Mutual Funds: Greater Transparency Needed in Disclosures to
Investors (09-JUN-03, GAO-03-763).
The fees and other costs that investors pay as part of owning
mutual fund shares can significantly affect their investment
returns. As a result, questions have been raised as to whether
the disclosures of mutual fund fees and other practices are
sufficiently transparent. GAO reviewed (1) how mutual funds
disclose their fees and related trading costs and options for
improving these disclosures, (2) changes in how mutual funds pay
for the sale of fund shares and how the changes in these
practices are affecting investors, and (3) the benefits of and
the concerns over mutual funds' use of soft dollars.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-03-763
ACCNO: A07114
TITLE: Mutual Funds: Greater Transparency Needed in Disclosures
to Investors
DATE: 06/09/2003
SUBJECT: Investments
Mutual funds
Fees
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GAO-03-763
A
Report to Congressional Requesters
June 2003 MUTUAL FUNDS Greater Transparency Needed in Disclosures to
Investors
GAO- 03- 763
Letter 1 Results in Brief 2 Background 6 Additional Disclosure of Mutual
Fund Costs May Benefit Investors 8
Independent Directors Play a Critical Role in Protecting Mutual Fund
Investors 20 Changes in Mutual Fund Distribution Practices Have Increased
Choices for Investors, but Have Raised Potential Concerns 29 Soft Dollar
Arrangements Provide Benefits, but Could Also Have an
Adverse Impact on Investors 42 Conclusions 54 Recommendations 56 Agency
Comments and Our Evaluation 57
Appendixes
Appendix I: Scope and Methodology 60
Appendix II: Comments from the Securities and Exchange Commission 61
Appendix III: Comments from the Investment Company Institute 64
Appendix IV: GAO Contacts and Staff Acknowledgments 67 GAO Contacts 67
Acknowledgments 67
Tables Table 1: Fee Disclosure Practices for Selected Financial Services
or Products 10
Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance Listing
Standards Compared to those Currently Required or Recommended for Mutual
Fund
Boards 28 Figure Figure 1: Factors Fund Directors Are to Consider in
Voting to
Approve or Continue 12b- 1 Plans 31
Abbreviations
ECN electronic communications network FSA Financial Services Authority ICI
Investment Company Institute NAV net asset value NYSE New York Stock
Exchange SAI Statement of Additional Information SEC Securities and
Exchange Commission SRO self- regulatory organization
This is a work of the U. S. Government and is not subject to copyright
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materials separately from GAO*s product.
June 9, 2003 Let er t The Honorable Michael G. Oxley Chairman, Committee
on Financial Services House of Representatives
The Honorable Richard H. Baker Chairman, Subcommittee on Capital Markets,
Insurance, and Government Sponsored Enterprises Committee on Financial
Services House of Representatives Millions of U. S. households have
invested in mutual funds with assets exceeding $6 trillion by year- end
2002. The fees and other costs that these investors pay as part of owning
mutual fund shares can significantly affect their investment returns. As a
result, questions have been raised as to
whether the disclosures of mutual fund fees and others costs, including
the trading costs that mutual funds incur when they buy or sell
securities, are sufficiently transparent. Some have also questioned the
effectiveness of mutual fund boards of directors in protecting shareholder
interests and overseeing the fees funds pay to investment advisers. Many
mutual funds market their shares to investors through broker- dealers or
other financial professionals, such as financial planners. However,
concerns have been raised over how the payments that fund advisers make to
the entities that sell fund shares affect investors. When mutual fund
investment advisers use broker- dealers to buy or sell securities for the
fund, they generally pay these broker- dealers a commission for executing
the trade. Under arrangements known as soft dollars, part of these
brokerage commissions may pay for research and brokerage services that the
executing brokerdealer or third parties provide to the fund*s investment
adviser. Because the amount of brokerage commissions a fund adviser pays
directly reduces the ultimate return earned by investors in its funds,
questions exist over the extent to which investors benefit from or are
harmed by these soft dollar arrangements.
To address these concerns, this report responds to your January 14, 2003,
request that we review issues relating to the transparency and
appropriateness of certain fees and practices among mutual funds.
Specifically, our objectives were to review (1) how mutual funds and their
advisers disclose their fees and related trading costs and options for
improving these disclosures, (2) mutual fund directors' role in overseeing
fees and various proposals for improving their effectiveness, (3) changes
in
how mutual funds and their advisers pay for the sale of fund shares and
how the changes in these practices are affecting investors, and (4) the
benefits of and the concerns over mutual funds' use of soft dollars and
options for addressing these concerns.
To determine how mutual funds currently disclose their fees and other
costs, we reviewed regulatory requirements and disclosures made by a
selection of mutual funds. We discussed various proposals to increase
disclosure with staff from regulators that oversee mutual funds, including
the Securities and Exchange Commission (SEC) and NASD, and staff from
mutual fund companies, industry groups and researchers. We also
interviewed officials of 10 mutual fund companies that sell their funds
through broker- dealers and a judgmental sample of 15 certified financial
planners. To identify the activities that mutual fund directors perform,
we reviewed federal laws and regulations, interviewed staff from an
association representing independent directors and used a structured
questionnaire to interview a judgmental sample of six independent director
members of this association. To determine how mutual funds and their
advisers pay for distribution, we interviewed various regulatory staff,
industry associations and researchers, fund companies, and two
brokerdealers that sell fund shares. We also reviewed and analyzed various
documents and studies of mutual fund distribution practices. To describe
the benefits and potential conflicts of interest raised by mutual funds*
use of soft dollars, we spoke with SEC, NASD, and regulators in the United
Kingdom and reviewed studies by regulators and industry experts on soft
dollar arrangements. We conducted our work in accordance with generally
accepted government auditing standards in Boston, MA; Kansas City, MO; Los
Angeles and San Francisco, CA; New York, NY; and Washington, DC from
February to June 2003. Our scope and methodology is described in detail in
appendix I.
Results in Brief Although mutual funds already disclose considerable
information about the fees they charge, regulators and others have
proposed additional
disclosures that could increase the transparency and investor awareness of
the costs of investing in mutual funds. Currently, mutual funds disclose
information about the fees and expenses that each investor specifically
pays on their mutual fund shares as percentages of fund assets, whereas
most other financial services disclose the actual costs to the purchaser
in dollar terms. Mutual funds also incur brokerage commissions and other
trading costs when they buy or sell securities, but these costs are not
prominently disclosed to investors. To provide more information about the
fees investors pay, SEC has proposed requiring mutual funds to disclose
additional fee- related information, but these would not provide investors
with the specific dollar amount of fees paid on their shares as others
have proposed, nor would these disclosures be provided in the document
generally considered to be of the most interest to investors* the
quarterly statement that shows the number and value of an investor*s
mutual fund shares. Although continuing to consider the need for
additional disclosures, SEC staff and industry participants noted that
data on the extent to which additional fee information would benefit
investors is generally lacking. However, continued consideration of the
costs and benefits of providing additional disclosure appears worthwhile
because some alternatives for providing fee information to mutual fund
investors in quarterly statement could provide some benefit and may cost
very little. Some industry participants have also called for more
disclosure of information about the brokerage commissions and other costs
that mutual funds incur when trading, but standard methodologies for
determining some of these amounts do not exist and regulators and others
raised concerns that such disclosures could be misleading. Mutual funds
also have boards of directors that are tasked with reviewing
the fees that fund investors are charged, but some industry participants
questioned whether directors have been effective in overseeing these fees.
In general, SEC rules require mutual fund boards to have a majority of
independent directors, who are individuals not employed by or affiliated
with the fund*s investment adviser. Among their many duties, these
directors are specifically tasked with overseeing the fees their funds
charge. However, some industry observers say that the process that fund
directors are required to follow under the law fails to produce sufficient
actions to minimize fees. To further reduce fees, some have suggested that
fund directors should be required to seek competitive bids from other
investment advisers. However, industry participants indicated that this
may not result in lower costs and fees for investors and noted that
directors seek to lower fund fees in other ways, such as by requiring the
investment adviser to charge progressively lower fees as the assets of the
fund grow. Regulators and industry bodies have also recommended various
changes to the composition and structure of mutual fund boards as a means
of increasing directors* effectiveness that many funds have already
adopted. Many reforms being proposed as a result of the recent corporate
scandals, such as Enron, also seek to enhance board of director oversight
of public
companies. Such reforms could serve to further improve corporate
governance of mutual funds, but industry participants report that,
although
not all of these proposed practices are currently required for mutual
funds, most fund boards are already following many of them.
Changes in the ways that investors pay for mutual fund shares have
produced benefits for investors but also raise concerns over their
transparency. In 1980, an SEC rule was adopted to allow mutual funds to
begin using fund assets to pay the distribution expenses, which included
marketing expenses and compensation for the financial professionals who
sell fund shares. Although rule 12b- 1 was originally envisioned as
providing funds a temporary means of increasing fund assets, the fees
charged under this rule have instead evolved into an alternative way for
investors to pay for the services of broker- dealers and other financial
intermediaries from whom they purchase fund shares. Concerns exist over
whether funds with 12b- 1 fees are more costly to investors and whether
current disclosures are sufficiently transparent to allow investors to
determine the extent to which their particular broker- dealer
representative or other financial professionals they use receive these
payments. In a December 2000 report, SEC staff recommended that rule 12b-
1 be modified
to reflect changes in how funds are being marketed, but SEC has yet to
develop a proposal to amend the requirements relating to this rule.
Another distribution practice* called revenue sharing* that has become
increasingly common involves investment advisers making additional
payments to broker- dealers that distribute fund shares. Although little
data on the extent of these payments exists, industry researchers say that
such payments have been increasing and have raised concerns about how
these
payments may affect the overall expenses charged to fund investors.
Concerns also exist over whether broker- dealers receiving payments to
promote certain funds creates a conflict of interest for their sales
representatives, who are responsible for recommending only investments
that are suitable to their clients* objectives and financial situation, or
whether this also limits the choices that investors are offered. Under
current disclosure requirements, an investor might not be explicitly told
that the adviser of the fund their broker- dealer is recommending made
payments to that broker- dealer, and some industry participants have
called for additional disclosures to address these potential conflicts.
Soft dollar arrangements allow investment advisers of mutual funds to use
part of the brokerage commissions paid to broker- dealers that execute
trades on the fund*s behalf to obtain research and brokerage services that
can potentially benefit fund investors but could increase the costs borne
by their funds. Industry participants said that soft dollars allow fund
advisers access to a wider range of research than may otherwise be
available and
can also be used to reduce fund expenses. However, others were concerned
that these arrangements can create conflicts of interest between
investment advisers and investors that could increase investors* costs.
For example, fund advisers might use some broker- dealers solely because
of the soft dollar services they offer rather than because of their
ability to execute the fund*s trades in the most advantageous way.
Concerns were raised that investment advisers might trade excessively to
obtain additional services using soft dollars, which would increase fund
investors* costs. In a series of regulatory examinations performed in
1998, SEC staff found
examples of problems relating to investment advisers* use of soft dollars,
although far fewer problems were attributable to the advisers for mutual
funds. In response, the SEC staff issued a report that included various
proposals to address the potential conflicts created by these
arrangements, including recommending that investment advisers keep better
records and disclose more information about their use of soft dollars.
Although this could increase the transparency of these arrangements and
help fund directors and investors better evaluate their fund advisers* use
of soft dollars, SEC has yet to take action on these proposed
recommendations. This report contains recommendations to SEC designed to
increase the
transparency of mutual fund fees and of certain distribution and trading
practices. Since both the extensiveness and the placement of mutual fund
disclosures can affect their transparency and how effectively they
increase investor awareness of the costs of investing in mutual funds, we
recommend that SEC consider the benefits of additional disclosure relating
to mutual fund fees, including requiring the account statements that
mutual fund investors receive provide more information about the fees
being paid. We also recommend that SEC consider developing disclosure
requirements about revenue sharing arrangements so investors may be better
able to
evaluate potential conflicts arising from revenue sharing payments.
Finally, we also recommend that SEC evaluate ways to provide more
information that fund investors and directors could use to better evaluate
the benefits and potential disadvantages of their fund adviser*s use of
soft dollars, including considering and implementing the recommendations
from its 1998 soft dollar examinations report.
We obtained comments from SEC and ICI, who generally agreed with the
contents of this report. The letter from the SEC staff indicated that as
part of their responsibilities in regulating mutual funds, they will
consider the recommendations in this report very carefully in determining
how best to inform investors about the importance of fees. The letter from
the ICI staff noted that our report presented a generally balanced and
well- informed
discussion of mutual fund regulatory requirements. However, the ICI staff
were concerned over how we compare the disclosures made by mutual fund
fees to those made by other financial products, and noted that mutual fund
fee disclosures, which in some ways exceed the information disclosed by
other products, allow individuals to make much more informed and accurate
decisions about the costs of their funds than do the disclosures
made by other financial service firms. We agree with ICI that mutual funds
are required to make considerable disclosures that are useful to investors
for comparing the level of fees across funds. However, we also believe
that supplementing the existing mutual fund disclosures with additional
information, particularly in the account statements that provide investors
with the exact number and value of their mutual fund shares, could also
prove beneficial for increasing awareness of fees and prompting additional
fee- based competition among funds. Background Mutual funds are distinct
legal entities owned by the shareholders of the
fund. Each fund contracts separately with an investment adviser, who
provides portfolio selection and administrative services to the fund. The
costs of operating a mutual fund are accrued daily and periodically
deducted from the fund*s assets. These costs include the fee paid to the
fund*s investment adviser for managing the fund and the expenses
associated with operating the fund, such as the costs for accounting and
preparing fund documents. Each mutual fund has a board of directors, which
is responsible for reviewing fund operations and overseeing the interests
of the fund*s shareholders, including monitoring for conflicts of interest
between the fund and its adviser. 1 1 Although the Investment Company Act
of 1940, which regulates mutual fund operations,
does not dictate a specific form of organization for mutual funds, most
funds are organized either as corporations governed by a board of
directors or as business trusts governed by trustees. When establishing
requirements relating to the officials overseeing a fund, the act
uses the term *directors* to refer to such persons, and this report will
also follow that convention.
The incredible growth of mutual fund assets and in the number of investors
that hold funds has raised concerns within Congress and elsewhere over the
fees funds charge investors. In a report issued in June 2000, we found
that the average fees charged by 77 of the largest stock and bond mutual
funds had declined between 1990 and 1998. 2 In our report, we also
concluded that although many mutual funds exist that compete for investor
dollars, they conduct this competition primarily on the basis of their
performance rather than on the basis of the price of their service, that
is, the fees they charge. In updating the results of the analysis from our
June 2000 report for a hearing on mutual funds in March 2003, we found
that the average fees for this group of funds had increased slightly, due
in part to some funds paying higher management fees to their investment
advisers because of the effect of performance fees. 3 Mutual funds are
sold through a variety of distribution channels. For
instance, investors can buy them directly by telephone or mail or they can
be sold by a sales staff employed by the adviser or by third parties, such
as broker- dealer account representatives. To compensate financial
professionals not affiliated with the adviser for distributing or selling
a fund*s shares, funds may levy a sales charge which is based on a
percentage of the amount being invested* called a load* that the investor
can either pay at the time the investment is made (a front- end load) or
later when
selling or redeeming the fund shares (a back- end load). 4 Many funds that
use broker- dealers or other financial professionals to sell their fund
shares may also charge investors ongoing fees, called 12b- 1 fees that are
used by funds to pay these distributors for recommending the fund or for
servicing the investor*s account after purchases have been made. Mutual
fund shares are also available for investors to purchase through mutual
fund supermarkets. These are offered by broker- dealers, including those
affiliated with a fund adviser, that allow their customers to purchase and
redeem the shares of mutual funds from a wide range of fund companies
through their accounts at the broker- dealer operating the supermarket.
2 U. S. General Accounting Office, Mutual Fund Fees: Additional Disclosure
Could Encourage Price Competition, GAO/ GGD- 00- 126 (Washington, D. C.:
June 7, 2000). 3 U. S. General Accounting Office, Mutual Funds:
Information on Trends in Fees and Their Related Disclosure, GAO- 03- 551T
(Washington, D. C.: Mar. 12, 2003). 4 Some funds charge what is known as a
contingent deferred sales load, which is a charge that is a percent of the
amount invested that declines the longer the investment is held and
usually becomes zero after a certain period.
SEC is the federal regulatory agency with responsibility for overseeing
the U. S. securities markets and protecting investors. Various self-
regulatory organizations (SRO) also oversee the activities of securities
industry participants. NASD is the SRO with primary responsibility for
overseeing
broker- dealers. SEC is responsible for oversight of the SROs and it also
oversees and regulates the investment management industry. Additional
Disclosure
Various alternatives with different advantages and disadvantages exist
that of Mutual Fund Costs
could increase the amount of information that investors are provided about
mutual fund fees and other costs. Currently, mutual funds disclose May
Benefit Investors
information about their fees as percentages of their assets whereas most
other financial services disclose their costs in dollar terms. SEC and
others have proposed various alternatives to disclose more information
about mutual fund fees, but industry participants noted these alternatives
could also involve costs to implement and data on the benefits associated
with
additional disclosures is not generally available. Mutual funds also incur
brokerage commissions and other costs when they buy or sell securities and
currently these costs are not routinely or explicitly disclosed to
investors and there have been increasing calls for disclosure as well as
debate on the benefits and costs of added transparency.
Unlike Other Financial Mutual funds provide various disclosures to their
shareholders about fees. Products, Mutual Funds Do
Presently, all funds must provide investors with disclosures about the
fund Not Disclose the Actual in a written prospectus that must be provided
to investors when they first
Dollar Amount of Fees Paid purchase shares. SEC rules require that the
prospectus include a fee table
containing information about the sales charges, operating expenses, and by
Individual Investors
other fees that investors pay as part of investing in the fund.
Specifically, the table that mutual funds must provide presents (1)
charges paid directly by shareholders out of their investment such as
front or back- end sales loads and (2) recurring charges deducted from
fund assets such as management fees, distribution fees, and other expenses
charged to shareholder accounts. The fees deducted from the fund*s assets
on an
ongoing basis are reported to investors as a percentage of fund assets and
are called the fund*s operating expense ratio. The fee table also contains
a hypothetical example that shows the estimated dollar amount of expenses
that an investor could expect to pay on a $10, 000 investment if the
investor received a 5- percent annual return and remained in the fund for
1, 3, 5, and 10 years. The examples do not reflect costs incurred as a
result of the
fund*s trading activity, including brokerage commissions that funds pay to
broker- dealers when they trade securities on a fund*s behalf.
Unlike many other financial products, mutual funds do not provide the
exact dollar amounts of fees that individual investors pay while they hold
the investment. Although mutual funds provide information about their fees
in percentage terms and in dollar terms using hypothetical examples, they
do not provide investors with information about the specific dollar
amounts of the fees that have been deducted from the value of their
shares. In contrast, most other financial products and services do provide
specific dollar disclosures. For example, when a borrower obtains a
mortgage loan the lender is required to provide a uniform mortgage costs
disclosure statement. This disclosure must show both the interest rate in
percentage terms that the borrow will be charged for the loan and also the
costs of the loan in dollar terms. Under the law, the lender must provide
a truth in lending statement, which shows the dollar amount of any finance
charges, the dollar amount being financed, and the total dollar amount of
all principal and interest payments that the borrower will make under the
terms of the loan. 5 As shown in table 1, investors in other financial
products or users of other financial services also generally receive
information that discloses the specific dollar amounts for fees or other
charges they pay.
5 The Real Estate Settlement Procedures Act, 12 U. S. C. S: 2601- 17.
Tabl e 1: Fee Disclosure Practices for Selected Financial Services or
Products Type of product or service Disclosure requirement
Mutual funds Mutual funds show the operating expenses as percentages of
fund assets and dollar amounts for hypothetical investment amounts based
on estimated future expenses in the prospectus. Deposit accounts
Depository institutions are required to disclose itemized fees, in dollar
amounts, on periodic statements.
Bank trust services Although covered by varying state laws, regulatory and
association officials for banks indicated that trust service charges are
generally shown as specific dollar amounts.
Investment services provided When the provider has the right to deduct
fees and other to individual investment
charges directly from the investor*s account, the dollar accounts (such as
those
amounts of such charges are required to be disclosed to managed by a
financial the investor. planner)
Wrap accounts a Provider is required to disclose dollar amount of fees on
investors* statements. Stock purchases Broker- dealers are required to
report specific dollar
amounts charged as commissions to investors. Mortgage financing Mortgage
lenders are required to provide at time of settlement a statement
containing information on the
annual percentage rate paid on the outstanding balance, and the total
dollar amount of any finance charges, the amount financed, and the total
of all payments required. Credit cards Lenders are required to disclose
the annual percentage
rate paid for purchases and cash advances, and the dollar amounts of these
charges appear on cardholder statements.
Source: GAO analysis of applicable disclosure regulations, rules, and
industry practices. a In a wrap account, a customer receives investment
advisory and brokerage execution services from a
broker- dealer or other financial intermediary for a *wrapped* fee that is
not based on transactions in the customer*s account.
Although mutual funds are not required to disclose specific dollar amounts
of fees paid by individual investors, the amount of information that they
do provide does exceed that provided by some investment products. For
example, fixed- rate annuities or deposit accounts that provide investors
a guaranteed return on their principal at a fixed rate do not specifically
disclose to the purchasers of these products the provider*s operating
expenses. The financial institutions offering these products generate
their profits on these products by attempting to invest their customers*
funds in other investment vehicles earning higher rates of return than
they are obligated to pay to the purchasers of the annuities. However, the
returns
they earn on customer funds and the costs they incur to generate those
returns are not required to be disclosed as operating expenses to their
customers.
Various Alternatives Could In recent years, a number of alternatives have
been proposed for improving
Improve Fee Disclosure, but the disclosure of mutual fund fees, which
could provide additional
the Benefits Have Not Been information to fund investors. In response to a
recommendation in our
June 2000 report that SEC consider additional disclosures regarding fees,
Quantified
SEC has introduced a proposal to improve mutual fund fee disclosure. 6 In
December 2002, SEC released proposed rule amendments, which include a
requirement that mutual funds make additional disclosures about their
expenses. 7 This information would be presented to investors in the annual
and semiannual reports prepared by mutual funds. Specifically, mutual
funds would be required to disclose the cost in dollars associated with an
investment of $10,000 that earned the fund*s actual return and incurred
the fund*s actual expenses paid during the period. In addition, the staff
also proposed that mutual funds be required to disclose the cost in
dollars, based on the fund*s actual expenses, of a $10,000 investment that
earned a standardized return of 5 percent.
The SEC*s proposed disclosures have various advantages and disadvantages.
If adopted, this proposal would provide additional information to
investors about the fees they pay when investing in mutual funds. In
addition, these disclosures would be presented in a format that would
allow investors to compare fees directly across funds. However, the
disclosures would not be investor specific because they would not use an
investor*s individual account balance or number of shares owned. In
addition, SEC is proposing to place these new disclosures in the
semiannual shareholder reports, instead of in quarterly statements.
Quarterly statements, which show investors the number of shares owned
and value of their fund holdings, are generally considered to be of most
interest and utility to investors. As a result, SEC*s proposal may be less
likely to increase investor awareness and improve price competition among
mutual funds. According to SEC staff, they are open to consider
6 GAO/ GGD- 00- 126. 7 Shareholder Reports and Quarterly Portfolio
Disclosure of Registered Management Investment Companies, Securities and
Exchange Commission Release Nos. 33- 8164; 34- 47023; IC- 2587068 (Dec.
18, 2002).
additional disclosures if the benefits to investors appear clear, but have
decided to continue pursuing approval of the proposed disclosure format
from their December 2002 rule proposal. This proposal has received a wide
range of comments. Most comments were in support of SEC*s proposed
requirement to include the dollar cost associated with a $10,000
investment. For example, one investment advisory firm commented in its
letter that the new disclosures SEC is proposing would benefit investors
by allowing them to estimate actual expenses and compare costs between
different funds in a meaningful way. Another alternative for disclosing
mutual funds fees would involve funds
specifically disclosing the actual dollar amount of fees paid by each
investor. In our June 2000 report, we noted that such disclosure would
make mutual funds comparable to other financial products and services such
as bank checking accounts or stock transactions through brokerdealers. As
our report noted, such services actively compete on the basis of price. If
mutual funds made similar specific dollar disclosures, investors would be
clearly reminded that they pay fees for investing in mutual funds and we
stated that additional competition among funds on the basis of price could
likely result among funds. An attorney specializing in mutual
fund law told us that requiring funds to disclose the dollar amount of
fees in investor account statements would likely encourage investment
advisers to compete on the basis of fees. He believed that this could spur
new entrants to the mutual fund industry and that the new entrants would
promote their funds on the basis of their low costs, in much the same way
that low- cost discount broker- dealers entered the securities industry.
Although some financial planners, who directly assist investors in
choosing among mutual funds, thought that requiring mutual funds to
provide investors with the specific dollar amounts of fees paid would be
useful, most indicated that other information was more important. We spoke
to a judgmental sample of 15 certified financial planners whose names were
provided by the Certified Financial Planner Board of Standards, a
nonprofit professional regulatory organization that administers the
certified financial planner examination. Of the 15 financial planners with
whom we
spoke, 6 believed specific dollar disclosure of mutual fund fees would
provide additional benefit to investors. For example, one said that
providing exact dollar amounts for expenses would be useful because
investors don*t take the next step to calculate the actual costs they bear
by multiplying their account value by the fund*s expense ratio. In
contrast, the
other 9 financial planners we interviewed said that the factor most
investors consider more than others is the overall net performance of the
fund and thus did not think that specific dollar disclosures of fees would
provide much additional benefit. Industry officials raised concerns about
requiring specific dollar fee
disclosures. For example, one investment company official stated that the
costs of making specific dollar disclosures would not justify any benefit
that might arise from providing such information, particularly because a
majority of investors make their investment decisions through
intermediaries, such as financial planners, and not on their own. Some
industry officials stated that additional disclosure could confuse
investors and create unintended consequences. For example, one official
noted that specific dollar disclosure might lead investors to think that
they could deduct those expenses from their taxes. Others noted that this
type of disclosure would tell current mutual fund investors what they were
paying in fees, but would not provide the proper context for evaluating
how much other funds would charge, and thus would be unlikely to increase
competition. Another official stated that disclosing fees paid in dollars
in account statements would not be beneficial to prospective investors.
Although the total cost of providing specific dollar fee disclosures might
be significant, the cost might not represent a large outlay on a per
investor basis. As we reported in our March 2003 statement, the Investment
Company Institute (ICI), the industry association representing mutual
funds, commissioned a study by a large accounting firm to survey mutual
fund companies about the costs of producing such disclosures. 8 The study
concluded that the aggregated estimated costs for the survey respondents
to implement specific dollar disclosures in shareholder account statements
would exceed $200 million, and the annual costs of compliance would be
about $66 million. 9 Although these are significant costs, when spread
over the accounts of many investors, the amounts are less sizeable. For
example, ICI reported that at the end of 2001, a total of about 248
million shareholder accounts existed. If the fund companies represented in
ICI*s study, which represent 77 percent of industry assets, also maintain
about the same percentage of customer accounts, then the companies would
hold about 191 million accounts. As a result, apportioning the estimated
$200 million in initial costs to these accounts would amount to about $1
per
8 GAO- 03- 551T. 9 However, this estimate did not include the reportedly
significant costs that would be borne by third- party financial
institutions, which maintain accounts on behalf of individual mutual fund
shareholders.
account. Apportioning the estimated $66 million in annual costs to these
accounts would amount to about $0.35 per account.
We also spoke with a full- service transfer agent that provides services
for about one third of the total 240 million accounts industrywide. 10
Staff from this organization prepared estimates of the costs to their
organization of producing specific dollar fee disclosures for fund
investors. They estimated that to produce this information, they would
incur one- time development costs between $1.5 and $3 million to revise
their systems to accept and maintain individual investor account expense
data, and ongoing data processing expenses of about $0.15 to $0.30 per
fund/ account per year. These ongoing expenses would reflect about 1
percent of the estimated $18 to $23 per year of administrative costs per
account already incurred. The officials also estimated that shareholder
servicing costs would increase as
investors would call in to try to understand the new disclosures or offer
to send payments under the mistaken impression that this was a new charge
that they had to explicitly pay. Funds would also incur costs to update
and modify their Web sites so that investors could find this specific
expense
information there as well. Another concern raised regarding requiring
mutual funds to disclose the specific dollar amount of fees was that
information on the extent to which such disclosures would benefit
investors is not generally available. For our work on this report, we
attempted to identify studies or analyses on the impact of disclosing
prices in dollars versus percentage terms, but no available information
was found to exist. We also reviewed surveys done of investor preferences
relative to mutual funds but none of the surveys we identified discussed
disclosure of mutual fund fees in dollar terms. In our June 2000 report,
we presented information from a survey of over 500 investors that was
administered by a broker- dealer to its clients. 11 As we reported, this
survey found that almost 90 percent of these investors indicated that
specific dollar disclosures would be useful or very useful. However, only
14 percent of these investors were very or somewhat likely to be willing
to pay for this information. SEC and industry participants
noted that having more definitive data on the extent to which investors
want and would benefit from receiving information on the specific dollar
10 A mutual fund transfer agent maintains shareholder account records and
processes share purchases and redemptions. 11 See GAO/ GGD- 00- 126, p.
78.
amount of fees they paid would be necessary before requiring mutual funds,
broker- dealers, and other intermediaries to undertake the costly
revisions to their systems necessary to capture such information.
Another option for disclosure was proposed by an industry official that
may not impose significant costs on the industry. The official said that
fund companies could include a notice in account statements to remind
investors that they pay fees as part of investing in mutual funds. The
notice, the official said could remind investors that, *Mutual funds, like
all investments, do have fees and ongoing expenses and such fees and
expenses can vary considerably and can affect your overall return. Check
your prospectus and with your financial adviser for more information.* By
providing this notice in the quarterly account statements that mutual fund
investors receive, mutual fund investors would be reminded about fees in a
document that, because it contains information about their particular
account and its holdings, is more likely to be read.
Trading and Other Costs In addition to the expenses reflected in a mutual
fund*s expense ratio* the
Impact Mutual Fund fund*s total annual operating expenses as a percentage
of fund assets*
Investor Returns, but Are mutual funds incur trading costs that also
affect investors* returns. Among
Not Prominently Disclosed these costs are brokerage commissions that funds
pay to broker- dealers
when they trade securities on a fund*s behalf. When mutual funds buy or
sell securities for the fund, they may have to pay the broker- dealers
that execute these trades a commission. In other cases, trades are not
subject to explicit brokerage commissions but rather to *markups,* which
is an amount a broker- dealer may add to the price of security before
selling it to
another party. Trades involving bonds are often subject to markups.
Commissions have also not traditionally been charged on trades involving
the stocks traded on NASDAQ because the broker- dealers offering these
stocks are compensated by the spread between the buying and selling prices
of the securities they offer. 12 Other trading- related costs that can
also affect investor returns include
potential market impact costs that can arise when funds seek to trade
large amounts of particular securities. For example, a fund seeking to buy
a large block of a particular company*s stock may end up paying higher
prices to
12 These different prices are called the bid price, which is the price the
broker- dealer is willing to pay for shares and the ask price, which is
the price at which the broker- dealer is willing to sell shares.
acquire all the shares it seeks because its transaction volume causes the
stock price to rise while its trades are being executed. Various
methodologies exist for estimating these types of trading costs, however,
no generally agreed upon approach exists for accurately calculating these
costs.
Although trading costs affect investor returns, these costs are not
currently required to be disclosed in documents routinely provided to
investors. ICI staff and others told us that the costs of trading,
including brokerage commissions, are required under current accounting
practices and tax regulations to be included as part of the initial value
of the security
purchased. As a result, this amount is used to compute the gain or loss
when the security is eventually sold and thus the amount of any
commissions or other trading costs are already implicitly included in fund
performance returns. 13 Investors do receive some information relating to
a
fund*s trading activities because funds are required to disclose their
portfolio turnover, (the frequency with which funds conduct portfolio
trading) in their prospectuses, which are routinely sent to new and
existing investors. However, the frequency with which individual mutual
funds conduct portfolio trading and incur brokerage commissions can vary
greatly and the amount of brokerage commissions a fund pays are not
disclosed in documents routinely sent to investors. Instead, SEC requires
mutual funds to disclose the amount of brokerage commissions paid in the
statement of additional information (SAI), which also includes disclosures
relating to a fund*s policies, its officers and directors, and various tax
matters. Regarding their trading activities, funds are required to
disclose in their SAI how transactions in portfolio securities are
conducted, how brokers are selected, and how the fund determines the
overall reasonableness of brokerage commissions paid. The amount disclosed
in the SAI does not include other trading costs borne by mutual funds such
as spreads or the market impact cost of the fund*s trading. Unlike fund
prospectuses or annual reports, SAIs do not have to be sent periodically
to
a fund*s shareholders, but instead are filed with SEC annually and are
sent to investors upon request. 13 For example, if a fund buys a security
for $10 a share and pays a $. 05 commission on each
share, its basis in the security is $10.05, and this is the amount that
will be used to calculate any subsequent gain or loss when the shares are
sold.
Academics and Others Have Academics and other industry observers have also
called for increased
Also Called for Increased disclosure of mutual fund brokerage commissions
and other trading costs
Disclosure of Mutual Fund that are not currently included in fund expense
ratios. In an academic
study we reviewed that looked at brokerage commission costs, the authors
Trading Costs, but Others
urged that investors pay increased attention to such costs. 14 For
example, Noted that Producing Such the study noted that investors seeking
to choose their funds on the basis of Disclosures Would be
expenses should also consider reviewing trading costs as relevant
Difficult
information because the impact of these unobservable trading costs is
comparable to the more observable expense ratio. The authors of another
study noted that research shows that all expenses can reduce returns so
attention should be paid to fund trading costs, including brokerage
commissions, and that these costs should not be relegated to being
disclosed only in mutual funds* SAIs. 15
Others who advocated additional disclosure of brokerage commissions cited
other benefits. Some officials have called for mutual funds to be required
to include their trading costs, including brokerage commissions,
in their expense ratios or as separate disclosures in the same place their
expense ratios are disclosed. For example, one investor advocate noted
that if funds were required to disclose brokerage commissions in these
ways, funds would likely seek to reduce such expenses and investors would
be better off because the costs of such funds would be similarly reduced.
He explained that this could result in funds experiencing less turnover,
which could also benefit investors as some studies have found that high-
turnover funds tend to have lower returns than low- turnover funds.
The majority of certified financial planners we interviewed also indicated
that disclosing transaction costs would benefit investors. Of the 15 with
whom we spoke, 9 stated that investors would benefit from having more cost
information such as portfolio transaction costs. For example, one said
that investors should know the costs of transactions paid by the fund and
that this information should be disclosed in a document more prominent
than the SAI. Another stated that brokerage commissions should be
14 J. M. R. Chalmers, R. M. Edelen, and G. B. Kadlec, *Mutual Fund Trading
Costs,* Rodney L. White Center for Financial Research, The Wharton School,
University of Pennsylvania (Nov. 2, 1999).
15 M. Livingston and E. S. O*Neal, *Mutual Fund Brokerage Commissions,*
Journal of Financial Research (Summer 1996).
reported as a percentage of average net assets. Overall they felt that
more information would help investors compare costs across funds, which
could likely result in more competition based on costs, but they also
varied in opinion on the most appropriate format and place to present
these disclosures. The planners who did not think transaction costs should
be disclosed generally believed that investors would not benefit from this
type of additional information because they would not understand it. Some
industry observers and financial planners we interviewed indicated
that investors should be provided all the information that affects a
fund*s returns in one place. This information could include the current
disclosed costs such as the total expense ratio, the impact of taxes, and
undisclosed
trading costs. Some financial planners and an industry consultant
suggested disclosing all such expenses in percentages. They also expressed
the importance of including after- tax performance returns. SEC adopted a
rule in January 2001 requiring all funds to disclose their after- tax
returns in their prospectus. A mutual fund industry analyst noted that
when an item is disclosed, investment advisers will likely attempt to
compete with one another to maximize their performance in the activity
subject to disclosure. Therefore, presenting investors with information on
the factors that affect their return and that are within the investment
adviser*s control could spur additional competition and produce benefits
for investors. A financial planner we interviewed also agreed that having
mutual funds disclose information about expenses, tax impacts, and trading
costs, particularly brokerage commissions all in one place would increase
investor awareness of the costs incurred for owning mutual fund shares and
could increase competition among funds based on costs and lead to lower
expenses for investors. Although additional disclosures in this format
could possibly benefit
investors, developing the information needed to provide a disclosure of
this type could pose difficulties. SEC officials said that, if funds were
required to separately disclose brokerage commission costs as a percentage
of fund assets, fund advisers would also likely want to present their
fund*s gross return before trading costs were included so that the
information does not appear to be counted twice. However, the SEC staff
noted that determining a fund*s gross return before trading costs could be
challenging because it could involve having to estimate markups and spread
costs. ICI officials also stated that disclosing gross returns could
create the idea of cost free investing, which is not a realistic
expectation for investors. They also worried that mutual funds could try
and market their gross return figures,
which would be misleading.
Mutual fund officials also raised various concerns about expanding the
disclosure of brokerage commissions and trading costs in general. Some
officials said that requiring funds to present additional information
about brokerage commissions by including such costs in the fund*s
operating expense ratios would not present information to investors that
could be easily compared across funds. For example, funds that invest in
securities on the New York Stock Exchange (NYSE), for which commissions
are usually paid, would pay more in total commissions than would funds
that invest primarily in securities listed on NASDAQ because the broker-
dealers offering such securities are usually compensated by spreads rather
than explicit commissions. Similarly, most bond fund transactions are
subject
to markups rather than explicit commissions. If funds were required to
disclose the costs of trades that involve spreads, officials noted that
such amounts would be subject to estimation errors. As discussed earlier,
ICI staff and others said that separate disclosure of these costs is not
needed because the costs of trading are already included in the
performance return percentages that mutual funds report. Officials at one
fund company told us that it would be difficult for fund companies to
produce a percentage
figure for other trading costs outside of commissions because no
agreedupon methodology for quantifying market impact costs, spreads, and
markup costs exists within the industry. Other industry participants told
us that due to the complexity of calculating such figures, trading cost
disclosure is likely to confuse investors. For example funds that attempt
to mimic the performance of certain stock indexes, such as the Standard &
Poors 500 stock index, and thus limit their investments to just these
securities have lower brokerage commissions because they trade less. In
contrast, other funds may employ a strategy that requires them to trade
frequently and thus would have higher brokerage commissions. However,
choosing among these funds on the basis of their relative trading costs
may
not be the best approach for an investor because of the differences in
these two types of strategies.
Finally, some financial planners and an industry expert stated that
additional disclosure of mutual fund costs would be monitored not by
investors but more so by financial professionals, such as financial
planners, and the financial media. These groups serve as intermediaries
between fund companies and investors, and are the primary channel through
which information on the performance and costs across mutual funds is
distributed. The financial planners and the industry expert believed that
increased disclosures of trading costs could prove beneficial to the
financial professionals that help select mutual funds for their investor
clients.
Independent Directors Mutual fund boards of directors have a
responsibility to protect
Play a Critical Role in shareholder interests. Independent directors, who
are not affiliated with
the investment adviser, play a critical role in protecting mutual fund
Protecting Mutual
investors. Specifically, independent directors have certain statutory Fund
Investors
responsibilities to approve investment advisory contracts and monitor
mutual fund fees. However, some industry observers believe that
independent directors could do more to assert their influence to reduce
fees charged by fund advisers. Alternatives are being considered to
improve public company governance such as changing board composition and
structure, however many practices are already in place within the
mutual fund industry. Mutual Fund Boards of
Because the organizational structure of a mutual fund can create conflicts
Directors Are Responsible
of interest between the fund*s investment adviser and its shareholders,
the for Protecting Shareholder
law governing U. S. mutual funds requires funds to have a board of
directors Interests
to protect the interest of the fund*s shareholders. A fund is usually
organized by an investment management company or adviser, which is
responsible for providing portfolio management, administrative,
distribution, and other operational services. In addition, the fund*s
officers are usually provided, employed, and compensated by the investment
adviser. The adviser charges a management fee, which is paid with fund
assets, to cover the costs of these services. With the level of the
management fee representing its revenue from the fund, the adviser*s
desire to maximize its revenues could conflict with shareholders* goal of
reducing fees. As one safeguard against this potential conflict, the
Investment Company Act of 1940 (the Investment Company Act) requires
mutual funds to have boards of directors to oversee shareholder*s
interests. These boards must also include independent directors who are
not
employed by or affiliated with the investment adviser. As a group, the
directors of a mutual fund have various responsibilities and in some
cases, the independent directors have additional duties. In addition to
approval by the full board, the Investment Company Act requires that a
majority of the independent directors separately approve the contracts
with the investment adviser that will manage the fund*s portfolio and the
entity that will act as distributor of the fund*s shares. A mutual fund*s
board, including a majority of the independent directors, are also
required to review other service arrangements such as transfer agency,
custodial, or bookkeeping services.
If the services to the fund are provided by an affiliate of the adviser,
the independent directors also generally consider several items before
approving the arrangement. Specifically they determine that the service
contract is in the best interest of the fund and its shareholders, the
services
are required for the operation of the fund, the services are of a nature
and quality at least equal to the same or similar services provided by
independent third parties, and the fees for such services are fair and
reasonable in comparison to the usual and customary fees charged for
services of the same nature and quality. The independent directors also
have specific duties to approve the
investment advisory contract between the fund and the investment adviser
and the fees that will be charged. Specifically, section 15 of the
Investment Company Act requires the annual approval of an advisory
contract by a fund*s full board of directors as well as by a majority of
its independent directors, acting separately and in person, at a meeting
called for that purpose. Under section 36( b) of the Investment Company
Act, investment advisers have a fiduciary duty to the fund with respect to
the fees they receive, which under state common law typically means that
the adviser must act with the same degree of care and skill that a
reasonably prudent person would use in connection with his or her own
affairs. Section 36( b) also authorizes actions by shareholders and the
SEC against an adviser for breach of this duty. Courts have developed a
framework for determining whether an adviser has breached its duty under
section 36( b), and directors typically use this framework in evaluating
advisory fees. This framework finds its origin in a Second Circuit Court
of Appeals decision, in which the court set forth the factors relevant to
determining whether an adviser*s fee is excessive. 16 In addition to
potentially considering how a fund*s fee compared to those of other funds,
this court indicated that directors may find other factors more important,
including
the nature and quality of the adviser*s services, the adviser*s costs
to provide those services, the extent to which the adviser realizes and
shares with the fund economies of scale as the fund grows,
16 Gartenberg v. Merrill Lynch Asset Management Inc., 528 F. Supp. 1038
(S. D. N. Y. 1981), aff*d, 694 F. 2d 923 (2d Cir. 1982), cert. denied, 461
U. S. 906( 1983).
the volume of orders that the manager must process, indirect benefits
to the adviser as the result of operating the fund, and the independence
and conscientiousness of the directors. Fund company officials and
independent directors with whom we spoke said their boards review
extensive amounts of information during the annual contract renewal
process to help them evaluate the fees and expenses paid by the fund. For
example, they stated that they hire a thirdparty
research organization, such as Lipper, Inc., to provide data on their
funds investment performance, management fee rates, and expense ratios as
they compare to funds of similar size, objective, and style. They also
compare performance to established benchmarks, such as the Standard &
Poors 500 Stock Index. For example, officials at one fund company told us
that, for each of their funds, their board reviews information on the
performance and fees charged by 20 funds with a similar investment
objective, including the 10 funds closest in size with more assets than
their fund and the 10 funds closest in size with fewer assets. In addition
to comparing themselves to peers, they explained that their board reviews
the profitability of the adviser, stability of fund personnel or staff
turnover, and quality of adviser services. Fund officials stated that
their boards receive a large package of information that includes all of
the necessary information
to be reviewed for the contract renewal process in advance of board
meetings. SEC oversight of mutual funds indicates that fund directors
generally
conduct their activities in accordance with the law. Staff from SEC*s
Office of Compliance Inspections and Examinations, which conducts
examinations of mutual funds and their investment advisers, told us that
as part of their examinations they review the minutes of past board
meetings to ensure that the directors were told and discussed the relevant
information as part of the board*s decision- making process. The SEC staff
also told us they review the information provided to the board by the
investment adviser to ensure its completeness and accuracy. Based on their
review, SEC staff said that they have not generally found problems
with mutual fund board proceedings. SEC has brought cases against mutual
fund directors but these involved other activities. For example, SEC
settled a case involving a mutual fund*s board of directors that had
knowingly filed misleading information in the fund's prospectus and other
fund disclosures regarding the liquidity and value of the shares of their
money market fund.
Critics Suggest Independent Some industry experts have criticized
independent directors for not
Directors Could Do More to exercising their authority to reduce fees. For
example, in a speech to
Assert Their Influence and shareholders, one industry expert stated that
mutual fund directors have
Reduce Fees failed in negotiating management fees. Part of the criticism
arises from the
fact that during the annual contract renewal process, when boards compare
fees of similar funds, the process maintains the status quo by comparing
fees with the industry averages thus keeping fees at their current level.
However, another industry expert complained that fund directors are not
required to ensure that fund fees are reasonable, much less as low as
possible, but instead are only expected to ensure that fees fall within a
certain range of reasonableness. An academic study we reviewed criticized
the court cases that have shaped director*s roles in overseeing mutual
fund fees because these cases generally found that comparing a fund*s fees
to other similar investment management services, such as pension funds was
inappropriate as fund advisers do not compete with each other to manage a
particular fund. Without being able to compare fund fees to these other
products, the study*s authors say that
investors bringing these cases have lacked sufficient data to show that a
fund*s fees are excessive. 17 One method offered by some industry critics
for improving the
effectiveness of boards in lowering fees for investors was to have fund
directors seek competitive bids for their fund*s investment advisory
contracts. Advocates of having boards take this action said that pension
funds more routinely seek competitive bids from investment advisers for
pension fund assets. A former Treasury Department official said that
pension funds commonly seek new investment advisers every 2 to 3 years,
and, as a result, pension fund investors pay two to three times less in
fees
than the average mutual fund investors. One academic study we reviewed
that compared advisory fees for similarly- sized pension funds and mutual
funds found that the average mutual fund advisory fee is twice as large as
a pension fund advisory fee. 18 The study showed that the average pension
fund pays 28 basis points for its advisory fee compared to 56 basis points
for mutual funds. The study concluded that the main reason for differences
between pension funds and mutual funds was that advisory fees for
17 J. P. Freeman and S. L. Brown, *Mutual Fund Advisory Fees: The Cost of
Conflicts of Interest,* 26 Journal of Corporation Law 609 (2001). 18 J. P.
Freeman and S. L. Brown.
pension funds are set in a marketplace in which arm*s- length bargaining
occurs because of the separation of the fund and the investment advisers.
Regulators and industry participants indicated that differences in the
costs and services provided by mutual funds can explain why mutual funds
charge more than pension funds. According to staff of SEC and ICI with
whom we spoke, investment advisers usually perform many other services
for their mutual funds than does the adviser of a pension fund and that
their advisory fee compensates them for these additional services. Among
the services that advisers of mutual funds would provide that a pension
fund adviser would not include around the clock telephone customer
service, preparing periodic account statements and shareholder
communications, and compiling annual tax information for fund investors.
Some industry officials also noted the difference in cost structure
between pension and mutual funds. One official stated that pension funds
have one institutional account, whereas mutual funds have thousands of
smaller accounts, which requires substantial record keeping and customer
service expenses. Mutual fund advisers would also have increased costs
because they have to
manage their fund*s daily inflows and outflows, whereas pool of assets
that a pension fund adviser manages are not subject to such frequent
fluctuations.
Based on information we collected, very few mutual funds change their
investment advisers. According to research organizations that monitor
developments in the mutual fund industry, less than 10 funds have changed
their primary investment adviser within the last 15 years. The process of
changing investment adviser is not solely dependent upon the board of
directors. If the fund board of directors made a decision to change an
investment adviser, the board would need to file a proxy statement and
have the shareholders of the fund vote to approve the change.
Industry participants also said that having mutual fund boards put out
their advisory service contracts for bid may not produce expected savings
and could increase fund shareholders* costs. According to staff at one
fund company, they would not likely bid on contracts to manage mutual fund
assets at the same rate that they bid for pension fund assets because
their costs to manage and administer mutual fund assets are higher. They
said that pension fund assets are offered to investment advisers in a
large preexisting pool. In contrast, mutual fund assets must be
accumulated over time from many investors. Each time a fund*s board hired
a new investment adviser, the fund*s shareholders costs would also likely
go up because all the accounts would have to be transferred to the new
adviser
and the fund would likely incur additional document preparation, legal,
and customer service costs. For example, we identified a case in which a
small fund had removed its investment adviser, which resulted in a
significant
increase of fund expenses. In this case, the fund*s investment adviser
resigned and a majority of the fund*s board of directors voted to take
over the fund*s management. The decision was submitted to the shareholders
for a proxy vote and passed. As a result the fund*s expense ratio went
from 1. 8 percent in 2001 to 3. 4 percent in 2002. The fund attributed
this significant increase to a number of one- time items, which consisted
primarily of legal expenses associated with the removal of the investment
adviser and the management of the fund*s portfolio. Finally, industry
participants indicated that mutual fund shareholders likely
do not expect their fund*s board to change the fund*s investment adviser.
They said that mutual fund shareholders often choose their funds because
of the reputation or services offered by a particular investment adviser
and having their fund*s board seek to move their fund to another company
would not likely be supported by the shareholders. Furthermore, having
fund boards seek new investment advisers is unnecessary because mutual
fund shareholders can choose to redeem their shares of a particular
adviser*s fund and invest them in the funds of other advisers if they are
unhappy with their existing fund or its adviser. In contrast, pension fund
participants cannot move their pension fund investments if they are
unhappy with their fund*s investment adviser or its performance. Instead,
the decisions about which advisers are hired to manage pension fund*s
assets are made by their fund administrators. ICI officials also
questioned
whether pension funds actually change investment advisers that frequently.
They said that pension funds often seek long- term relationships with
investment advisers. Although they do not frequently change advisers,
mutual fund directors
engage in other activities to lower fees. Industry officials said that
advisers typically institute management fee *breakpoints* based on the
level of fund assets or performance. These breakpoints reduce the level of
management fees when funds exceed certain asset levels, thus as a fund*s
assets grow, the investment adviser*s fee is reduced for those additional
assets above the levels set in the breakpoint. Directors could also
approve performance fees as a part of an investment adviser*s compensation
that would reduce the fee the adviser was able to charge if the fund*s
performance fails to meet or exceed a specified performance benchmark,
such as the Standard & Poors 500 Stock Index. Industry officials also
stated that advisers will at times offer to waive management fees, and may
also waive or cap certain
expenses such as certain transfer agency fees. Noting that the fees for
mutual funds in the United States are lower compared to those of other
countries, SEC and ICI officials attributed this to the role and influence
of U. S. funds* board of directors because such independent oversight is
not
always required in other countries. Mutual Funds Already
Changes in the structure of mutual fund boards of directors have been
Employ Many Practices proposed and adopted in recent years and recent
corporate scandals have
Being Suggested to Improve prompted consideration of additional reforms
but industry participants
Public Company note that most funds have already adopted such practices.
In February
1999, SEC held a forum on the role of independent mutual fund directors to
Governance consider ways to improve mutual fund governance. At the forum,
the SEC Chairman at that time requested proposals for improving fund
governance. At the same time, ICI created the Advisory Group on Best
Practices for Fund Directors. This advisory group identified 15 best
practices used by fund boards to enhance the independence and
effectiveness of mutual fund directors and recommended that all fund
boards adopt them. The ICI recommendations included having
independent directors constitute at least two thirds of the fund*s
board, independent directors select and nominate other independent
directors,
and independent counsel for the independent directors. After evaluating
the ideas and suggestions of the forum participants, SEC proposed various
rule and form amendments designed to reaffirm the important role that
independent directors play in protecting fund investors. These amendments
were adopted in January 2001. They included requiring funds relying on
certain exemptive rules* which includes almost all funds
according to SEC staff* to have a majority of independent directors on
their boards and to have their independent directors select and nominate
other independent directors. SEC also required that any legal counsel for
the independent directors also be independent. 19 19 Role of Independent
Directors of Investment Companies, Securities and Exchange
Commission Release Nos. 33- 7932; 34- 43786; IC- 24816 (Jan. 2, 2001).
As a result of recent scandals such as Enron and Worldcom, various new
reforms have been proposed to increase the effectiveness and
accountability of public companies* boards of directors. In July 2002, the
Sarbanes- Oxley Act (Sarbanes- Oxley) was enacted to address concerns
related to corporate responsibility. 20 In addition to enhancing the
financial reporting regulatory structure, Sarbanes- Oxley sought to
increase corporate accountability by reforming the structure of corporate
boards audit committees. Section 301 of Sarbanes- Oxley requires that
directors who serve on a public company*s audit committee also be
*independent* and be responsible for selecting and overseeing outside
auditors. In response to the scandals at public companies, officials at
the two primary venues where public companies are traded* the NYSE and
NASDAQ* have also proposed changes to the corporate governance standards
that public companies seeking to be listed on their markets must meet.
However, many of the corporate governance reforms being proposed for
public companies are already either required or have been recommended as
best practices for mutual fund boards. Table 2 presents how the corporate
governance practices that are currently required by mutual fund law or
rules or recommended by ICI*s best practices for mutual fund boards
compare to the current and proposed NYSE and NASDAQ listing standards
applicable to public company boards. As the table shows, the mutual funds
boards are already recommended to have in place all of the proposed
corporate listing standards.
20 Pub. L. No. 107- 204, 116 Stat. 745 (codified in scattered sections of
11, 15, 18, 28, and 29 U. S. C. A.).
Table 2: Current and Proposed NYSE and NASDAQ Corporate Governance Listing
Standards Compared to those Currently Required or Recommended for Mutual
Fund Boards
NYSE/ NASDAQ listing standards Mutual funds
Required by ICI Governance Currently Proposed statute or
recommended requirement required requirement SEC rule a
best practice
Board must have a X X X majority of independent directors
Independent directors X X X must be responsible for nominating new
independent directors
Audit committee must X X X consist of only independent directors b
Standards that define X X X X who qualifies as an independent director c
Independent directors X X required to meet separately in executive
sessions Source: GAO analysis of ICI Best Practices, statutes, SEC rules,
and NYSE and NASDAQ rule proposals. a SEC requires the board of directors
of any fund that takes advantage of various exemptive rules to meet these
requirements and SEC staff indicated that, as a result, almost all funds
must comply. b Although fully independent audit committees is not a
requirement for funds, SEC has adopted a rule
to encourage fund boards to have audit committees consisting exclusively
of independent directors by exempting such committees from having to seek
shareholder approval of the fund*s auditor. c Both the NYSE and NASDAQ
definitions of director independence currently apply only to members of
the audit committee, but their rule proposals would extend this definition
to the full board.
According to industry participants, most mutual fund boards already have
the corporate governance practices recommended by these various standards
in place. Officials of the fund companies and the independent directors
that we interviewed told us that the majority of their boards
consisted of independent directors, and, in many cases, had only one
interested director. For public companies, some commenters have called for
boards of directors to have supermajorities of independent directors as a
means of ensuring that the voices of the independent directors are heard.
As noted above, this practice has already been advocated by ICI*s best
practice recommendations and one fund governance consulting official
said that a 2002 survey conducted by his firm found that, in 75 percent of
the mutual fund complexes they surveyed, over 70 percent of the directors
were independent. An academic study we reviewed also found that funds*
independent directors already comprised funds* nominating committees and
most funds have self- nominating independent directors. Another change
related to board composition that has been proposed for
mutual funds would be to have an independent director serving as the
board*s chair, but industry participants did not see this as a beneficial
change. Some industry critics have stated that the lack of an independent
chair allows the board*s activities during the meeting to be controlled by
fund management, as the fund*s board chair is typically the chairman or
other senior official of the investment adviser. A number of fund
companies and independent directors we spoke with indicated that their
board did have an independent chair. For the fund companies that did not
have an independent chair, they had instead a lead independent director.
An official from the Mutual Fund Directors Forum, an independent
directors association which provides continuing education and outreach on
mutual fund governance, said that the most important factor is the
initiative demonstrated by the independent director, whether the
individual is the lead or chair. He stated that if the lead independent
director is motivated, it doesn*t matter who the chair is, because the
lead director will be proactive and effective on behalf of fund
shareholders. Other fund company officials indicated that an independent
chair could be harmful to the board. One stated that investors are better
served by having a fund company executive chair the fund*s board because
such an official is better positioned to ensure that all of the
information that the adviser needs to share with the independent directors
is provided efficiently. Changes in Mutual
Concerns have been raised over changes in how mutual funds pay for the
Fund Distribution
distribution of their shares to investors. SEC Rule 12b- 1 allows mutual
fund companies to use fund assets to pay expenses for distributing their
Practices Have
funds through broker- dealers, and has evolved into a means for fund
Increased Choices for companies to offer investors a variety of ways to
pay for the services of
Investors, but Have financial professionals, such as broker- dealer staff
or financial planners.
However, 12b- 1 fees remain controversial among mutual fund researchers
Raised Potential
because, in addition to increasing a fund*s overall expense ratio, funds
with Concerns
12b- 1 fees may be more costly to own in other ways. In a recent study,
SEC staff recommended rule 12b- 1 modifications to reflect changes in how
funds are being marketed, but as of May 2003, SEC had not proposed any
amendments. Concerns also have been raised as to whether the disclosure
of 12b- 1 fees is sufficient and whether, another distribution practice*
referred to as revenue sharing, in which investment advisers make payments
to broker- dealers for selling and marketing their funds* could limit the
number of mutual fund choices offered to investors. Revenue sharing also
may result in a broker- dealer*s failure to recommend funds from which the
brokerage firm is not being compensated by the funds* advisers, which some
suggest could conflict with broker- dealers* responsibilities to recommend
suitable investments.
12b- 1 Plans Provide Previously, mutual funds distribution expenses were
paid for either by
Alternative Means for charging investors a sales charge or load or by
paying for such expenses
Compensating Financial out of the investment adviser*s own profits.
However, in 1980, SEC adopted
Professionals but Also Raise rule 12b- 1 under the Investment Company Act
to help funds counter a
period of net redemptions by allowing them to use fund assets to pay the
Concerns Over Costs
expenses associated with the distribution of fund shares. Rule 12b- 1
plans were envisioned as temporary measures to be used during periods of
declining assets. Any activity that is primarily intended to result in the
sale of mutual fund shares must be included as a 12b- 1 expense and can
include advertising; compensation of underwriters, dealers, and sales
personnel; printing and mailing prospectuses to persons other than current
shareholders; and printing and mailing sales literature.
To be allowed to use fund assets for marketing purposes, funds are
required to adopt 12b- 1 plans that outline how they intend to use these
payments. A fund*s written 12b- 1 plan must describe all material aspects
of the proposed financing of distribution and related agreements with
distributors about how the plan is to be implemented. Before implementing
a plan that will allow a fund to begin charging 12b- 1 fees, rule 12b- 1
requires fund shareholders and directors to approve 12b- 1 plans and
places other requirements on plan adoption. The plans must also be
approved by a vote of a majority of outstanding shareholders and by a
majority of funds* directors, including a majority of the fund*s
independent directors. Because such plans were envisioned to be of a
limited duration, a majority of funds* directors, including a majority of
the fund*s
independent directors, must also make various approvals on an ongoing
basis, including approving the 12b- 1 plans annually. They must also
approve any amendment to the plan and approve on at least a quarterly
basis the reports of plan expenditures and the purposes of the
expenditures. 12b- 1 plans must also provide for plan termination upon the
vote of a majority of independent directors or a majority of shareholders.
In the adopting release for the rule, SEC presented various factors that
directors should consider when approving a fund*s 12b- 1 plan. These
factors were offered to provide guidance to directors in determining
whether to use fund assets to bear expenses for fund distribution. The
nine factors are shown in figure 1.
Figure 1: Factors Fund Directors Are to Consider in Voting to Approve or
Continue 12b- 1 Plans 1.
The need for independent counsel or experts to assist the directors in
reaching a determination.
2.
The nature of the problems or circumstances which purportedly make
implementation or continuation of such a plan necessary or appropriate.
3.
The causes of such problems or circumstances.
4.
The way in which the plan would address these problems or circumstances
and how it would be expected to resolve or alleviate them, including the
nature and approximate amount of the expenditures; the relationship of
such expenditures to the overall cost structure of the fund; the nature of
the anticipated benefits, and the time it would take for those benefits to
be achieved.
5.
The merits of possible alternative plans.
6.
The interrelationship between the plan and the activities of any other
person who finances or has financed distribution of the company's shares,
including whether any payments by the company to such other person are
made in such a manner as to constitute the indirect financing of
distribution by the company.
7.
The possible benefits of the plan to any other person relative to those
expected to inure to the company.
8.
The effect of the plan on existing shareholders.
9.
In the case of a decision on whether to continue a plan, whether the plan
has in fact produced the anticipated benefits for the company and its
shareholders. Source: SEC Release Nos. 33- 6254 and IC- 11414.
The 12b- 1 fees that are used to pay marketing and distribution expenses
are deducted directly from fund assets and are reported as a separate line
item in the fund*s fee table and included in funds* expense ratios. NASD,
whose rules govern the distribution of fund shares by broker- dealers,
limits the annual rate at which 12b- 1 fees may be paid to broker- dealers
to no more than 0.75 percent of a fund*s average net assets per year. 21
Funds are allowed to include an additional service fee of up to 0.25
percent of average net assets each year to compensate sales professionals
for providing
ongoing services to investors or for maintaining their accounts.
Therefore, 12b- 1 fees included in a fund*s total expense ratio are
limited to a maximum of 1 percent per year. The actual dollar amount of
distribution and service
expenses paid under a fund*s 12b- 1 plan must be disclosed in an SAI,
which supplements the prospectus, and in the fund*s annual report.
As part of its oversight, SEC staff periodically examines mutual funds and
their advisers for compliance with securities laws and rules and generally
find that mutual fund boards adequately oversee their fund*s 12b- 1 plan.
An SEC official told us that SEC examiners check to see that the directors
and shareholders have approved 12b- 1 plans and whether the funds have
controls in place to ensure that relationships with distributors are
reasonable, such as having the directors review 12b- 1 fees. The official
said that some examinations have found that funds lack adequate control
procedures, but the SEC staff rarely have found serious material
deficiencies.
12b- 1 Plans Provide Additional Rule 12b- 1 provides investors an
alternative way of paying for investment Ways for Investors to Pay for
advice and purchases of fund shares. Funds can be sold directly to
Investment Advice and Fund
investors by a fund company or through financial intermediaries such as
Companies to Market Fund
broker- dealers or financial advisers. According to ICI, approximately 80
Shares
percent of investors* mutual fund purchases are made through brokers,
financial advisers, and other intermediaries, including employer-
sponsored pension plans. Apart from 12b- 1 fees, brokers can be paid with
sales charges called *loads*; *front- end* loads are applied when shares
in a fund are purchased and *back- end* loads when shares are redeemed.
With a 12b1
plan, the fund can finance the broker*s compensation with installments
deducted from fund assets over a period of several years. Thus, 12b- 1
plans allow investors to consider the time- related objectives of their
investment and possibly earn returns on the full amount of the money they
have to 21 NASD Conduct Rule 2830( d).
invest, rather than have a portion of their investment immediately
deducted to pay their broker. Rule 12b- 1 has also made it possible for
fund companies to market fund shares through a variety of share classes
designed to help meet the
different objectives of investors. For example, Class A shares might
charge front- end loads to compensate brokers and may offer discounts
called breakpoints for larger purchases of fund shares. Class B shares,
alternatively, might not have front- end loads, but would impose asset-
based 12b- 1 fees to finance broker compensation over several years. Class
B
shares also might have deferred back- end loads if shares are redeemed
within a certain number of years and might convert to Class A shares if
held a certain number of years, such as 7 or 8 years. Class C shares might
have a higher 12b- 1 fee, but generally would not impose any front- end or
back- end loads. While Class A shares might be more attractive to larger,
more sophisticated investors who wanted to take advantage of the
breakpoints,
smaller investors, depending on how long they plan to hold the shares,
might prefer Class B or C shares because no sales charges would be
deducted from their initial investments.
Industry officials and analysts generally viewed the alternative marketing
arrangements fostered by rule 12b- 1 favorably. ICI and fund company
officials generally agreed that rule 12b- 1 plans gave fund distributors
more options for offering investors multiple ways to pay for fund
investments. For example, one company official said that 12b- 1 plans have
allowed investors to choose the type of fund in which they want to invest
and have helped stabilize fund assets. Another official said that rule
12b- 1 has provided investors choices on how to pay their broker, which
investors have grown to like. He said that in his fund complex, 50 percent
of shares are now held in Class B shares that charge 12b- 1 fees as
opposed to other share classes. A broker- dealer official that distributes
funds said that 12b- 1 plans are beneficial because the fees provide a
revenue stream that encourages financial advisers to plan for the long-
term. A mutual fund shareholders advocate said that this incentive is good
because it would cause the financial advisers to recommend funds that will
work out well for
investors over time, rather than focus on earning front- end loads.
12b- 1 Fees Raise Some Concerns Although providing alternative means for
investors to pay for the advice of
Over Cost of Funds financial professionals, some concerns exist over the
impact of 12b- 1 fees
on investors* costs. For example, an academic study of 3,861 multiple
share class funds available at the end of 1997 found that funds with
multiple share classes and 12b- 1 fees also had higher management fees
than those charged by funds with only a single share class, and,
therefore, were more costly to investors before considering the additional
expenses used to compensate their financial professional. 22 However,
another study found that funds with 12b- 1 fees might provide investors
with greater performance. This study, which reviewed the risk- adjusted
performance of a sample of 568 mutual funds for the period 1987- 1992,
found that 12b- 1 plans increased fund expenses but on average generated
higher riskadjusted performance than funds with front- end loads. For this
reason, the study concluded that investors should not avoid funds with
12b- 1 plans. 23 Questions involving funds with 12b- 1 fees have also been
raised over
whether some investors are paying too much for their funds depending on
which share class they purchase. Earlier in 2003, in federal court in
Nashville, Tennessee, investors filed lawsuits against a brokerage firm
alleging that the firms* brokers placed the investors* funds into share
classes with higher 12b- 1 fees when other share classes with different
fee structures would have been more appropriate for the investors. A 1999
academic study also found that differing distribution arrangements cause
broker- dealer sales representatives to be compensated differently
depending on the class of shares they sell. These individuals, the study
found, have monetary incentives to steer long- term investors to low load,
high 12b- 1 fee share classes and to steer short- term investors to high
load, 12b- 1 fee share classes. 24 However, depending on the time that
they are likely to hold the investment, some investors would be better off
investing in funds that charge a front- end load and have smaller 12b- 1
fees than by purchasing shares in funds without loads but higher 12b- 1
fees. The study noted that this conflict of interest between investors and
brokers is most
22 Lesseig, Vance P.; Long, D. Michael; and Smythe, Thomas I. *Gains to
Mutual Fund Sponsors Offering Multiple Share Class Funds,* Journal of
Financial Research (March 1990).
23 Dellva, Wilfred L. and Olson, Gerard T. *The Relationship Between
Mutual Fund Fees and Expenses and Their Effects on Performance,* The
Financial Review (February 1998). 24 O*Neal, Edward S., *Mutual Fund Share
Classes and Broker Incentives,* Financial Analysts Journal (September/
October 1999).
serious when broker- dealer representatives advise relatively uninformed
investors, who are more likely to seek advice on mutual fund investing.
In addition to concerns over 12b- 1 fees, regulators have recently begun
investigations of whether investors are receiving the appropriate
discounts in mutual fund sales loads. In March 2003, NASD, NYSE, and SEC
staff reported on the results of jointly administered examinations of 43
registered broker- dealers that sell mutual funds with a front- end load.
The purpose of the examinations was to determine whether investors were
receiving the benefit of available breakpoint discounts on front- end
loads in mutual fund transactions. The examinations found that most of the
brokerage firms examined, in some instances, did not provide customers
with breakpoint discounts for which they appeared to have been eligible.
In instances where investors were not afforded the benefit of a breakpoint
discount, the average discount not provided was $364 per transaction. The
most frequent causes for the broker- dealers not providing a breakpoint
discount were not linking a customer*s ownership of different funds within
the same mutual fund family, not linking shares owned in a fund or fund
family in all of a customer*s accounts at the firm, and not linking shares
owned in the same fund or fund family by persons related to the customer
in accounts at the firm. The regulators concluded that many of the
problems did not appear to have been intentional failures to charge
correct loads. Among other things, the report noted that, although most of
the firms had written supervisory procedures addressing breakpoints, the
procedures often were not comprehensive.
SEC Report Recommended That In a December 2000 report on mutual fund fees
and expenses, staff in SEC*s
Rule 12b- 1 Be Updated to Reflect Division of Investment Management
recommended that SEC consider
Changes in Fund Marketing reviewing the requirements of rule 12b- 1 that
govern how funds adopt and
renew their 12b- 1 plans. 25 The division*s staff noted that modifications
might be needed to reflect changes in the manner in which funds are
marketed and distributed and the experience gained from observing how rule
12b- 1 has operated since its adoption in 1980. The report noted that the
development of multiple fund share classes permit investors to choose how
distribution expenses are to be paid* for example, up front, in
installments over time, or at redemption. Many funds that offer shares
through broker- dealer fund supermarkets also adopt 12b- 1 plans to pay
for the fees that the sponsoring broker- dealer charges the funds sold
through
25 U. S. Securities and Exchange Commission, Division of Investment
Management: Report on Mutual Fund Fees and Expenses (Washington, D. C.:
December 2000).
their supermarket. The division*s report noted that because these 12b- 1
plans are essential to the funds* participation in these supermarkets,
such plans could be viewed as indefinite commitments. Also since 1980,
some
fund distributors have been using 12b- 1 receivable revenues as collateral
to obtain loans to finance their distribution efforts. The SEC staff noted
that such changes illustrate that 12b- 1 fees have come to be used in
different ways than were originally envisioned under the rule and that
changes may be needed to reflect current practices. Because of these
changes, the report noted that SEC should consider whether it needed to
give additional or different guidance to fund directors with respect to
their review of rule 12b- 1 plans, including whether the nine factors
published in the 1980 release of rule 12b- 1 were still valid (shown in
fig. 1 of this report).
Although SEC has not yet provided additional guidance on or updated rule
12b- 1 to reflect market changes, SEC staff told us that any amendment of
rule 12b- 1 could also involve changes to how distribution fees and
expenses are disclosed. One fund independent director with whom we spoke
said that rule 12b- 1 should be amended to allow payment only to broker-
dealers with net sales of fund shares and broker- dealers with net
redemptions would not be paid. He said that this change would make sense
for rule 12b- 1 to fulfill its original purpose of increasing fund assets.
Concerns Raised over Adequacy Some concerns have been raised over the
adequacy of 12b- 1 fee
of 12b- 1 Fee Disclosure disclosures. A mutual fund shareholder advocacy
organization has called
for reform in the disclosure of fund distribution expenses to better
inform investors of possible conflicts of interest that could compromise
the adviser*s responsibility to control fund costs and provide investors a
satisfactory return. For example, this group notes that 12b- 1 fee
disclosure is misleading to investors because a fund*s money can be paying
for distribution expenses either through a 12b- 1 fee or the adviser*s
management fee. However, the group asserts, the fee table in the
prospectus could give the investor the impression all distribution
expenses are covered by 12b- 1 fees, while the fund adviser benefits from
all of the expenses paid from fund assets, the group noted. The group also
noted that 12b- 1 disclosures do not inform investors of potential
conflicts of interest affecting brokers because, based on the fee
disclosures in the prospectus,
an investor cannot determine whether his broker received compensation from
the 12b- 1 fees.
Revenue Sharing Revenue sharing payments are compensation that investment
advisers pay
Arrangements Provide from their profits to the broker- dealers that
distribute their funds. Some
Additional Distribution broker- dealers whose sales representatives market
mutual funds have
Options and Are narrowed their offerings of funds or created preferred
lists of funds, which
then become the funds that receive the most marketing by these
brokerdealer Increasingly Used to
sales representatives. In order to be selected as one of the preferred
Compensate Fund
fund families on these lists, the mutual fund adviser often is required to
Distributors compensate the broker- dealer firms. According to one
research organization official, there are significantly fewer distributing
brokerdealers than there are mutual fund investment advisers. As a result,
the mutual fund distributors have the clout to require advisers to pay
more to have their funds sold by the distributing broker- dealers staff.
For example, distributors sometimes require investment advisers to share
their profits and pay for expenses incurred by the distributing broker-
dealers, such as advertising or marketing materials that are used by the
distributing brokerdealers.
The revenue sharing payments that come from the adviser*s profits may
supplement distribution- related payments out of fund assets. As noted,
funds may annually pay up to one percent of fund assets to distributors
pursuant to 12b- 1 plans. However, SEC officials state that revenue
sharing arrangements, paid out of the adviser*s management fee, can permit
brokerdealer
distributors to receive payments outside of the 12b- 1 limits. Further,
broker- dealers have discretion as to how to use these payments, including
using them to defray expenses incurred in marketing funds or to invest
them in other areas of the broker- dealer*s business.
Mutual funds and their investment advisers also may make distribution
payments or incur revenue sharing costs when they offer funds through
mutual fund supermarkets. Various broker- dealers, including those
affiliated with a mutual fund adviser, allow their customers to purchase
through their brokerage accounts the shares of funds operated by a wide
range of investment advisers. Although these fund supermarkets provide
the advisers of participating funds with an additional means of acquiring
investor dollars, the firms that provide such supermarkets generally
require investment advisers or funds themselves to pay a certain
percentage on the dollars attracted from purchases by customers of the
firm*s supermarket. For example, funds or advisers for the funds
participating in the Charles
Schwab One Source supermarket pay that broker- dealer firm up to 0.40
percent of the amount invested by that firm*s customers. While some
portion of those payments may be paid out of fund assets pursuant to 12b-
1 plans, those payments also may represent sharing of advisory fees. Some
or all of these payments may be for transfer agency and shareholder
services.
According to SEC officials, revenue sharing is legitimate and consistent
with provisions of rule 12b- 1. SEC*s adopting release of Rule 12b- 1
states that the rule should apply to both direct and indirect distribution
expenses. However, because there can be no precise definition of what
expenses are
indirect, SEC decided that fund directors, particularly independent
directors, would bear the responsibility for determining on a case- by-
case basis whether the use of fund assets for distribution is in
compliance with the rule. SEC further noted that fund advisers can use the
revenues they receive from their management fee to pay for distribution
expenses as long as the adviser*s profits are legitimate and not
excessive. Actual Amount of Revenue
Mutual funds are not required to disclose the revenue sharing payments
Sharing Occurring Is Unknown
made by their advisers as they are other distribution expenses paid by the
funds. As noted above, any sales loads or 12b- 1 fees that funds charge
are disclosed in funds* prospectuses and annual reports. However, the
amount of revenue sharing payments, which are paid out of the fund
adviser*s profits earned from the management fee or income from other
sources, are not typically disclosed to investors, except for possible
general disclosure in a fund*s prospectus or SAI. Funds do disclose 12b- 1
payments and may disclose that they may make other distribution- related
payments but do not have to disclose the total amount paid or identify the
recipients of those payments. As a result, complete data are not available
on the extent to which mutual fund advisers are making revenue sharing
payments. An industry researcher said that the cost of revenue sharing
does not show up in advisers* financial reports because there is no line
item for it and costs that fund advisers may incur to pay for sales
meetings attended by brokerdealer staff or other promotion efforts are not
specifically shown in fund adviser income statements. According to an
article in one trade journal, revenue sharing payments made by major fund
companies to brokerdealers may total as much as $2 billion per year. These
amounts have been growing. According to the officials of a mutual fund
research organization, revenue sharing costs are hard to quantify but are
rising. For example, the organization reports that about 80 percent of
fund companies that partner with major broker- dealers make cash revenue
sharing payments.
Some Industry Participants Are The increased use of revenue sharing
payments is raising concerns among
Concerned that Revenue Sharing some industry participants. Although
revenue sharing payments are Could Negatively Impact
becoming a major expense for fund advisers, industry research Investors
organization officials told us that most fund advisers are not willing to
publicly discuss the extent to which they are making such payments. A 2001
report on fund distribution practices states that *the details and levels
of revenue sharing vary widely across the industry and are seldom codified
in written contracts.* In one industry magazine article, a mutual fund
industry researcher referred to revenue sharing as *the dirty little
secret of the mutual fund industry.*
One of the concerns raised about revenue sharing payments is the effect on
overall fund expenses. The 2001 research organization report on fund
distribution practices noted that the extent to which revenue sharing may
affect other fees that funds charge, such as 12b- 1 fees or management
fees, is uncertain. For example, the report noted that it was not clear
whether the increase in revenue sharing payments had increased any fund*s
fees but noted that by reducing fund adviser profits, revenue sharing
would likely prevent advisers from lowering their fees. In addition, fund
directors normally would not question revenue sharing arrangements because
they are paid from the adviser*s profits, unless the payments are financed
directly from fund assets as part of the adviser*s management fee or a
12b- 1 plan. Fund directors, however, in the course of their review of the
advisory contract, consider the adviser*s profits before marketing and
distribution
expenses, which also may limit the ability of advisers to shift these
costs to the fund.
Revenue sharing payments may also create conflicts of interest between
broker- dealers and their customers. By receiving compensation to
emphasize the marketing of particular funds, broker- dealers and their
sales representatives may have incentives to offer funds for reasons other
than the needs of the investor. For example, these revenue sharing
arrangements may have the effect of unduly focusing the attention of
investors and their broker- dealers on particular mutual fund choices,
which can reduce the number of funds they consider as part of the
investment decision. That not only may lead to inferior investment
choices, but may also reduce fee competition among funds. Finally,
concerns have been raised that revenue sharing arrangements may conflict
with securities selfregulatory organization rules requiring that brokers
recommend purchasing a security only after ensuring that the investment is
suitable given the investor*s financial situation and risk profile. Mutual
fund officials* opinions about revenue sharing were mixed. Some of
the fund officials with whom we spoke viewed revenue sharing as a cost of
doing business, which enabled them to obtain *shelf space* for their funds
with major broker- dealers and did not regard these arrangements as
potentially conflicting with investors* interests. They explained that the
payments are made directly to the brokerage firm and not to individual
staff financial advisers. One fund official said that there would be no
incentive for broker- dealers* sales staff to push certain funds, unless
managers exerted pressure on sales staff to sell those funds. Officials of
one large broker- dealer with whom we spoke said that their fund sales
platform has an *open architecture* through which all participating funds*
agreements and payments are the same, which creates a level playing field
on which no funds are given priority. One fund official commented that
NASD rules require that broker- dealers sales staff recommend funds that
are most suitable to the individual investor*s financial situation.
However, in letters commenting on certain compensation arrangements among
broker- dealers, ICI has stated that cash compensation creates potential
conflicts of interest between the broker- dealer receiving the
compensation and the customer because the sale of a recommended security
could increase the compensation paid to the broker- dealer*s sales
representative.
Although the extent to which revenue sharing payments are affecting the
appropriateness of the fund recommendations that broker- dealers make is
not known, investor*s complaints regarding mutual fund shares they
purchased have recently increased dramatically. According to NASD
statistics, the number of NASD- administered arbitration cases involving
mutual funds have increased by over 900 percent from 121 cases in 1999 to
1,249 cases in 2002. According to NASD staff, about 34 percent of the 2002
cases involved complaints of unsuitable mutual fund purchases. The extent
to which revenue sharing payments are involved with these cases is unknown
and NASD staff said the likely reason behind the increase in arbitrations
involving mutual funds is the decline in the stock market and the
associated declines in mutual fund performance.
Extent to Which Investors Are Although revenue sharing payments can create
conflicts of interest
Told About the Potential Conflict between broker- dealers and their
clients, the extent to which brokerdealers
That Revenue Sharing Creates Is disclose to their clients that their firms
receive such payments from Unclear
fund advisers is not clear. Rule 10b- 10 under the Securities Exchange Act
of 1934 requires, among other things, that broker- dealers provide
customers with information about third- party compensation that
brokerdealers receive in connection with securities transactions. While
brokerdealers generally satisfy the requirements of rule 10b- 10 by
providing customers with written *confirmations,* the rule does not
specifically require broker- dealers to provide the required information
about thirdparty compensation related to mutual fund purchases in any
particular document. SEC staff told us that they interpret rule 10b- 10 to
permit
broker- dealers to disclose third- party compensation related to mutual
fund purchases through delivery of a fund prospectus that discusses the
compensation. However, investors will not receive a confirmation, and may
not view a prospectus, until after purchasing mutual fund shares.
According to SEC staff, the compensation- disclosure requirements of rule
10b- 10 in large part are geared toward providing investors with
information that is useful over a course of dealing with a broker- dealer,
rather than just one transaction. Information disclosed following the
first transaction in a security can help the investor determine whether to
continue to use that broker- dealer for future transactions. That is
particularly applicable in the context of mutual funds, given that
investors often purchase fund shares over time in a series of
transactions.
Regulators and others acknowledged that additional disclosures may be
necessary to better help investors assess the potential conflicts of
interest associated with mutual fund transactions when distributing
broker- dealers receive revenue sharing payments. According to SEC staff,
additional disclosure is consistent with the principle that investors
should be informed about the financial interest that their broker- dealers
have with
respect to mutual fund transactions. Additional disclosure about revenue
sharing also may help investors be more sensitive to the question of
whether they are being presented with an adequate range of investment
choices within a fund class. SEC officials also told us that additional
disclosure of revenue sharing payments may be justified so that investors
can better assess whether the fund*s advisory fees are excessive. SEC
officials, in addition, noted that additional disclosure also might help
promote fee competition among funds. NASD officials said that mutual
funds* revenue sharing arrangements with
broker- dealers could present a conflict of interest for the broker-
dealer. However, NASD looked at this issue in the past and found no hard
evidence of sales representatives recommending unsuitable funds, but they
acknowledged that making such a determination would be difficult. The NASD
officials told us that it may be time to reexamine this issue. They said
that NASD Rule 2830 prohibits member brokers from accepting
compensation from fund advisers unless the funds disclose these payments
in fund prospectuses. ICI has also endorsed regulatory rule changes that
would require broker- dealers to disclose if they are receiving
compensation from fund advisers, in addition to requiring disclosure of
these payments in fund prospectuses. However, an official at one mutual
fund adviser with
whom we spoke said that disclosure of funds* revenue sharing agreements
would not be helpful because it would include only their largest
distributors and might mislead investors about the extent of revenue
sharing.
Soft Dollar Soft dollar arrangements allow investment advisers of mutual
funds and Arrangements Provide
other clients to use part of the brokerage commissions paid to
brokerdealers that execute trades on the fund's behalf to obtain research
and Benefits, but Could
brokerage services that can potentially benefit fund investors but could
Also Have an Adverse
increase the costs borne by their funds. The research and brokerage Impact
on Investors
services that fund advisers obtain through the use of soft dollars can
benefit a mutual fund investor by increasing the availability of research.
This practice also creates potential conflicts of interest that could harm
fund investors. Some industry participants argued that when mutual fund
investment advisers use fund assets to pay brokerage commissions and
receive research or brokerage services as part of soft dollar
arrangements, such services improve the investment advisers* management of
the fund.
However, others expressed concerns that such arrangements create conflicts
of interest that could result in fund advisers paying higher brokerage
commissions than necessary, which increases costs to fund investors.
Investors* expenses also could be higher if investment advisers use
brokerage commissions to pay for research and brokerage services that they
do not need or would otherwise pay for out of their own profits.
Expenses to investors would also be higher if investment advisers traded
more to generate and receive more soft dollar services. According to SEC,
soft dollar arrangements could also compromise advisers* fiduciary
responsibility to seek brokers capable of providing the best execution on
fund trades by choosing broker- dealers on the basis of their soft dollar
offerings. With these potential conflicts of interest in mind, several
interested parties in the United States and abroad have made suggestions
for how potential soft dollar abuses could be mitigated, although some of
these actions could have other negative consequences.
Soft Dollars Pay for When investment advisers buy or sell securities for a
fund, they may have
Research and Brokerage to pay the broker- dealers that execute these
trades a commission using
fund assets. 26 In return for brokerage commissions, many broker- dealers
Services
provide advisers with a bundle of services, including trade execution,
access to analysts and traders, and research products. Soft dollar
arrangements refer to the exchange of research and brokerage services from
broker- dealers to fund advisers in return for brokerage commissions. For
example, many full- service broker- dealers offer trade execution
services, and in exchange for paying their stated institutional commission
rate, advisers conducting trades through them could be entitled to
research produced by the broker- dealers* analysts or receive priority
notification of
market or company- specific news. In addition to providing this
proprietary research, these broker- dealers may also allow the fund
adviser to generate soft dollar credits with a portion of the brokerage
commissions paid that the fund adviser can then use to purchase other
research from third parties. These third parties can be other broker-
dealers, independent research or
analytical firms, or service providers such as market data or trading
systems software and hardware vendors. In a 1998 inspection report that
documented reviews of soft dollar practices at 75 broker- dealers and 280
investment advisers and investment companies, SEC reported for every $1.70
in commissions paid to a broker- dealer, the adviser would receive $1.00
worth of soft dollar products and services. 27
Soft dollar arrangements are not unique to the mutual fund industry. They
are widely used by investment advisers who manage portfolios for other
clients besides mutual funds, including pension funds, hedge funds, and
individual retail clients.
Soft Dollar Arrangements Many of the features of soft dollar arrangements
that exist today are the
Have Evolved Over Time result of regulatory changes in the 1970s. Until
the mid- 1970s, the
commissions charged by all brokers were fixed at one equal price. To
compete for commissions, broker- dealers differentiated themselves by
offering research- related products and services to advisers. In 1975, to
26 As noted previously, instead of commissions, broker- dealers executing
trades also could be compensated through markups or spreads. 27 U. S.
Securities and Exchange Commission, Inspection Report on the Soft Dollar
Practices of Broker- Dealers, Investment Advisers and Mutual Funds
(Washington, D. C.: Sept. 22, 1998).
increase competition, SEC abolished fixed brokerage commission rates.
However, investment advisers were concerned that they could be held in
breach of their fiduciary duty to their clients to obtain best execution
on trades if they paid anything but the lowest commission rate available
to
obtain research and brokerage services. In response, Congress created a
*safe harbor* under section 28( e) of the Securities Exchange Act of 1934
that allowed advisers to pay more than the lowest available commission
rate for security transactions in return for research and brokerage
services and not be in breach of their fiduciary duty. In order to be
protected against a claim of breach of fiduciary duty under this safe
harbor, the adviser must make a good faith determination that the amount
of commission paid is reasonable in relation to the value of the brokerage
and research services provided by the broker- dealer. The definition of
what research and brokerage services can be obtained
through soft dollar arrangements has evolved over time. In a 1976 release,
SEC issued guidelines for determining when a product or service is within
the meaning of brokerage and research services and available for the safe
harbor under section 28( e). The 1976 guidelines provided the product or
service must not be *readily and customarily available and offered to the
general public on a commercial basis.* In 1986, noting that this standard
was difficult to apply and unduly restrictive in certain instances, SEC
reinterpreted the safe harbor as permitting soft dollar arrangements to
purchase products and services that *provide lawful and appropriate
assistance to the money manager in the performance of his investment
decision- making responsibilities,* which could then include those
commercially available to the public. 28 Under the revised interpretation,
the cost of products and services that provide lawful and appropriate
assistance, such as computer hardware and seminars, may be paid for with
soft dollars.
28 Securities; Brokerage and Research Services, Securities and Exchange
Commission Release No. 34- 23170, 51 F. R. 16004 (Apr. 23, 1986).
Although the Complete Because soft dollar research is often bundled, only
aggregate value
Extent of Soft Dollar Use Is estimates of soft dollar arrangements are
available. According to one
Unknown, Soft Dollars industry research organization, the total amount
paid in brokerage
commissions for U. S. stocks totaled $8.6 billion in 2001, up from $7.7
billion Could Represent a
in 2000. 29 Of this amount, industry participants estimate that 15 percent
of Significant Portion of total annual brokerage commissions, or roughly
$1 billion, is used to obtain Trading Commissions
third- party research. However, this figure does not include the value of
proprietary research, which cannot be unbundled as easily as third- party
research. Moreover, in light of recent declines in fund assets, concern
has been raised that advisers are under increased pressure to use soft
dollars to pay for research rather than incur additional fund expenses.
Soft dollar products and services appear to represent a substantial
portion of the cost of brokerage commissions on individual trades.
Industry participants estimate that on average broker- dealers charge
commissions of between $. 05 and $. 06 per share traded. In contrast, one
industry expert has noted that it costs less than $. 01 per share to
execute a trade through an electronic communications network (ECN). ECNs
are registered broker- dealers that operate as electronic exchanges.
Because ECNs do not
offer as many of the services offered by full service broker- dealers and
execute trades electronically, the cost of executing trades through these
brokers is lower. However, the estimated costs of trading on an ECN may
not be representative of trading in all securities because most activity
on ECNs involves widely traded, liquid stocks. Other estimates of the
portion of individual brokerage commissions represented by soft dollars
and execution services varied. One academic study, for example, attributes
67
percent of the cost of brokerage commissions on individual trades to soft
dollars that pay for proprietary or third- party research. 30 However,
recognizing that a portion of brokerage commissions goes towards
brokerdealer
profits, a consulting firm that specializes in mutual funds estimates more
conservatively that soft dollars constitute 33 percent of brokerage
commission costs.
Advisers who offer mutual funds use soft dollar arrangements to varying
degrees. According to one SEC official, many fund companies do their own
29 Greenwich Associates, Commission and Soft- Dollar Practices in U. S.
Equities (May 3, 2002). 30 M. Livingston and E. S. O*Neal, *Mutual Fund
Brokerage Commissions,* The Journal of Financial Research (Summer 1996).
research and thus have less use for broker- dealer or third- party
research. Fixed- income funds, because their trades largely do not involve
paying commissions, may not generate many soft dollar credits that could
be used to obtain third- party research. However, one adviser of fixed-
income funds with whom we spoke said that his firm does receive
proprietary research from the full- service broker- dealers with whom they
trade. Nine of the ten fund companies with whom we spoke also used soft
dollars to varying degrees. One of the fund companies indicated that they
did not engage in any soft dollar arrangements. However, this company
specializes in indexed funds, which do not require research, and therefore
seeks execution- only trades when it engages in portfolio transactions.
Officials from other firms indicated that they limited the items that they
obtained with soft dollars to research reports and analysis. On the other
hand, some fund companies with whom we spoke indicated that their funds
engaged in greater use of soft dollar arrangements for a variety of
research and brokerage services permissible under section 28( e),
including computer monitors and analytical software.
Disclosure of Soft Dollar Fund advisers and investment companies must make
some disclosure of
Use to Mutual Fund their soft dollar arrangements, but these disclosures
are not specific and
Investors Is Limited not required to be routinely provided to mutual fund
investors. Under the
Investment Advisers Act of 1940, advisers must disclose details of their
soft dollar arrangements in Part II of Form ADV, which is the form that
investment advisers use to register with SEC and are required to send to
their advisory clients. Specifically, Form ADV requires advisers to
describe the factors considered in selecting brokers and determining the
reasonableness of their commissions when the adviser has discretion in
choosing brokers. If the value of the products, research and services
given to the adviser affects the choice of brokers or the brokerage
commission paid, the adviser must also describe the products, research and
services
and whether clients may pay commissions higher than those obtainable from
other brokers in return for those products. The adviser is also to
disclose whether research is used to service all of the adviser*s accounts
or
just those accounts paying for it and any procedures the adviser used
during the last fiscal year to direct client transactions to a particular
broker in return for products and research services received. However, SEC
staff told us that the Form ADV disclosures tend to use standardized
language that is difficult for advisory clients to evaluate.
The information that investment advisers disclose about their choice of
broker- dealers and their use of soft dollars in their Form ADV is not
required to be routinely provided to mutual fund investors. As noted
above, investment advisers are required to provide their Form ADV to their
advisory clients. However, in the case of mutual funds, the client is
considered to be the legal entity that is registered as the investment
company with SEC and not the individual shareholders of the mutual fund.
SEC rules also require advisers to disclose the aggregate brokerage
commissions paid by the investment adviser with fund assets, the criteria
for broker selection, and the products and services obtained through soft
dollar arrangements in their SAI. 31 However, SAIs are only sent to
investors upon request, and industry officials noted that investors rarely
request SAIs. As a result, mutual fund shareholders do not routinely
receive information about the extent to which their funds* advisers
receives and uses soft dollar credits when making purchases or sales of
the securities in the mutual funds that they own.
In addition to oversight of fees and fund distribution expenses, mutual
fund directors also have a responsibility to monitor advisers* soft dollar
arrangements to ensure best execution on portfolio trades. According to
SEC, fund directors typically have access to more detailed information
about an adviser*s soft dollar practices than described in the Form ADV,
including a list of brokers used and the total commissions dollars paid to
each broker, the average commission rate per share by broker, the list of
brokers with which the fund adviser has soft dollar arrangements and a
description of research and brokerages services received by the fund.
Additionally, directors often receive the advice of independent counsel
about an adviser*s soft dollar practices. Both SEC examiners and fund
directors evaluate soft dollar arrangements in the context of whether
advisers are getting best execution on portfolio transactions. Directors
and
31 The information that investment advisers are required to file with SEC
that comprises the SAI is contained in Form N- 1A, which is the
registration statement for open- ended management investment companies.
Information about soft dollar arrangements are also contained in Form N-
SAR, which is the form registered management investment companies file
with SEC on a semi- annual basis. Disclosures regarding brokerage
practices are found in items 20, 21, 22, and 26 of this form. In
particular, item 26 requires the fund to answer yes or no as to various
considerations that affected the participation of brokers or dealers in
commissions or other compensation paid on portfolio transactions of the
fund. These
considerations include sales of the fund's shares; receipt of investment
research and statistical information; receipt of quotations for portfolio
valuations; ability to execute portfolio transactions to obtain best price
and execution; receipt of telephone line and wire services; affiliated
status of the broker or dealer; and arrangements to return or credit part
or all of commissions or profits thereon to the fund and other affiliated
persons of the fund.
industry participants with whom we spoke indicated that boards evaluate
how advisers use soft dollars, whether these charges are reasonable, and
whether these arrangements affect best execution of portfolio
transactions.
Soft Dollars Benefit Some industry participants argue that the use of soft
dollar benefits
Investors in Various Ways, investors in various ways. They note that the
prevalence of soft dollar
but Could Also Increase arrangements allow specialized, independent
research to flourish, thereby
Investor Costs or Raise providing money managers a wider choice of
investment ideas. As a result,
this research could contribute to better fund performance. The Conflicts
of Interest
proliferation of research available as a result of soft dollars may also
have other benefits. For example, an investment adviser official told us
that the research on smaller companies for which soft dollars pay helps
create a more efficient market for such companies* securities, resulting
in greater market liquidity and lower spreads.
However, concerns have been raised about soft dollar arrangements because
they could increase the costs that investors incur when investing in a
mutual fund. For example, soft dollars could cause investors to pay
higher brokerage commissions than they otherwise would, because advisers
might choose broker- dealers on the basis of soft dollar products and
services, not trade execution quality. As a result, soft dollar trades
might have both higher brokerage commissions and worse trade execution.
One academic study, for example, shows that trades executed by
brokerdealers
that specialize in providing soft dollar products and services tend to be
more expensive than those executed through other broker- dealers,
including full- service broker- dealers. 32 Soft dollar arrangements could
also encourage advisers to trade more in order to pay for more soft dollar
products and services. Overtrading would cause investors to pay more in
brokerage commissions than they otherwise would. These arrangements might
also tempt advisers to *over- consume* research because they were not
paying for it directly. In turn, advisers might have less incentive to
negotiate lower commissions, resulting in investors paying more for
trades. Some believe soft dollars are used to purchase research and
brokerage services for which advisers should pay out of their own profits
and not out
of fund assets. As a result, the investor assumes the direct financial
burden for the advisers* costs. 32 J. S. Conrad, K. M Johnson, and S.
Wahal, *Institutional Trading and Soft Dollars,* Journal of Finance
(February 2001).
Concerns have also been expressed that the range of products and services
that advisers are obtaining with client commissions might be too broad.
Critics of soft dollar arrangements have argued that the 1986 principle
has
legitimized the use of investor dollars to pay for products and services
with only marginal research applications, such as computer terminals,
telephone bills, and magazine subscriptions. Using soft dollars for such
services could harm investors because advisers have an incentive to freely
obtain such services that they would otherwise have to pay for out of
their
profits. SEC noted that mutual fund advisers tend to abide by the spirit
of section 28( e) more diligently than other investment advisers. In 1996
and 1997, SEC examiners conducted an examination sweep into the soft
dollar practices of broker- dealers, investment advisers and mutual funds.
In their 1998 inspection report, SEC staff documented instances of soft
dollars being used for products and services outside the safe harbor, as
well as inadequate disclosure and bookkeeping of soft dollar arrangements.
However, SEC staff indicated that their review found that mutual fund
advisers engaged in far fewer soft dollar abuses than other types of
advisers. They attributed mutual fund adviser compliance to the role that
independent directors play in overseeing and approving advisers* soft
dollar arrangements. The SEC staff also indicated that active involvement
by legal counsel in the affairs of mutual funds may contribute to the
relative lack of soft dollar abuses among mutual fund advisers as well.
Investment advisers also receive services in exchange for part of the
brokerage commissions they pay with fund assets that directly reduce the
costs borne by mutual fund investors. In these cases, instead of the
adviser receiving research or brokerage services, the adviser, at the
request of the fund board, could direct the broker- dealer executing a
trade to use a portion of the commission paid to pay an expense of the
mutual fund. For
example, the executing broker- dealer could mail a payment to the fund*s
custodian for the services rendered to the mutual fund that could reduce
the amount the fund itself would have to directly pay the custodian out of
fund assets. Alternatively, the executing broker- dealer could rebate part
of the brokerage commission to the fund in cash. Such directed brokerage
arrangements do not fall under the section 28( e) safe harbor and do not
present the same conflicts of interest as traditional soft dollar
arrangements, because the investor, not the adviser, is directly
benefiting from them. An industry participant has indicated that such
arrangements are not very common in the mutual fund industry.
Regulators and Industry As a result of its 1998 inspection report on its
soft dollar examination
Participants Have Proposed sweep, SEC staff made several proposals that
could help investors better
Alternatives for Mitigating evaluate advisers* use of soft dollars. In the
examination sweep, SEC
Potential Conflicts Involving examiners found inconsistencies in how
advisers and broker- dealers
interpreted the section 28( e) safe harbor. Staff also found poor record
Soft Dollar Use
keeping and internal controls for soft dollar arrangements and that
advisers were not adequately disclosing their soft dollar usage. As a
result, SEC staff recommended that Form ADV be modified to require more
meaningful disclosure. To facilitate this disclosure, SEC staff also
recommended that SEC publish the inspection report and issue additional
guidance to clarify the scope of the safe harbor. SEC published the
inspection report to reiterate guidance with respect to the scope of the
safe harbor and to emphasize the obligations of broker- dealers,
investment advisers, and investment companies that participate in soft
dollar arrangements. This recommendation may help industry participants
apply the standards articulated in the 1986 interpretive release more
consistently and ensure that investor dollars only pay for research and
brokerage services within the scope of section 28( e). Additionally, SEC
staff recommended that SEC consider adopting a bookkeeping requirement. A
bookkeeping requirement would enable advisers to disclose more easily to
investors the products and services for which soft dollars are paying. It
would also ensure that
directors are able to receive information that fairly reflects the
adviser*s soft dollar arrangements. SEC staff told us that if the expanded
disclosure and other changes envisioned in their sweep report were
implemented, clients of investment advisers also would have more specific
information that could allow them to evaluate the appropriateness of their
own adviser*s use of soft dollars. The Department of Labor, which oversees
pension funds, and the Association for Investment Management and Research,
which administers professional certification examinations for financial
analysts, have also called for improved disclosure of soft dollar usage by
investment advisers. 33
33 See Department of Labor Advisory Council on Employee Welfare and
Benefit Plans, Report of the Working Group on Soft Dollars/ Commission
Recapture (Nov. 13, 1997); and Association for Investment Management and
Research, AIMR Soft Dollar Standards (August 1999).
However, SEC has yet to implement some of these recommendations due to
staff turnover and other high priority business. Except for publishing the
inspection report and issuing interpretative guidance that classifies
certain riskless principal transactions as falling under the section 28(
e) safe
harbor, SEC has not issued further guidance regarding soft dollars. 34 A
soft dollar bookkeeping requirement has been discussed as part of a larger
SEC initiative on bookkeeping, but no formal proposal has been presented.
Finally, the SEC issued a proposed rule on Form ADV modifications in April
2000, which solicited comments on several changes that could force
advisers to make more meaningful disclosures of soft dollar arrangements.
However, this rule has not been adopted. 35 SEC staff told us that they
have not taken further actions on these proposals due to staff turnover
and the press of business in other areas. Some industry participants are
not convinced that greater disclosure would
benefit investors. Form ADV is sent to advisory clients, not fund
investors. Thus, the proposed disclosure requirements do not address the
needs of fund investors. Investors do have access to information on a
fund*s soft dollar arrangements through the SAI, which is available upon
request. However, representatives of one fund company with whom we spoke
indicated that investors very rarely request SAIs. Industry participants
also noted that it might be difficult for investors to evaluate an
adviser*s best execution policies, which are not uniform across funds.
Moreover, more disclosure might lead investors to infer that soft dollar
arrangements are necessarily harmful and therefore adverse to their best
interests.
34 In SEC Interpretation: Commission Guidance on the Scope of Section 28(
e) of the Exchange Act, Securities and Exchange Commission Release No. 34-
45194 (12/ 27/ 2001), SEC clarified that the term *commission* for
purposes of the Section 28( e) safe harbor encompasses, among other
things, certain riskless principal transactions.
35 Proposed Rule: Electronic Filing by Investment Advisers; Proposed
Amendments to Form ADV, Securities and Exchange Commission, Release No.
IA- 1862; 34- 42620 (Apr. 5, 2000).
Some proposals would seek to restrict or ban the use of soft dollars in
order to encourage brokerage commissions to fall. As a result of
recommendations from a government- commissioned review of institutional
investment in the United Kingdom, the Financial Services Authority (FSA),
which regulates the financial services industry in that country, issued a
consultation paper that argued that soft dollar arrangements create
incentives for advisers to route trades to brokerdealers on the basis of
soft dollar arrangements and, further, that these practices do not result
in a good value for investors. 36 As a result of these findings, the paper
proposed banning soft dollars for market pricing and information services,
as well as various other products. This
recommendation would provide a more direct incentive for advisers to
consider what services are necessary for efficient fund management, which
could lower investors costs by reducing the extent to which advisers use
client funds for services that the adviser does not need. The paper also
recommended that advisers quantify, or unbundle, the cost of all other
soft
dollar products and services and rebate those costs to investors* accounts
with hard dollars, which would result in investors having lower trading
costs in their funds.
Whether implementing the actions envisioned by the FSA*s proposals is
feasible is not certain. For example, FSA staff acknowledged that
restricting soft dollar arrangements in the United Kingdom could hurt the
international competitiveness of their fund industry because fund advisers
outside their country would not have to comply with these restrictions.
Such restrictions could also encourage UK advisers to move their
operations elsewhere. In addition, SEC staff told us that implementing the
FSA proposal would be more difficult here without legislative change
because the United States has the statutory safe harbor under Section 28(
e), whereas the United Kingdom does not. We learned of another proposal
related to soft dollars and brokerage
commissions from an industry participant who was concerned that the
general practice of full- service broker- dealers charging about $0.05 to
$0.06 per share in commissions and then offering discounts in the form of
soft dollars was serving to keep commissions artificially high. His first
suggestion would be to ban soft dollar arrangements to obtain products
36 See P. Myners, Institutional Investment in the United Kingdom: A Review
(Mar. 6, 2001); and Financial Services Authority, Bundled Brokerage and
Soft Commission Arrangements (April 2003).
and services with marginal research applications, forcing advisers to pay
for these products with their own profits rather than with fund assets and
therefore reducing the trading costs borne by fund investors. Another
suggestion he had would have broker- dealers quantify the execution- only
portion of their brokerage commissions. If this information were collected
by SEC and reported as industry averages, mutual fund directors would have
more information to use to evaluate their fund*s trading activities.
However, many industry participants are skeptical about whether soft
dollar arrangements contribute to investors paying higher brokerage
commissions. For example, according to SEC officials and an industry
participant, many broker- dealers claim that they would not negotiate
lower commission rates with investment advisers regardless of whether an
adviser was willing to forfeit soft dollar products and services in
return. One group with whom we spoke suggested that soft dollars might be
more of a volume rebate for brokerage than a factor influencing commission
rates. Moreover, surveys of investment advisers and broker- dealers
conducted in the United Kingdom found that third- party soft dollar
arrangements were a very minor factor on which broker- dealers competed
for business and advisers selected broker- dealers. These results suggest
that advisers* incentive to compromise their fiduciary responsibility to
seek best execution in return for generous soft dollar arrangements might
be overstated.
Concern has also been raised about how the value of some soft dollar
products and services could be fairly determined. Because proprietary soft
dollar products and services are bundled, their values as individually
purchased items are difficult to estimate. For example, SEC officials
noted that it is hard to put a meaningful value on the cost of information
exchanged in a phone call between a fund adviser and a broker- dealer.
Nevertheless, brokerage commissions pay for this type of informal access.
Some industry experts, including SEC, have noted that attempts to require
the industry to quantify the value of soft dollar services could have a
disproportionate impact on third- party research. Third- party research is
free from the potential conflicts of interest that have recently tainted
some
proprietary research from brokerage houses. Additionally, several fund
companies have indicated that they find research provided by specialized
research firms does provide valuable insights into investment decisions.
Because broker- dealers use soft dollar credits to purchase third- party
research, its value is more easily determined than proprietary research.
As
a result, some have expressed concern that this distinction could make
third- party research more vulnerable if regulatory changes were enacted.
Some have suggested that limiting the products and services that could be
obtained with soft dollars might have some unintended consequences.
According to some fund officials, this option could shift a greater
financial
burden onto advisers, who might be tempted to raise management fees as a
result. While having investment advisers pay directly for research and
brokerage services rather than receive them through soft dollars could
increase the transparency of these arrangements, the increased costs to
the adviser could cause advisers to seek fee increases or at least prevent
further reductions in the fees advisers do charge. Conclusions Although
mutual funds disclose considerable information about their costs
to investors, some industry participants urge that additional disclosures
are needed to further increase the awareness of investors of the fees they
pay as part of investing in mutual funds and to encourage greater
competition among mutual funds on the basis of these fees. The SEC staff*s
proposal to require funds to disclose the actual expenses in dollars based
on an investment amount of $10,000 would provide investors with more
information on fund fees and in a form that would allow for direct
comparison across funds. If adopted, this will provide investors selecting
among different funds with useful information prior to investing. However,
additional disclosures could also improve investor awareness and the
transparency of these fees. Providing existing investors with the specific
dollar amounts of the fees paid on their shares and placing fee related
disclosures in the quarterly account statements that investors receive
would put mutual fund disclosures on comparable footing to many other
financial services that already disclose specifically in dollars the cost
of their services. Seeing the specific dollar amount paid on their shares
could be the incentive that some investors need to take action to compare
their fund*s expenses to those of other funds and make more informed
investment decisions on this basis. Such disclosures may also increasingly
motivate fund companies to respond competitively by lowering fees.
Given the cost of producing such disclosures and the lack of data on the
additional benefits to investors, the SEC staff have indicated that they
were not certain that specific dollar disclosures are warranted. However,
we
believe that actively weighing the costs and benefits of providing
additional disclosure is worthwhile. In addition, other less costly
alternatives are also available that could increase investor awareness of
the fees they are paying on their mutual funds by providing them with
information on the fees they pay in the quarterly statements that provide
information on an investor*s share balance and account value. For example,
one alternative that would
not likely be overly expensive would be to require these quarterly
statements to present the information that SEC has proposed be added to
mutual fund*s semiannual reports that would disclose the dollar amounts of
a fund*s fees based on a set investment amount. Doing so would place this
additional fee disclosure in the document generally considered to be of
the most interest to investors. An even less costly alternative could be
to require quarterly statements to also include a notice that reminds
investors
that they pay fees and to check their prospectus and with their financial
adviser for more information. If additional fee disclosures such as these
were used to supplement the existing information already provided in
prospectuses and semiannual reports, both prospective and existing
investors in mutual funds would have access to valuable information about
the relative costs of investing in different funds.
Mutual fund directors play a critical role in overseeing fund advisers
activities and have been credited with ensuring that U. S. mutual funds
have lower fees than those charged in other countries. However, the
popularity of mutual fund investing and the increasing importance of such
investments to investors* financial well being and ability to retire
securely also increases the need for regulators and industry participants
to continually seek to ensure that mutual fund corporate governance
practices remain strong. The recent corporate scandals have resulted in
various corporate governance reforms being proposed to improve the
oversight of public companies by their boards of directors. We have
supported regulatory and industry efforts to strengthen the corporate
governance of public companies. Although many of the reforms being sought
for public companies are already either embodied in regulatory
requirements or recommended as best practices by the mutual fund industry
group, additional improvements to mutual fund governance, such
as mandating supermajorities of independent directors, are likely to
continue to be considered by regulators and industry participants, which
should further benefit mutual fund investors. Although the ways that funds
use 12b- 1 fees has changed over time, these
fees appear to have provided investors with increased flexibility in
choosing how to pay for the services of the individual financial
professionals providing them with advice on fund purchases. As a result,
they appear to provide benefits to the large number of investors that
require assistance with their financial decisions. The revenue sharing
payments that funds make to broker- dealers illustrate that mutual funds
must compete to obtain access to the distribution networks that these
firms provide. How and the extent to which these payments affect the
overall level of fees that fund investors pay is not clear. However, by
compensating broker- dealers to market the funds of a particular company,
they can introduce a conflict with the broker- dealer obligation to
recommend the funds most suitable to the investor*s needs. Further, even
if the payments do not conflict with this obligation, the payments can
result in financial professionals providing investors with fewer
investment choices. Regulators acknowledged that the currently required
disclosures might not provide needed transparency to investors at the time
that mutual fund shares are being recommended for purchase. Having
additional disclosures made at the time that fund shares are recommended
about the compensation that a broker- dealer receives from fund companies
could provide investors with more complete information to consider when
making their investment decision. Fund investors can benefit when their
fund*s investment adviser uses soft
dollars to obtain research and brokerage services that benefit the fund or
to pay other fund expenses. However, investment advisers may also use soft
dollars for services that may just reduce the adviser*s own expenses. The
SEC staff has recommended various changes that would increase the
transparency of soft dollar practices by clarifying the acceptable uses of
soft dollars and providing fund investors and directors with more
information about how their fund*s adviser is using soft dollars. However,
the rule proposal to expand advisers* disclosure of their use of soft
dollars was issued about 3 years ago and has not yet been acted upon. In
addition, the SEC staff have not developed and issued a formal rule
proposal to implement its recommendation to require increased soft dollar
recordkeeping by broker dealers and advisers that would increase the
transparency of these arrangements. SEC relies on disclosure of
information as a primary means of addressing potential conflicts between
investors and financial professionals. However, by not acting on these
soft dollar- related measures, investors and mutual fund directors have
less complete and transparent information with which to evaluate the
benefits and potential disadvantages of their fund adviser*s use of soft
dollars.
Recommendations To promote greater investor awareness and competition
among mutual funds on the basis of their fees, we recommend that the
Chairman, SEC
increase the transparency of the fees and practices that relate to mutual
funds by
considering the benefits of additional disclosure relating to mutual
fund fees, including requiring more information in mutual fund account
statements about the fees investors pay;
evaluating ways to provide more information that investors could use to
evaluate possible conflicts of interest resulting from any revenue sharing
payments their broker- dealers receive; and evaluating ways to provide
more information that fund investors and
directors could use to better evaluate the benefits and potential
disadvantages of their fund adviser*s use of soft dollars, including
considering and implementing the recommendations from its 1998 soft dollar
examinations report.
Agency Comments and SEC and ICI generally agreed with the contents of this
report. Regarding
Our Evaluation our recommendation that SEC consider additional ways to
provide fee
information to investors in account statements, the letter from the
director of the Division of Investment Management notes that the SEC staff
agreed that mutual fund shareholders need to understand the amount of fees
that mutual funds charge and indicated that they would consider whether
some form of fee disclosure could be included in account statements as
they continue to evaluate the comments they have received on their
proposed disclosure changes. Regarding our recommendations on increasing
the amount of information disclosed about revenue sharing and soft dollar
arrangements, the SEC staff also indicated that they intend to consider
ways in which additional information about these practices could be
disclosed.
The letter from the president of ICI notes that our report*s discussion of
mutual fund regulatory requirements is generally balanced and well
informed. However, his letter indicates concern over how we compare the
disclosures made by mutual fund fees to those made by other financial
products. According to the letter, ICI staff are convinced that current
mutual fund fee disclosures allow individuals to make much more informed
and accurate decisions about the costs of their funds than do the
disclosures made by other financial service firms. In particular, they
indicated that they are not aware of any other financial product that is
legally required to provide standardized information that reveals the
exact level of all of its fees and expenses and projects their impact in
dollar terms over various time periods.
We agree with ICI that mutual funds are already required to make
considerable disclosures that are useful to investors for comparing the
level of fees across funds. Although our report notes that, unlike mutual
funds, other financial products generally do disclose their costs in
specific dollar terms, we do not make a judgment as to whether the overall
disclosures provided by these products are superior to that provided for
mutual funds. Instead, we believe that supplementing the existing mutual
fund disclosures with additional information, particularly in the account
statements that provide investors with the exact number and value of their
mutual fund shares, could also prove beneficial for increasing awareness
of fees and prompting additional fee- based competition among funds. The
ICI*s staff*s letter also indicates that our report presents a thorough
and
useful discussion of the role played by independent directors in
overseeing mutual fund fees. However, they expressed concern that mutual
fund independent directors are not usually given sufficient credit for
protecting fund shareholder interests. ICI noted that independent
directors have helped keep the industry free of major scandal and that
mutual fund governance standards, as set by the Investment Company Act of
1940, places strict requirements on funds that exceed the voluntary
standards with which public companies are expected to adhere. We agree
with ICI that independent directors have played important roles in
overseeing funds and, in each of the issues addressed by our report, we
discuss the actions taken by mutual fund directors to oversee the issues
and that SEC reviews generally find that directors have fulfilled their
duties in accordance with the law. However, given recent scandals and
concerns related to corporate
responsibility in the financial sector and the growing importance of fund
investments to the financial health and retirement security of investors,
continued debate by the Congress and among regulators and industry
participants about the effectiveness of existing mutual fund corporate
governance standards is appropriate. SEC*s and ICI*s written responses are
shown in appendixes II and III.
As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution of this report until
30 days from the report date. At that time, we will provide copies of this
report to the Chairman and the Ranking Minority Member, Senate Committee
on Banking, Housing, and Urban Affairs, and the Ranking Minority Members,
House Committee on Financial Services and its Subcommittee on Capital
Markets, Insurance, and Government Sponsored Enterprises. Copies also will
be provided to the Chairman, SEC; the President, ICI; and other
interested parties. The report will also be available at no charge on
GAO*s home page at http:// www. gao. gov.
If you or your staff have any questions regarding this report, please
contact Mr. Cody Goebel or me at (202) 512- 8678. GAO staff that made
major contributions to this report are shown in appendix IV.
Richard J. Hillman Director, Financial Markets and Community Investment
Appendi Appendi xes I x Scope and Methodology To describe mutual fund fee
and trading cost disclosures and other financial product disclosures and
the related costs we reviewed SEC rules and studies by academics and
others, and various mutual fund company fund literature including
prospectuses and SAIs, as well as prior GAO work. To evaluate the benefits
of additional mutual fund cost disclosure we collected opinions from a
judgmental sample of 15 certified financial planners with the use of a
structured questionnaire.
To describe the role of mutual fund independent directors we reviewed
federal laws and regulations, academic studies, and prior GAO work. We
collected opinions from officials representing an independent directors
association and from a judgmental sample of independent directors with the
use of a structured questionnaire.
To obtain information on mutual fund distribution practices we interviewed
officials of ten mutual fund companies, two broker- dealers, ICI, NASD,
SEC, mutual fund research organizations, and investor
advocacy organizations and individuals. We also reviewed and analyzed
various documents and studies of mutual fund distribution practices.
To address the benefits and potential conflicts of interest raised by
mutual funds* use of soft dollars, we spoke with the FSA and other
industry experts on soft dollars. We also reviewed studies by regulators
and industry experts on soft dollar arrangements. Some groups we spoke to
had made specific recommendations for regulatory changes to soft dollar
arrangements. To the extent possible, we discussed the potential
advantages and disadvantages of these recommendations with officials of
the ten mutual fund companies, two broker- dealers, ICI, NASD, SEC, mutual
fund research organizations, and investor advocacy organizations
and individuals. For each of the topics we reviewed in this report we
gathered views from staff at SEC, mutual fund company officials, broker-
dealers, ICI, mutual fund research organizations, and investor advocacy
organizations and individuals. We conducted our work in Washington, D. C.;
Boston, MA; Kansas City, MO; Los Angeles, CA; New York, N. Y.; and San
Francisco, CA,
from February to June 2003, in accordance with generally accepted
government auditing standards.
Comments from the Securities and Exchange
Appendi I I x Commission
Comments from the Investment Company
Appendi I I I x Institute
Appendi V I x GAO Contacts and Staff Acknowledgments GAO Contacts Richard
J. Hillman (202) 512- 8678 Cody J. Goebel (202) 512- 7329 Acknowledgments
In addition to the individuals named above, Toayoa Aldridge, Jonathan
Altshul, Marc Molino, Robert Pollard, Barbara Roesmann, David Tarosky, and
Sindy Udell made key contributions to this report.
(250132)
a
GAO United States General Accounting Office
Although mutual funds disclose considerable information about their costs
to investors, the amount of fees and expenses that each investor
specifically pays on their mutual fund shares are currently disclosed as
percentages of fund assets, whereas most other financial services disclose
the actual costs to the purchaser in dollar terms. SEC staff has proposed
requiring funds to disclose additional information that could be used to
compare fees across funds. However, other disclosures could
also increase the transparency of these fees, such as by providing
existing investors with the specific dollar amounts of the expenses paid
or by placing fee- related disclosures in the quarterly account statements
that investors receive. Although some of these additional disclosures
could be costly and data on their benefits to investors was not generally
available, less costly alternatives exist that could increase the
transparency and investor awareness of mutual funds fees that make
consideration of additional fee disclosures worthwhile.
Changes in how mutual funds pay intermediaries to sell fund shares have
benefited investors but have also raised concerns. Since 1980, mutual
funds, under SEC Rule 12b- 1 have been allowed to use fund assets to pay
for certain marketing expenses. Since then, funds have developed ways to
apply Rule 12b- 1 fees to provide investors greater flexibility in
choosing how to pay for the services of individual financial professionals
that advise them on fund purchases. Another increasingly common marketing
practice called revenue sharing involves fund investment advisers making
additional payments to the broker- dealers that distribute their funds*
shares. However, receiving these payments can limit fund choices offered
to investors and conflict with the broker- dealer*s obligation to
recommend the most suitable funds. Regulators acknowledged that the
current disclosure regulations might not always result in complete
information about these payments being disclosed to investors.
Under soft dollar arrangements, mutual fund investment advisers use part
of the brokerage commissions they pay to broker- dealers for executing
trades to obtain research and other services. Although industry
participants said that soft dollars allow fund advisers access to a wider
range of research than may otherwise be available and provide other
benefits, these arrangements also can create incentives for investment
advisers to trade excessively to obtain more soft dollar services, thereby
increasing fund shareholders* costs. SEC staff has recommended various
changes that would increase transparency by expanding advisers* disclosure
of their use of soft dollars. By acting on the staff*s recommendations SEC
would provide fund investors and
directors with needed information about how their funds* advisers are
using soft dollars. The fees and other costs that investors pay as part of
owning mutual fund shares can
significantly affect their investment returns. As a result, questions have
been raised as to whether the
disclosures of mutual fund fees and other practices are sufficiently
transparent. GAO reviewed (1)
how mutual funds disclose their fees and related trading costs and options
for improving these
disclosures, (2) changes in how mutual funds pay for the sale of fund
shares and how the changes in these practices are affecting
investors, and (3) the benefits of and the concerns over mutual funds* use
of soft dollars. GAO recommends that SEC consider the benefits of
requiring additional disclosure relating to mutual fund fees and evaluate
ways
to provide more information that investors could use to evaluate the
conflicts of interest arising from payments funds make to brokerdealers
and fund advisers* use of soft dollars. SEC agreed with the contents of
this report and indicated that it will consider the recommendations in
this report
carefully in determining how best to inform investors about the importance
of fees. It also indicated that it will be considering ways to expand
disclosure and improve other regulatory aspects of fund distribution and
soft dollar
practices.
www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 763. To view the full report,
including the scope and methodology, click on the link above. For more
information, contact Richard Hillman at (202) 512- 8678 or hillmanr@ gao.
gov. Highlights of GAO- 03- 763, a report to the
Chairman, House Committee on Financial Services and Chairman, Subcommittee
on Capital Markets, Insurance and Government Sponsored Enterprises, House
Committee on Financial Services
June 2003
MUTUAL FUNDS
Greater Transparency Needed in Disclosures to Investors
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Appendix I
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Appendix II
Appendix II Comments from the Securities and Exchange Commission Page 62
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Appendix III
Appendix III Comments from the Investment Company Institute Page 65 GAO-
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Appendix IV
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