Mutual Funds: Additional Disclosures Could Increase Transparency 
of Fees and Other Practices (27-JAN-04, GAO-04-317T).		 
                                                                 
Concerns have been raised over whether the disclosures of mutual 
fund fees and other fund practices are sufficiently fair and	 
transparent to investors. Our June 2003 report, Mutual Funds:	 
Greater Transparency Needed in Disclosures to Investors, GAO-03- 
763, 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. This testimony summarizes the results
of our report and discusses certain events that have occurred	 
since it was issued.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-317T					        
    ACCNO:   A09159						        
  TITLE:     Mutual Funds: Additional Disclosures Could Increase      
Transparency of Fees and Other Practices			 
     DATE:   01/27/2004 
  SUBJECT:   Fees						 
	     Information disclosure				 
	     Investments					 
	     Mutual funds					 
	     Expenses						 

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GAO-04-317T

United States General Accounting Office

GAO Testimony

Before the Subcommittee on Financial Management, the Budget and
International Security, Committee on Governmental Affairs, U.S. Senate

For Release on Delivery

Expected at 10:00 a.m. EST MUTUAL FUNDS

Tuesday, January 27, 2004

 Additional Disclosures Could Increase Transparency of Fees and Other Practices

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

GAO-04-317T

Highlights of GAO-04-317T, a testimony to the Chairman, Subcommittee on
Financial Management, the Budget and International Security, Committee on
Governmental Affairs, U.S. Senate

Concerns have been raised over whether the disclosures of mutual fund fees
and other fund practices are sufficiently fair and transparent to
investors. Our June 2003 report,

Mutual Funds: Greater Transparency Needed in Disclosures to Investors,
GAO-03763, 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. This testimony summarizes
the results of our report and discusses certain events that have occurred
since it was issued.

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 generally agreed with the contents of our 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 and other disclosures.

www.gao.gov/cgi-bin/getrpt?GAO-04-317T.

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 [email protected].

January 27, 2004

MUTUAL FUNDS

Additional Disclosures Could Increase Transparency of Fees and Other Practices

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, 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 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,
making 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. Over time the use of these fees has
evolved 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, these payments may cause the broker-dealers receiving them to
limit the fund choices they offer to investors and conflict with their
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.

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 disclosures of mutual fund practices. The
fees and other costs that mutual fund investors pay as part of owning fund
shares can significantly affect their investment returns. In addition,
changes over time in how mutual funds pay intermediaries to sell fund
shares have also raised concerns. 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 report entitled Mutual Funds:
Greater Transparency Needed in Disclosures to Investors, GAO-03-763
(Washington, D.C.: June 9, 2003). Specifically, I will discuss (1) mutual
fund fee disclosures and opportunities for improving these disclosures,
(2) the potential conflicts that arise when mutual fund advisers pay
broker-dealers to sell fund shares, and (3) the benefits and concerns over
fund advisers' use of soft dollars. I will also provide information
relating to certain events that have occurred since our June 2003 report
was issued.

In summary:

The results of our work suggest a need to consider ways to increase the
transparency of mutual fund fees and other fund practices. 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. 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. 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 might not represent a
large outlay on a per investor basis. 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.

The work that we conducted for our report also found that 12b-1 fees,
which allow fund companies to deduct certain distribution expenses such as
sales commissions from fund assets, can raise costs to investors but also
provide additional ways for investors to pay for investment advice. Our
work 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 of 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 broker-dealers 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. Our report recommends that more
disclosure be made to investors about any revenue sharing payments their
broker-dealers are receiving. On January 14, 2004, SEC proposed new rules
and rule amendments designed to enhance the information that
broker-dealers provide to their customers concerning conflicts of interest
that arise from the sale of mutual funds.

We also reviewed a practice known as soft dollars, in which 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.
These soft dollar arrangements can result in mutual fund advisers
obtaining research or other services, including research 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. Our report recommends 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.

Finally, since September 2003, federal and state authorities' widening
investigation of illegal late trading and improper timing of fund trades
has involved a growing number of prominent mutual fund companies and
brokerage firms. To address these abusive practices, regulators are
considering the merits of various proposals that have been put forth. In
addition, in November 2003, the House of Representatives acted on
legislation that addresses abusive trading and various other mutual fund
issues and legislation was introduced in the Senate. The House of
Representatives passed H.R. 2420, the Mutual Funds Integrity and Fee
Transparency Act of 2003. H.R. 2420's purpose is to (1) improve
transparency of mutual fund fees and costs and (2) improve corporate
governance and management integrity of mutual funds. Also in November
2003, three bills addressing mutual fund concerns were introduced in the
Senate. The Mutual Fund Transparency Act of 2003, S. 1822, would require
disclosure of financial relationships between brokers and mutual fund
companies and of certain brokerage commissions paid by mutual fund
companies. S. 1958, the Mutual Fund Investor Protection Act of 2003, was
introduced to prevent the practice of late trading by mutual funds, and
for other purposes. S. 1971, the Mutual Fund Investor Confidence
Restoration Act of 2003 seeks to improve transparency relating to the fees
and costs that mutual fund investors incur and to improve corporate
governance of mutual funds.

Although mutual funds already disclose considerable information about the
fees they charge, our report recommends 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 investors could expect to pay in fees if they invested
$10,000 in a fund and held it for various periods. It is important to
understand the fees charged by a mutual fund because fees can
significantly affect investment returns of the fund over the long term.
For example, over a 20-year period a $10,000 investment in a fund earning
8 percent annually, with a 1-percent expense ratio, would be worth
$38,122; but with a 2-percent expense ratio it would be worth $31,117-over
$7,000 less.

  Additional Disclosure of Mutual Fund Costs Might Benefit Investors

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.

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 When the provider has the right to deduct fees and other
services provided charges directly from the investor's account, the dollar
amounts
to individual of such charges are required to be disclosed to the
investor.
investment
accounts (such as
those managed by
a financial planner)

Wrap accountsa	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.

aIn 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.

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 the disclosures in funds'
annual and semiannual reports, SEC staff also indicated 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, the
Investment Company Institute (ICI) indicated that, to shareholders, the
account statement is probably the most important communication that they
receive

1"Shareholder Reports and Quarterly Portfolio Disclosure of Registered
Management Investment Companies, Securities and Exchange Commission,"
Release Nos. 33-8164; 3447023; IC-2587068 (Dec. 18, 2002).

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 for the record
to the Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises, House Committee on Financial Services, ICI
commissioned a large accounting firm to survey mutual fund companies about
the costs of 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 the
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 0.0038 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

2U.S. General Accounting Office, Mutual Funds: Information on Trends in
Fees and Their Related Disclosure, GAO-03-551T (Washington, D.C.: Mar. 12,
2003).

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
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. In September 2003, SEC amended fund advertising rules, which
require funds to state in advertisements that investors should consider a
fund's fees before investing and directs investors to consult their funds'
prospectus.4 However, also including this information in the quarterly
statement could increase investor awareness of the impact that fees have
on their mutual fund's returns. H.R. 2420 would require that funds
disclose in the quarterly statement or other appropriate shareholder
report an estimated amount of the fees an investor would have to pay on
each investment of $1,000. S. 1958, like H.R. 2420, would require
disclosure of fees paid on each $1,000 invested. S. 1971, among other
disclosures, would require that funds disclose the actual cost borne by
each shareholder for the operating expenses of the fund.

SEC's current proposal, while offering some advantages, does not make
mutual funds comparable to other products and provide information in the

3To determine these amounts, we used the operating expense ratios that ICI
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
0.0038 percent would therefore add $1.07 to this amount.

4Final Rule: Amendments to Investment Company Advertising Rules,
Securities and Exchange Commission, Release Nos. 33-8294; 34-48558;
IC-26195 (Sep. 29, 2003).

document that is most relevant to investors-the quarterly account
statement. Our report recommends that SEC consider requiring additional
disclosures relating to fees be made to investors in the account
statement. In addition to providing specific dollar disclosures, we also
noted that investors could be provided with a variety of other disclosures
about the fees they pay on mutual funds that would have a range of
implementation costs, including some that would be less costly than
providing specific dollar disclosures. However, seeing the specific dollar
amount paid on shares owned 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 these documents and the account statements, which would
provide both prospective and existing investors in mutual funds access to
valuable information about the costs of investing in funds.

Disclosures of Trading Costs Could Benefit Investors

Academics and other industry observers have also called for increased
disclosure of mutual fund brokerage commissions and other trading costs
that are not currently included in fund expense ratios. In an academic
study we reviewed that looked at brokerage commission costs, the authors
urged that investors pay increased attention to such costs.5 For example,
the study noted that investors seeking to choose their funds on the basis
of expenses should also consider reviewing trading costs as relevant
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' Statement of Additional Information.6

5J.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).

6M. Livingston and E.S. O'Neal, "Mutual Fund Brokerage Commissions,"
Journal of Financial Research (Summer 1996).

Mutual fund officials 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
brokerdealers 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. 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 agreed upon 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.

To improve the disclosure of trading costs to investors, the House-passed
H.R. 2420 would require mutual fund companies to make more prominent their
portfolio turnover disclosure which, by measuring the extent to which the
assets in a fund are bought and sold, provides an indirect measure of
transaction costs for a fund. The bill directs funds to include this
disclosure in a document that is more widely read than the prospectus or
Statement of Additional Information, and would require fund companies to
provide a description of the effect of high portfolio turnover rates on
fund expenses and performance. H.R 2420 also requires SEC to issue a
concept release examining the issue of portfolio transaction costs. S.
1822 would require mutual funds to disclose brokerage commissions as part
of fund expenses. S. 1958 would require SEC to issue a concept release on
disclosure of portfolio transaction costs. S. 1971 would require funds to
disclose the estimated expenses paid for costs associated with

  Changes in Some Fund Distribution Practices Likely Beneficial But Others Raise
  Potential Conflicts of Interest

management of the fund that reduces the funds overall value, including
brokerage commissions, revenue sharing and directed brokerage
arrangements, transactions costs and other fees. In December 2003, SEC
issued a concept release to solicit views on how SEC could improve the
information that mutual funds disclose about their portfolio transaction
costs.7

The way that investors pay for the advice of financial professionals about
their mutual funds has evolved over time. Approximately 80 percent of
mutual fund purchases are made through broker-dealers or other financial
professionals, such as financial planners and pension plan administrators.
Previously, the compensation that these financial professionals received
for assisting investors with mutual fund purchases were paid by either
charging investors a sales charge or load or by paying for such expenses
out of the investment adviser's own profits.

However, in 1980, SEC adopted 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 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. 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. Rule
12b-1 provides investors

7Concept Release: Request for Comments on Measures to Improve Disclosure
of Mutual Fund Transaction Costs, release Nos. 33-8349; 34-48952;
IC-26313; File No. S7-29-03 (Dec. 19, 2003).

an alternative way of paying for investment advice and purchases of fund
shares. 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 12b-1
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 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 assetbased
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.

Although providing alternative means for investors to pay for the advice
of financial professionals, some concerns exist over the impact of 12b-1
fees on investors' costs. For example, our June 2003 report discussed
academic studies that found that funds with 12b-1 plans had higher
management fees and expenses. 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. For example, SEC
recently brought a case against a major broker dealer that it accused of
inappropriately selling mutual fund B shares, which have higher 12b-1
fees, to investors who would have been better off purchasing A shares that
had much lower 12b-1 fees. Also, 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 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.

Revenue Sharing Raises Conflict of Interest Concerns

One mutual fund distribution practice-called revenue sharing-that has
become increasingly common raises potential conflicts of interest between
broker-dealers and their mutual fund investor customers. 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 compensate 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 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 brokerdealers
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. To address revenue sharing issues, we were pleased to see that a
recent NASD rule proposal would require broker-dealers to disclose in
writing when the customer first opens an account or purchases mutual fund
shares compensation that they receive from fund companies for providing
their funds "shelf space" or preference over other funds. On January 14,
2004, SEC proposed new rules and rule amendments designed to enhance the
information that broker-dealers provide to their customers. H.R. 2420
would require fund directors to review revenue sharing arrangements
consistent with their fiduciary duty

to the fund. H.R. 2420 also would require funds to disclose revenue
sharing arrangements and require brokers to disclose whether they have
received any financial incentives to sell a particular fund or class of
shares. S. 1822 would require brokers to disclose in writing any
compensation received in connection with a customer's purchase of mutual
fund shares. S. 1971 would require fund companies and investment advisers
to fully disclose certain sales practices, including revenue sharing and
directed brokerage arrangements, shareholder eligibility for breakpoint
discounts, and the value of research and other services paid for as part
of brokerage commissions.

  Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact
  Investors

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. 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
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.8 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
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 its proposed recommendations.

8J.S. Conrad, K.M Johnson, and S. Wahal, "Institutional Trading and Soft
Dollars," Journal of Finance (February 2001).

As a result, our June 2003 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.

To address the inherent conflicts of interest with respect to soft dollar
arrangements, H.R. 2420 would

o  	require SEC to issue rules mandating disclosure of information about
soft dollar arrangements;

o  	require fund advisers to submit to the fund's board of directors an
annual report on these arrangements, and require the fund to provide
shareholders with a summary of that report in its annual report to
shareholders;

o  	impose a fiduciary duty on the fund's board of directors to review
soft dollar arrangements;

o  	direct SEC to issue rules to require enhanced recordkeeping of soft
dollar arrangements; and

o  	require SEC to conduct a study of soft-dollar arrangements, including
the trends in the average amounts of soft dollar commissions, the types of
services provided through these arrangements, the benefits and
disadvantages of the use of soft dollar arrangements, the impact of soft
dollar arrangements on investors' ability to compare the expenses of
mutual funds, the conflicts of interest created by these arrangements and
the effectiveness of the board of directors in managing such conflicts,
and the transparency of soft dollar arrangements.

S. 1822 would discourage use of soft dollars by requiring that funds
calculate their value and disclose it along with other fund expenses. S.
1971 also would require disclosure of soft dollar arrangements and the
value of the services provided. Also, it would require that SEC conduct a
study of the use of soft dollar arrangements by investment advisers.

  Various Scandals Involving Mutual Funds Surfaced in 2003

Since we issued our report in June 2003, various allegations of misconduct
and abusive practices involving mutual funds have come to light. In early
September 2003, the Attorney General of the State of New York filed
charges against a hedge fund manager for arranging with several mutual
fund companies to improperly trade in fund shares and profiting at the
expense of other fund shareholders. Since then federal and state
authorities' widening investigation of illegal late trading and improper
timing of fund trades has involved a growing number of prominent mutual
fund companies and brokerage firms.

The problems involving late trading arise when some investors are able to
purchase or sell mutual fund shares after the 4:00 pm Eastern Time close
of U.S. securities markets, the time at which funds price their shares.
Under current mutual fund regulations, orders for mutual fund shares
received after 4:00 pm are required by regulation to be priced at the next
day's price.9 An investor permitted to engage in late trading could be
buying or selling shares at the 4:00 pm price knowing of developments in
the financial markets that occurred after 4:00 pm, thus unfairly taking
advantage of opportunities not available to other fund shareholders.
Clearly, to ensure compliance with the law, funds should have effective
internal controls in place to prevent abusive late trading. Regulators are
considering a rule change requiring that an order to purchase or redeem
fund shares be received by the fund, its designated transfer agent, or a
registered securities clearing agency, by the time that the fund
establishes for calculating its net asset value in order to receive that
day's price.

The problems involving market timing occur when certain fund investors are
able to take advantage of temporary disparities between the share value of
a fund and the values of the underlying assets in the fund's portfolio.
For example, such disparities can arise when U.S. mutual funds use old
prices for their foreign assets even though events have occurred overseas
that will likely cause significant movements in the prices of those assets
when their home markets open. Market timing, although not illegal, can be
unfair to funds' long-term investors because it provides the opportunity
for selected fund investors to profit from fund assets at the expense of
fund long-term investors. To address these issues, regulators are
considering the merits of various proposals that have been put forth to

9SEC rule 22c-1, promulgated under the Investment Company Act of 1940,
prohibits the purchase or sale of mutual fund shares except at a price
based on current net asset value of such shares that is next calculated
after receipt of a buy or sell order.

discourage market timing, such as mandatory redemption fees or fair value
pricing of fund shares.10

To protect fund investors from such unfair trading practices H.R. 2420
would, with limited exceptions, require that all trades be placed with
funds by 4:00 pm and includes provisions to eliminate conflicts of
interest in portfolio management, ban short-term trading by insiders,
allow higher redemption fees to discourage short-term trading, and
encourage wider use of fair value pricing to eliminate stale prices that
makes market timing profitable. S. 1958 would require that fund companies
receive orders prior to the time they price their shares. S. 1958 would
also increase penalties for late trading and require funds to explicitly
disclose their market timing policies and procedures. S.1971 also would
restrict the placing of trades after hours, require funds to have internal
controls in place and compliance programs to prevent abusive trading, and
require wider use of fair value pricing.

In conclusion, GAO believes that various changes to current disclosures
and other practices would benefit fund investors. Additional disclosures
of mutual fund fees could help increase the awareness of investors of the
fees they pay and encourage greater competition among funds on the basis
of these fees. Likewise, better disclosure of the costs funds incur to
distribute their shares and of the costs and benefits of funds' use of
soft dollar research activities could provide investors with more complete
information to consider when making their investment decision. In light of
recent scandals involving late trading and market timing, various reforms
to mutual fund rules will also likely be necessary to better protect the
interests of all mutual fund investors.

10Fair value pricing is a process that mutual funds use to value fund
shares in the absence of current market values, such as for assets traded
in foreign markets.

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

  Contacts and

For further information regarding this testimony, please contact Cody J.
Goebel at (202) 512-8678. Individuals making key contributions to this
Acknowledgements testimony include Toayoa Aldridge and David Tarosky.

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