do that.
    Mr. Bachus. Can you note, as several gentlemen have said, 
this is not confined to the mutual fund industry.
    Chairman Baker. It is larger. Yes, sir.
    If I may, let me recognize Mr. Castle. If we go to Mr. 
Castle, we can get everybody done before we have to leave for 
this vote.
    Mr. Castle. Thank you, Mr. Chairman. I appreciate being 
recognized and I apologize for being out of the room during the 
question-answer, but I heard each of your testimony before I 
left. Let me just say, I am an admirer of almost all of you, 
and I agree with virtually everything that you said. I think 
you are the cream of the crop. We went down about two or three 
more panels and start to get into some of the more dubious 
areas of mutual funds and what has happened.
    I am just going to put together one question, and again I 
apologize if some of this has been asked before, and then ask a 
couple of you to answer, and then open it up to all of you. I 
believe in consumer knowledge, and I believe the American 
public is a heck of a lot smarter than often given credit for, 
and the American consumer is, too, if they know what they are 
looking at. I think it is very hard, frankly, when you look at 
mutual funds to know what you are looking at. With all due 
respect to Vanguard's ads about lower costs and saving more 
money and everything else, I just think it is very hard to 
figure this out.
    So I have a couple of thoughts, and I do not know if this 
has been asked before or not, but on the whole regulatory board 
question, should there be a separate regulatory board for 
mutual funds? It is a huge industry at this point. Or is that 
not a good idea, because it becomes a captive board, as so many 
others do, and perhaps it is better to be left in the SEC.
    Another question I have is, what else could Congress do? 
Talking about it here is great, and there are a couple of TV 
cameras, but I have a hunch it is not going to lead the news 
tonight and people are not going to know a heck of a lot more 
after today. Perhaps we do, but a lot of other people will not. 
I think we need to get that information out. So what else could 
the government do in terms of regulations, laws, whatever it 
may be? What do you think about the SEC? Any ideas you have of 
getting the word out? I agree with the problems you stated. 
What is our strategy to try to correct these things?
    I would like to start with Mr. Gensler because he has some 
experience in that. And I would like Mr. Bogle to answer this 
just because he is Mr. Bogle, and I think he does have the 
temerity of Warren Buffett. I disagree with what he said 
earlier. And I would then open it up to anybody else who wants 
to take a step at it.
    Mr. Gensler. Congressman, it is very good to see you again, 
by the way.
    I think that the SEC has put forth what is called a concept 
release on a possible new regulatory structure in this area. 
With that, they raise some very thoughtful questions, 
particularly internal compliance officers and how to address 
compliance issues at mutual funds.
    In terms of regulatory structure, I find myself torn. The 
SEC, as best I can tell, has the authority to do that which 
they need to do. So it may well be a funding issue that they 
want to devolve this to what they call a self-regulatory 
organization, with the hopes of assessing fees so that they do 
not have to go through the annual appropriations dance that 
every agency must and under our constitution ought to go 
through. So I find myself feeling there are a lot of tough 
issues here; a lot of issues that could hopefully be dealt with 
around fund governance, and maybe some marginal additional 
disclosure. But in terms of the regulatory structure, I think 
at the core what the SEC is grappling with is probably more a 
funding issue, and to devolve it to something just to assess 
fees does not seem like their case has yet been made.
    Mr. Castle. Mr. Bogle?
    Mr. Bogle. Yes, sir. Thank you, Congressman Castle.
    I would like to put this in a little broader context. It is 
very clear that in corporate America we have moved from an era 
of owners' capitalism to managers' capitalism, where companies 
are run in the interests of their managers, rather than their 
owners. We have to get back to our roots. That is a long and 
complicated job.
    The mutual fund industry really never has had an era of 
owners' capitalism. In its first 25 or 30 years it had a 
fiduciary-type orientation. That is why fees were so much 
lower. The average equity fund fee back in, say, 1951, was less 
than half of what it is today. Then, the fiduciaries took the 
place of the fund owners, who are large and disorganized, small 
investors and so on. But just like corporate America, we have 
moved into an era of managers capitalism in the mutual fund 
business.
    Managers make a lot of money in this business. I am 
reminded of Upton Sinclair's comment that it is amazing how 
difficult it is for a man to understand something if he is paid 
a huge salary not to understand it. That is really true. It is 
a universal rule of life. How do we get back to our industry's 
fiduciary roots? Well, we start off, I would say, by much 
better disclosure--in shareholders' statements, yes, the amount 
they pay; in annual reports with a dedicated page on the first 
or second page showing the fund's returns relative to its 
costs, turnover costs, turnover, dollar amount of fees--things 
like that, every fund has to show on one of the first two 
pages; and other disclosure issues that we have talked about 
today.
    Next, I think there is something we can do to improve the 
structural imbalance between the rights of fund shareholders as 
manifested through their fiduciary boards of directors and the 
rights of the managers. That is, strengthen the board. The 1940 
Act calls for that implicitly. One thing you can do, and should 
do, is have an independent chairman of the board, just like we 
are calling for in corporate America, because in both cases the 
manager as chief executive has too much power. Another 
improvement would be a larger number of independent directors. 
Finally, I think, and I am not a lawyer here, which may make 
this better or worse, is a federal standard of fiduciary duty 
for mutual fund directors. That would open up a lot of 
opportunities to have the fund owners served properly and 
fairly.
    Mr. Castle. Thank you, Mr. Bogle. Unfortunately, we are 
going to have to cut it off. I am interested in the question. 
If any of you have a written answer you would like to submit on 
that--the whole issue of what can the government be doing to 
help resolve some of the problems which we have discussed here 
today.
    With that, I yield back to the Chairman.
    Chairman Baker. Thank you, Mr. Castle.
    There is one further question I had. Mr. Haaga, does the 
ICI have a formal position with regard to the SEC proposal now 
pending with regard to disclosure of proxy voting?
    Mr. Haaga. The proposal has been adopted. Our position 
was--and I am glad you asked that, because we get characterized 
as being against it. There were a number of parts of that 
proposal, and we agreed with most of them--all but one of them. 
We even suggested a more rigorous alternative to another one of 
them, which is to include the independent directors to oversee 
potential conflicts. The only part with which we disagreed was 
that of sharing the individual proxy votes with, in the 
original proposal it was anybody who asked in paper. Now, we 
are gratified that we can put it up on our Web site or the 
SEC's Web site.
    Chairman Baker. And with that modification, does that--
    Mr. Haaga. It has been adopted and we will live with it.
    Chairman Baker. I know the SEC has adopted it, but the OMB 
is in the process of promulgation, I believe, so it is not 
effective.
    Mr. Haaga. Right.
    Chairman Baker. I just wanted to clarify the industry 
position.
    Mr. Haaga. Well, the industry, of course, we will live with 
it. We want to make sure that the OMB and the SEC properly take 
into account, costs. This was adopted in a great hurry, and I 
think there was not, frankly, an adequate analysis of the 
potential costs. If they do an analysis of the potential costs 
and they adopt it, we will comply with it, as always.
    Chairman Baker. Let me express to you and all the panelists 
today my appreciation for your longstanding patience. This was 
a lengthy hearing, but I think it provided members with a much 
better insight into the areas that are performing properly; 
into those areas where perhaps we need to make some 
enhancements. To that end, I have conferred with Mr. Kanjorski 
and Members, as I said repeatedly, we will get a letter out to 
the SEC to try to get professional resolution of making that 
statement. So all parties who are interested can make 
appropriate comment. And then we would, at some future time, 
return to this subject to try to bring some closure.
    I think the most important asset of the hearing, as Mr. 
Haaga indicated in his opening statement this morning, was that 
we want to bring about consumer confidence that capital markets 
are efficient, transparent, and most importantly, responsive to 
shareholders. That is our goal, and we will work diligently 
toward that end, and I appreciate your courtesies in helping 
the committee get there. Thank you.
    Our meeting is adjourned.
    [Whereupon, at 1:34 p.m., the subcommittee was adjourned.]


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