Mutual Funds: Additional Disclosures Could Increase Transparency 
of Fees and Other Practices (18-JUN-03, GAO-03-909T).		 
                                                                 
Concerns have been raised over whether the disclosures of mutual 
fund fees and other fund practices are sufficiently transparent  
and fair to investors. GAO's testimony discusses (1) mutual fund 
fee disclosures, (2) the extent to which various corporate	 
governance reforms are in place in the mutual fund industry, (3) 
the potential conflicts that arise when mutual fund advisers pay 
broker-dealers to sell fund shares, and (4) the benefits and	 
concerns over fund advisers' use of soft dollars.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-909T					        
    ACCNO:   A07244						        
  TITLE:     Mutual Funds: Additional Disclosures Could Increase      
Transparency of Fees and Other Practices			 
     DATE:   06/18/2003 
  SUBJECT:   Brokerage industry 				 
	     Fees						 
	     Information disclosure				 
	     Investments					 
	     Mutual funds					 

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GAO-03-909T

The work that GAO has conducted at the request of this Committee addresses
              several of the areas that are included in the re...

The work that GAO has conducted at the request of this Committee addresses
several of the areas that are included in the recently introduced Mutual
Funds Integrity and Fee Transparency Act of 2003 (H. R. 2420). Mutual
funds disclose considerable information about their costs to investors,
but unlike many other financial products and services, they do not
disclose to each investor the specific dollar amount of fees that are paid
on their fund shares. Consistent with H. R. 2420, our report recommends
that SEC consider requiring mutual funds to make additional disclosures to
investors, including considering requiring funds to specifically disclose
fees in dollars to each investor in quarterly account statements, which we
estimate may result in minimal increases in fund expenses. Our report also
discusses other alternatives that could also prove beneficial to investors
and spur increased competition among mutual funds on the basis of fees but
be even less costly to the industry overall.

U. S. mutual funds have boards of directors who are charged with
overseeing the interests of fund shareholders. Various corporate
governance reforms have been proposed to improve the effectiveness of
mutual fund boards. As a result of SEC requirements or industry best
practice recommendations, many of these practices were already in place at
many funds, but not all such practices were mandatory. H. R. 2420 would
ensure that all mutual funds implement these practices.

Mutual fund advisers have been increasingly making additional payments out
of their own profits to the broker- dealers that sell their fund shares.
Although allowed under current rules, these revenue sharing payments can

create conflicts between the interests of broker- dealers and their
customers that could limit the choices of funds that investors are
offered. Under current disclosure requirements, however, investors may not
always be explicitly informed that their broker- dealer, who is obligated
to recommend

only suitable investments based on the investor*s financial condition, is
also receiving payments to sell particular funds. Consistent with H. R.
2420, our report also recommended that more disclosure be made to
investors about any revenue sharing payments their broker- dealers are
receiving.

Under a practice known as soft dollars, a mutual fund adviser uses fund
assets to pay commissions to broker- dealers for executing trades in
securities for the mutual fund*s portfolio but also receives research or
other brokerage services as part of the transaction. Although this
research and other services can benefit fund investors, these arrangements
could result in increased expenses for fund shareholders if fund advisers
trade excessively to obtain additional soft dollar research. SEC has
addressed soft dollar practices in the past and recommended actions could
provide additional information to fund directors and investors, but has
not yet acted on all of its own recommendations. Consistent with H. R.
2420, our report recommended that more disclosure be made to mutual fund
directors and investors.

Testimony Before the Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises, Committee on Financial Services, House
of Representatives

United States General Accounting Office

GAO For Release on Delivery Expected at 10: 00 a. m. EST Wednesday, June
18, 2003 MUTUAL FUNDS

Additional Disclosures Could Increase Transparency of Fees and Other
Practices

Statement of Richard J. Hillman, Director, Financial Markets and Community
Investment

GAO- 03- 909T

Concerns have been raised over

whether the disclosures of mutual fund fees and other fund practices are
sufficiently transparent and fair to investors. GAO*s testimony

discusses (1) mutual fund fee disclosures, (2) the extent to which various
corporate governance reforms are in place in the mutual fund industry, (3)
the potential

conflicts that arise when mutual fund advisers pay broker- dealers to sell
fund shares, and (4) the benefits and concerns over fund advisers' use of
soft dollars.

GAO*s report recommends that SEC consider requiring additional disclosure
by mutual funds of

 the fees that investors pay in account statements,  revenue sharing
payments that broker- dealers receive; and  fund adviser*s use of soft
dollars.

www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 909T. 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- 909T, a testimony to

the Chairman, Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises, Committee on Financial Services, House of
Representatives

June 18, 2003

MUTUAL FUNDS

Additional Disclosures Could Increase Transparency of Fees and Other
Practices

Page 1 GAO- 03- 909T Mutual Fund Disclosures

Mr. Chairman and Members of the Subcommittee: I am pleased to be here to
discuss GAO*s work on the disclosure of mutual fund fees and the need for
other related mutual fund disclosures to investors. The fees and other
costs that mutual fund investors pay as part of owning fund shares can
significantly affect their investment returns. As

a result, it is appropriate to debate whether the disclosures of mutual
fund fees and fund marketing practices are sufficiently transparent and
fair to investors.

Today, I will summarize the results from our recently issued report
entitled Mutual Funds: Greater Transparency Needed in Disclosures to
Investors, GAO- 03- 763 (Washington, D. C.: June 9, 2003) and describe how

the results of this work relates to certain provisions of the proposed
Mutual Funds Integrity and Fee Transparency Act of 2003 (H. R. 2420).
Specifically, I will discuss (1) mutual fund fee disclosures and
opportunities for improving these disclosures, (2) the extent to which
various corporate governance reforms are in place in the mutual fund
industry, (3) the potential conflicts that arise when mutual fund advisers
pay broker- dealers to sell fund shares, and (4) the benefits and concerns
over fund advisers' use of soft dollars.

In summary: The study that we have conducted at the request of this
Committee directly supports several of the key provisions of H. R. 2420.
In particular, it addresses the need to consider ways to increase the
transparency of mutual fund fees and other disclosures. Mutual funds
disclose considerable information about their costs to investors,
including presenting the operating expense fees that they charge investors
as a percentage of fund assets and providing hypothetical examples of the
amount of fees that an investor can expect to pay over various time
periods. However, unlike many other financial products and services,
mutual funds do not disclose to individual investors the specific dollar
amount of fees that are paid on their fund shares. The Securities and
Exchange Commission (SEC) has proposed that mutual funds make additional
disclosures to investors that would provide more information that
investors could use to compare fees across funds. However, SEC is not
proposing that funds disclose the specific dollar amount of fees paid by
each investor nor is it proposing to require that any fee disclosures be
made in the account statements that inform investors of the number and
value of the mutual fund shares they own. Consistent with H. R. 2420, our
report recommends that SEC consider requiring mutual funds to make

Page 2 GAO- 03- 909T Mutual Fund Disclosures

additional disclosures to investors, including considering requiring funds
to specifically disclose fees in dollars to each investor in quarterly
account statements. SEC has agreed to consider requiring such disclosures
but was unsure that the benefits of implementing specific dollar
disclosures outweighed the costs to produce such disclosures. However, we
estimate that spreading these implementation costs across all investor
accounts may result in minimal increases in fund expenses. Our report also
discusses less costly alternatives that could also prove beneficial to
investors and spur increased competition among mutual funds on the basis
of fees.

Each mutual fund in the United States is required to have a board of
directors that is charged with overseeing the interests of fund
shareholders. These boards also must include directors that are not
employed or affiliated with the fund*s adviser, and these independent
directors have specific duties to oversee the fees their fund*s charge.
However, some industry critics have questioned whether fund directors are
adequately performing their duties and various corporate governance
reforms have been proposed to improve the effectiveness of mutual fund
boards. We found that many of the corporate governance reforms are already
being practiced by many funds as a result of either recent SEC actions or
because they are recommended as best practices by the mutual fund industry
body, the Investment Company Institute. By amending the Investment Company
Act of 1940 to require these and other corporate governance practices, H.
R. 2420 would further strengthen certain corporate governance practices
and ensure that all mutual funds implement these practices.

The work that we conducted for our report also found that mutual fund
advisers have been increasingly engaged in a practice known as revenue
sharing under which they make additional payments to the broker- dealers
that sell their fund shares. Although we found that the impact of these
payments on the expenses to fund investors was uncertain, these payments
can create conflicts between the interests of broker- dealers and their
customers that could limit the choices of funds that these brokerdealers
offer investors. However, under current disclosure requirements investors
may not always be explicitly informed that their broker- dealer, who is
obligated to recommend only suitable investments based on the investor*s
financial condition, is also receiving payments to sell particular funds.
Consistent with H. R. 2420, our report also recommended that more
disclosure be made to investors about any revenue sharing payments their
broker- dealers are receiving.

Page 3 GAO- 03- 909T Mutual Fund Disclosures

Finally, we also reviewed a practice known as soft dollars, in which a
mutual fund adviser uses fund assets to pay commissions to brokerdealers
for executing trades in securities for the mutual fund*s portfolio but
also receives research or other brokerage services as part of the
transaction. These soft dollar arrangements can result in mutual fund
advisers obtaining research or other services, including from third party
independent research firms, that can benefit the investors in their funds.
However, these arrangements also create a conflict of interest that could
result in increased expenses to fund shareholders if a fund adviser trades
excessively to obtain additional soft dollar research or chooses
brokerdealers more on the basis of their soft dollar offerings than their
ability to execute trades efficiently. SEC has addressed soft dollar
practices in the past and recommended actions could provide additional
information to fund directors and investors, but has not yet acted on some
of its own recommendations. Consistent with H. R. 2420, our report
recommended that more disclosure be made to mutual fund directors and
investors to allow them to better evaluate the benefits and potential
disadvantages of their fund adviser*s use of soft dollars.

Although mutual funds already disclose considerable information about the
fees they charge, our report recommended that SEC consider requiring that
mutual funds make additional disclosures to investors about fees in the
account statements that investors receive. Mutual funds currently provide
information about the fees they charge investors as an operating expense
ratio that shows as a percentage of fund assets all the fees and other
expenses that the fund adviser deducts from the assets of the fund.

Mutual funds also are required to present a hypothetical example that
shows in dollar terms what an investor could expect to pay if they
invested $10,000 in a fund and held it for various periods.

Unlike many other financial products, mutual funds do not provide
investors with information about the specific dollar amounts of the fees
that have been deducted from the value of their shares. Table 1 shows that
many other financial products do present their costs in specific dollar
amounts. Additional Disclosure

of Mutual Fund Costs Might Benefit Investors

Page 4 GAO- 03- 909T Mutual Fund Disclosures

Table 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
to individual investment accounts (such as those managed by a financial
planner)

When the provider has the right to deduct fees and other charges directly
from the investor*s account, the dollar amounts of such charges are
required to be disclosed to the investor.

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 do not disclose their costs to each individual
investor in specific dollars, the disclosures that they make do exceed
those of many products. For example, purchasers of fixed annuities are not
told of the expenses associated with investing in such products. Some
industry

participants and others including SEC also cite the example of bank
savings accounts, which pay stated interest rates to their holders but do
not explain how much profit or expenses the bank incurs to offer such
products. While this is true, we do not believe this is an analogous
comparison to mutual fund fees because the operating expenses of the bank
are not paid using the funds of the savings account holder and are
therefore not explicit costs to the investor like the fees on a mutual
fund.

Page 5 GAO- 03- 909T Mutual Fund Disclosures

A number of alternatives have been proposed for improving the disclosure
of mutual fund fees, that could provide additional information to fund
investors. In December 2002, SEC released proposed rule amendments, which
include a requirement that mutual funds make additional disclosures about
their expenses. 1 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, SEC 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. If
these disclosures become mandatory, investors will have additional
information that could be directly compared across funds. By placing it in
funds* annual and semiannual reports, SEC staff also indicate that it will
facilitate prospective investors comparing funds* expenses before making a
purchase decision.

However, SEC*s proposal would not require mutual funds to disclose to each
investor the specific amount of fees in dollars that are paid on the
shares they own. As result, investors will not receive information on the
costs of mutual fund investing in the same way they see the costs of many
other financial products and services that they may use. In addition, SEC
did not propose that mutual funds provide information relating to fees in
the quarterly or even more frequent account statements that provide

investors with the number and value of their mutual fund shares. In a 1997
survey of how investors obtain information about their funds, ICI
indicated that to shareholders, the account statement is probably the most
important communication that they receive from a mutual fund company and
that nearly all shareholders use such statements to monitor their

mutual funds. SEC and industry participants have indicated that the total
cost of providing specific dollar fee disclosures might be significant;
however, we found that the cost might not represent a large outlay on a
per investor basis. As we reported in our March 2003 statement, ICI
commissioned a large accounting firm to survey mutual fund companies about
the costs of

1 *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).

Page 6 GAO- 03- 909T Mutual Fund Disclosures

producing such disclosures. 2 Receiving responses from broker- dealers,
mutual fund service providers, and fund companies representing
approximately 77 percent of total industry assets as of June 30, 2000,
this study estimated 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. Although the ICI study included
information from some broker- dealers and fund service providers, it did
not include the reportedly significant costs that all broker- dealers and
other third- party financial institutions that maintain accounts on behalf
of individual mutual fund shareholders could incur. However, using
available information on mutual fund assets and accounts from ICI and
spreading such costs across all investor accounts indicates that the
additional expenses to any one investor are minimal. Specifically, at end
of 2001, ICI reported that mutual fund assets totaled $6.975 trillion. If
mutual fund companies charged, for example, the entire $266 million cost
of implementing the disclosures to investors in the first year, then
dividing this additional cost by the total assets outstanding at the end
of 2001 would increase the average fee by .000038 percent or about one-
third of a basis point. In addition, ICI reported that the $6.975 trillion
in total assets was held in over 248 million mutual fund accounts,
equating to an average

account of just over $28,000. Therefore, implementing these disclosures
would add $1.07 to the average $184 that these accounts would pay in total
operating expense fees each year* an increase of six- tenths of a percent.
3 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

2 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). 3 To determine these amounts, we used the operating expense
ratios that ICI has estimated in its September 2002 fee study* which
reported average expense ratios of 0.88 percent for equity funds, 0. 57
percent for bond funds, and 0.32 percent for money market funds. By
weighting each of these by the total assets invested in each fund type, we
calculated that

the weighted average expense ratio for all funds was 0.66 percent. Using
this average expense ratio, the average account size of $28, 000 would pay
$184 in fees. The additional expense of implementing specific dollar
disclosures of 0.000038 percent would therefore add $1. 07 to this amount.

Page 7 GAO- 03- 909T Mutual Fund Disclosures

to present the information* the dollar amount of a fund*s fees based on a
set investment amount* that SEC has proposed be added to mutual fund
semiannual reports. 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.

Because SEC*s current proposal, while offering some advantages, does not
make mutual funds comparable to other products and provide information in
the document that is most relevant to investors* the quarterly account
statement* our report recommended that SEC consider requiring additional
disclosures relating to fees be made to investors in these documents. In
addition to specific dollar disclosures, we also noted that investors
could be provided with other disclosures about the fees they pay on mutual
funds that would have a range of implementation costs, including some that
would have even less overall cost to the industry. H. R. 2420 also
mandates that SEC require additional information about fees be disclosed
to investors. 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. Because the disclosures that SEC is currently proposing be included
in mutual fund annual and semiannual reports could also prove beneficial,
it could choose to require disclosures in both these documents and account
statements, which would provide both prospective and existing investors in
mutual funds access to valuable information about the costs of investing
in funds.

H. R. 2420 also mandates that SEC require mutual funds to disclose more
information about portfolio transactions costs, including commissions paid
with respect to the trading of portfolio securities. Although additional
information about such costs could be beneficial to investors, we found
that determining these costs in a way that allows them to be accurately
and fairly compared across funds could prove difficult.

Page 8 GAO- 03- 909T Mutual Fund Disclosures

Mutual funds implemented many sound practices concerning their boards of
directors, but these practices are not mandatory for all funds. The law
governing U. S. mutual funds promotes investor protection by requiring
funds to have a board of directors to protect fund shareholder interests.
As a group, the directors of a mutual fund have various statutory
responsibilities to oversee fund operations. In particular, the directors
independent of the fund*s investment adviser have additional duties
including approval of the contracts with the investment adviser. As a
matter of practice, independent directors also review other arrangements
such as transfer agency, custodial, or bookkeeping services.

As a result of recent scandals such as Enron and Worldcom, new legislative
and regulatory reforms have been adopted or 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 and governance. 4 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 be *independent* and select and oversee outside auditors.
The New York Stock Exchange (NYSE) and NASDAQ have also proposed changes
to the corporate governance listing standards for public companies.
However, many of the proposed reforms for public companies are either
already required or have been recommended as best practices for mutual
fund boards. Table 2 shows how the current or recommended corporate
governance practices for mutual fund boards compare to current and
proposed NYSE and NASDAQ listing standards applicable to public company
boards. 4 Pub. L. No. 107- 204, 116 Stat. 745 (codified in scattered
sections of 11, 15, 18, 28, and 29 U. S. C. A.). Mutual Fund Boards Follow
Many Sound

Corporate Governance Practices but Such Practices are Not Mandatory for
All Funds

Page 9 GAO- 03- 909T Mutual Fund Disclosures

Table 2: Current and Proposed NYSE and NASDAQ Listing Standards Compared
to Current or Recommended Mutual Fund Corporate Governance Requirements

NYSE/ NASDAQ listing standards Mutual Funds Governance

requirement Currently required Proposed

requirement Required by

statute or SEC rule a

ICI recommended

best practice

Board must have a majority of independent directors

X X X Independent directors must be responsible for nominating new
independent directors

X X X Audit committee must consist of only independent directors b X X X
Standards that define

who qualifies as an independent director c X X XX Independent directors

required to meet separately in executive sessions

X X Source: GAO analysis of ICI Best Practices, 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 regulators and data from industry participants that we
obtained, many mutual funds have implemented many of the practices that
are being recommended for public companies. As shown in table 2 above,
many of these practices are already required for many funds by SEC
regulation or are recommended by ICI as a best practice. 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. ICI already advocates this
practice in its 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

Page 10 GAO- 03- 909T Mutual Fund Disclosures

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.

However, not all of these sound corporate governance practices are
currently mandatory for mutual funds. For example, if a fund does not take
advantage of any of the exemptive rules that SEC cited in requiring
certain corporate governance practices, such a fund may not already be
following these practices. In addition, some of the reforms advocated by

ICI*s best practices and by those advocating change for public companies
are not currently required for mutual funds. H. R. 2420 would make these
and other practices mandatory for all funds, which would ensure consistent
implementation of the practices across the industry.

One mutual fund distribution practice* called revenue sharing* that has
become increasingly common involves mutual fund investment advisers making
additional payments beyond those made under 12b- 1 plans to broker-
dealers that sell fund shares. Approximately 80 percent of mutual fund
purchases are made through broker- dealers or other financial
professionals, such as financial planners and pension plan administrators.
To be compensated for providing advice and ongoing assistance to
investors, many of these financial professionals receive payments from the
mutual fund either through the sales charges paid up front by the investor
(called loads) or from ongoing fees that are deducted from the fund*s
assets. These fees are called 12b- 1 fees after the rule that allows fund
assets to be used to pay for fund marketing and distribution expenses.
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
brokerdealers to no more than 0.75 percent of a fund*s average net assets
per year. 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.

However, broker- dealers, whose extensive distribution networks and large
staffs of financial professionals who work directly with and make
investment recommendations to investors, have increasingly required mutual
funds to make additional payments to their firms beyond the sales loads
and 12b- 1 fees. These payments, called revenue sharing payments, come
from the adviser*s profits and may supplement distribution- related
Changes in Mutual

Fund Distribution Practices Raise Potential Conflicts of Interest Between
Broker- Dealers and Investors

Page 11 GAO- 03- 909T Mutual Fund Disclosures

payments from fund assets. 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. According to the officials of a
mutual fund research organization, about 80 percent of fund companies that
partner with major broker- dealers make cash revenue sharing payments. For
example, some broker- dealers have narrowed their offerings of funds or
created preferred lists that include the funds of just six or seven fund
companies that then become the funds that receive the most marketing by
these broker- dealers. In order to be selected as one of the preferred
fund families on these lists, the mutual fund adviser often is required to
compensate the broker- dealer firms with revenue sharing payments.

One of the concerns raised about revenue sharing payments is the effect on
overall fund expenses. A 2001 research organization report on fund
distribution practices noted that the extent to which revenue sharing
might affect other fees that funds charge, such as 12b- 1 fees or
management fees, was uncertain. For example, the report noted that it was
not clear whether the increase in revenue sharing payments increased any
fund*s fees, but also 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 paid from the adviser*s profits. In the course of reviewing
advisory contracts, fund directors consider the adviser*s profits not
taking into account marketing and distribution expenses, which also could
prevent advisers from shifting 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, revenue sharing arrangements
might unduly focus the attention of broker- dealers on particular mutual
funds, reducing the number of funds considered as part of an investment
decision potentially leading to inferior investment choices and
potentially reducing fee competition among funds. Finally, concerns have
been raised

that revenue sharing arrangements might 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.

Although revenue sharing payments can create conflicts of interest between
broker- dealers and their clients, the extent to which broker-

Page 12 GAO- 03- 909T Mutual Fund Disclosures

dealers disclose to their clients that their firms receive such payments
from 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 10b- 10 requirements by providing
customers with written *confirmations,* the rule does not specifically
require brokerdealers to provide the required information about third-
party 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 would not receive a confirmation and
might not view a prospectus until after purchasing mutual fund shares.

As a result of these concerns, our report recommends that SEC evaluate
ways to provide more information to investors about the revenue sharing
payments that funds make to broker- dealers. 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. This recommendation is consistent with
the requirement in H. R. 2420 that mandates that SEC require mutual funds
to further disclose revenue sharing payments and make annual or more
frequent reports of such payments to fund boards of directors.

Soft dollar arrangements allow fund investment advisers to obtain research
and brokerage services that could potentially benefit fund investors but
could also increase investors* costs. When investment advisers buy or sell
securities for a fund, they may have to pay the brokerdealers that execute
these trades a commission using fund assets. 5 In return for these
brokerage commissions, many broker- dealers provide advisers with a bundle
of services, including trade execution, access to analysts and traders,
and research products.

Some industry participants argue that the use of soft dollars benefits
investors in various ways. The research that the fund adviser obtains can

5 Instead of commissions, broker- dealers executing trades also could be
compensated through markups or spreads. Soft Dollar Arrangements Provide

Benefits, but Could Adversely Impact Investors

Page 13 GAO- 03- 909T Mutual Fund Disclosures

directly benefit a fund*s investors if the adviser uses it to select
securities for purchase or sale by the fund. The prevalence of soft dollar
arrangements also allows specialized, independent research to flourish,
thereby providing money managers a wider choice of investment ideas. As a
result, this research could contribute to better fund performance. The
proliferation of research available as a result of soft dollars might also
have other benefits. For example, an investment adviser official told us
that the research on smaller companies helps create a more efficient
market for such companies* securities, resulting in greater market
liquidity and lower spreads, which would benefit all investors including
those in

mutual funds. Although the research and brokerage services that fund
advisers obtain through the use of soft dollars could benefit a mutual
fund investor, this practice also could increase investors* costs and
create potential conflicts of interest that could harm fund investors. 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. One academic
study shows that trades executed by broker- dealers that specialize in
providing soft dollar products and services tend to be more expensive than
those executed through other broker- dealers, including full- service
brokerdealers. 6 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 are not paying for it directly. In
turn, advisers might have less incentive to negotiate lower commissions,
resulting in investors paying more for trades.

Under the Investment Advisers Act of 1940, advisers must disclose details
of their soft dollar arrangements in Part II of Form ADV, which investment
advisers use to register with SEC and must send to their advisory clients.
However, this form is not provided to the shareholders of a mutual fund,
although the information about the soft dollar practices that the adviser
uses for particular funds are required to be included in the Statement of
Additional Information that funds prepare, which is available to investors
upon request. Specifically, Form ADV requires advisers to describe the

6 J. S. Conrad, K. M Johnson, and S. Wahal, *Institutional Trading and
Soft Dollars* Journal of Finance, (February, 2001).

Page 14 GAO- 03- 909T Mutual Fund Disclosures

factors considered in selecting brokers and determining the reasonableness
of their commissions. 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 might pay commissions higher than those
obtainable from other brokers in return for those products.

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 mutual fund advisers. In
response, SEC staff issued a report that included 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 the recommendations could
increase the transparency of these arrangements and help fund directors
and investors better evaluate advisers* use of soft dollars, SEC has yet
to take action on some of these proposed recommendations.

As a result, our report recommends that SEC evaluate ways to provide
additional information to fund directors and investors on their fund
advisers* use of soft dollars. SEC relies on disclosure of information as
a primary means of addressing potential conflicts between investors and
financial professionals. However, because SEC has not acted to more fully
address soft dollar- related concerns, 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. If H. R. 2420 is enacted, investors and fund directors would get
more information to allow them to make these evaluations. Also, the study
that H. R. 2420 would require SEC to conduct of soft dollars would likely
provide SEC with valuable information to allow it to best decide the form
of these disclosures and whether any other changes to soft dollar
practices are warranted.

This concludes my prepared statement and I would be happy to respond to
questions.

(250152)

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