    Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition
    (Chapter Report, 06/07/2000, GAO/GGD-00-126).

    Pursuant to a congressional request, GAO reviewed issues relating to
    mutual fund fees, focusing on: (1) the trend in mutual fund advisers'
    costs and profitability; (2) the trend in mutual fund fees; (3) how
    mutual funds compete; (4) how fees are disclosed to fund investors and
    how industry participants view these disclosures; and (5) what mutual
    fund directors' responsibilities are regarding fees and how industry
    participants view directors' activities.

    GAO noted that: (1) GAO was unable to determine the extent to which the
    growth of mutual fund assets during the 1990s provided the opportunity
    for mutual fund advisers to reduce fees on the funds they operated; (2)
    according to research, mutual fund advisers experience operational
    efficiencies as their assets grow that could allow them to reduce their
    funds' expense ratios; (3) because information on most fund advisers'
    costs is not collected by regulators or otherwise publicly disclosed,
    GAO was unable to determine if advisers' costs had increased more, or
    less, rapidly than fund assets; (4) GAO determined that the 480 percent
    growth in total fee revenues for advisers and other service providers
    for stock and bond funds commensurate with the total 490 percent asset
    growth in those funds during the period 1990 to 1998; (5) because of the
    unavailability of comprehensive financial and cost information, GAO was
    unable to determine overall industry profitability; (6) although unable
    to measure the extent to which mutual fund advisers experienced
    economies of scale, GAO's analysis indicated that mutual fund expense
    ratios for stock funds had generally declined between 1990 and 1998; (7)
    however, this decline did not occur consistently over this period, and
    not all funds had reduced their expense ratios; (8) GAO found that not
    all of the largest funds with the greatest asset growth had reduced
    their fees; (9) while thousands of mutual funds compete actively for
    investor dollars, competition in the mutual fund industry may not be
    strongly influencing fee levels because fund advisers generally compete
    on the basis of performance or services provided rather than on the
    basis of the fees they charge; (10) requiring that investors be provided
    information about the fees they pay on their mutual funds is another way
    regulators seek to help investors evaluate fees charged by mutual funds;
    (11) although most industry officials GAO interviewed considered mutual
    fund disclosures to be extensive, others indicated that the information
    currently provided does not sufficiently make investors aware of the
    level of fees they pay; (12) under the law, mutual fund directors are
    expected to review various data to ensure that the fees are not
    excessive and that the fees are similar to those of comparable funds;
    and (13) however, industry participants commented that directors'
    activities may be keeping fees at higher levels because of the focus on
    maintaining fees within range of other funds.

    --------------------------- Indexing Terms -----------------------------

     REPORTNUM:  GGD-00-126
         TITLE:  Mutual Fund Fees: Additional Disclosure Could Encourage
    	     Price Competition
          DATE:  06/07/2000
       SUBJECT:  Securities regulation
    	     Brokerage industry
    	     Information disclosure
    	     Investments
    	     Competition
    	     Mutual funds
    	     Fees

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    United States General Accounting Office
    GAO

    Report to the Chairman, Subcommittee on Finance

    and Hazardous Materials; and the Ranking Member,

    Committee on Commerce, House of Representatives

    June 2000

    GAO/GGD-00-126

    MUTUAL FUND FEES
    Additional Disclosure Could Encourage Price

    Competition

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    Contents
    Page 201           GAO/GGD-00-126 Mutual Fund Fees
    Executive Summary                                                           4

    Chapter 1                                                                  24
    Introduction
                               Background                                      24
                               Objectives, Scope, and Methodology              30

    Chapter 2                                                                  33
    Data Inadequate For
    Determining How Asset
    Growth Affected Adviser
    Costs
                               Fund Asset Growth Expected to Produce           33
                               Economies of Scale
                               Cost Data Not Generally Available for           36
                               Mutual Fund Advisers' Overall
                               Operations
                               Fund and Other Industry Officials               37
                               Report that Mutual Fund Operating
                               Costs Have Risen
                               Asset Growth Has Varying Effects on             41
                               Fund Advisers' Costs
                               Fee Revenues Have Increased                     42
                               Significantly
                               Data for Some Mutual Fund Advisers              44
                               Indicates Profitability Has Been
                               Increasing

    Chapter 3                                                                  46
    Mutual Fund Operating
    Expense Ratios Generally
    Declined
                               Studies Also Find Mixed Trend in Fees           46
                               Across Industry
                               Largest Mutual Funds Generally Grew             48
                               Faster Than Industry Average
                               Among Largest Funds, Average Expense            48
                               Ratios Declined for Stock Funds but
                               Less so for Bond Funds
                               Asset Growth Usually Resulted in Lower          50
                               Expense Ratios but Not All Funds Made
                               Reductions

    Chapter 4                                                                  56
    Competition in Mutual
    Fund Industry Does Not
    Focus on Fees
                               Mutual Fund Industry Exhibits                   56
                               Characteristics of Monopolistic
                               Competition
                               Mutual Fund Industry Generally Does             62
                               Not Attempt to Compete On Basis of
                               Fees

    Chapter 5                                                                  66
    Mutual Funds Are Not
    Required to Disclose
    Actual Amounts Charged
    to Individual Investors
                               Required Fee Disclosures Do Not                 66
                               Provide Amounts Paid by Individual
                               Investors in Dollars
                               Charges for Other Financial Services            70
                               Typically Disclosed in Dollars
                               Mutual Fund Fees Are Not a Primary              72
                               Consideration for Investors
                               Opinions Varied on Adequacy of Current          76
                               Fee Disclosures

    Chapter 6                                                                  82
    Mutual Fund Directors
    Required to Review Fees
                               Mutual Funds' Organizational Structure          82
                               Embodies Conflict of Interest Over
                               Fees
                               Mutual Fund Directors Have Specific             87
                               Responsibilities Regarding Fees
                               Opinions on Boards' Effectiveness in            92
                               Overseeing Fees Vary

    Chapter 7                                                                  96
    Conclusions and
    Recommendations
                               Conclusions                                     96
                               Recommendations                                 97
                               Agency and Industry Comments and Our            98
                               Evaluation

    Appendixes                 Appendix I: Comments From the                  102
                               Securities and Exchange Commission
                               Appendix II: Comments From the                 111
                               National Association of Securities
                               Dealers Regulation, Inc.
                               Appendix III: Comments From the                117
                               Investment Company Institute
                               Appendix IV: GAO Contacts and Staff            125
                               Acknowledgments

    Tables                     Table 1: Total Assets for Stock and              9
                               Bond Mutual Fund as of 1998
                               Table 2:  Estimated Mutual Fund                 10
                               Adviser and Service Provider Revenues
                               From Operating Expense Fees 1990-1998
                               Table 3:  Average Expense Ratio for 77          11
                               Largest Stock and Bond Funds From
                               1990 to 1998 in Dollars Per $100 of
                               Fund Assets
                               Table 4: Fee Reductions by Large Funds          12
                               Whose Asset Growth Exceeded 500
                               Percent From 1990 to 1998
                               Table 1.1: Growth in Mutual Fund                25
                               Assets, 1990-1998
                               Table 2.1: Source of Asset Growth for           35
                               All Stock and Bond Funds From 1990 to
                               1998
                               Table 2.2: Growth in Mutual Fund                42
                               Assets and Estimated Fund Adviser and
                               Other Service Provider Fee Revenues
                               1990-1998
                               Table 2.3: Assets and Fee Revenues for          43
                               77 Largest Mutual Funds for 1990-1998
                               Table 2.4: Average Fees Collected For           44
                               Stock and Bond Funds In Dollars Per
                               Account from 1990 to 1997
                               Table 2.5: Change in Revenue and                45
                               Expenses From Prior Year and
                               Resulting Operating Margin for Public
                               Asset Management Companies
                               Table 3.1: Average Size of Stock and            48
                               Bond Mutual Funds from 1990 to 1998
                               Table 3.2: Asset-Weighted Average               50
                               Operating Expense Ratios for 77
                               Largest Stock and Bond Funds From
                               1990 to 1998 in Dollars Per $100 of
                               Fund Assets
                               Table 3.3: Change in Operating Expense          50
                               Ratios Charged by 77 Largest Stock
                               and Bond Funds 1990-1998
                               Table 3.4: Relationship of Asset                52
                               Growth and Change in Operating
                               Expense Ratios for Largest Stock
                               Funds 1990-1998
                               Table 3.5: Relationship of Asset                52
                               Growth and Change in Operating
                               Expense Fees for Largest Bond Funds
                               1990-1998
                               Table 3.6: Change in Average Size in            55
                               Assets and Operating Expense Ratios
                               from 1990 to 1998 for Largest Funds
                               by Relative Fee in 1990
                               Table 5.1: Fee Disclosure Practices             71
                               for Selected Financial Services or
                               Products
                               Table 5.2: Sales of Mutual Funds for            75
                               Select Years 1984 to 1998 by Type of
                               Distribution Method

    Figures                    Figure 3.1: Average Expense Ratios for          49
                               77 Largest Stock and Bond Mutual
                               Funds From 1990 to 1998
                               Figure 3.2: Average Operating Expense           54
                               Ratio From 1990 to 1998 for Funds
                               With Above and Below Average Fees in
                               1990
                               Figure 4.1:  Number of Mutual Funds             58
                               from 1984 to 1998
                               Figure 4.2: Number of Mutual Fund               59
                               Famillies for Selected Years From
                               1984 Through 1998
                               Figure 5.1: Example of a Fee Table              68
                               Required as Part of Mutual Fund Fee
                               Disclosures
                               Figure 6.1: Comparison of                       84
                               Organizational Structure of Typical
                               Corporation and Typical Mutual Fund
                               Figure 6.1: Continued                           85

    Abbreviations

    ICI       Investment Company Institute
    NASD      National Association of Securities
    Dealers
    NASDR     NASD Regulation
    NAV       net asset value
    SEC       Securities and Exchange Commission
    CDSL      contingent deferred sales load

     MUTUAL FUND FEES  Additional Disclosure Could Encourage Price Competition        GAO/GGD-00-126
    B-281444
    Page 2                         GAO/GGD-00-126 Mutual Fund Fees
    B-281444

    June 5, 2000

    The Honorable John D. Dingell
    Ranking Minority Member
    Committee on Commerce
    House of Representatives

    The Honorable Michael G. Oxley
    Chairman, Subcommittee on
       Finance and Hazardous Materials
    Committee on Commerce
    House of Representatives

    This report presents the results of our review of issues
    relating to mutual fund fees. Assets in mutual funds have
    grown significantly during the 1990s. However, conflicting
    views existed as to whether the fees that funds charge
    investors had declined as would have been expected given the
    operational efficiencies that mutual fund advisers likely
    experience as their fund assets grow. As you requested, we
    reviewed (1) the trend in mutual fund advisers' costs and
    profitability, (2) the trend in mutual fund fees, (3) how
    mutual funds compete, (4) how their fees are disclosed to
    investors, and (5) the responsibilities that mutual fund
    directors have regarding fees.

    This report recommends that the Chairman of the Securities and
    Exchange Commission (SEC) require that the quarterly account
    statements that mutual fund investors receive include
    information on the specific dollar amount of each investors'
    share of the operating expenses that were deducted from the
    value of the shares they own. Because these calculations could
    be made various ways, SEC should also consider the costs and
    burdens that various alternative means of making such
    disclosures would place on either (1) the industry or (2)
    investors as part of evaluating the most effective way of
    implementing this recommendation. In addition, where the form
    of these statements is governed by rules of the National
    Association of Securities Dealers, SEC should ensure that this
    organization requires mutual funds to make such disclosures.

    As agreed with you, unless you publicly release its contents
    earlier, we plan no further distribution of this report until
    30 days from its issue date. At that time, we will provide
    copies to interested Members of Congress, appropriate
    congressional committees, SEC, the National Association of
    Securities Dealers, the Office of the Comptroller of the
    Currency, the Federal Deposit Insurance Corporation, and the
    Board of Governors of the Federal Reserve System.

    Key contributors to this report are listed in appendix IV. If
    you have any questions, please call me at (202) 512-8678.

    Thomas J. McCool
    Director, Financial Institutions
      and Market Issues

    Executive Summary

    Page 11            GAO/GGD-00-126 Mutual Fund Fees
    Purpose
    The U.S. mutual fund industry, which offers
    investors an easy way to invest in diversified
    portfolios of stocks, bonds, or other securities,
    has grown dramatically, with assets rising from
    $371 billion in 1984 to $5.5 trillion in 1998. As
    of 1998, the proportion of U.S. households owning
    mutual funds had risen to 44 percent; and the
    returns on mutual funds, particularly those
    invested in stocks, had also generally exceeded
    those that could have been earned on savings
    accounts or certificates of deposit. Because
    mutual funds are expected to operate more
    efficiently as their assets grow, the significant
    asset growth in recent years has prompted concerns
    about fund fee levels. Academics, industry
    researchers, and others have also raised questions
    about whether competition, fund disclosures, and
    mutual fund directors are sufficiently affecting
    the level of fees

    In response to requests by the Chairman of the
    Subcommittee on Finance and Hazardous Materials,
    House Committee on Commerce, and the Ranking
    Minority Member of the Committee on Commerce, GAO
    conducted a review of the mutual fund industry to
    determine (1) the trend in mutual fund advisers'
    costs and profitability, (2) the trend in mutual
    fund fees, (3) how mutual funds compete, (4) how
    fees are disclosed to fund investors and how
    industry participants view these disclosures, and
    (5) what mutual fund directors' responsibilities
    are regarding fees and how industry participants
    view directors' activities.

    Background
    Mutual funds can be grouped into three basic types
    by the securities in which they invest. These
    include stock, (also called equity) funds, which
    invest in the common and preferred stock issued by
    public corporations; bond funds, which invest in
    debt securities; and money market funds, which
    generally invest in interest-bearing securities
    maturing in a year or less. Funds that invest in a
    combination of stocks, bonds, and other
    securities, known as hybrid funds, are included in
    this report under the category of stock funds.

    Mutual funds are distinct legal entities owned by
    the shareholders of the fund. Each fund contracts
    separately with an investment adviser, who
    provides portfolio selection and administrative
    services to the fund. The fund's directors, 1 who
    are responsible for reviewing fund operations,
    oversee the interests of the shareholders and the
    services provided by the adviser.

         Mutual fund fees that investors pay include
    operating expenses, which cover the day-to-day
    costs of running a fund. These expenses are
    accrued daily, and generally paid monthly, from
    overall fund assets rather than from individual
    investor accounts. The difference between the
    value of the securities in a fund's portfolio and
    its accrued liabilities represents the daily net
    asset value, or NAV, of fund shares. Generally
    shown as a percentage of the fund's average net
    assets, the annual total operating fee amount is
    referred to as the fund's operating expense ratio.
    The largest portion of a fund's expense ratio is
    generally the fund adviser's compensation, which
    is used to cover its operating costs and earn
    profits for its owners.

         Mutual fund investors may also incur other
    charges in addition to those included in the
    operating expense ratio, depending on how they
    purchase their funds. Mutual funds are sold
    through a variety of distribution channels. For
    instance, investors can buy them directly by
    telephone or mail; or they can be sold by
    dedicated sales forces or by third-party sales
    forces, such as broker-dealer account
    representatives. To compensate such sales
    personnel, some mutual funds charge investors
    sales charges (called loads), which can be paid at
    the time of purchase, over a specified period, or
    at time of redemption.

         Although a mutual fund's expense ratio
    appears to represent just a small percentage of
    its total assets, the impact of these fees can be
    significant. For example, increasing an expense
    ratio from 1 percent to 2 percent on a $10,000
    investment earning 8 percent annually can reduce
    an investor's total return by about $7,000 over a
    20-year period.

         Neither federal statute nor Securities and
    Exchange Commission (SEC) regulations, which
    govern the mutual fund industry, expressly limit
    the fees that mutual funds charge as part of their
    expense ratios. Instead, mutual fund regulations
    focus on ensuring that investors are provided
    adequate disclosure of the risks and costs of
    investing in mutual funds. The National
    Association of Securities Dealers, Inc. (NASD),
    whose rules govern the distribution of fund shares
    by broker-dealers, has placed certain limits on
    the sales charges and fees used to compensate
    sales personnel.

    Results in Brief
         GAO was unable to determine the extent to
    which the growth in mutual fund assets during the
    1990s provided the opportunity for mutual fund
    advisers to reduce fees on the funds they
    operated. According to research conducted by
    academics and others, as well as the industry
    participants GAO interviewed, mutual fund advisers
    experience operational efficiencies-or economies
    of scale-as their assets grow that could allow
    them to reduce their funds' expense ratios.2  Such
    efficiencies arise when the fund assets increase
    at a faster rate than do the costs of managing
    those additional assets. Because information on
    most fund advisers' costs is not collected by
    regulators or otherwise publicly disclosed, GAO
    was unable to determine if advisers' costs had
    increased more, or less, rapidly than fund assets.
    Industry officials reported that some costs of
    operating mutual funds have been increasing, in
    part, because funds have been expanding the level
    of services they provide investors. Using data
    provided by the mutual fund industry association,
    GAO determined that the 480 percent growth in
    total fee revenues for advisers and other service
    providers for stock and bond funds3 was
    commensurate with the total 490 percent asset
    growth in those fundsduring the period 1990 to
    1998. Because of the unavailability of
    comprehensive financial and cost information,
    however, GAO was unable to determine overall
    industry profitability.

         Although unable to measure the extent to
    which mutual fund advisers experienced economies
    of scale, GAO's analysis indicated that mutual
    fund expense ratios for stock funds had generally
    declined between 1990 and 1998. However, this
    decline did not occur consistently over this
    period, and not all funds had reduced their
    expense ratios. Because concerns had been raised
    over methodologies for existing mutual fund fee
    studies, GAO conducted its own analysis. GAO's
    analysis of data on the 77 largest mutual funds
    indicated that the expense ratios of these funds
    were generally lower in 1998 than they were in
    1990, although average expense ratios for stock
    funds rose in the early 1990s before declining.
    The extent to which expense ratios declined also
    varied across types of funds as the ratios for the
    largest stock funds declined while those for bond
    funds generally remained the same. Furthermore,
    GAO found that not all of the largest funds with
    the greatest asset growth had reduced their fees.
    Among the 77 large funds analyzed, 51 of these
    funds had experienced asset growth of at least 500
    percent from 1990 to 1998. Of these 51 funds, 38
    (or 74 percent) reduced their operating expense
    ratios by at least 10 percent over the 9-year
    period from 1990 to 1998. However, the remainder
    had not reduced their expense ratios as much,
    including six funds that either had not changed,
    or had increased, their ratios.

         As is customary for U.S. financial markets,
    regulators rely on competition to be a primary
    means of influencing the fees that mutual fund
    advisers charge. In general, industries where many
    firms compete for business generally have lower
    prices than industries where fewer firms compete.
    However, although thousands of mutual funds
    compete actively for investor dollars, competition
    in the mutual fund industry may not be strongly
    influencing fee levels because fund advisers
    generally compete on the basis of performance
    (measured by returns net of fees) or services
    provided rather than on the basis of the fees they
    charge.

         Requiring that investors be provided
    information about the fees they pay on their
    mutual funds is another way regulators seek to
    help investors evaluate fees charged by mutual
    funds. Mutual funds currently disclose information
    on fund operating expense ratios and other charges
    when investors make their initial purchases.
    However, unlike other financial products, the
    periodic disclosures to investors who continue to
    hold their shares do not show, in dollars, each
    investor's share of the operating expenses that
    were deducted from the fund.4 Although most
    industry officials GAO interviewed considered
    mutual fund disclosures to be extensive, others,
    including some private money managers and academic
    researchers, indicated that the information
    currently provided does not sufficiently make
    investors aware of the level of fees they pay.
    These critics have called for mutual funds to
    disclose to each investor the actual dollar amount
    of fees paid on their fund shares. Providing such
    information could reinforce to investors the fact
    that they pay fees on their mutual funds and
    provide them information with which to evaluate
    the services their funds provide. In addition,
    having mutual funds regularly disclose the dollar
    amounts of fees that investors pay may encourage
    additional fee-based competition that could result
    in further reductions in fund expense ratios. GAO
    is recommending that this information be provided
    to investors. Because producing such information
    would entail systems changes and additional costs,
    GAO is also recommending that cost-effectiveness
    and investor burden be considered when alternative
    means for disclosing the dollar amount of fees are
    evaluated.

         Regulators also look to a mutual fund's
    directors to oversee the operating expense fees
    their funds charge. The organizational structure
    of the typical mutual fund embodies a conflict of
    interest between the fund shareholders and the
    fund's adviser that can influence the fees
    charged. This conflict arises primarily because
    the adviser has the incentive to maximize its own
    revenues, but such action could come at the
    expense of the fund's shareholders. Because of
    this inherent conflict, mutual fund directors are
    tasked under federal law with reviewing and
    approving the fees charged by the fund adviser.
    Under current law, mutual fund directors are
    expected to review various data to ensure that the
    fees are not excessive and that the fees are
    similar to those of comparable funds. Mutual fund
    adviser officials told GAO that the directors of
    the funds they operate have been vigorous in
    reviewing fees and seeking reductions. However,
    others, including research organizations,
    academics, and private money managers, commented
    that the directors' activities may be keeping fees
    at higher levels because of this focus on
    maintaining fees within the range of other funds.

         GAO received comments on a draft of this
    report from SEC; NASD Regulation (NASDR), which is
    the regulatory arm of NASD; and the mutual fund
    industry association, the Investment Company
    Institute. Overall, each of the commenting
    organizations agreed that GAO's report raised
    important issues and contributed to the public
    dialogue on mutual fund fees. However, these
    organizations also commented, among other things,
    that mutual funds already make extensive
    disclosures about fees and that competition on the
    basis of performance does represent price
    competition among mutual funds. GAO agrees that
    mutual fund disclosures are extensive but also
    believes that additional information on the
    specific dollar amounts of fees for operating
    expenses could be useful to investors and
    encourage additional price competition among fund
    advisers on the basis of fees directly.

    Principal Findings

    Principal Findings
    Although Advisers Expected to Experience Cost
    Efficiencies, Comprehensive Data on Their Costs
    Were Not Available
    Academic studies and other research find that as
    mutual fund assets grow, mutual fund advisers
    experience operational efficiencies or economies
    of scale that would allow them to reduce their
    funds' expense ratios. As shown in table 1 below,
    data compiled by ICI indicate that mutual fund
    assets have grown considerably during the 1990s,
    with stock funds alone growing 1,081 percent as of
    year-end 1998.

    Table 1: Total Assets for Stock and Bond Mutual
    Fund as of 1998
    Dollars in billions
                           1990       1998  Percentage
                                                change
    Stock funds            $283     $3,343      1,081%
    Bond funds              284        831         193
    Total                   567      4,174         636
    Source: GAO analysis of ICI data.

         As the assets in a mutual fund grow,
    economies of scale in a fund adviser's operations
    would result in the adviser's costs increasing
    more slowly than the rate at which its fund assets
    and revenues are increasing. For example, if the
    adviser of a fund employing 10 customer service
    representatives experiences 100-percent growth in
    its fund assets, this adviser may find that only
    5, or 50 percent, more representatives would be
    needed to address the workload arising from the
    additional assets. In addition, GAO's analysis of
    data from ICI also indicated that although
    additional purchases by existing and new investors
    account for some of the increase in the industry's
    assets, as much as 64 percent of the mutual fund
    asset growth has come from appreciation in the
    value of the securities in these funds'
    portfolios. Fund growth resulting from portfolio
    appreciation would also provide additional
    economies of scale because such growth is not
    accompanied by many of the administrative costs
    associated with inflows of money to new and
    existing fund accounts.

         However, GAO was unable to determine the
    extent to which mutual fund advisers experienced
    such economies of scale because comprehensive data
    on the total costs incurred by mutual fund
    advisers are not publicly available. Currently,
    mutual funds disclose to regulators and to their
    investors only those operating costs that have
    been deducted from the assets of the fund, but not
    the costs that the advisers incur to operate these
    funds. Although total cost data were not
    available, industry officials reported that fund
    advisers' costs have been increasing. Industry
    officials explained that these increased costs are
    the result of new services for mutual fund
    investors, increased distribution expenses, and
    higher personnel compensation expenses.

         GAO estimated the total revenue that fund
    advisers and other service providers receive from
    the funds they operate. 5 Largely as a result of
    growth in mutual fund assets, mutual fund advisers
    and service providers were collecting
    significantly more revenues from fund operations
    in 1998 than they did in 1990. As shown in table 2
    below, the revenues stock funds produced for their
    advisers and other providers had increased over
    800 percent from 1990 to 1998.

    Table 2:  Estimated Mutual Fund Adviser and
    Service Provider Revenues From Operating Expense
    Fees 1990-1998
    Dollars in millions
                                Estimated fee revenues
    Fund type                      1990   1998 Percent
                                                   age
                                                change
    Stock                        $2,544 $22,931    801%
    Bond                          2,408  5,933     146
    Totals                        4,952 28,864     483
    Source: GAO analysis of data from ICI.

         Fee revenues for the largest funds have
    similarly increased. Using data on 77 of the
    largest stock and bond funds,6 GAO found that the
    advisers and service providers operating these
    funds collected $7.4 billion in fee revenues in
    1998. This was over $6 billion, or almost 560
    percent, more than they collected in 1990. Over
    this same period, the assets of these funds
    increased by over 600 percent. Mutual fund
    advisers and service providers were also
    collecting more in fees on a per account basis.
    For example, the total dollars collected annually
    in fee revenues from stock funds rose 59 percent
    from an average of $103 per account in 1990 to
    $164 per account in 1997.

         Although comprehensive cost data for most
    fund advisers were not available, analyses of
    information for 18 publicly traded mutual fund
    advisers indicated that these firms' operating
    profits as a percentage of their revenues have
    been increasing for at least 5 years.

    Average Mutual Fund Expense Ratios Have Generally
    Declined, But Not All Funds Reduced Their Ratios
         GAO identified various studies and analyses
    of the trends in mutual fund fees. Some of these
    analyses found that mutual fund expense ratios and
    other charges had been declining, but other
    analyses found that expense ratios had increased.
    However, some industry participants criticized the
    methodologies used by these studies. For example,
    many of these studies failed to adjust for the
    increase in newer funds, which generally charge
    higher expense ratios than older funds.

         Therefore, GAO conducted its own analysis of
    the trend in expense ratios. Data on the 77
    largest mutual funds indicated that that these
    funds had grown faster since 1990 than the average
    fund in the industry.7 Therefore, their advisers
    were more likely to have experienced economies of
    scale in their operations that would have allowed
    them to reduce their expense ratios. Because the
    sample consisted primarily of the largest and
    fastest growing funds in the industry, it may not
    reflect the characteristics and the trend in fees
    charged by other funds.

         To calculate the average expense ratios for
    these funds, GAO weighted each fund's expense
    ratio by its total assets. The resulting average
    expense ratios represent the fees charged on the
    average dollar invested in these funds during this
    period. As shown in table 3, the average expense
    ratio declined by 12 percent for the largest stock
    funds and by 6 percent for the largest bond funds
    from 1990 to 1998, although this decline did not
    occur steadily over the period.

    Table 3:  Average Expense Ratio for 77 Largest
    Stock and Bond Funds From 1990 to 1998 in Dollars
    Per $100 of Fund Assets
    Type of Number   1990  1991  1992  1993  1994  1995  1996  1997  1998 Percent
       fund    of                                                           age
            funds                                                        change
    Stock      46   $.74  $.78  $.78  $.80  $.81  $.79  $.75  $.68  $.65   -12%
    Bond       31    .62   .61   .61   .60   .61   .63   .61   .60   .58     -6
    Source: GAO analysis of data from Morningstar,
    Inc. and Barron's Lipper Mutual Funds Quarterly.

         Although the average expense ratio for these
    funds generally declined during the 1990s, not all
    of them reduced their fees. Overall, 23 of the 77
    funds reported higher expense ratios in 1998 than
    in 1990. Table 4 shows the changes in expense
    ratios for the 51 funds among the 77 largest funds
    that experienced asset growth of at least 500
    percent from 1990 to 1998. Of these funds, 38 (74
    percent) had reduced their expense ratios by at
    least 10 percent during this 9-year period. Of the
    remaining 13 funds, 7 (14 percent) reduced their
    expense ratios by less than 10 percent, and 6 (12
    percent) had either not changed their fees or had
    increased them.

    Table 4: Fee Reductions by Large Funds Whose Asset
    Growth Exceeded 500 Percent From 1990 to 1998
    Total change in fee from 1990 to 1998                  Number of Percentage
                                                               funds
    Reduction over 30 percent                                     17        33%
    Reduction of 10 to 30 percent                                 21         41
    Subtotala                                                     38         74
    Reduction under 10 percent                                     7         14
    No change                                                      3          6
    Increase under 10 percent                                      2          4
    Increase of 10 to 30 percent                                   0          0
    Increase over 30 percent                                       1          2
    Subtotal                                                      13         26
    Total                                                         51        100
    aMay not total due to rounding.
    Source: GAO analysis of Morningstar and Barrons
    Lipper Mutual Funds Quarterly data.

    Competition Does Not Focus on Price of Service
         Active competition among firms within a given
    industry is generally expected to result in lower
    prices than in those industries in which few firms
    compete. Although hundreds of fund advisers
    offering thousands of mutual funds compete
    actively for investor dollars, their competition
    is not primarily focused on the fees funds charge.
    Instead, mutual fund advisers generally seek to
    differentiate themselves by promoting their funds'
    performance returns8 and services provided.9
    Marketing their performance and service as
    different from those offered by others allows fund
    advisers to avoid competing primarily on the basis
    of price, as represented by the expense ratios
    they charge mutual funds investors. This applies
    particularly to actively managed funds investing
    in stocks. Advisers for money market funds; index
    funds;10 and to some degree, bond funds are
    generally less able to differentiate their funds
    from others because these types of funds invest in
    a more limited range of securities than stock
    funds do. As a result, the returns and fees of
    such funds generally tend to be more similar, and
    the fees are generally lower than the fees charged
    on most stock funds.

    Fee Disclosures Do Not Provide Investors With
    Specific Dollar Amounts
         The disclosures mutual funds are legally
    required to make are, among other things, intended
    to assist investors with evaluating the fees
    charged by the funds they are considering for
    investment. As required by SEC rules, mutual funds
    are required to provide potential investors with
    disclosures that present operating expense fees as
    a percentage of a fund's average net assets. In
    addition, these disclosures provide a hypothetical
    example of the amount of fees likely to be charged
    on an investment over various holding periods.
    However, after they have invested, fund
    shareholders are not provided the specific dollar
    cost of the mutual fund investments they have
    made. For example, mutual fund investors generally
    receive quarterly statements detailing their
    mutual fund accounts. 11 These statements usually
    indicate the beginning and ending number of shares
    and the total dollar value of shares in each
    mutual fund owned. They do not show the dollar
    amount of operating expense fees that were
    deducted from the value of these shares during the
    previous quarter.12  This contrasts with most other
    financial products or services, such as bank
    accounts or brokerage services, for which customer
    fees are generally disclosed in specific dollar
    amounts.

         Surveys conducted by industry research
    organizations, fund advisers, and regulators
    indicate that investors generally focus on funds'
    performance (net of fees), service levels, and
    other factors before separately considering fee
    levels. In contrast, investors appeared more
    concerned over the level of mutual fund sales
    charges, and industry participants acknowledged
    that as a result, the loads charged on funds have
    been reduced since the 1980s.

         The mutual fund and regulatory officials GAO
    contacted generally considered mutual fund
    disclosures to be extensive and adequate for
    informing prospective investors of the fees they
    would likely incur on their mutual fund
    investments. However, some private money managers,
    industry researchers, and legal experts indicated
    that the current fee disclosures are not making
    investors sufficiently aware of the fees they pay.
    One suggestion for increasing investor awareness
    was that mutual funds should disclose to each
    investor the actual dollar amount of the portion
    of the funds' fees they paid. Some of the
    officials GAO contacted indicated that having the
    specific dollar amount of fees disclosed to
    investors would spur additional fee-based
    competition among fund advisers. For example, a
    legal expert GAO contacted noted that having such
    information appear in investors' mutual fund
    account statements might also encourage some fund
    advisers to reduce their fees in order to be more
    competitive. Requiring that such information be
    provided to mutual fund investors would also make
    such disclosures more comparable to fee
    disclosures for other financial services, such as
    stock brokerage or checking accounts. Compared to
    mutual funds, the markets for these services
    appear to exhibit greater direct price
    competition.

         Fund adviser officials GAO interviewed
    indicated that calculating such amounts exactly
    would entail systems changes and additional costs,
    but they also acknowledged that less costly means
    of calculating such amounts may exist. For
    example, instead of calculating the exact amount
    of fees charged to each account daily, a fund
    adviser could provide an estimate of the fees an
    investor paid by multiplying the average number of
    shares the investor held during the quarter by the
    fund's expense ratio for the quarter. Another
    alternative would be to provide the dollar amount
    of fees paid for preset investment amounts, such
    as $1,000, which investors could use to estimate
    the amount they paid on their own accounts. In
    determining how such disclosures could be
    implemented, regulators will have to weigh the
    costs that the industry may incur to calculate
    fees for each investor against the burden and
    effectiveness of providing investors with the
    requisite information and having them be
    responsible for making such calculations on their
    own.

    Mutual Fund Directors Tasked With Reviewing Fees,
    But Opinions on Their Effectiveness Were Mixed
         The structure of most mutual funds embodies a
    potential conflict of interest between the fund
    shareholders and the adviser. This conflict arises
    because the fees the fund charges the shareholders
    represent revenue to the adviser. For this reason,
    mutual funds have directors who are tasked with
    overseeing the adviser's activities. Under the
    Investment Company Act of 1940, fund directors are
    required to review and approve the compensation
    paid to the fund's adviser.

    In 1970, this act was amended after concerns were
    raised over the level of fees being charged by
    mutual funds. The amendments imposed a fiduciary
    duty on fund advisers and tasked fund directors
    with additional responsibilities regarding fees.
    These amendments to the act also granted investors
    the right to bring claims against the adviser for
    breaching this duty by charging excessive fees.
    Various court cases subsequently have interpreted
    this duty, and the decisions rendered have shaped
    the specific expectations currently placed on fund
    directors regarding fees. As a result, directors
    are expected to review, among other things, the
    adviser's costs, whether fees have been reduced as
    fund assets grow, and the fees charged by other
    advisers for similar services to similar funds.

         The officials at the 15 mutual fund advisers13
    GAO contacted said that their boards have been
    vigorous in reviewing fees and have frequently
    sought reductions in the fees received by the
    adviser. However, some private money managers,
    industry researchers, and others have stated that
    the activities undertaken by directors may be
    serving, instead, to keep fees at higher levels
    than necessary, because the directors are just
    expected to keep their funds' fees within a range
    of similar funds instead of actively attempting to
    lower them.

    Recommendations
    To heighten investors' awareness and understanding
    of the fees they pay on mutual funds, GAO
    recommends that the Chairman, SEC, require that
    the periodic account statements already provided
    to mutual fund investors include the dollar amount
    of each investor's share of the operating expense
    fees deducted from their funds. This disclosure
    would be in addition to presently required fee
    disclosures. Because these calculations could be
    made in various ways, SEC should also consider the
    cost and burden that various alternative means of
    making such disclosures would impose on (1) the
    industry and (2) investors as part of evaluating
    the most effective way of implementing this
    requirement. Where the form of these statements is
    governed by NASD rules, SEC should require NASD to
    require the firms it oversees to provide such
    disclosures.

    Agency Comments and GAO's Evaluation
    GAO obtained comments on a draft of this report
    from the heads, or their designees, of SEC, NASDR,
    and ICI. These comments are summarized and
    evaluated in chapter 7, with specific comments
    made by each organization addressed in appendixes
    I through III.

    Overall, each of the commenting organizations
    agreed that GAO's report raised important issues
    and contributed to the public dialogue on mutual
    fund fees. In his letter, the director of SEC's
    Division of Investment Management indicated that
    SEC staff agreed that investors need to be aware
    of and understand the fees that mutual funds
    charge. The letter also indicated that the SEC
    staff welcomed the report's recommendation and
    intended to consider it carefully. The vice
    president of NASDR's Investment
    Companies/Corporate Financing Department agreed in
    his letter that investors should consider fees,
    expenses, and other issues in addition to
    performance in making investment decisions.

    However, the letters from the SEC, NASDR and ICI
    officials also raised several issues about GAO's
    report. All three organizations commented that
    mutual funds currently make extensive disclosures
    about their fees to investors at the time of
    purchase and in semiannual reports thereafter. For
    example, ICI's letter noted that promoting
    investor awareness of the importance of fund fees
    is a priority for ICI and its members. However,
    ICI expressed reservations about GAO's
    recommendation that investors periodically receive
    information on the specific dollar amounts of the
    operating expense fees deducted from their mutual
    fund accounts. Their concern is that this
    requirement could erode the value of the fee
    information currently provided in the prospectus
    and thus impede informed assessments of fee levels
    at competing funds, which could paradoxically
    diminish rather than enhance investors' overall
    understanding of fund fees.

    GAO agrees with ICI and the other commenters that
    the current disclosures made by mutual funds,
    which provide fund expense ratios expressed as a
    percentage of fund assets and include an example
    of the likely amount of expenses to be incurred
    over various holding periods for a hypothetical
    $10,000 account, are useful for investors in
    comparing among funds prior to investing. The
    additional disclosure GAO recommends is intended
    to supplement, not replace, the existing
    disclosures. It should also serve to reinforce to
    investors that they do pay for the services they
    receive from their mutual funds as well as
    indicate to them specifically how much they pay
    for these services.

         SEC, NASDR, and ICI also commented on GAO's
    observation that other financial products and
    services disclose specific dollar amounts for the
    fees charged to their users, but mutual funds do
    not. In their comments, these organizations
    generally indicated that not all charges are
    disclosed for other financial products and
    services and; thus, the disclosures for mutual
    funds are not that dissimilar. For example, SEC
    noted that funds disclose to investors specific
    dollar charges subtracted from their accounts,
    such as for sales loads or account fees, but do
    not disclose the specific charges that are levied
    outside the account. SEC stated that this is
    similar to banks not disclosing the spread between
    the gross amount earned by the financial service
    provider on customer monies and the net amount
    paid to the customer.

         GAO does not agree with the commenting
    organizations that mutual funds' lack of
    disclosure of the specific operating expenses to
    individual investor accounts is comparable to the
    practices of banks or other businesses that do not
    disclose the difference between their investment
    or operating earnings and the amounts they pay to
    the individuals who provided those operating or
    investment funds. Investors in mutual funds have
    in essence hired the adviser to perform the
    service of managing their investment dollars for
    them. The fees that the advisor and the other
    service providers deduct from the fund's assets
    represent the price of the services they perform.
    Although such fees are deducted from the fund
    overall, each individual investor's account is
    ultimately reduced in value by their individual
    share of these deductions. However, the specific
    amount of these deductions is not disclosed in
    dollar terms to each investor. In contrast,
    customers and users of other financial services,
    such as private money managers, banks, and
    brokerage firms, are told of the specific dollar
    amounts subtracted from their individual assets or
    accounts.

    All three commenting organizations also generally
    questioned this report's finding that mutual funds
    do not compete primarily on the price of their
    services. SEC noted that although an argument
    could be made that more price competition should
    occur in the mutual fund industry, it is not
    completely absent. ICI emphasized that because
    funds report performance on an after fees and
    expenses basis, mutual funds do compete on the
    basis of their fees. NASDR stated that the draft
    report did not address the fact that mutual funds
    present performance net of expenses.

    GAO's report notes that mutual funds' performance
    returns, which are the primary basis upon which
    funds compete, are required to be disclosed net of
    fees and expenses. However, competition on the
    basis of net returns may or may not be the same as
    competition on the basis of price. Separating the
    fee from the return would remind investors that a
    fee is embedded in their net returns. In addition,
    GAO also notes that when customers are told the
    specific dollar amounts of the fees or charges,
    such as they are for stock brokerage transactions
    or bank checking accounts, firms in those
    industries appear to more frequently choose to
    compete directly on that basis and, in some cases,
    the charges for such services have been greatly
    reduced. Implementing GAO's recommendation to have
    such information provided to mutual fund investors
    could provide similar incentive for them to
    evaluate the services they receive in exchange for
    the fees they pay. Disclosing such information
    regularly could also encourage more firms to
    compete directly on the basis of the price at
    which they are willing to provide mutual fund
    investment services.

    SEC and ICI also questioned the legal accuracy of
    some of the statements made by individuals GAO
    interviewed regarding the role of mutual fund
    directors in overseeing fees. Although the
    individuals quoted in this report were critical of
    mutual fund directors setting their funds' fees
    only in relation to the fees charged by other
    funds, both SEC and ICI indicated that fund
    directors, by law, are required to review a wide
    range of information when assessing the fees
    charged by their fund advisor and other service
    providers.

         In response to these comments, text has been
    added to the report to indicate that comparing one
    fund's fees to those charged by other funds is not
    the only factor that directors are required to
    consider when evaluating fees. However, in the
    opinion of the individuals whose comments are
    presented in the report, directors are primarily
    emphasizing such comparisons over the other
    factors they are also are required to consider as
    part of their fee reviews. As a result, these
    individuals see directors as maintaining fee
    levels, or at least allowing fees to be lowered
    only to the extent that other funds are taking
    similar actions.

    _______________________________
    1 Although the Investment Company Act of 1940,
    which governs mutual fund operations, does not
    dictate a specific form of organization for mutual
    funds, most funds are organized either as
    corporations governed by a board of directors or
    as business trusts governed by trustees. When
    establishing requirements relating to the
    officials governing a fund, the act uses the term
    "directors" to refer to such persons, and this
    report will also follow that convention.
    2 As discussed in chapter 1 of this report, the
    operating expense ratio for a mutual fund is the
    cumulative total of various fees and expenses
    charged to the fund during a particular period
    shown as a percentage of the fund's average net
    assets. The expense ratio includes a management
    fee that compensates the adviser for selecting and
    managing the fund's portfolio, distribution fees,
    and any other expenses associated with
    administering the fund that have been deducted
    from the fund's assets.
    3 Data on stock funds presented in this report
    also include information on hybrid funds. The
    report focuses primarily on stock and bond funds
    because money market funds generally have not been
    the subject of the recent concerns over fees.
    4 Mutual fund shareholder account statements do
    include the specific dollar amounts of certain
    fees or charges, such as for wire transfers,
    maintenance fees, or sales loads.
    5 Fund adviser and service provider revenues were
    estimated by multiplying fund assets by operating
    expense ratios.
    6 These 77 funds included all of the largest stock
    and bond funds in existence from 1990 to 1998.
    These 77 funds comprised 46 stock funds, including
    all stock funds with assets over $8 billion; and
    31 bond funds, including all those with assets
    over $3 billion. The data for the stock funds
    include five hybrid funds that also invest in
    bonds or other debt securities.
    7 The sample focused on the time period since 1990
    because it represented the most current and
    consistent period of mutual fund industry history
    and market conditions.
    8 SEC requires funds to report their performance
    returns net of the fees deducted from fund assets.
    9 As discussed in chapter 4 of this report, the
    type of competition prevailing in the mutual
    industry appears to resemble "monopolistic
    competition," which is one of the primary
    competitive market types described by economists.
    Markets with monopolistic competition
    characteristically include large numbers of
    competing firms, ease of entry, and products
    differentiated on the basis of quality, features,
    or services included.
    10 Index funds invest in the securities represented
    in a broad-based index, such as the Standard &
    Poor's 500 Index.
    11 A requirement for quarterly statements arises
    under NASD rules, which govern the actions of the
    securities broker-dealers that act as the
    distributors of most mutual fund shares.
    12 Sales charges, redemption fees, and other
    transactional fees are disclosed in dollar amounts
    in either account statements or confirmation
    statements.
    13 These firms included the advisers for 13 of the
    77 largest funds and 2 smaller fund advisers.

    Chapter 1
    Introduction
    Page 27            GAO/GGD-00-126 Mutual Fund Fees
    Mutual funds offer investors a means of investing
    in a diversified pool of stocks, bonds, and other
    securities. As of 1998, 44 percent of U.S.
    households owned mutual funds, and the returns,
    particularly for stock funds, had generally
    exceeded returns that could have been earned on
    savings accounts or certificates of deposit. Since
    1984, assets in U.S. mutual funds increased about
    14-fold, growing from $371 billion in 1984 to $5.5
    trillion in 1998.  Because costs of providing
    mutual fund services are generally expected to
    rise less rapidly as fund assets increase, the
    significant growth in recent years has prompted
    some concerns by some industry participants and
    the news media over the level of fees funds
    charge.

    This report responds to requests by the Chairman,
    Subcommittee on Finance and Hazardous Materials;
    and the Ranking Minority Member of the House
    Committee on Commerce.

    Background
    A mutual fund is an investment company that pools
    the money of many investors-individuals or
    institutions-that it invests in a diversified
    portfolio of securities. Mutual funds provide
    investors the opportunity to own diversified
    securities portfolios and to access professional
    money managers, whose services they might
    otherwise be unable to obtain or afford.

    A mutual fund is owned by its investors, or
    shareholders. Fund share prices are based on the
    market value of the assets in the fund's
    portfolio, after subtracting the fund's expenses
    and liabilities, and then dividing by the number
    of shares outstanding. This is the fund's net
    asset value (NAV). Per share values change as the
    value of assets in the fund's portfolio changes.
    Investors can sell their shares back to the fund
    at the current NAV,1 and funds must calculate the
    shareholders' share prices on the day a purchase
    or redemption request is made. Many newspapers
    publish daily purchase and redemption prices for
    mutual funds.

    Various types of funds are offered to investors.
    Three basic types of mutual funds include stock
    (also called equity), bond, and money market
    funds. Some funds that invest in a combination of
    stocks, bonds, and other securities are known as
    hybrid funds and are discussed in this report as
    part of the information presented for stock funds.
    Money market funds are referred to as short-term
    funds because they invest in securities that
    generally mature in about 1 year or less; stock,
    bond, and hybrid funds are known as long-term
    funds. The firms that operate mutual funds
    frequently offer investors a family of funds that
    includes at least one each of the three basic fund
    types, although some firms may offer only one fund
    while others specialize in funds of a particular
    type, such as stock or bond funds. Of the total
    $5.5 trillion invested in mutual funds at the end
    of 1998, $2.98 trillion was invested in stock
    funds, $1.35 trillion was in money market funds,
    $831 billion was in bond funds, and $365 billion
    was in hybrid funds. This report will focus
    primarily on stock and bond funds because money
    market funds generally have not been the focus of
    recent concerns regarding fees.

    Mutual Fund Assets Increased Dramatically in the
    1990s
    As shown in table 1.1, mutual fund assets grew
    dramatically in the 1990s, with stock funds
    growing 1,082 percent in the 1990-1998 period.

    Table 1.1: Growth in Mutual Fund Assets, 1990-1998
    Fund type                  Total assets   Percenta
                               (dollars in       ge
                                millions)      growth
                                1990     1998
    Stock fundsa                   $        $   1,082%
                             282,800 3,342,900
    Bond funds               284,300  830,600      192
    Money Market funds       498,300 1,351,700      171
    Total                   1,065,50 5,525,200      419
                                   0
    a  This category combines equity and hybrid fund
    data.
    Source: GAO analysis of Investment Company
    Institute data.

    Mutual Funds Contract with Investment Advisers to
    Conduct Their Operations
    Although it is typically organized as a
    corporation, a mutual fund's structure and
    operation differ from that of a traditional
    corporation. In a typical corporation, the firm's
    employees operate and manage the firm; and the
    corporation's board of directors, elected by the
    corporation's stockholders, oversees its
    operations. Mutual funds also have a board of
    directors that is responsible for overseeing the
    activities of the fund and negotiating and
    approving contracts with an adviser and other
    service providers for necessary services.2

    However, mutual funds differ from other
    corporations in several ways. A typical mutual
    fund has no employees; it is created and operated
    by another party, the adviser, which contracts
    with the fund, for a fee, to administer fund
    operations. The adviser is an investment
    adviser/management company that manages the fund's
    portfolio according to the objectives and policies
    described in the fund's prospectus.3 Advisers may
    also perform various administrative services for
    the funds they operate, although they also
    frequently subcontract with other firms to provide
    these services. Functions that a fund adviser or
    other firms may perform for a fund include the
    following:

    �    Custodian: A custodian holds the fund assets,
    maintaining them separately to protect shareholder
    interests.
    �    Transfer agent: A transfer agent processes
    orders to buy and redeem fund shares.
    �    Distributor: A distributor sells fund shares
    through a variety of distribution channels, such
    as directly through advertising or telephone or
    mail solicitations handled by dedicated sale
    forces, or by third-party sales forces. Funds that
    are marketed primarily through third parties are
    usually available through a variety of channels,
    including brokers, financial planners, banks, and
    insurance agents.

    Distinct from the fund itself, the fund's adviser
    is generally owned by another entity with its own
    group of directors. (Ch. 6 of this report
    discusses in more detail the relationship between
    funds and their advisers and the specific legal
    duties placed on mutual fund directors.)

    Mutual Fund Fees Include Operating Expenses and
    Sales Charges
    Various fees are associated with mutual fund
    ownership. All mutual funds incur ongoing
    operating expenses for which they pay the adviser
    and other providers who operate and service the
    funds. AnThT annual total of these operating
    expenses, commonly known as the fund's operating
    expense ratio, is expressed as a percentage of the
    fund's average net assets in a fund's prospectus
    and other reports. Fund operating expenses can
    vary in accordance with the work required by fund
    managers; the complexity of the fund's
    investments; or the extent of shareholder services
    provided, such as toll-free telephone numbers,
    Internet access, check writing, and automatic
    investment plans. The largest component of a
    fund's total expense ratio usually is the
    management fee, which is the ongoing charge paid
    to the investment adviser for managing the fund's
    assets and selecting its portfolio of securities.
    The management fee is customarily calculated as a
    percentage of the fund's average net assets.4

    Included as part of the operating expenses that
    are directly deducted from some funds' assets are
    fees that go to compensate sales professionals and
    others for selling the fund's shares as well as
    for advertising and promoting them. These fees,
    known as "12b-1 fees," are named after the
    Securities and Exchange Commission (SEC) rules
    authorizing mutual funds to pay for marketing and
    distribution expenses directly from fund assets.
    The National Association of Securities Dealer,
    Inc. (NASD), whose rules govern the distribution
    of fund shares by broker dealers, limits 12b-1
    fees used for these purposes 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, any 12b-1
    fees included in a fund's total expense ratio are
    limited to a maximum of 1 percent per year.

    In addition to the fees in the expense ratio, some
    mutual funds include a sales charge known as a
    "load." Loads usually compensate a sales
    representative or investment professional for
    advice they provide investors in selecting a fund.
    Loads can be applied at the time of purchase (a
    "front-end load") or at redemption (a "back-end
    load").5 NASD rules limit the load that can be
    charged as part of purchasing fund shares to no
    more than 8.5 percent6 of the initial investment.
    Some mutual funds, known as "no-load" funds, do
    not have sales charges7. Other fees that may be
    charged directly to investors for specific
    transactions include exchange fees (for
    transferring money from one fund to another within
    the same fund family) and account maintenance
    fees.

    Mutual Fund Investors' Total Costs Vary Depending
    on How Shares are Purchased
    The total charges for investing in a mutual fund
    can vary according to how the investor purchases
    shares. In some cases, investors may purchase
    mutual fund shares on the advice of an investment
    professional, including sales representatives
    employed by securities broker-dealers or banks or
    independent financial planners. When recommending
    mutual funds, these individuals may also be
    entitled to receive the sales loads charged by the
    funds as well as to charge the investors for
    providing investment services.

    Many mutual funds can be purchased without
    professional assistance. To purchase the shares of
    these funds, investors contact the mutual fund
    companies directly, by visiting fund offices, or
    by telephone, mail, or Internet. Funds sold
    directly to investors in this way are known as
    "direct market" funds. In addition, investors can
    purchase direct market mutual funds through
    accounts they hold with broker-dealers. Investors
    may also use retirement benefit plans, such as
    401(k) plans, to invest in any mutual funds.

    Long-Term Impact of Annual Fees on Mutual Fund
    Investment Returns Can Be Significant
         The annual fees that investors pay can
    significantly affect investment returns over the
    long term. For example, over a 20-year period a
    $10,000 investment in a fund earning 8 percent
    annually, and with a 1-percent expense ratio,
    would be worth $38,122; but with a 2-percent
    expense ratio it would be worth $31,117.

    Various studies have also documented the impact of
    fees on investors' returns by finding that funds
    with lower fees tended to be among the better
    performing funds.  A March 1998 analysis by an
    industry research organization examined stock
    funds across six different investment objectives
    over a 5-year period and found that lower fee
    funds outperformed higher fee funds over 1-, 3-,
    and 5-year periods through November 1997.8 For
    example, of the large funds that invest in
    undervalued securities, the funds in the quartile
    with the lowest fees, which averaged 78 cents per
    $100 of assets, had the highest average
    performance--returning 138 percent over 5 years.
    Conversely, the funds in the quartile with the
    highest fees-averaging $2.26 per $100 of
    assets-had the lowest performance return over the
    period, averaging 112 percent.

    Various Federal Statutes Apply to Mutual Fund
    Activities
    SEC oversees the regulation of mutual funds under
    the Investment Company Act of 1940. Among the
    act's objectives is to ensure that investors
    receive adequate, accurate information about the
    mutual funds in which they invest. Other
    securities laws also apply to mutual funds. Under
    the Securities Exchange Act of 1934, persons
    distributing mutual fund shares or executing
    purchase or sale transactions in mutual fund
    shares are to be registered with SEC as securities
    broker-dealers. Broker-dealers who sell mutual
    funds are regulated and examined by both SEC and
    by the regulatory arm of NASD, called NASD
    Regulation, Inc. (NASDR). NASD, which is subject
    to SEC's oversight, acts a self-regulatory
    organization for brokerage firms, including those
    firms that engage in mutual fund distribution.

    Neither federal statute nor SEC regulations, which
    govern the mutual fund industry, expressly limit
    the fees that mutual funds charge as part of their
    expense ratios. Instead, mutual fund regulations
    focus on ensuring that investors are provided
    adequate disclosure of the risks and costs of
    investing in mutual funds. As noted previously,
    NASD rules have placed certain limits on the sales
    charges and fees used to compensate sales
    personnel.

    Although most mutual fund activities are subject
    to SEC and NASD requirements, the mutual fund
    activities conducted by some banks are overseen by
    the various bank regulatory agencies. 9 Because
    banks are exempt from the Securities Exchange Act
    of 1934, they are allowed to offer mutual funds
    and other securities to their customers without
    registering with SEC as broker-dealers. However,
    most banks have chosen to conduct their securities
    activities, including mutual funds, in
    subsidiaries or affiliates that are subject to SEC
    oversight. A small number of banks conduct
    securities activities either from within the bank
    or in other affiliates that are not subject to SEC
    oversight.10 Depending on how such a bank is
    chartered, its mutual fund activities would be
    overseen by the Federal Reserve System, the
    Federal Deposit Insurance Corporation, or the
    Office of the Comptroller of the Currency.11

    Objectives, Scope, and Methodology
    The objectives of this report were to review the
    mutual fund industry to determine (1) the trend in
    mutual fund advisers' costs and profitability, (2)
    the trend in fees, (3) how mutual funds compete,
    (4) the requirements for fee disclosures to fund
    investors and how industry participants view these
    disclosures, and (5) the responsibilities of
    mutual fund directors regarding fees and how
    industry participants view directors' activities.

         As part of analyzing the trend in mutual fund
    advisers' costs and profitability, we interviewed
    various industry officials. These officials
    included representatives of 15 mutual fund
    advisers, including 13 large firms and 2 smaller
    firms. These firms included some of the largest
    mutual fund families, one firm affiliated with a
    bank, and several firms known for charging lower
    fees. We also interviewed officials from 10
    industry research organizations that compile
    information, conduct analyses, or perform
    consulting services relating to the mutual fund
    industry. These firms included the major providers
    of data and analysis on the mutual fund industry.
    We also interviewed three officials from money
    management or financial planning firms and two
    former senior regulatory officials. In addition,
    we interviewed officials from two financial
    industry associations, including the Investment
    Company Institute (ICI), which is the national
    association of the U.S. mutual fund industry; and
    the American Association of Individual Investors.
    We also interviewed, and obtained information
    from, SEC and NASDR officials who oversee mutual
    fund activities.

         We also obtained and analyzed data from ICI
    on the number of funds and total assets invested
    in mutual funds. ICI officials indicated that
    these data included information representing over
    90 percent of the funds and the assets invested in
    mutual funds in the United States. We reviewed
    studies and analyses of the trend in mutual fund
    fees by academic organizations, industry
    associations, and regulators.

         To identify what costs funds are required to
    disclose, we reviewed SEC regulations. We also
    reviewed the annual reports for a random selection
    of 35 funds, including at least 1 of the funds
    whose officials we interviewed, to identify the
    types of cost information these funds disclosed.
    We also discussed the trends in costs associated
    with operating mutual funds with industry
    officials at the organizations identified above.
    We also reviewed various academic research papers
    and analyses by industry research organizations
    and others. To identify the trends in average
    account size, we obtained and analyzed data from
    ICI. We also analyzed cost, revenue, and
    profitability data compiled by an industry
    research organization on 18 public mutual fund
    advisers, which represent all of the public
    companies whose primary business activity involves
    operating mutual funds as an adviser.

         To determine the trend in mutual fund fees,
    we interviewed industry participants and reviewed
    studies, analyses, and academic research regarding
    mutual fund fees. To conduct our own analysis of
    the trend in fees, we collected and analyzed data
    on the largest mutual funds. These included the 77
    largest mutual funds in existence for the entire
    1990-1998 period based on asset size as of
    February, 28, 1999, as reported in the Lipper
    Mutual Funds Quarterly section in the April 5,
    1999, issue of Barron's. We focused on the time
    period since 1990 because it represented the most
    current and consistent period of mutual fund
    industry history and market conditions. The 77
    largest funds consisted of 41 stock funds and 5
    hybrid funds, each with assets over $8 billion;
    and 31 bond funds, each with assets over $3
    billion. We excluded 10 other stock, hybrid, and
    bond funds that were above the asset minimums but
    came into existence after 1990. We obtained annual
    expense, sales load, and asset data for each of
    the 77 funds for each year from 1990 to 1998 from
    Morningstar, Forbes Magazine, and Standard &
    Poor's; and from annual reports, prospectuses, and
    registration statements filed by the mutual funds
    with SEC or available at mutual fund internet
    sites.

    To determine the nature and structure of
    competition in the mutual fund industry, we
    reviewed academic research papers, economic
    literature, speeches, testimonies, and other
    documents discussing mutual fund competition. We
    collected data on numbers of funds, fund
    complexes, and advisers. We also discussed the
    extent of competition with the funds with industry
    officials at the organizations identified above.
    To identify what factors funds emphasized in their
    advertisements, we collected and analyzed the
    content of selected business, news, and personal
    finance magazines.

    To determine how mutual funds disclose their fees,
    we reviewed the relevant laws, rules, and
    regulations governing mutual fund fee disclosure
    and interviewed officials from SEC, NASDR, the
    Office of the Comptroller of the Currency, the
    Federal Deposit Insurance Corporation, and the
    Board of Governors of the Federal Reserve System.
    To compare mutual fund disclosures to those for
    other financial products and services, we reviewed
    the relevant regulations for those products and
    consulted with regulatory and industry association
    officials. To determine how investors use the
    information on fees, we reviewed studies and
    surveys done by industry research organizations.
    We also interviewed industry participants to
    obtain their opinions regarding the effectiveness
    of existing fee disclosures and suggestions for
    additional disclosures. A broker dealer also
    provided us summary information from a customer
    survey that included questions about the utility
    and desirability of current and proposed fee
    disclosures.

         To determine the responsibilities of mutual
    fund directors regarding fees, we reviewed the
    relevant laws, rules, and regulations governing
    mutual fund organizational structure and
    directors' responsibilities. We also interviewed
    officials from SEC and NASDR. In addition, we
    discussed the effectiveness of fund directors with
    industry participants. From legal databases, we
    also obtained and reviewed decisions and other
    documents pertaining to various court cases
    involving mutual fund fees.

         We conducted our work in Washington, DC;
    Chicago, IL; New York, NY; Boston, MA; San
    Francisco, CA; and Los Angeles, CA, between
    November 1998 and April 2000, in accordance with
    generally accepted government auditing standards.
    We requested comments on a draft of this report
    from the heads, or their designees, of SEC and
    NASDR. In addition, we requested comments from the
    mutual fund industry association, ICI. Each of
    these organizations provided us with written
    comments, which appear along with our responses to
    individual comments in appendixes I through III.
    Additional technical comments received from SEC
    were incorporated into this report as appropriate.

    _______________________________
    1 Shareholders of open-end mutual funds, which
    continuously issue and redeem shares, have a right
    to redeem shares at the current NAV. Closed-end
    funds, in which the number of shares is fixed,
    trade at market prices that are frequently above,
    or below, the actual NAV of the assets held by the
    fund.
    2 Although the Investment Company Act of 1940 does
    not dictate a specific form of organization for
    mutual funds, most funds are organized either as
    corporations governed by a board of directors or
    as business trusts governed by trustees. When
    establishing requirements relating to the
    officials governing a fund, the act uses the term
    "directors" to refer to such persons, and this
    report also follows that convention.
    3 In some cases, the adviser may contract with
    other firms to provide investment advice, becoming
    a subadviser to those funds.
    4 The fees investors pay to the fund adviser
    constitute some of the adviser's revenue from
    operating the fund. For this reason, there is a
    potential conflict between the interests of the
    fund shareholders who pay the fund expenses and
    those of the adviser, which seeks to maximize its
    own revenues and profits. Chapter 6 of this report
    discusses how the laws that govern mutual funds
    have attempted to address this conflict of
    interest.
    5 A common type of back-end load, called a
    contingent deferred sales charge, typically is
    calculated as a percentage of the net asset value
    or offering price at the time of purchase and is
    payable upon redemption. However, such charges
    generally decrease incrementally on an annual
    basis and would not be applied to redemptions
    after a certain number of years.
    6 The maximum permissible front-end and deferred
    sales load varies depending on factors, such as
    whether the fund offers certain rights or imposes
    an asset-based sales charge or service fee.
    7 NASD rules prohibit members from describing a
    mutual fund as "no load" if the fund has a front-
    end or deferred sales charge, or if the fund's
    total asset-based sales charges and service fees
    exceed ..25 percent of average net assets per
    year.
    8 Correlating Total Expenses to the Performance of
    Four and Five Star Equity Funds, Financial
    Research Corporation and Wechsler Ross & Partners
    (Mar. 2, 1998).
    9 Additional information on the mutual fund
    activities of banks is contained in Bank Mutual
    Funds: Sales Practices and Regulatory Issues
    (GAO/GGD-95-210, Sep. 27, 1995).
    10 However, the Gramm-Leach-Bliley Act passed in
    1999 will require any banks conducting more than
    500 securities transactions per year to move such
    activities into a securities broker-dealer after
    May 12, 2001.
    11 The Office of the Comptroller of the Currency
    oversees banks with national charters. The Federal
    Reserve System oversees bank holding companies
    and, in conjunction with state banking
    authorities, also oversees any state-chartered
    banks that are Federal Reserve members. The
    Federal Deposit Insurance Corporation oversees
    state-chartered banks that are federally insured
    but not members of the Federal Reserve. Any mutual
    fund activities conducted by thrifts would be
    subject to SEC's oversight because thrifts are not
    exempted from the definition of "broker" and
    "dealer" under the Securities Exchange Act of
    1934.

    Chapter 2
    Data Inadequate For Determining How Asset Growth
    Affected Adviser Costs
    Page 45            GAO/GGD-00-126 Mutual Fund Fees
         Academic studies and other research suggest
    that as mutual fund assets grow, mutual fund
    advisers should experience operational
    efficiencies-or economies of scale-that could
    allow them to reduce their funds' operating
    expense ratios.1 However, we were unable to
    determine the extent to which mutual fund advisers
    experienced these economies of scale because
    information on the costs and profitability of most
    fund advisers was not generally publicly
    available. Industry officials reported that the
    costs of operating and providing mutual fund
    services have been increasing. Although
    comprehensive cost data were not available, we
    were able to determine that mutual fund advisers
    and other mutual fund service providers were
    earning significantly more in fee revenues in 1998
    from the funds they operated than they had in
    1990. In addition, analyses by industry research
    organizations of 17 public mutual fund management
    firms indicated that such firms were generally
    profitable and that their profitability had been
    increasing.

    Fund Asset Growth Expected to Produce Economies of
    Scale
         As fund assets grow, advisers usually
    experience increases in both their revenues and
    their costs. However, the research we reviewed and
    the officials we interviewed agreed that fund
    advisers experience operational efficiencies that
    result in their costs growing less rapidly than
    the assets of the funds they manage. Academic
    researchers and industry officials acknowledged
    that mutual fund advisers' operations likely
    experienced economies of scale as fund assets
    grew. Fund advisers also likely experienced
    economies of scale in their operations because the
    majority of fund asset growth has come from
    increases in the value of the securities in funds'
    portfolios, which is a less costly source of
    growth than additional share purchases by new or
    existing investors.

    Many Agree that Mutual Fund Advisers Experience
    Economies of Scale
         As fund assets grow, the adviser earns
    additional revenue because its fee is a percentage
    of the fund's average net assets. However, in
    performing the various services necessary to
    operate the fund, the adviser incurs various costs
    for services, such as researching selections for
    the portfolio and managing the investments to
    maximize returns. Fund advisers also incur costs
    to administer accounts, process account
    transactions, and promote their funds to attract
    new shareholders and additional investor inflows.
    The difference between the adviser's costs and the
    amount of revenue it collects is its operating
    profit from the fund. If the adviser's revenues
    are increasing faster than its costs, then the
    adviser is experiencing operational efficiencies,
    or economies of scale.

         Academics, industry research organizations,
    regulators, and fund advisers we consulted
    generally agreed that mutual fund operations are
    subject to economies of scale as their assets
    grow. Most studies we reviewed found that as fund
    size increased, average operating expense fees
    decreased. A December 1999 ICI study reported that
    stock funds with assets of $250 million or less
    had an average expense ratio of $1.39 per $100 of
    assets, and funds with assets of over $5 billion
    had an average expense ratio of 70 cents per $100
    of assets.2 The ICI study also reported that funds
    with significant asset growth tended to reduce
    their expense ratios as they grew, suggesting the
    presence of economies of scale.

    In this study, ICI states that the operating
    efficiencies that mutual fund advisers experience
    arise, not from spreading fixed costs across a
    growing asset base, but from needing
    proportionally fewer additional resources as
    assets grew. The study found that fund advisers
    typically expend additional resources for
    portfolio management, investment research, and
    fund administration as fund assets grow. For
    example, an adviser of a fund experiencing 100-
    percent growth in fund assets may need to add only
    5 new hires to a staff of 10 customer service
    representatives, rather than doubling the staff to
    address the workload arising from the additional
    assets. Therefore, customer service personnel
    costs would be proportionally less for twice the
    assets.

         Industry officials we interviewed also
    generally agreed that mutual fund operations
    experience economies of scale. An official at a
    money management firm whose customers invest in
    mutual funds told us that mutual fund advisers'
    operations are subject to large economies of
    scale, and additional investor inflows result in
    little additional cost. Officials of the fund
    advisers we interviewed also agreed that their
    operations experienced economies of scale.

    Some of the studies and industry officials noted
    that economies of scale should not be assumed to
    exist on an industrywide level. For example, a
    study by one industry research organization,
    Lipper Analytical Services, Inc., stated that the
    mutual fund industry as a whole does not
    experience economies of scale, but individual
    funds do.3 In his testimony before Congress, the
    ICI president offered various explanations as to
    why asset growth for the industry has not
    translated into economies of scale for all funds.
    For example, asset growth arising from the
    creation of new funds would not likely result in
    economies of scale because new funds usually incur
    high costs in their initial periods of operation.
    In addition, asset growth by certain funds could
    produce operating efficiencies for those funds but
    not for others that had not grown.

    Substantial Asset Growth From Portfolio
    Appreciation Should Also Result in Economies of
    Scale
         An additional factor that should contribute
    to economies of scale among mutual fund advisers
    was the extent to which their assets grew due to
    portfolio appreciation. Such growth results as the
    securities that have been selected and purchased
    for the fund's portfolio increase in value. As the
    value of the fund assets increase, the adviser's
    revenues also increase because it deducts its fee
    as a percentage of all of the assets in the fund.
    However, these additional assets would not be
    accompanied by the additional account processing
    costs that result from asset growth arising from
    additional share purchases by new or existing
    shareholders.

         Mutual fund advisers likely experienced such
    economies of scale because most of the industry's
    growth in the 1990s resulted from portfolio
    appreciation. We analyzed industrywide data from
    ICI on the growth in mutual funds to determine the
    extent to which funds' asset growth resulted from
    either additional share purchases by existing and
    new investors or from appreciation of the
    securities within fund portfolios. As shown in
    table 2.1, portfolio appreciation accounted for
    about 56 percent of the mutual fund asset growth
    for all stock and bond funds. In contrast, growth
    resulting from additional investor share purchases
    accounted for about 44 percent these funds'
    growth.

    Table 2.1: Source of Asset Growth for All Stock
    and Bond Funds From 1990 to 1998
    Fund type       Portfolio Investor share    Totals
                 appreciation      purchases
    Stock               56.5%          43.5%      100%
    funds
    Bond                54.2%          45.8%      100%
    funds
    Totals              56.1%          43.9%      100%
    Source: GAO analysis of ICI data.

    Cost Data Not Generally Available for Mutual Fund
    Advisers' Overall Operations
         Determining the extent to which mutual fund
    advisers experienced economies of scale was not
    possible because comprehensive data on advisers'
    costs are not publicly available. Mutual funds are
    required to disclose certain fees and costs paid
    by investors that are deducted from fund assets,
    but these disclosures do not specify the costs
    that the adviser incurs in providing services to
    the fund.

         Under the requirements of the securities
    laws, a fund is required to periodically disclose
    to fund shareholders the costs attributable to
    individual funds. Among these costs is the fee
    that the adviser to the fund charges for managing
    the fund and selecting the investments to be
    included in its portfolio. In addition, these
    costs include those resulting from various
    administrative functions performed as part of
    operating a fund, such as those for legal services
    or the printing of required reports.

         Under the laws governing mutual fund
    activities, mutual funds must make publicly
    available certain financial information applicable
    to the fund when initially offering shares to the
    public and on a semiannual basis thereafter. This
    information includes a balance sheet, which lists
    the fund's assets and liabilities; and a statement
    of operations. The statement of operations
    presents the income and expenses incurred by the
    fund. A fund's income is generally the dividends
    and interest earned on the securities in its
    portfolio. For expenses, the disclosure
    requirements for the statement of operations are
    relatively brief and require separate reporting of

    �    investment advisory, management, and service
    fees in connection with expenses associated with
    the research, selection, supervision, and custody
    of investments;
    �    amounts paid as part of a 12b-1 plan; and
    �    any other expense items that exceed 5 percent
    of the total expenses.

     In addition, funds are required to disclose in
    footnotes to this statement how the management and
    service fees were calculated. Funds are also
    required to provide information on the net change
    in the assets of the fund resulting from
    operations, which includes any realized and
    unrealized gains or losses .

         Review of the financial statements issued for
    35 funds4 indicated the information disclosed for
    these funds was generally similar. The total
    amounts expended for the management or advisory
    fee and for expenses relating to the directors
    were disclosed for every one of the funds we
    reviewed. The amounts expended for audit services
    and shareholder reporting were also shown in the
    reports of a majority of the 35 funds.

    Although funds provide some information on the
    operating costs of individual mutual funds, the
    trend in the costs and profitability of advisers
    that manage mutual funds cannot be identified from
    the required reporting for individual funds.  The
    information disclosed by funds pertains to the
    funds' associated income and expenses, but the
    advisers that operate these funds are separate
    legal entities with their own revenues and costs.
    Some of the revenue earned by fund advisers can be
    determined from the amount of management/advisory
    fees shown in fund disclosures. . However, the
    reporting does not include disclosure of the
    specific costs that advisers incur to operate a
    fund. Nor does the material that mutual fund
    advisers file with SEC include such information.
    For example, the salaries of portfolio managers or
    other executives an adviser employs or the
    research expenses it incurs are not required to be
    disclosed. Without knowing the specific costs the
    adviser incurred to operate the funds it offers,
    the profitability of most mutual fund advisers
    cannot be determined. Some of the advisers that
    manage mutual funds are publicly owned companies
    and thus are required under other SEC regulations
    to periodically disclose the financial results of
    their operations. However, the majority of
    advisers are privately held and thus not subject
    to these requirements.

    Fund and Other Industry Officials Report that
    Mutual Fund Operating Costs Have Risen
         Only limited public data existed on the
    individual costs incurred by mutual fund advisers,
    but this information and industry officials'
    statements indicated that costs have been rising.
    Some of the increase in overall operating costs
    stemmed from the costs of the new services that
    advisers have added to those they already perform
    for investors or for the firms that market mutual
    funds. In addition, overall operating costs have
    risen due to increases in other areas, including
    the costs of distribution, advertising, and
    personnel .

    New Services Increase Operating Costs
         Mutual fund officials cited new services as
    an important reason for the increasing costs of
    operating mutual funds. Testifying before
    Congress, the president of ICI stated that mutual
    fund advisers are under substantial competitive
    pressure to provide enhanced and sometimes costly
    services. Officials at the industry research
    organizations and at the mutual fund advisers we
    contacted also indicated that new and expanded
    services have raised costs. Among the new services
    that these firms are adding were new
    telecommunication services. These included such
    services as 24-hour telephone centers and voice-
    recognition systems to provide investors with
    information and more convenient access to their
    accounts. Mutual fund advisers are also
    increasingly providing information and account
    access services over the Internet.

    Distribution Costs Also Increasing
         Mutual fund advisers have also apparently
    experienced increased costs incurred as part of
    having their funds distributed. Some broker-
    dealers whose sales representatives market mutual
    funds have narrowed their offerings of funds or
    have created preferred lists of funds, which then
    become the funds that receive the most emphasis in
    the marketing efforts made by broker-dealer sales
    representatives. When a fund is selected as one of
    the preferred fund families on these lists, the
    mutual fund adviser is required to compensate the
    broker-dealer firms. According to one research
    organization official, there are significantly
    fewer distributing firms than there are mutual
    fund advisers. As a result, the mutual fund
    distributors have the clout to require the
    advisers to pay more to have their funds sold by
    the distributing firms' staff. For example,
    distributors sometimes require fund advisers to
    share their profits and pay for expenses incurred
    by the distributing firms, such as requiring an
    adviser to pay for advertising or for marketing
    materials that are used by the distributing firms.5

         Mutual fund advisers' distribution costs are
    also increased when they offer their funds through
    mutual fund supermarkets. Various broker-dealers,
    including those affiliated with a mutual fund
    adviser, allow their customers to purchase through
    their brokerage accounts the shares of funds
    operated by a wide range of fund advisers.
    Although these fund supermarkets provide the
    advisers of participating funds with an additional
    means of acquiring investor dollars, the firms
    that provide such supermarkets generally require
    fund advisers to pay a certain percentage on the
    dollars attracted from purchases by customers of
    the firm's supermarket. For example, advisers for
    the funds participating in the Charles Schwab One
    Source supermarket pay that broker-dealer firm up
    to 0.35 percent of the amount invested by that
    firm's customers .

    Fund Advertising Costs Also Increasing
         Another area in which mutual fund advisers
    were reportedly experiencing higher costs was in
    advertising expenditures. According to data
    compiled by one industry research organization,6
    consumer investment advertising by financial
    services companies has grown at an annual rate of
    33 percent from 1995 to 1998, with nearly $1
    billion spent in 1998.

         Industry officials offered various reasons
    for increased advertising expenditures. As
    discussed in chapter 4 of this report, mutual fund
    advisers attempt to compete primarily by
    differentiating their firms' fund offerings from
    those of other firms. For example, one industry
    research organization official indicated that
    competition among so many funds requires advisers
    to increasingly promote their particular funds.
    Mutual fund supermarkets may also increase fund
    advisers' advertising expenses. Advisers selling
    through fund supermarkets may find that they avoid
    the costs associated with a salesforce or certain
    other expenses. However, increasing the likelihood
    that investors will select their funds out of all
    those offered through such supermarkets usually
    requires that advisers must spend on advertising
    to increase investor awareness of their funds.

    Personnel Costs Also Increasing
         Although already paying among the highest
    levels of compensation, mutual fund advisers
    apparently have to pay increasing amounts to
    attract and retain personnel. Mutual fund
    personnel are among the best-compensated staff
    among various financial organizations. In 1999, an
    association for the investment management
    profession and an executive recruiting firm
    sponsored a study of compensation for 19 different
    positions among 7 types of financial industries.7
    Along with mutual funds, the other industries were
    (1) banking; (2) insurance; (3) investment
    counseling; (4) pension consulting; (5) plan
    sponsors, endowments, and foundations; and (6)
    securities broker-dealers. The study obtained data
    by survey for staff employed in these industries
    in various positions; including chief executives,
    chief investment officers, research directors,
    securities analysts, and portfolio managers for
    four different investment types. According to our
    analysis of the information presented in this
    study, the industry median compensation for mutual
    fund industry overall was the highest among the
    seven industries. Across the various positions,
    the compensation for mutual fund industry
    personnel was ranked as the highest or second
    highest in 13 of the 19 positions surveyed.
    Specifically, mutual fund industry personnel had
    the highest compensation in six of the positions,
    including having the highest median compensation
    for chief executive officers and for each of the
    four portfolio manager positions.

         Personnel costs are also reportedly rising
    for mutual fund advisers. Officials with three of
    the industry research organizations we contacted
    cited expenses for personnel as an area in which
    fund advisers have experienced increased costs. An
    official at one such organization told us that
    with the low unemployment rate, fund advisers must
    pay personnel more to avoid losing them and having
    to replace them with new and untrained personnel.

         Officials at the mutual fund advisers we
    contacted also cited personnel as an area in which
    their costs were increasing. Many officials noted
    that mutual fund industry personnel costs are
    being driven higher due to competition for quality
    personnel from hedge funds.8 An official with one
    large fund adviser told us that increasing the
    size of compensation packages for portfolio
    managers was necessary to keep them from leaving
    to join hedge funds. He likened the market for
    such staff to that for sports stars.

    Information Technology Expenditures Also Increase
    But May Eventually Reduce Adviser Costs
         Fund adviser and other officials also cited
    the need to make continued investments in their
    overall information technology resources as a
    source of increased costs to their operations. For
    example, officials at one mutual fund adviser told
    us the staffing of their information technology
    department has risen from 1 person to over 700
    over a 26-year period. Mutual fund adviser and
    industry research officials also described other
    information technology expenditures that firms are
    making; including implementing automated telephone
    voice processing systems and creating Internet Web
    sites.

    Although mutual fund advisers are reportedly
    experiencing increased costs resulting from the
    increased investments they are making in
    technology and service enhancements, some of these
    investments may result in reduced operating costs
    in the future. According to officials at two
    industry research organizations, the investments
    that fund advisers make in technologies such as
    the Internet and voice-processing systems will
    eventually allow them to reduce service costs.
    According to an article prepared by one of these
    research organizations,9 companies that deploy Web-
    based customer services can cut their costs by
    close to half, if not more. For example, the
    article cites research by one organization that
    indicated that typical customer service
    transactions cost $5 if responded to by a live
    agent, 50 cents if by a voice response system, and
    a few cents if done on the Web.

    Asset Growth Has Varying Effects on Fund Advisers'
    Costs
         Fund asset growth can affect advisers' costs
    in varying ways. Although mutual fund advisers'
    costs were reportedly rising, industry officials
    explained that these costs do not generally rise
    smoothly as assets increase. Officials also
    indicated that advisers' costs rise more when
    their asset growth comes from new accounts rather
    than from existing shareholders.

    Adviser Costs Do Not Rise Smoothly
         According to industry officials, the costs of
    providing mutual fund services may not rise in a
    smooth, continuous way. Officials at the mutual
    fund advisers we contacted told us that some of
    their operating costs increase in a staggered
    fashion as their assets grow. For example,
    officials at one adviser said that as their assets
    grow, they find that the number of staff
    performing certain functions, such as answering
    customer inquiries, can stay the same for some
    time. However, when assets reach a certain level,
    they find that they must add additional staff to
    address the additional workload. Therefore,
    although assets may be growing steadily, many of
    their costs remain temporarily fixed until certain
    asset levels are reached; then their costs rise to
    a new, higher fixed level. Officials at another
    fund adviser explained that other costs are more
    fixed; thus, as assets grow, these costs go down
    on a per-share basis. Such costs would include the
    cost of maintaining custody10 over the securities
    invested in by their funds.

    New Accounts Also Increase Adviser Costs
         Fund adviser officials also explained that if
    their asset growth comes from new accounts, then
    their costs correspondingly increase more than if
    the additional dollars came instead from existing
    shareholders. Officials at one mutual fund adviser
    told us much of the industry's asset growth has
    come from new, smaller accounts. They said that
    such accounts are more expensive to service than
    larger accounts on a per dollar basis, because
    each account requires a minimum level of service
    regardless of size.

         However, we analyzed data on shareholder
    accounts compiled by ICI. Although the number of
    shareholder accounts for stock funds has grown by
    over 430 percent, from 22 million in 1990 to about
    120 million in 1998, this was less than the growth
    in the assets of these funds, which grew by over
    1,100 percent during that same time frame.

         Changes in the average account size at
    individual mutual fund advisers can affect these
    firms' costs. For example, officials at one mutual
    fund adviser reported to us that their average
    account size had fallen from $12,000 to $9,000,
    with its median size being $1,500. According to
    this firm's officials, having more, smaller
    accounts increases their overall servicing costs.

    Although some firms may experience a decline in
    their average account size that results in an
    increased cost per account, industrywide data
    indicated that this is not affecting all firms.
    According to our analysis of ICI data, the average
    account size for all stock funds in the industry
    has risen by 127 percent, from just under $11,000
    in 1990 to almost $25,000 in 1998. The average
    account size in 1998 for bond funds has increased
    similarly since 1990 as well.

    Fee Revenues Have Increased Significantly
         Although comprehensive data on the costs fund
    advisers incurred was not available, the revenue
    fund advisers and other service providers collect
    as fees from the mutual funds they operate appears
    to have increased significantly. The fee revenues
    earned by the advisers and service providers of
    the largest mutual funds have also risen
    significantly during the 1990s.11 The amount of
    fees collected on a per account basis has also
    risen .

         As mutual fund assets have grown, the
    revenues that fund advisers and other service
    providers collect through the fees they deduct
    from these funds have also risen. ICI provided us
    with data on the assets and operating expense fee
    revenues for 4,868 stock and bond funds, which
    their officials indicated represented over 90
    percent of the total industry assets for these
    fund types.12 As shown in table 2.2, our analysis
    of this data indicated that asset growth has led
    to comparable growth in the fee revenues earned by
    mutual fund advisers and other service providers.

    Table 2.2: Growth in Mutual Fund Assets and
    Estimated Fund Adviser and Other Service Provider
    Fee Revenues 1990-1998
    Dollars in millions
    Fund    Total assets          Estimated fund
    type                         adviser and provider
                                fee revenuesa
              1990   1998 Percent   1990   1998 Percent
                             age                   age
                          change                change
    Stock   $256,7 $2,396,   833% $2,544 $22,931    801%
                66    410
    Bond    268,52           160  2,408  5,933     146
                 9 698,365
    Totals  525,29 3,094,7    489  4,952 28,864     483
                 5     75
    Source: GAO analysis of data from ICI.

         The largest funds have also produced more
    revenue for their advisers and other service
    providers during the 1990s. Using 1998 data, we
    identified the 77 largest stock and bond funds
    that had been in existence since 1990.13 For these
    funds, we found that the advisers and service
    providers operating these funds collected $7.4
    billion in revenues from the fees deducted from
    these funds' assets in 1998. As shown in table
    2.3, this was over $6 billion, or almost 560
    percent more than they earned in 1990.

    Table 2.3: Assets and Fee Revenues for 77 Largest
    Mutual Funds for 1990-1998
    Dollars in millions
                1990   1991  1992   1993  1994  1995   1996  1997   1998 Percent
                                                                            age
                                                                         change
                                                                          1990-
                                                                           1998
    Total      $164,4 $232,9 $303,3 $409,7 $432,2 $595,8 $745,8 $954,7 $1,157   604%
    assets        25     85    39     55    41    57     89    25   ,219
    Total fee  $1,128 $1,640 $2,157 $2,986 $3,255 $4,488 $5,387 $6,347 $7,428    559
    revenue
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

         Some of the largest funds experienced
    significant increases in their fee revenues from
    1990 to 1998. For example, the assets of the
    largest stock fund grew 580 percent from $12.3
    billion in 1990 to $83.6 billion in 1998. The
    revenues of the adviser and other service
    providers for this fund grew 308 percent,
    increasing from about $127 million to over $518
    million during the same period. As the assets of
    another stock fund grew 825 percent from $5.6
    billion in 1990 to $51.8 billion in 1998, its
    adviser's adviser and other service providers'
    revenue increased 729 percent, growing from $38.7
    million to $321 million during the same period.

         On an industrywide basis, the average amount
    of total revenues fund advisers and other service
    providers earned per investor account has also
    risen. According to data compiled by ICI, the
    increase in fee revenues on a per account basis
    has been less dramatic than the increases in total
    fee revenues shown above. As shown in table 2.4,
    the average fees collected by fund advisers and
    other service providers per account rose 61
    percent for stock funds and 37 percent for bond
    funds from 1990 to 1997.14

    Table 2.4: Average Fees Collected For Stock and
    Bond Funds In Dollars Per Account from 1990 to
    1997
    Type of    1990   1991    1992   1993    1994    1995   1996    1997 Percent
    fund                                                                    age
                                                                         change
    Stock      $102   $106    $122   $136    $138    $135   $150    $164    61%
    Bond        184    180     210    230     237     223    235     251     37
    Source: GAO analysis of data from ICI.

    Data for Some Mutual Fund Advisers Indicates
    Profitability Has Been Increasing
         Recent data on the profitability of mutual
    fund advisers were generally limited to a few
    studies done by industry research organizations.15
    As noted previously, financial statements are not
    available for most mutual fund adviser firms.
    Although hundreds of mutual fund advisers exist,
    information was available for only a small subset
    of firms that have issued securities to the
    public, which requires them to file publicly
    available financial statements with SEC. The
    financial results of these public mutual fund
    adviser firms may not be representative of the
    industry as a whole because the public firms tend
    to be among the largest firms. However, analysis
    of information for some of these firms indicated
    that they were generally profitable and that their
    profitability had been increasing.

         An analysis by 1 industry research
    organization of 18 mutual fund advisers indicated
    that these firms' revenues were generally growing
    faster than their expenses. This organization,
    Strategic Insight, LLC., annually reports on
    trends in mutual fund adviser costs and profits by
    using data for those advisers that have issued
    securities to the public and thus are required to
    make their financial statements publicly
    available. For its analysis, Strategic Insight
    reviewed the financial results from 1994 to 1998
    for 18 public companies16 that manage mutual funds
    and other private account assets. According to its
    report, these 18 firms managed about $1.1 trillion
    in mutual fund assets and accounted for about 20
    percent of total industry assets in 1998. As shown
    in table 2.5, the operating expenses for the 18
    companies have been rising since 1995, but their
    data indicated that the rate of increase has been
    slowing each year.

    Table 2.5: Change in Revenue and Expenses From
    Prior Year and Resulting Operating Margin for
    Public Asset Management Companies
                                                 1995     1996     1997    1998
    Fee revenue growth                            43%      36%      34%     28%
    Operating expense growth                       48       34       31      27
    Operating profit margina                       33       34       35      36
    a Operating margin is the percentage that
    operating profit (revenue minus expenses)
    represents of total revenue before taxes.
    Source: Strategic Insight, LLC., analysis of 18
    public companies

         Although the Strategic Insight data shows
    that expenses have been increasing for these
    companies, it also showed that their revenues
    were, on average, increasing at a higher rate than
    their expenses between 1996 to 1998.

         As table 2.5 also shows, Strategic Insight
    found that as measured by profit margins, the
    profitability of these mutual fund management
    companies has been increasing. In 1998, Strategic
    Insight's calculations indicated that these 18
    companies' pretax operating profits, calculated by
    subtracting total expenses from total revenues
    before subtracting taxes, averaged about 36
    percent of their revenues.

         These mutual fund advisers also appear
    generally profitable compared to firms in other
    industries. A commonly used measure of
    profitability is return on equity, which is the
    ratio of profits to the amount of equity invested
    in the business by the firm's owners, which is
    derived by subtracting the firm's liabilities from
    its assets.

         The Strategic Insight data lacked complete
    information on all 18 publicly traded mutual fund
    advisers, but we were able to assess the rates of
    return on equity of 9 of the advisers as far back
    as 1995. From 1995 to 1998, the returns on equity
    for these nine firms were generally consistent and
    ranged, on average, between 23 and 26 percent
    during these years, with the 26 percent occurring
    in 1998. This was comparable to the 500 U.S.
    companies in the Standard & Poor's 500 index,
    whose return on equity had averaged 22 percent
    from 1995 to 1999.

    _______________________________
    1 As discussed in chapter 1 of this report, the
    operating expense ratio for a mutual fund is the
    total of various fees and expenses charged to the
    fund during a particular period shown as a
    percentage of the fund's total assets. The expense
    ratio includes a management fee that compensates
    the adviser for selecting and managing the fund's
    portfolio, 12b-1 fees used for expenses associated
    with distributing fund shares, and any other
    expenses associated with administering the fund
    that have been deducted from its assets.
    2 Investment Company Institute Perpective:
    Operating Expense Ratios, Assets, and Economies of
    Scale in Equity Mutual Funds, John D. Rea, Brian
    K. Reid, and Kimberlee W. Millar, (Washington,
    D.C.: Dec. 1999).
    3 The Third White Paper: Are Mutual Fund Fees
    Reasonable? (September 1998 Update), Lipper
    Analytical Services, Inc. (Sep. 1998).
    4 Included among these 35 funds were at least 1 of
    the funds offered by the 15 advisers that we
    contacted and a random selection of others that we
    obtained from public filings made to SEC.
    5 Amounts paid to fund distributors deducted from
    fund assets must be paid pursuant to a 12b-1 plan.
    Other amounts paid to distributors would come out
    of adviser profits.
    6 "Fund Advertising: Evolving Trends Among
    Television, Internet, and Print Media," Mutual
    Fund Caf�: Blue Plate Special, Financial Research
    Corporation (Jan. 18, 1999).
    7 1999 Investment Management Compensation Survey,
    Association for Investment Management and Research
    and Russell Reynolds Associates (Jul. 20, 1999).
    8 Hedge funds are private investment partnerships
    or offshore investment corporations that include a
    general partner, which manages the fund, and a
    limited number of other investors that usually
    must meet high minimum investment requirements.
    9 "How Fund Companies Are Using the Internet to
    Strengthen Customer Relationships and Cut Costs,"
    Mutual Fund Caf�: Inside Scoop, DeRemer &
    Associates and Wechsler Ross & Partners (Aug.
    1998)
    10 Mutual funds pay such costs to entities known as
    custodians, which provide for the safekeeping of
    stock certificates and other assets owned by the
    funds.
    11 Fund adviser and service provider revenues were
    estimated by multiplying fund assets by operating
    expense ratios.
    12 The total asset amounts differ from those
    presented elsewhere in this report because the
    data ICI provided for this revenue analysis did
    not include any funds sold as part of variable
    annuity products.
    13 Using data as of February 24, 1998, we
    identified these funds as being the largest funds
    that had been in existence since at least 1990.
    These 77 funds included 46 stock funds (including
    5 hybrid funds that invested in both stocks and
    bonds), each with assets over $8 billion; each of
    the 31 bond funds had assets of $3 billion.
    Collectively, these 77 funds had combined assets
    of $1,157 billion in 1998 and represented nearly
    28 percent of the $4,174 billion in total industry
    assets invested in these types of funds. As of
    that date, 10 other funds had similar levels of
    assets as the funds in our analysis; we did not
    include them in our analysis because they had been
    created after 1990.
    14 ICI did not provide data on the number of
    accounts for 1998.
    15 The studies we identified that addressed mutual
    fund adviser costs or profitability included Money
    Management Financial Comparisons 1998, Strategic
    Insight, LLC. (New York, NY: Apr. 1999); The Third
    White Paper: Are Mutual Fund Fees Reasonable?
    (September 1998 Update), Lipper Analytical
    Services, Inc. (Sep. 1998); and Price Valuation
    and Performance Analytics, Putnam Lovell Thornton
    & LaGuardia (Apr. 1999).
    16 The companies include AMVESCAP PLC, Affiliated
    Managers Group, Alliance Capital L.P., Eaton
    Vance, Franklin Resources, Federated Investment,
    Gabelli Asset Management, Kansas City Southern
    (financial group only), Liberty Financial, PIMCO
    Advisors L.P., Phoenix Investment Partners,
    Pioneer Group, Pilgrim America, The John Nuveen
    Company, Nvest L.P., T. Rowe Price, United Asset
    Management, and Waddell & Reed.

    Chapter 3
    Mutual Fund Operating Expense Ratios Generally
    Declined
    Page 51            GAO/GGD-00-126 Mutual Fund Fees
    Previously completed studies of trends in the
    operating expense ratios charged by mutual funds
    produced varying conclusions as to whether such
    fees were declining or increasing and faced
    criticism over the methodologies they used. Our
    own analysis indicated that the expense ratios
    charged by the largest funds were generally lower
    in 1998 than their 1990 levels, but this decline
    did not occur consistently over this period. The
    expense ratios for the largest stock funds, which
    experienced the greatest asset growth during the
    1990s, declined more than had the largest bond
    funds, whose expense ratios had generally remained
    flat. Finally, not all funds have reduced their
    fees despite experiencing growth in their assets.
    Our analysis of the largest funds indicated that
    25 percent of the funds whose assets grew by 500
    percent or more since 1990 had not reduced their
    expense ratios by at least 10 percent by 1998,
    including some funds that raised their fees.

    Studies Also Find Mixed Trend in Fees Across
    Industry
         Studies and analyses that looked at the trend
    in operating expense ratios and other charges to
    mutual fund investors had generally mixed
    findings, with some finding fees have risenand
    others finding them to have declined. Questions
    were raised about the conclusions of some of these
    studies because of the methodologies they used.

    Some Studies Find Declines in Mutual Fund Fee
    Charges
         Some of the studies we reviewed that had
    looked at the overall trend in mutual fund fees
    since 1990 found that the operating expense ratios
    and other charges were declining. Among these were
    a series of studies conducted by ICI, which looked
    at the trend in mutual fund fees charged by stock
    and bond funds .1 In these studies, ICI combined
    funds' annual operating expense ratios with an
    amortized portion of any sales loads charged.2 To
    calculate the average total annual costs for all
    funds, ICI multiplied each fund's total cost by
    the proportion that its sales represented of all
    fund sales that year. ICI stated that this
    methodology was intended to incorporate all of the
    costs that an investor would expect to incur in
    purchasing and holding mutual fund shares.
    Weighting these costs by fund sales was intended
    to reflect the costs of funds actually being
    chosen by investors each year.

         Using this methodology, ICI found that the
    total costs investors incurred as part of
    purchasing mutual funds declined 40 percent
    between 1980 and 1998 for stock funds and 25
    percent between 1980 and 1997 for bond funds. The
    studies also reported that a significant factor in
    the declining investor costs was the shifting by
    investors to lower cost funds. This shift by
    investors was also reflected in data showing
    faster growth in no-load funds than load funds.
    The ICI studies reported that a general decline in
    distribution costs (sales loads and 12b-1 fees)
    also contributed to the overall decline in
    investor costs.

    Other Studies Found Fees Rising
         In contrast, some studies or analyses that
    looked at the trend in mutual fund fees found that
    fees had been rising. These included analyses by
    academic researchers, industry research
    organizations, and regulators. For example, an
    analysis by an academic researcher indicated that
    the median asset-weighted average operating
    expense ratio of funds in the industry had
    increased by 7 percent from 1987 to 1998. An
    internal study by SEC staff found that median
    expense ratios had increased by 11 basis points
    from 1979 to 1992.

    Criticisms Raised Regarding the Methodologies Used
    by Some Fee Studies
         The conclusions reached by some of the mutual
    fund fee studies have been criticized because of
    the methodologies used. Some industry participants
    were critical of the conclusions reached in the
    ICI studies because it calculated average annual
    shareholders' costs by weighting them by each
    fund's sales volume. For example, analysts at one
    industry research organization acknowledged that
    the ICI data may indicate that the total cost of
    investing in mutual funds has declined. However,
    they said that because ICI weighted the fund fees
    and other charges by sale volumes, the decline ICI
    reports results mostly from actions taken by
    investors rather than advisers of mutual funds.3
    These research organization officials noted that
    ICI acknowledged in its study that about half of
    the decline in fund costs resulted from investors
    increasingly purchasing shares in no-load funds.

         Criticisms were also made of some studies or
    data that reported that the mutual funds fees had
    been rising. Such studies usually did not focus on
    a fixed number of funds over time but instead
    averaged the fees of all funds in existence each
    year. Critics noted that the averages calculated
    by these studies would be biased upwards by the
    increasing number of new funds, which tend to have
    high initial expenses until certain asset levels
    are reached. Such averages would also be
    influenced upwards by the increasing prevalence of
    funds with more specialized investment objectives,
    such as international funds, which usually have
    higher research costs and thus tend to have higher
    expense ratios overall than other funds.

    Largest Mutual Funds Generally Grew Faster Than
    Industry Average
         Our analysis indicated that the largest funds
    grew more than other funds in the industry. As
    shown in table 3.1, the average size of the 46
    largest stock funds increased by about 1,100
    percent from 1990 to 1998; the average size of all
    other stock funds increased by about 300 percent.
    Combined, the average size of the largest stock
    and bond funds grew by about 600 percent during
    this period as compared to the approximately 200-
    percent increase in the size of all other stock
    and bond funds.

    Table 3.1: Average Size of Stock and Bond Mutual
    Funds from 1990 to 1998
    Dollars in millions
    Largest Funds             Average size of fund
                            1990      1998  Percentage
                                                change
     46 stock funds       $1,828   $21,459      1,074%
     31 bond funds         2,551     5,828         128
    Total for largest      2,135    15,029         604
    funds
    All other funds in
    industry
     Stock funds             159       602         279
     Bond funds              206       291          41
    Total for all other      178       484         172
    funds
    Source: GAO analysis of data from ICI;
    Morningstar, Inc.; and Barron's Lipper Mutual
    Funds Quarterly.

    Among Largest Funds, Average Expense Ratios
    Declined for Stock Funds but Less so for Bond
    Funds
    Because they grew more than other funds, the
    largest funds would likely have been subject to
    the greatest economies of scale, which could have
    allowed their advisers to reduce the fees they
    charge investors. In general, the expense ratios
    on large mutual funds investing in stocks have
    been reduced since 1990, but the ratios of funds
    investing primarily in bonds have declined only
    slightly since then. In addition, these declines
    did not occur consistently over the period from
    1990 to 1998.

    According to our own analyses and those performed
    by others, larger mutual funds have generally
    reduced their operating expense ratios during the
    1990s. Using the data we collected on the 46
    largest stock and 31 largest bond funds in
    existence from 1990 to 1998, we calculated a
    simple average of their operating expense ratios.
    The simple average represents the fee an investor
    would expect to pay by choosing among the funds at
    random. As shown in figure 3.1, the average
    expense ratio per $100 of assets for largest stock
    funds declined from 89 cents in 1990 to 71 cents
    in 1998, which was a decline of 20 percent. The
    expense ratio for the largest bond funds was 66
    cents in 1990 and 64 cents in 1998, a decline of 3
    percent.

    Figure 3.1: Average Expense Ratios for 77 Largest
    Stock and Bond Mutual Funds From 1990 to 1998

    Source: GAO analysis of data from from ICI;
    Morningstar, Inc.; and Barron's Lipper Mutual
    Funds Quarterly.

    Analysis by the mutual fund industry association,
    ICI, also found that the advisers of large stock
    funds had generally reduced their funds' operating
    expense ratios. In its November 1998 study, ICI
    presented its analysis of data on the 100 largest
    stock funds established before 1980. It reported
    that the simple average of the operating expense
    ratios for these funds had declined from 82 cents
    in 1980 to 70 cents in 1997, representing a
    decline of about 15 percent.

         The decline in the fees charged by the
    largest stock and bond funds did not occur
    consistently over the period from 1990 to 1998.
    For both the stock funds and the bond funds in our
    analysis, we calculated the percentage that
    operating expense revenues represented of these 77
    funds' total assets during 1990 to 1998. This
    represents what the average dollar invested in
    these funds was charged in fees during this
    period. As shown in table 3.2, the fees paid by
    the average dollar invested in the largest stock
    funds rose in the first years of this period
    before declining in the last several years. As
    table 3.2 also shows, the fees paid by the average
    dollar invested in the largest bond funds remained
    relatively constant during this period but also
    declined in the most recent years.

    Table 3.2: Asset-Weighted Average Operating
    Expense Ratios for 77 Largest Stock and Bond Funds
    From 1990 to 1998 in Dollars Per $100 of Fund
    Assets
    Type of    Number 1990 1991 1992 1993 1994 1995 1996 1997  1998    Percentage
    fund           of                                              change 1990-
                funds                                                      1998
    Stock          46 $.74 $.78 $.78 $.80 $.81 $.79 $.75 $.68  $.65          -12%
    Bond           31 .62  .61  .61 .60  .61  .63  .61  .60   .58            -6
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

    Asset Growth Usually Resulted in Lower Expense
    Ratios but Not All Funds Made Reductions
    Although mutual funds in general appear to have
    reduced their operating expense ratios, our
    analysis and those by others indicated that not
    all funds had. The more funds' assets had grown,
    the more likely the fund adviser was to have
    reduced the expense ratios of those funds. Even
    among funds that grew significantly, however, not
    all had reduced their ratios by more than 10
    percent.

    Most Large Funds Had Reduced Expense Ratios
    Our analysis and those by others indicated that
    the advisers for most large funds had reduced
    their funds' expense ratios. Of the 77 large funds
    for which we collected data, 54 funds, or 70
    percent, had lower operating expense ratios in
    1998 than they had in 1990 (see table 3.3). As can
    also be seen, the largest bond funds were less
    likely to be charging lower fees than were stock
    funds; 48 percent of the bond funds had lower
    expense ratios compared to 85 percent of the stock
    funds.

    Table 3.3: Change in Operating Expense Ratios
    Charged by 77 Largest Stock and Bond Funds 1990-
    1998
    Type of    Funds that reduced    Funds with no      Funds that        Total
    fund              fees          change in fees      raised fees   number of
                                                                          funds
                  Number Percentag   Number Percentag Number Percentag
                                e                  e                e
    Stock             39      85%        2        4%      5       11%        46
    Bond              15       48        2         6     14        45        31
    Total             54       70        4         5     19        25        77
    Note: percentages do not total to 100 percent due
    to rounding.
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

         ICI also found that the expense ratios of
    large funds had declined over time. In its
    December 1999 study that discussed economies of
    scale for mutual funds, ICI provided data on the
    trend in operating expense ratios for 497 stock
    funds in existence as of 1998. ICI selected these
    funds because they all had assets of at least $500
    million and thus had experienced significant asset
    growth and likely reached sufficient size to
    realize economies of scale. ICI reported that 368,
    or 74 percent, of these 497 funds had lower
    operating expense ratios as of 1998 than they had
    charged in their first full year of operation.
    Conversely, the expense ratios of the other 129,
    or 26 percent, of the funds ICI reviewed had
    either not reduced their ratios or had raised them
    since their first full year of operation.

         The data on the largest funds cannot be used
    to ascertain what the trend in operating expense
    ratios has been for the industry as a whole.  As
    noted, our sample consisted of the 77 largest
    funds in existence since 1990.  ICI's study
    reviewed 497 funds with assets of over $500
    million.  In both analyses, the percentage of
    funds that had reduced their expense ratios was
    about the same.  SEC officials that reviewed our
    analysis noted that reviewing data for only the
    largest funds would bias the results towards those
    funds most likely to have reduced their expense
    ratios.  As a result, a review of funds outside
    the largest funds could find that a smaller
    percentage of funds had reduced their expense
    ratios to any significant degree.

    Funds With More Asset Growth More Likely to Reduce
    Expense Ratios, But Not all Funds Made Significant
    Reductions
    In analyzing the largest mutual funds, we found
    that the largest reductions in expense ratios
    generally involved funds with the greatest growth
    in assets. Conversely, increases in expense ratios
    tended to involve funds with more modest asset
    growth and a few funds with asset reductions.
    However, our analysis also showed that not all
    funds that experienced significant asset growth
    had reduced their operating expense fees by at
    least 10 percent over the period from 1990 to
    1998.4

    The more a fund's assets grew, the more likely its
    adviser was to have reduced the expense ratio. As
    shown in table 3.4, the more the assets of the 46
    largest stock funds had increased since 1990, the
    more likely they were to have lower operating
    expense ratios in 1998. However, not all funds had
    lower expense ratios even when they experienced
    significant asset growth. As can be determined
    from table 3.4, the assets of 40 of the large
    stock funds grew 500 percent or more from 1990 to
    1998. Of these 40 funds, 10 funds, or 25 percent,
    had not reduced their operating expense ratios by
    at least 10 percent in the 9 years since 1990; and
    2 of the funds were charging higher ratios in 1998
    than they had in 1990.

    Table 3.4: Relationship of Asset Growth and Change
    in Operating Expense Ratios for Largest Stock
    Funds 1990-1998
    Change in operating               Percentage change in assets         Total
    expenses
                              +1,000  +500 to  +200 to +200 to Decline in
                                        1,000      500       0     assets
    Reduction over 30 percent     14        2                                16
    Reduction between 10 and       7        7                1               15
    30 percent
    Reduction under 10             4        2        2                        8
    percent
    No change                      1        1                                 2
    Increase under 10 percent      1                                          1
    Increase between 10 and                                  1                1
    30 percent
    Increase over 30 percent       1                 1       1                3
    Total                         28       12        3       3          0    46
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

    Although bond funds had generally experienced less
    growth than had stock funds, a similar
    relationship between asset growth and operating
    expense reductions also existed for the largest
    bond funds that we analyzed. As table 3.5
    indicates, bond funds whose assets had grown since
    1990 were more likely to be charging lower
    operating expense ratios in 1998. However, similar
    to the stock funds, not all of the advisers for
    bond funds with significant asset growth had
    reduced their funds' fees. As can be determined
    from table 3.5, the assets of 11 of the large bond
    funds grew 500 percent or more from 1990 to 1998.
    Of these 11 funds, 3 funds, or 27 percent, had not
    reduced their expense ratios by at least 10
    percent in the 9 years since 1990.

    Table 3.5: Relationship of Asset Growth and Change
    in Operating Expense Fees for Largest Bond Funds
    1990-1998
    Change in                        Percentage change in assets             Total
    operating expenses
                          +1,000   +500 to   +200 to +200 to    Decline in
                                    1,000       500       0        assets
    Reduction over 30          1                                               1
    percent
    Reduction between          4         3         2       1                  10
    10 and 30 percent
    Reduction under 10         1                   2       1                   4
    percent
    No change                             1                 1                   2
    Increase under 10                     1                               2     3
    percent
    Increase between                                2       5             1     8
    10 and 30 percent
    Increase over 30                                        2             1     3
    percent
    Total                      6         5         6      10             4    31
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

    The December 1999 ICI study also reported that
    advisers for funds with greater asset growth had
    generally reduced their funds' operating expense
    fees by the largest amounts. Among the 497 funds,
    ICI determined that the funds in the top 20
    percent of asset growth had reduced their
    operating expense ratios on average by 51 cents
    per $100 of assets. In contrast, the decrease in
    the expense ratio for the funds in the bottom 20
    percent of asset growth averaged only 5 cents per
    $100 of assets

    Funds with Higher Operating Expense Ratios Made
    Greater Reductions Than Funds With Lower Ratios
    The extent to which advisers reduced a fund's
    expense ratio appears to depend on the initial
    level of the ratio. In its December 1999 study,
    ICI found that changes in operating expense ratios
    among the 497 stock funds they analyzed were
    related to the level of the fees the funds charged
    when they first began operations. To conduct its
    analysis, ICI divided the 497 stock funds into 5
    equal groups (quintiles) after ranking them by the
    expense ratios they charged during their first
    full year of operations. ICI reported that the
    funds in the quintile with the lowest ratios
    initially were charging an average of about 50
    cents per $100 of assets. By 1998, the average
    expense ratio charged by these funds had increased
    by 7 cents. In contrast, the funds in the quintile
    with the highest fees had an average operating
    expense ratio in the initial period of $1.86, and
    by 1998 they had reduced their ratios by an
    average of 76 cents.

    Our own analysis of the largest mutual funds
    confirmed this relationship between relative fee
    levels and subsequent operating expense ratio
    changes. To perform this analysis, we separated
    the 77 largest stock and bond funds into 2 groups
    based on whether their operating expense ratios
    were higher or lower than the combined average for
    each type of fund5 in 1990. This resulted in 29
    funds whose 1990 expense ratios were higher than
    the average charged by funds of their type in 1990
    and 48 funds whose ratios were lower. As shown in
    figure 3.2, the average ratio for the 29 high-fee
    funds declined from $1.22 to 92 cents; the average
    ratio charged by 48 low-fee funds remained
    relatively flat at about 54 cents.

    Figure 3.2: Average Operating Expense Ratio From
    1990 to 1998 for Funds With Above and Below
    Average Fees in 1990

    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

    The relative asset growth of these funds also may
    help to explain the changes in their operating
    expense ratios. Our analysis of these large funds
    indicated that the 29 higher fee funds had
    experienced a larger increase in assets than the
    48 lower fee funds. As shown in table 3.6, the 29
    funds grew 901 percent in average fund size during
    1990-98, almost twice the 496-percent growth in
    average fund size of the other 48 funds. These
    results are consistent with our previously
    discussed findings discussed previously that
    greater asset growth is generally associated with
    greater reductions in expense ratios.

    Table 3.6: Change in Average Size in Assets and
    Operating Expense Ratios from 1990 to 1998 for
    Largest Funds by Relative Fee in 1990
    Type of fund N  Asset size of average fund     Operating expense ratio (in
                u    (dollars in millions)        dollars per $100 of assets)
                m
                b
                e
                r
                o
                f
                f
                u
                n
                d
                s
                      1990      1998 Percentage     1990       1998   Percentage
                                        change                           change
    High fee     3  $1,515   $15,162       901%    $1.22       $.92         -25%
    funds        0
    Low fee      4   2,510    14,948        496      .54        .54            0
    funds        7
    Total        7   2,135    15,029        604       80         68         -15%
                7
    Source: GAO analysis of data from Morningstar,
    Inc., and Barron's Lipper Mutual Funds Quarterly.

    _______________________________
    1 The three ICI studies were: Trends in the
    Ownership Cost of Equity Mutual Funds, November
    1998; Total Shareholder Cost of Bond and Money
    Market Mutual Funds, (Washington, D.C.: Mar.
    1999); and Mutual Funds Costs, 1980-1998,
    (Washington, D.C.: Sep. 1999). ICI also issued a
    related study of economies of scale that also
    included fee trend information: Investment Company
    Institute Perspective: Operating Expense Ratios,
    Assets, and Economies of Scale in Equity Mutual
    Funds, John D. Rea, Brian K. Reid, and Kimberlee
    W. Millar, (Washington, D.C.: Dec. 1999).
    2 To account for any sales loads charged, the ICI
    researchers spread (or amortized) the load charges
    over numerous years according to estimates of the
    average period over which investors hold their
    funds. Thus, the total costs to fund shareholders
    each year was calculated as the annual operating
    expenses plus that year's proportionate share of
    any applicable sales load.
    3 Morningstar.Net Commentary: Revisiting Fund
    Costs: Up or Down?, Scott Cooley, Morningstar,
    Inc. (Feb. 19, 1999).
    4 We used 10 percent as the threshold for
    identifying a significant reduction because 10
    percent is a traditional accounting measure of
    materiality, and it appeared to be a reasonable
    amount given the level of asset growth that
    occurred during this 9-year period.
    5We computed separate averages for each fund type.
    This resulted in the 46 stock funds being
    separated into 19 funds with fees higher than the
    stock fund average fee and 27 funds below the
    average. The 31 bond funds included 10 high-fee
    funds and 21 low-fee funds.

    Chapter 4
    Competition in Mutual Fund Industry Does Not Focus
    on Fees
    Page 64            GAO/GGD-00-126 Mutual Fund Fees
    The structure and nature of competition in the
    mutual fund industry appear to resemble the type
    of market referred to by economists as
    "monopolistic competition."1 In industries with
    this type of competition, entry is easy and many
    firms are present. Also, products differ from one
    another, which lessens direct competition on the
    basis of price. Our review found that the mutual
    fund industry has characteristics of a
    monopolistically competitive market. Although
    thousands of mutual funds appear to compete
    actively for investor dollars, this competition
    has not focused primarily on the price of the
    service-i.e., fees charged to shareholders.
    Instead, mutual funds compete primarily on
    performance returns, which implicitly consider
    fees, services, and other fund characteristics.

    Mutual Fund Industry Exhibits Characteristics of
    Monopolistic Competition
    In general, the mutual fund industry exhibits the
    characteristics of monopolistic competition. As
    stated above, markets or industries where
    monopolistic competition prevails typically have
    large numbers of firms and easy entry into the
    market/industry. Such industries also offer
    products that differ from one another in terms of
    quality, features, or services included. Our
    review, and the analyses of others, found that the
    mutual fund industry, with its numerous
    participants, easy entry, and many different
    products, has the traits of a monopolistically
    competitive market.

    Characteristics of a Monopolistically Competitive
    Market
    Economists often classify industries by the
    prevailing type of competition for products in
    those markets. For instance, perfectly competitive
    markets have large numbers of competing firms,
    easy entry into the industry, and standardized
    products. Such markets have commodity-like
    products; all units offered are basically the
    same, such as agricultural products. In such
    markets, the products of one firm are often very
    close or perfect substitutes for those offered by
    other firms. Firms in markets with perfect
    competition are unable to charge a price different
    from that set by the market.

    Industries where monopolistic competition prevails
    usually have large numbers of firms and andanan
    easy industry entry, but products are
    differentiated by characteristics, such as quality
    or service. Because their products differ, firms
    can charge different prices from other firms in
    the industry. This ability to distinguish one
    firm's product from that of others, results in
    somewhat higher pricing levels than would result
    from a perfectly competitive market. In such
    markets or industries products are promoted by
    brand, rather than price. Various features, such
    as quality, service, or other characteristics,
    differentiate products from one another,
    accordingly, prices differ.

    The markets for various retail products and
    personal services are among those generally
    characterized by monopolistic competition. For
    example, one market that could be considered to
    have such competition could be medical services,
    such as doctors or dentists. These professionals
    generally do not compete primarily on the basis of
    the price of their services but instead rely on
    their reputations for quality and their physical
    location to attract customers. Other product
    markets that could be characterized as
    monopolistically competitive could include those
    for snack foods. Although a grocery would likely
    offer the widest selection and the lowest prices
    for snack foods, such products are also available
    at convenience stores, gas stations, and vending
    machines. These other retail outlets generally
    charge more for similar items but attract
    customers by offering more convenient locations
    and a reduced effort on the part of customers to
    make a purchase.

    Large Numbers of Competing Funds and Fund
    Complexes Exist
    The mutual fund industry is characterized by a
    large and growing number of funds.  As shown in
    figure 4.1, the number of individual mutual funds
    in the industry has grown significantly since the
    early 1980s.

    Figure 4.1:  Number of Mutual Funds from 1984 to
    1998

    Source: GAO analysis of data from ICI.

         Figure 4.1 shows that from 1984 to 1998, the
    total number of funds grew almost 500 percent,
    from over 1,200 to about 7,300. The number of
    stock funds increased 650 percent during this 15-
    year span to about 3,500, and the number of bond
    funds grew by 730 percent to about 2,300. The
    number of funds increased most dramatically during
    the 1990s, as over 4,200 new funds were created
    between 1990 and 1998. Stock funds represented
    more than half of the 1990s growth, increasing in
    number by over 2,300 funds.

         The number of fund families also rose
    significantly during the same period. As shown in
    figure 4.2, the number of families grew from 193
    in 1984 to 418 in 1998, a 117-percent increase
    over the 15-year period. Growth during the 1990s
    was more modest than in the 1980s, as the number
    of fund families increased by 94 from 1990 to 1998
    compared to an increase of 201 from 1984 to 1990.

    Figure 4.2: Number of Mutual Fund Famillies for
    Selected Years From 1984 Through 1998

    Source: ICI.

         Concentration of assets under management in
    the mutual fund industry has changed little since
    1984. Data compiled by an industry research
    organization showed that the 20 largest fund
    families accounted for about 65 percent of the
    total assets as of November 1998, compared to
    about 67 percent in March 1984. A statistical
    measure of industry concentration known as the
    Herfindahl-Hirshman Index,2 which is used by the
    Department of Justice in assessing antitrust
    cases, also shows that the mutual fund industry is
    not concentrated. On a scale with a maximum value
    of 10,000, the mutual fund industry scored 329 as
    of May 1997, slightly lower than its score of 350
    in 1984.

    Although Some Barriers Exist, Most Saw Relative
    Ease of Entry into Industry
         Most of the officials we contacted, and
    documents we reviewed, indicated that entry into
    the mutual fund industry has been relatively easy.
    As previously discussed, ease of entry is a
    characteristic of monopolistic competition. In
    1998 testimony before Congress,3 the ICI president
    indicated that barriers to entry were low, as
    start-up costs were not high and firms did not
    have to register in each state. Some officials
    explained that entry into the industry was also
    easy because new mutual fund advisers can quickly
    be operational by contracting with one or more of
    the various organizations that specialize in
    providing many, if not all, of the administrative
    services and functions required to operate a
    mutual fund.

         Another factor officials cited that likely
    increases funds' ability to compete is the advent
    of fund "supermarkets." In recent years, various
    mutual fund or broker dealer firms have created
    fund supermarkets, through which they provide
    their customers the opportunity to invest in a
    wide range of funds offered by different mutual
    fund families. Industry officials said that such
    supermarkets provide small or new fund advisers
    access to investors.

         Not all of the officials we contacted agreed
    that barriers to entry are low in the mutual fund
    industry. For example, an official of an
    organization that researches the mutual fund
    industry told us that start-up costs for new funds
    are high because a fund typically needs to attract
    at least $100 million in assets before it
    adequately covers its costs. Another industry
    research organization official said that one
    significant barrier to entry is that new entrants
    lack a long enough performance history to be rated
    by the major mutual fund rating services. Many
    officials remarked that these ratings greatly
    influence investors' fund choices. Thus, new funds
    without such ratings would have much more
    difficulty attracting investors. Another barrier
    to entry faced by new fund advisers is obtaining
    adequate distribution of their funds. Recently,
    fund distributors, such as broker-dealer firms,
    have been reducing the number of funds and fund
    families they are willing to promote and
    increasing charges for their services, further
    escalating start-up costs.

    Alternative Financial Products Also Represent
    Competition to Mutual Funds
         In addition to the large numbers of competing
    firms in the mutual fund industry, other similar
    financial products also likely create competition
    for mutual funds. Currently investors seeking to
    invest in portfolios of securities, which is the
    type of investment that mutual funds offer, can
    also choose to purchase other products whose
    values are derived from the prices of various
    underlying securities. For example, World Equity
    Benchmark Shares (WEBS), which are traded on the
    American Stock Exchange, allow investors to
    purchase shares whose values are intended to track
    the prices of a selection of foreign stocks from
    various countries. Other firms have begun offering
    investors the opportunity to invest in custom-
    designed baskets of securities. With the dramatic
    decrease in the commissions charged to conduct
    individual securities transactions and the ability
    of investors to conduct their own transactions
    through on-line brokerage accounts, investors
    could also create their own portfolio of
    securities without having to invest in mutual
    funds.

    Mutual Funds Offer Differentiated Products
         Another characteristic of the mutual fund
    industry consistent with monopolistic competition
    is that it offers differentiated products.
    Although all mutual funds basically offer
    investors a standardized means for investing in a
    pool of diversified securities, firms offering
    mutual funds compete by attempting to
    differentiate their products from others. Mutual
    funds invest in a variety of securities that can
    be grouped primarily into three categories:
    stocks, bonds, and money market instruments.
    However, within these categories, funds can
    further differentiate the nature and/or mix of
    securities or bonds in the fund's portfolio, such
    as by investing in

    �    stocks of large, mid-size, or small
    companies;
    �    bonds of corporations or government entities;
    �    bonds with different maturities; or
    �    stocks or bonds of domestic or foreign
    companies or governments.

    A fund's portfolio manager can be another
    differentiating factor. Funds commonly have
    specific portfolio managers who make investment
    decisions for the fund. At times, the popularity
    of a particular fund portfolio manager can be such
    that investors view that manager's fund as unique
    even though many other funds may exist that invest
    in similar types of securities.

    Yet other differentiating factors would be the
    number and quality of services provided to
    shareholders. Among other services, the fund
    officials we met with spoke of providing 24-hour
    telephone service, allowing investors to access
    their accounts over the Internet, and providing
    well-trained customer service staff.

    Mutual Fund Industry Generally Does Not Attempt to
    Compete On Basis of Fees
    The competitive conduct of firms within the mutual
    fund industry does not generally emphasize the
    fees investors pay for the service. Instead,
    mutual fund advisers seek to differentiate their
    offerings primarily by promoting their funds'
    returns and their fund families' services.
    However, the potential for differentiation varies
    among the three primary fund categories. Because
    equity funds generally have the greatest variety
    of investment alternatives and styles, they have
    the greatest potential for differentiation.
    Because money market funds are the most
    standardized, they have the least potential for
    differentiation. Bond funds tend to be somewhere
    between the other two, although more like money
    market funds. Most officials saw these differences
    as leading to greater variation in the level of
    fees charged by stock funds than for bond and
    money market funds.

    In general, firms offering mutual funds attempt to
    compete by emphasizing factors other than the
    operating expense fees they charge for their
    services. Although markets with commoditylike
    products usually compete primarily on the basis of
    price, when products can be differentiated, price
    competition tends to be less important than other
    factors. One academic analysis4 characterizes a
    monopolistically competitive industry as offering
    products that are near, but imperfect,
    substitutes. According to this study, to avoid
    competing on price, firms will strive to
    differentiate their products from those of their
    rivals, allowing them to set prices within a
    market niche. The authors describe various other
    factors, besides price, through which mutual funds
    can seek to differentiate themselves. These
    factors include funds' investment selections,
    trading and execution abilities, customer
    recordkeeping and reporting, and investor
    liquidity services. For example, funds can
    emphasize investor liquidity services by allowing
    investors to switch from one fund to other funds
    in the fund family by telephone .

    In the academic papers and speeches we reviewed
    and the interviews we conducted, observers agreed
    that although the importance of fees to
    competition varies by fund type, mutual funds do
    not compete primarily on the basis of their
    operating expense fees . Observers noted that
    because the range of securities in which money
    market funds and bond funds can invest is
    generally more restricted than for other funds,
    they are not as differentiated and are more
    commoditylike. Therefore, fees for these funds can
    have a greater effect on their performance
    relative to other money market and bond funds and,
    thus, on their ability to compete. According to
    one industry research organization's analysis,
    fees can dictate whether bond funds succeed or
    fail. This analysis indicated that for one type of
    fund-municipal bond funds-just a few basis points
    difference in operating expense fees can be
    critical to the overall performance of the fund
    because the returns on these funds vary so little
    from those of their peers.5

    The greater importance of operating expense fee
    levels to money market and bond funds influences
    the fees that fund companies set for these types
    of funds. For example, firms offering money market
    funds, for competitive reasons, often waive
    portions of asset fees as a means of attracting
    additional assets to their funds. Industry
    officials also said that the less diverse nature
    of money market and bond funds contributes to
    their having lower fees than most stock funds.

    For stock funds, industry officials explained that
    the large variety of investment objectives could
    lead to a wider range of investment returns and
    thus greater possibilities for differentiation
    among funds. An industry research organization
    official explained that because investment returns
    can vary much more from one stock fund to another,
    the fee levels of stock funds may be much less
    relevant to their relative performance. For this
    reason, officials generally acknowledged that
    firms offering stock funds did not attempt to
    compete primarily on the basis of operating
    expense fees charged by the fund. The chairman of
    one mutual fund firm stated that although price
    competition exists among money market and bond
    funds, for which the impact of operating expense
    fees was more obvious, stock funds were not
    subject to nearly as much price competition. In
    addition, an official of an industry research
    organization told us that because the range of
    returns for stock funds can be wider, the
    investment manager can add more value; thus, the
    operating expense fees on such funds are higher
    than those for money market and bond funds.

         Instead of competing on the basis of the
    price of providing mutual fund services, fund
    advisers generally emphasize the performance of
    their funds when attempting to differentiate their
    funds from those of their competitors. Mutual fund
    firm officials and others in the industry
    acknowledged that funds compete primarily on the
    basis of their performance. However, mutual fund
    adviser and other industry officials also observed
    that because funds are required to report
    performance figures net of expenses, operating
    expense fees are indirectly taken into account in
    their competition.

         To document factors mutual fund companies
    emphasize in their promotions, we analyzed a
    selection of mutual fund print advertisements for
    content. We evaluated 43 mutual fund
    advertisements for 28 different mutual fund
    families, which appeared in 5 randomly selected
    issues of popular business, news, or personal
    finance magazines and 1 business newspaper between
    July and November 1999. In 27 of the 43
    advertisements, performance was the primary
    emphasis; and attributes of the fund adviser, such
    as its experience or strategy, were primarily
    emphasized in another 11. Fees and other charges
    were the primary emphasis in 2 of the 43
    advertisements, both of which were from the same
    fund family. However, 16 of the 43 advertisements
    included statements that the funds described did
    not charge sales loads.

    Opinions Were Mixed on the Effect of Competition
    on Fees
         Opinions were mixed as to whether the large
    number of competing funds and fund complexes
    provided effective fee competition. Officials from
    mutual fund advisers, industry associations, and
    research organizations we contacted generally
    agreed that the large number of funds and fund
    complexes in the industry leads to active
    competition, which affects fees. An official of a
    bank-affiliated fund adviser told us that the
    industry is extremely competitive because the
    competition among so many different companies and
    funds highlights and maintains downward pressure
    on fees. Ease of entry to the industry could also
    exert downward pressure on fees. One mutual fund
    adviser official remarked that in an environment
    of easy entry where fees were too high, other
    firms would enter the industry and charge lower
    fees.

         However, other officials, including financial
    planning firm representatives and academic
    researchers, disagreed with the contention that
    competition among the many mutual fund firms in
    the industry serves to effectively lower fees. An
    academic researcher testified before Congress on
    mutual fund issues that although the industry
    competes vigorously against other financial
    services industries, fee competition within the
    industry is not as effective, noting that most
    economists view competition in the mutual fund
    industry as imperfect. A senior official at one
    mutual fund firm said in a speech6 that about 50
    fund advisers actually attempt to compete across
    all types of funds. He asserted that in other
    industries, this number would be enough to produce
    fierce price competition, but he found price
    competition conspicuously absent among mutual fund
    advisers.

    Competition on the Basis of Price Not Completely
    Absent
         Despite the fact that competition in the
    mutual fund industry does not focus primarily on
    the price of mutual fund services, some evidence
    of competition on the basis of fees did exist. For
    example, the two largest fund groups are among the
    industry's low-cost providers, with one group
    actively promoting its low fees and expenses as a
    means of attracting customers. Regulatory
    officials told us that the increased popularity of
    low-cost index funds, whose share of total stock
    fund assets increased from less than 2 percent in
    1990 to 7 percent in 1999, was evidence that
    competition on the basis of fees occurs and that
    some investors are mindful of it.

    _______________________________
    1 In addition to monopolistic competition,
    economists also classify the nature of competition
    prevailing in markets into at least three other
    types that include perfect competition, oligopoly,
    and monopoly. The distinguishing features of each
    type vary across various characteristics,
    including the number of firms, ease of entry,
    degree of product differentiation, and competitive
    strategies used.
    2 The index determines a score of industry
    concentration based on the percentage market share
    of each firm in the industry. An index score of
    close to 0 would indicate perfect competition --
    where all firms have equal market shares--but a
    score of 10,000 would indicate a monopoly--where
    one firm has the entire market to itself.
    Therefore, the lower the index score, the higher
    the level of competition in the industry;
    conversely, the higher the score, the lower the
    level of competition.
    3 "Improving Price Competition for Mutual Funds
    and Bonds," before the Subcommittee on Finance and
    Hazardous Materials, House Commerce Committee,
    September 29, 1998.
    4 "Competition and Change in the Mutual Fund
    Industry," Financial Services: Perspectives and
    Challenges, Erik R. Sirri and Peter Tufano, HBS
    Press (Boston, MA.: 1993).
    5 Industry-Wide Expense Trends: Should Industry
    Growth Necessarily Translate into Lower Average
    Expense Ratios?, Blue Plate Special, Mutual Fund
    Caf�, Financial Research Corporation (Jan. 5,
    1998;
    http://www.mcafe.com/pantry/bps_010598.html).
    .6 Remarks on Receiving the Special Achievement
    Award of the National Association of Personal
    Financial Advisors, John C. Bogle, Senior
    Chairman, The Vanguard Group (Washington, D.C.:
    Jun. 4, 1999).

    Chapter 5
    Mutual Funds Are Not Required to Disclose Actual
    Amounts Charged to Individual Investors
    Page 81            GAO/GGD-00-126 Mutual Fund Fees
         Under existing law, mutual funds are required
    to inform investors of sales charges and ongoing
    operating expenses for the funds in which they
    invest. However, funds are not required to provide
    information on the actual dollar amount of each
    investor's share of the operating expenses that
    were deducted from the fund. This contrasts with
    most other financial products and services for
    which specific dollar charges are generally
    required to be disclosed. Studies and data that
    others, and we, collected indicate that mutual
    fund investors have focused more on fund
    performance and other factors than on fee levels.
    In contrast to the consideration they give fees,
    investors appeared more concerned over the level
    of mutual fund sales charges (loads). Industry
    participants acknowledged that such concerns have
    resulted in fund advisers lowering the loads
    charged on mutual funds since the 1980s.

         Opinions varied on the usefulness to
    investors of the required fee disclosures. The
    mutual fund and regulatory officials we contacted
    generally considered mutual fund disclosures to be
    extensive and adequate for informing prospective
    investors of the fees they would likely incur on
    their mutual fund investments. However, some
    private money managers, industry researchers, and
    legal experts indicated that the current fee
    disclosures do not make investors sufficiently
    aware of the fees they pay. Having mutual funds
    disclose to each investor the actual dollar amount
    of fees he or she paid was one way suggested to
    increase investor awareness and to potentially
    stimulate fee-based competition among fund
    advisers. Although exact fee computations would
    require fund advisers and others to make systems
    changes and incur additional costs, alternative,
    less costly ways may exist for computing the fee.

    Required Fee Disclosures Do Not Provide Amounts
    Paid by Individual Investors in Dollars
         Neither federal statute nor SEC regulations
    expressly limit the fees that mutual funds deduct
    for operating expenses. Instead, mutual fund
    regulations focus on ensuring that investors are
    provided with adequate disclosure of the risks and
    costs of investing in mutual funds. At the time of
    purchase, mutual funds are required by law to
    provide certain information to potential fund
    investors about the funds, including information
    about the fees they will pay. This fee information
    is governed by certain provisions of the
    Investment Company Act of 1940 and various SEC
    rules and regulations that require fee disclosures
    so that investors can make more informed
    investment decisions.

         Presently, all funds must provide investors
    with disclosures about the fund in a written
    prospectus. SEC rules require that the prospectus
    include a fee table containing certain specific
    information about the sales charges, operating
    expenses, and other fees that an investor will pay
    as part of investing in the fund.

         Figure 5.1 shows an example of a fee table
    for a typical mutual fund. As shown in the figure,
    the fee table required for mutual funds primarily
    consists of three sections. The first section
    presents information on shareholder transaction
    expenses, which investors pay out of the amount
    they invest. These include any sales charges or
    loads that will apply to the purchase of the fund
    shares, which are shown as a percentage of the
    amount to be invested. Investors are also to be
    informed of the percentage charges that may be
    assessed at redemption1 or that apply to
    reinvested dividends or other distributions.2 In
    addition, some funds charge redemption or exchange
    fees. Redemption fees are expressed as a
    percentage of the amount redeemed and are paid at
    the time the investor sells fund shares. Exchange
    fees can be assessed when investors exchange
    shares of one fund for shares of another fund in
    the same family. The fund depicted in figure 5.1
    charges its investors a 5.75-percent load but does
    not levy any other sales charges.

    Figure 5.1: Example of a Fee Table Required as
    Part of Mutual Fund Fee Disclosures

    Source: GAO example based on fee table in actual
    mutual fund prospectus.

    The middle section of the fee table shown in
    figure 5.1 presents the fund's total operating
    expenses incurred over the previous year. Funds
    are required to provide information on the
    management fee, distribution and/or service fees
    (referred to as 12b-1 fees), and any other
    expenses that are deducted from the fund's assets
    or charged to all shareholder accounts. Other
    expenses deducted from fund assets would include
    amounts the fund paid for transfer agent services,
    as well as record-keeping, printing, mailing, or
    other services. These fees and expenses are
    deducted from the fund's assets on an ongoing
    basis and presented in the fee table, in
    aggregate, as a percentage of the fund's average
    net assets for the prior year. In the fee table
    shown in figure 5.1, the total expenses deducted
    from the fund's assets over the course of the
    prior year represented 0.70 percent of its average
    net assets for that period.

         In the last section of the fee table, mutual
    funds are required to present a hypothetical
    example of the total charges an investor is likely
    to incur on a fund investment. This portion of the
    fee table must show costs the investor will likely
    incur over 1-, 3-, 5-, and 10-year periods,
    assuming a $10,000 investment in the fund, a 5-
    percent return each year, and fund operating
    expenses that remain constant throughout each
    period. SEC requires that the fee table include a
    statement that information in the example is
    intended to allow investors to compare the cost of
    investing in the fund with that of investing in
    other mutual funds.3

         In addition to the disclosures required when
    investors initially purchase shares, mutual funds
    are required to provide shareholders of their
    funds, at least semiannually, reports that also
    include certain fee and expense information. In
    these reports, funds are to include a statement of
    operations that shows the total dollar amount of
    the various expenses the fund incurred over the
    prior period. Funds must also indicate the
    percentage of average net fund assets that these
    total expenses represent.4 Also, shareholders who
    purchase additional shares during the year must be
    provided an updated prospectus document, at least
    annually, which would include the fee table with
    the latest year's expense information. In
    practice, many mutual funds send an updated
    prospectus to all of their shareholders annually.

    However, mutual funds are not required to provide
    investors with information showing the specific
    dollar amount of operating expenses that they paid
    as part of holding their mutual fund shares.
    Mutual fund shareholders generally receive a
    quarterly statement of account5 that denotes any
    money balances or account activity during the
    quarter. These quarterly statements generally
    indicate the number of shares held by the
    investor, the NAV of those shares as of the
    statement date, and the corresponding total value
    of the shares. These statements do not show, in
    either dollars or as a percentage of assets,6 the
    shareholder's portion of the operating expenses
    that were deducted from the fund's assets.

    Charges for Other Financial Services Typically
    Disclosed in Dollars
    Although mutual funds do not provide individual
    shareholders information on the specific dollar
    amounts of all fees paid, most other financial
    services or products are generally required to
    make such disclosures.

    To compare the information investors receive on
    mutual funds, we collected information on the
    extent to which the users of certain other
    financial products or services are informed of
    specific dollar charges for such products or
    services. We collected this comparative
    information on products and services that we
    believed mutual fund investors would be likely to
    use, such as bank deposit accounts or stock or
    bond transactions through a securities broker-
    dealer. Our information sources for determining
    disclosure requirements for these other products
    included applicable federal statutes or
    regulations; in some cases, we summarized common
    industry practices regarding fee disclosure
    information. As shown in table 5.3, investors in
    other financial products or users of other
    financial services generally receive information
    that discloses the specific dollar amounts for
    fees or other charges they pay.

    Table 5.1: Fee Disclosure Practices for Selected
    Financial Services or Products
    Type of product Disclosure requirement
    or service
    Deposit         Depository institutions are
    accounts        required to disclose itemized fees,
                   in dollar amounts, on periodic
                   statements.
    Bank trust      Although covered by varying state
    services        laws, regulatory and association
                   officials for banks indicated that
                   trust service charges are generally
                   shown as specific dollar amounts.
    Investment      When the adviser has the right to
    services        deduct fees and other charges
    provided by     directly from the investor's
    individual      account, the dollar amounts of such
    investment      charges are required to be
    advisers        disclosed to the investor.
    Wrap accountsa  Provider is required to disclose
                   dollar amount of fees on investors'
                   statements.
    Stock, bond, or Broker-dealers are required to
    other           report specific dollar amounts
    securities      charged as commissions to
    purchases       investors.
    Real estate     Brokerage commissions generally are
    property        specified as a percentage of
    purchases       property value but disclosed as a
                   specific dollar amount on purchase
                   documents.
    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.
    Source: Applicable disclosure regulations and/or
    rules, and/or industry practice.

    The information in the table illustrates that in
    contrast to mutual funds, the providers of the
    featured services and products usually disclose
    the specific dollar amount of the charges their
    users incur. We believe that such disclosures may
    be one reason for the apparently vigorous price
    competition among firms offering these services
    and products. For example, securities commissions
    were formerly fixed by law, with transactions
    commonly costing hundreds of dollars. In 1975, SEC
    invalidated fixed commission rates as being in
    violation of the antitrust laws. Subsequently,
    certain securities firms began competing for
    customers primarily by promoting their lower
    charges for conducting transactions. Competition
    among these firms, commonly known as discount
    brokers, has been heightened by their increasing
    use of the Internet, with their commissions for
    buying or selling securities now less than $10 or
    $20 at some firms. Banks also frequently compete
    for customers on the basis of the fees they charge
    on checking accounts, and advertisements for "no-
    fee checking" have become common.

    However, the fee disclosures provided by mutual
    funds may exceed those of certain other investment
    products, although such products may not be
    completely analogous to mutual funds. For example,
    fixed-rate annuities or deposit accounts that
    provide investors a guaranteed return on their
    principal at a fixed rate do not charge the
    purchasers of these products any operating expense
    fees. The financial institutions offering these
    products generate their profits on these products
    by attempting to invest their customers' funds in
    other investment vehicles earning higher rates of
    return than they are obligated to pay to the
    purchasers of the annuities. However, the returns
    they earn on customer funds and the costs they
    incur to generate those returns are not disclosed
    as operating expenses to their customers.

    Mutual funds differ from such products in that
    they do not guarantee their investors a specific
    return, and their fund fees are directly deducted
    from fund assets for specific expenses associated
    with operating the funds, including adviser
    compensation for its investment management
    services. Thus, investors placing money in mutual
    funds are essentially hiring the fund adviser to
    provide money management services rather than
    purchasing an investment product with a stated
    return as they do with annuities and other fixed-
    rate investment products. As a result, disclosure
    of the dollar amounts of mutual fund fees would be
    akin to the dollar amount disclosures that
    customers receive for brokerage services or
    checking account services. In contrast, customers
    purchasing or placing money in fixed-rate
    investments, such as certificates of deposit or
    annuities, are not told the amount that the
    financial institution earns on the customer's
    capital. In these cases, the customer is
    purchasing a product with specific features,
    including its promised return, rather than
    obtaining a service from the provider as they are
    with mutual funds.

    Mutual Fund Fees Are Not a Primary Consideration
    for Investors
         According to surveys and other information,
    investors tend to consider other factors before
    considering fees charged by mutual funds. On the
    other hand, investors appear to be more sensitive
    to mutual fund loads, and these charges have
    declined over time.

    Various Other Factors Get Greater Consideration
    Than Fees
         Investors themselves have indicated that
    other factors take precedence over fees when they
    evaluate mutual funds.  To assess the extent to
    which investors consider fee information when
    selecting and evaluating mutual funds, we
    consulted a wide variety of sources, including
    academic literature, industry research firms and
    other industry experts, mutual fund advisers,
    industry associations, and regulators. Our review
    of this information revealed that when evaluating
    funds, investors generally gave greater
    consideration to several other factors before
    considering fund fees. The primary factor
    investors used in selecting mutual funds was
    generally the fund's performance. Other factors
    also given greater consideration than fees
    included fund manager or company characteristics,
    the investments made by funds, or fund risk
    levels. For example, a 1995 random survey
    conducted on ICI's behalf of individuals who had
    recently made stock or bond fund purchases7 asked
    what information they had considered beforehand.
    Cited by 75 percent of the 653 respondents, fund
    performance was most frequently considered,
    followed by fund risk (69 percent), investment
    goals (49 percent), and portfolio securities (46
    percent). Cited by only 43 percent of the
    respondents, fees and expenses ranked fifth.

         Even after purchasing shares, investors
    apparently continue to consider other factors
    ahead of fund fees when reviewing their mutual
    funds. A 1997 ICI report8 relating the results of
    interviews with over 1,000 recent mutual fund
    purchasers, selected at random,stat stated that 76
    percent of those surveyed had considered fees and
    expenses before making their purchases. However,
    respondents cited five other factors, including
    account value and rate of return, as information
    they monitored more frequently than fees and
    expenses after they had made their purchases.

    The apparent lack of investors' attention to fees
    by investors has been a source of concern for
    regulators. During testimony before the House
    Subcommittee on Finance and Hazardous Materials of
    the Committee on Commerce,9 SEC's Chairman stated:
    "The Commission is very concerned. that many fund
    investors are not paying attention to the
    available information about fees." He further
    stated that the agency's research showed that
    fewer than one in six fund investors understood
    that higher expenses can lead to lower returns,
    and fewer than one in five could give any estimate
    of expenses for their largest mutual fund. He
    cited other research that found that about 40
    percent of fund investors surveyed believed
    incorrectly that a fund's annual operating
    expenses have no effect on its gains.

         Both critics and industry participants told
    us that the unprecedented bull market of the last
    10 years has allowed investors to ignore the
    impact of fees. In a January 1998 study10 that
    looked at the trend in mutual fund fees, one
    research organization noted that fees are not a
    primary consideration for investors and that as
    long as stock prices are rising, investors would
    accept even the highest of fees. Some industry
    participants stated that when market returns
    eventually revert to lower levels, investors might
    then take more interest in the fees they pay on
    their mutual funds.

    Some research indicated that the majority of
    mutual fund investors are likely to be less
    sensitive to the fees their funds charge because
    they rely on the advice of investment
    professionals when selecting funds. According to
    research by ICI and others, the majority of mutual
    fund investors make their purchases on the basis
    of advice from an investment professional, such as
    a broker-dealer representative or private money
    manager. For example, ICI's 1997 report on the
    1995 survey of over 1,000 investors who had
    recently purchased mutual funds stated that about
    60 percent had consulted with investment advisors
    to assist with their decisions. Some industry
    participants said that investors who rely on
    investment advisors are not likely to exert much
    pressure for lowering fees.

    Investors Appear More Aware of Sales Loads than
    Operating Expense Fees
         Although investors do not appear to give
    primary consideration to the fees funds charge as
    a percentage of fund assets, they are aware of
    loads. Many officials we interviewed attributed
    load declines to investor awareness.

         Various studies have documented the fact that
    the share of funds charging front-end loads has
    been declining over time. For example, one
    industry research organization reported that the
    share of front-end load fund sales had gone from
    90 percent of sales by third-party sales forces
    (such as broker-dealers) in 1990 to about 38
    percent by 1998.11

         In addition to the declining sales of front-
    end load funds, sales of no-load funds have risen.
    Table 5.2 shows the relative share of mutual funds
    purchased by investors using two of the primary
    distribution methods used by fund advisers: (1)
    sales by proprietary or third-party sales forces,
    such as the sales representatives of a broker-
    dealer, who are generally compensated by a sales
    load; and (2) sales directly to investors by the
    fund through its own mutual fund distributor,
    which is the customary method for no-load funds.
    As shown in table 5.2, new sales of funds sold
    directly to investors rose from about a third, to
    almost 40 percent of the dollar volume of all new
    mutual funds sold in 1998.

    Table 5.2: Sales of Mutual Funds for Select Years
    1984 to 1998 by Type of Distribution Method
    Dollars in millions
    Year                            Distribution method
             Sales by third-party sales   Direct sales by advisers to investors
                       forces
                    Sales    Market share      Dollar volume       Market share
    1984          $26,893             67%            $13,522                33%
    1991          124,522             62%             74,806                38%
    1998          542,600             61%            348,210                39%
    Source: GAO analysis of ICI data.

         The level of loads charged by mutual funds
    has also declined since the 1980s. The customary
    percentage charged as a front-end load in 1980 or
    earlier was 8.5 percent. This amount has declined
    to the 5-percent range, according to officials
    from the fund advisers, industry research, and
    other organizations we contacted. Our analysis of
    the 77 largest stock, bond, and hybrid mutual
    funds in existence from 1990 to 1998 also
    illustrated this trend. In 1990, 43 of these funds
    charged investors loads. Using data from 1984,
    which was the earliest period we reviewed, we
    found that 16 of these funds had loads of more
    than 6 percent, including 14 that charged at least
    8 percent. However, by 1998, 5 funds had
    eliminated their loads; of the remaining 38 load
    funds, none charged a load greater than 6 percent,
    with the average load being 4.62 percent. During
    this same period, some of these funds were raising
    their loads. The loads charged by six funds
    increased from 4.00 to 4.25 percent, and one fund
    raised its load from 4.00 to 4.75 percent.

         Investor awareness was the reason industry
    participants cited for investor resistance to
    paying loads and the overall decline in loads.
    According to some industry participants, investors
    had become increasingly resistant to paying the
    higher front-end loads. An industry expert told us
    that investors are generally more concerned about
    the concept of a front-end load because they "see
    it occur" when the amount is deducted from their
    initial investments on their account statements.
    Operating expense fees, on the other hand, are
    deducted from fund assets rather than from the
    individual investor's account. Research findings
    indicate that investors continue to resist load
    charges. For example, officials from one industry
    research organization told us their research found
    that up to a third of mutual fund investors would
    never be willing to pay a load or commission when
    buying a fund. In another research organization's
    survey, only 4 percent of over 4,000 investors and
    potential investors queried cited mutual fund
    loads as their preferred means of paying for
    investment advice.12

    Opinions Varied on Adequacy of Current Fee
    Disclosures
         Industry participants' opinions varied on the
    adequacy of mutual fund fee disclosures to
    investors. Many, including fund adviser officials
    and researchers, indicated that current
    disclosures adequately highlight the fees that
    investors can expect to pay on their mutual fund
    investments. However, others, including academic
    researchers and private money managers we
    contacted, raised concerns about the adequacy of
    the disclosures. Some officials suggested that
    additional information, such as dollar amounts or
    comparative data on other funds' charges, would be
    useful.

    Most Officials Found Disclosures Adequate
         Most of the officials from the mutual fund
    advisers, research organizations, regulators, and
    other organizations we contacted said that mutual
    fund fee disclosures made under the current
    requirements provided adequate and important
    information to investors. Several officials noted
    that investors can use the standardized
    information found in the fee table of the
    prospectus to compare costs easily between funds.
    For example, one mutual fund adviser official
    likened the percentage fee information in the fee
    table to unit pricing that allows consumers to
    compare the cost per ounce of various products in
    grocery stores. Several officials also said that
    mutual funds make more extensive disclosures than
    those made byother financial services and
    products, and two noted that U.S. mutual fund
    disclosures are more detailed than those of other
    countries.

    Some Expressed Concerns Regarding the Adequacy of
    Mutual Fund Fee Disclosures
         Although most opinions were positive about
    the fee information that mutual funds are
    currently required to disclose, some industry
    observers raised concerns about the adequacy of
    these disclosures. Several, including academic
    researchers, investment advisers and regulatory
    representatives, saw problems with the fee
    disclosures. AAAa  private money manager we
    interviewed questioned the usefulness of
    hypothetical fee disclosures in prospectuses,
    citing the fact that investors have not exited
    from high-cost funds to any large degree. In his
    opinion, these disclosures are too simplistic, and
    they fail to include benchmarks or indicate the
    impact of fees on returns. He commented that "No
    one sends the investor a bill, and the fund simply
    quietly and continually deducts its fees. The
    result is that the information is ignored." Two
    researchers and a mutual fund representative also
    stated that investors ignore fee disclosures.

         Some mutual fund adviser officials told us
    that current disclosures may actually provide
    investors too much information. Given the
    prominence of fee information in required
    disclosures, some fund adviser officials expressed
    concern that disclosures could emphasize cost over
    performance or other factors important to
    investors. Another criticized the fee table as
    being too complex, and possibly confusing, for
    investors.

         As mentioned earlier, the SEC Chairman has
    stated that investors are not paying attention to
    the available fee information. He voiced concern
    that the fee structures of some mutual funds are
    too complex, making it more difficult for
    investors to evaluate overall costs and services.
    In a 1998 speech to an ICI gathering, the chairman
    asked "Do you really expect investors to
    understand alphabet soup of A, B, C, D, I, Y, and
    Z shares? To figure what combination of front-end
    loads, CDSLs,13 12b-1 charges, commissions and who
    knows what else they are paying?" He also has
    urged the mutual fund industry to place less
    emphasis on fund performance and more emphasis on
    clearly detailing fund risks and expenses, or
    fees, as the industry markets its products. He
    warned the industry that by focusing fund selling
    strategy on the bull market to the exclusion of
    other key variables, such as risk and expense, the
    industry is setting itself up to disappoint
    millions of investors.

         To address this issue, SEC has taken steps of
    its own to encourage investors' use of
    disclosures. In April 1999, the agency began
    offering a computer program, publicly accessible
    over the Internet, which lets investors compare
    the cost of owning a particular fund with the
    costs of similar funds. To use this program, an
    investor enters information from a fund
    prospectus, and the program calculates the effect
    of fees and other charges on the investment in the
    fund over time.14

    Disclosing to Investors Actual Dollars Paid in
    Fees Was One Suggested Improvement
    To improve fee disclosure to mutual fund
    investors, some officials favored providing
    investors with a personalized fee statement that
    would show the specific amount of fees paid by the
    investor on his or her holdings. In his September
    1998 testimony, the SEC Chairman indicated that
    the information from such statements might help
    investors understand the relationship between fees
    and returns on their mutual fund investments.

    Others who advocated requiring mutual funds to
    provide investors with the dollar amount of fees
    they paid indicated that such disclosure would
    increase investors' awareness of the fees they are
    charged. We interviewed representatives of
    industry research firms, industry experts, and
    private money managers, who supported personalized
    expense statements for investors. Generally, they
    told us that such personalized expense statements
    would be useful to investors, and they would be
    more likely to focus shareholders' attention on
    costs than the fee table in the prospectus
    currently does. Representatives of some mutual
    fund advisers also acknowledged that such
    statements could serve to focus investors'
    attention on the fees they pay on their mutual
    funds.

    Some officials indicated that such disclosures may
    also increase competition among fund advisers on
    the basis of fees. An attorney specializing in
    mutual fund law told us that requiring funds to
    disclose the dollar amount of fees in investor
    account statements would likely encourage fund
    advisers to compete on the basis of fees. He
    believed that this could spur new entrants to the
    mutual fund industry that would promote their
    funds on the basis of their low costs, in much the
    same way that low-cost discount broker-dealers
    entered the securities industry. A market
    participant told us that having dollar amounts
    disclosed on investors' periodic statements could
    also lead to increased fee-based competition among
    mutual fund advisers. His expectation is that
    after such information begins to appear in
    investor statements, fees will probably be more
    frequently mentioned in fund advertisements.

    Information from a survey of investors generally
    indicated that they supported getting dollar
    amount disclosures of the mutual fund fees they
    paid but would be unwilling to pay for this
    disclosure. We obtained information from a large
    securities broker-dealer that had recently
    included a number of mutual fund fee questions in
    a November 1999 survey as part of a series of
    periodic customer surveys it conducts.  Of more
    than 500 responses to the question "If mutual fund
    companies were to provide the specific dollar
    amount of fees paid on your investment per
    quarter, how useful would it be to you?" about 89
    percent indicated that the information would be
    useful or very useful. However, of over 500
    responses to a question asking if respondents
    would be willing to pay for this information,
    about 54 percent indicated "very unlikely," versus
    about 14 percent who checked "very likely" or
    "somewhat likely," although no estimates of the
    cost were provided.

    Industry Representatives Raised Concerns Over the
    Effort to Produce, and the Usefulness of, Such
    Statements
         We also solicited the views of industry
    representatives on the feasibility of providing
    personalized fee statements for their
    shareholders. Representatives of several mutual
    fund advisers and broker-dealer firms that market
    mutual funds to their customers responded that
    changing their accounting systems to accommodate
    such statements would be costly and would be of
    limited benefit to individual investors. They
    stated that providing accurate fee information
    specific to each investor would require keeping
    detailed records on fund expenses incurred each
    day and apportioning them daily among investor
    holdings.

         Another complication mutual fund adviser
    officials cited was that in some cases, broker-
    dealers, rather than the advisers, maintain a
    significant portion of mutual fund investors'
    records. As a result, these broker-dealers, too,
    would have to change their accounting and
    information management systems. A fund adviser
    maintains a single account for each broker, called
    an omnibus account, which includes all shares held
    by that broker-dealer's customers. Because the
    fund adviser has no record of the individual
    customers included in each omnibus account, broker-
    dealers would have to set up their own systems to
    apportion fee information among their customers'
    accounts. This would require broker-dealers to
    revise their accounting and information management
    systems to receive the cost data from each fund
    adviser and then apportion this information among
    customer accounts holding that adviser's funds.

         One broker-dealer with about 6.5 million
    customer accounts estimated that developing the
    systems necessary to produce such statements might
    cost as much as $4 million, with additional annual
    costs of $5 million. At our request,
    representatives of a prominent industry research
    firm estimated the likely costs to funds for
    providing quarterly personalized expense
    statements. They responded that programming to get
    the necessary information would require some up-
    front fixed costs, but they would probably amount
    to less than a penny per shareholder. Besides
    these up-front costs, fund adviser representatives
    had indicated to us that there would also be
    annual costs to provide the statements. Using the
    estimates of the broker-dealer mentioned
    previously, we calculated that its costs to
    provide such statements would be less than $1 per
    customer per year.

         Mutual fund adviser officials and others also
    questioned whether the information provided by
    these personalized fee statements would be
    meaningful. One objection they raised was that
    unlike the standardized percentage fee information
    in the fee table, individual investors' fee
    information would not be directly comparable to
    the fees they incur on other funds because of
    differences in the number of shares held or the
    investment objectives of the funds. Some officials
    said that investors might make inappropriate
    investment decisions solely on the basis of the
    dollar amounts of fees they paid. Some said, for
    example, that investors might choose to exchange
    their stock fund shares for those of money market
    funds, which typically have lower fees than stock
    funds, even though it may not be appropriate in
    light of their investment and financial goals.
    Industry representatives also pointed out that
    because fee disclosure is intended to help
    investors make investment decisions, the
    information on periodic statements would come too
    late, after an investor has already made his or
    her investment decision.

    We agree with industry representatives that the
    operating expenses, currently shown in the
    required fee table disclosures as a percentage of
    fund assets, are more appropriate for comparing
    fee levels across funds when investors are
    initially choosing between funds. However, the
    purpose of the dollar amount disclosures would be
    to further highlight for investors the costs of
    the mutual funds in which they have invested and
    to supplement the disclosures they already
    receive. Concerns that investors might make
    inappropriate investment decisions based solely on
    the dollar costs of their mutual funds could be
    addressed by advising investors to consider such
    specific fee information in conjunction with their
    own investment goals and other factors, rather
    than isolated from other considerations.

    Less Costly Means of Calculating the Individual
    Dollar Costs of Fees Might Be Considered
    Providing investors with information on the dollar
    amounts they pay in mutual fund fees likely could
    be accomplished in various ways. As noted above,
    some industry participants provided estimates of
    their costs to calculate exact dollar amounts of
    fees each investor paid during a statement period.
    However, less costly alternatives may exist. For
    example, one fund adviser representative suggested
    that an alternative means of calculating the fee
    would be to multiply the average number of shares
    in each account during the statement period by the
    fund's expense ratio for that period. He stated
    that the figure derived in this way would be a
    reasonable approximation of the dollar amount of
    fees the investor paid. He added that it also
    would be less costly and burdensome than computing
    an exact amount, because it would not entail
    maintaining daily expense and share records for
    each investor.

    Another way of disclosing the dollar amount of
    investor fees would be to use preset investment
    amounts. For example, each investor's statement
    could include the dollar amount of fees paid on
    $1,000 invested in the fund. Investors could then
    use this dollar amount to determine how much in
    fees they paid based on the value of their own
    particular accounts. One market participant we
    spoke with offered a similar example of a
    disclosure involving preset investment amounts.
    Although he would prefer that periodic statements
    disclose the specific dollar amount that was
    deducted for fees from each investor's account
    during that period, he believes an acceptable
    alternative would be for statements to include a
    table showing fees for the reporting period on
    accounts of various sizes, such as $1,000, $5,000,
    $10,000, and others.

    Another Option Was to Provide Comparative Fee
    Information
         We also sought opinions on whether mutual
    funds should be required to provide investors with
    comparative information on fees charged by both
    their own, and comparable, funds. Such disclosures
    would be similar to requirements for automakers or
    major appliance producers to provide data on gas
    mileage or efficiency ratings to prospective
    purchasers of those items.

         Survey information indicated that investors
    would support receiving such information but not
    if it was costly to prepare. In the previously
    mentioned survey conducted by a large broker-
    dealer,  about 97 percent of the over 500
    respondents indicated that such data would be very
    useful or somewhat useful. However, about 54
    percent indicated that they would be "very
    unlikely" to pay, compared to about 14 percent who
    checked "very likely" or "somewhat likely,"
    although no estimates of the cost were provided.

    Industry participants also raised various concerns
    over requiring funds to provide comparative
    information on fees. Most industry participants
    told us that this requirement would be difficult
    to implement while providing little, if any,
    benefit to investors. One concern was that
    determining the appropriate fund groupings for
    comparison purposes would be problematic. Another
    was that lack of comparability could result if
    fund advisers were left to identify the peers for
    their own funds. In addition, one industry
    research organization official questioned why
    mutual funds should be subjected to such a
    requirement when other financial products are not
    similarly required to provide such comparative
    information.

    _______________________________
    1 Funds must disclose the maximum of any deferred
    sales charges, which include sales charges that
    apply to the purchase of fund shares payable
    either upon redemption, in installments, or both
    expressed as a percentage of the offering price at
    the time of purchase or the NAV at time of
    purchase. These charges typically decline over a
    period of years such that if an investor holds the
    shares for the specified time, the charge will be
    waived.
    2 Funds must disclose the sales charges imposed on
    reinvested dividends and other distributions, such
    as returns of capital, as a percentage of the
    amount to be invested or distributed.
    3 The disclosure requirements described here have
    been the result of various changes over time. The
    fee table was first required to be provided as the
    result of rule amendments in 1988. In 1998, the
    hypothetical investment amount illustrated in the
    fee table example was also increased from $1,000
    to $10,000 to reflect the size of the more typical
    fund investment. Most recently, in March 2000, SEC
    proposed that mutual funds be required to report
    investment returns on an after-tax basis in
    prospectuses and shareholder reports because of
    the significant impact that taxes can have on an
    investor's return.
    4 Specifically, the statement of operations must
    list the amounts paid by a fund for all services
    and other expenses in dollar amounts. These may
    include amounts paid for investment advisory
    services, management and administrative services,
    marketing and distribution, taxes, custodian fees,
    auditing fees, shareholder reports, and annual
    meeting and proxy costs.
    5 Mutual fund shares distributed by broker-dealers
    are subject to SEC and NASD rules, including NASD
    rule 2340 that requires that quarterly account
    statements be provided to investors. Some banks
    also sell mutual funds but most use securities
    broker-dealers to conduct such activities. In a
    limited number of transactions, bank personnel
    sell mutual funds to investors and will either
    issue periodic statements similar to those issued
    by broker-dealers themselves, or such periodic
    statements will be issued by the broker-dealer who
    distributed the shares to the bank. Furthermore,
    Title II of the Gramm-Leach-Bliley Act passed in
    1999 will require that banks conducting more than
    500 securities transactions per year move such
    activities into a securities broker-dealer after
    May 12, 2001.
    6 Funds sometimes charge investors other fees,
    such as for account maintenance or wire transfers,
    that are set dollar amounts that may be deducted
    from an investor's account and shown on subsequent
    statements.
    7 Shareholder Assessment of Risk Disclosure
    Methods, ICI (Washington, DC: Spr. 1996).
    8 Understanding Shareholders' Use of Information
    and Advisers, ICI (Washington, DC: Spr. 1997).
    9 "Improving Price Competition for Mutual Funds
    and Bonds," before the Subcommittee on Finance and
    Hazardous Materials, House Commerce Committee,
    Sept. 29, 1998.
    10 "Industry-wide Expense Trends", Mutual Fund
    Caf�: Blue Plate Special , Financial Research
    Corporation, (Boston, MA: Jan. 5, 1998).
    11 "Pricing Structure Trends: Prime Destination for
    Net Flows is Back-End Loaded Shares," Mutual Fund
    Caf�: Blue Plate Special, Financial Research
    Corporation (Boston, MA: Feb. 1, 1999).
    12 1996 Series on Personal Financial Advice:
    Payment Practices Preferred by Customers (Report 5
    of 9), Dalbar, Inc. (Boston, MA: Nov. 1996).
    13 CDSL is an acronym that stands for "contingent
    deferred sales load," a charge, or load, imposed
    at the time of redemption. This is an alternative
    to front-end loads to compensate financial
    professionals for their services, and it typically
    applies only for the first few years of share
    ownership.
    14 Information about the mutual fund cost
    calculator is available on the Internet at
    www.sec.gov/news/press/99-36.txt.

    Chapter 6
    Mutual Fund Directors Required to Review Fees
    Page 83            GAO/GGD-00-126 Mutual Fund Fees
    The organizational structure of most mutual funds
    embodies a conflict between the interests of the
    fund shareholders and those of the adviser that
    can influence the fees a fund charges. This
    conflict arises primarily because part of the fees
    charged by the fund, which reduce investors'
    returns, are the adviser's revenue and a source of
    profit to the adviser's owners. As one safeguard
    against this potential conflict, the Investment
    Company Act of 1940 requires the presence of
    independent directors on a mutual fund's board of
    directors, who review and approve the fees their
    fund charges. Congress passed amendments to the
    act in 1970 that imposed a fiduciary duty on fund
    advisers, tasked fund directors with additional
    responsibilities regarding fees, and gave
    investors the right to bring legal action against
    fund advisers charging excessive fees. A series of
    court cases interpreting this duty has served to
    clarify the information that fund directors must
    review to determine if fees are excessive. As a
    result, mutual fund directors are expected to
    review, among other things, the adviser's costs,
    whether fees are reduced as fund assets grow, and
    the fees charged by other advisers for similar
    services to similar funds. Although mutual fund
    adviser representatives indicated that their
    boards are vigorous in reviewing fees and seeking
    reductions, some other industry participants were
    critical of mutual fund directors' fee oversight,
    stating that the current practices serve to keep
    fees at higher levels than necessary. SEC has
    recently proposed changes regarding the
    requirements applicable to fund directors, but
    these are not specifically fee-related, and their
    impact on the level of fees is uncertain.

    Mutual Funds' Organizational Structure Embodies
    Conflict of Interest Over Fees
    Although most mutual funds are organized as
    corporations, their structure and operation differ
    from a typical corporation because of the
    relationship between the fund and its adviser.
    Typically, the adviser, who is a legal entity
    separate from the fund, conducts the fund's
    operations, and the advisory fees it charges to
    the fund represent revenue to the adviser,
    creating a possible conflict of interest. However,
    at least one mutual fund family's organizational
    structure appeared to reduce this conflict between
    the interests of its shareholders and the adviser
    by operating similarly to a credit union, wherein
    the shareholders of its funds own the entity that
    operate the funds.

    Mutual Funds Organization Includes Two Primary
    Legal Entities
    The mutual fund structure and operation differ
    from those of a traditional corporation. In a
    typical corporation, the firm's employees operate
    and manage the firm; and the corporation's board
    of directors, elected by the corporation's
    stockholders, oversees its operations. After
    subtracting its expenses from its revenues, a
    corporation can use the resulting profits to
    conduct further operations; or its board of
    directors can vote to distribute a portion of
    these profits to the stockholders as dividends.

    Although generally organized as a corporation, a
    mutual fund differs from other corporations in
    several ways. A typical mutual fund has no
    employees but is created by and operated by
    another party, the adviser, who contracts with the
    fund, for a fee, to administer fund operations. A
    primary service the adviser typically provides is
    to select and manage the fund's investment
    portfolio.1 Advisers can provide additional
    services but frequently subcontract with other
    organizations, such as transfer agents, for
    services such as maintaining shareholder records.
    Advisers are legal entities separate from the
    mutual funds they manage, and any profits they get
    from operating the fund accrue to the owners of
    the adviser. The fund shareholders are entitled to
    the income from, and gains or losses in the value
    of, securities in the fund's portfolio but are not
    entitled to profits from the adviser's operations.
    In addition, the relationship between a fund and
    its adviser is rarely severed.2 Figure 6.1
    illustrates the contrast between the structure of
    a traditional corporation and that of most mutual
    funds.

    Figure 6.1: Comparison of Organizational Structure
    of Typical Corporation and Typical Mutual Fund

    Figure 6.1: Continued

    Source: GAO analysis of corporate and mutual fund
    structures.

    As shown in figure 6.1, the mutual fund's expenses
    are collected by its adviser and other service
    providers as revenue. In most cases, some of the
    expenses deducted from a fund's assets are paid by
    the fund to other entities, such as transfer
    agents or custodians, but some advisers may also
    perform such services for a fund. An adviser's
    profits are derived after subtracting any payments
    to third parties and its own operating expenses,
    separate from those of the fund, from the revenue
    it collects from the fund. In addition, an adviser
    may have other revenues and expenses from other
    lines of business in which it engages.

    Regulators and Congress have recognized that the
    interrelationship between the mutual fund and its
    adviser creates a potential for conflict between
    the adviser's duties to the fund shareholders and
    the adviser's duties to provide profits to its
    owners. In describing this conflict, SEC recently
    noted that fund shareholders would generally
    prefer lower fees (to achieve greater returns),
    but the stockholders or owners of the adviser
    would prefer to maximize profits through higher
    fees.3

    Congress also acknowledged this potential
    conflict; in the Investment Company Act of 1940,
    it established certain safeguards designed to
    protect the interests of fund shareholders. The
    primary safeguard was to have mutual fund
    directors4 oversee certain of the adviser's
    activities. Although representatives of the
    adviser generally participate as fund directors,
    the act requires that at least 40 percent of the
    directors be individuals without any significant
    relationship with the fund's adviser. Congress
    intended that the unrelated directors, known as
    the independent directors,5 serve as an
    independent check on the adviser. The board's
    remaining directors, which are typically employees
    of the fund's investment adviser, are known as
    "interested" directors. An additional safeguard
    provided by the act is the requirement that fund
    shareholders approve the advisory contract.

    The Organizational Structure of One Mutual Fund
    Family Appears to Minimize the Potential Conflict
    of Interest
    Although most mutual funds are organized as
    described above, one mutual fund
    family-Vanguard-has a unique organizational
    structure that its officials credit for allowing
    it to have among the lowest fees in the industry.
    As of November 1998, Vanguard was the second
    largest fund family in the industry, operating
    more than 100 different funds with over $367
    billion in total mutual fund assets. Most other
    mutual funds are operated by advisers owned
    separately by a third party; however, the Vanguard
    Group, Inc.-which operates the Vanguard funds6-is
    jointly owned by the funds themselves and,
    therefore, by the funds' shareholders. The company
    required specific permission from SEC to deviate
    from the standard structure envisioned by the
    Investment Company Act of 1940 in order to
    organize itself in this way.

    According to documents obtained from Vanguard,
    this structure allows the Vanguard Group to
    provide the funds' services on an at-cost basis.
    As a result, the profits from operating the funds
    are returned to the fund shareholders through
    lower operating expenses rather than going to the
    owners/stockholders of a separate adviser, as is
    the case for most other mutual funds. According to
    materials provided by Vanguard, the Vanguard
    family's operating expense ratios averaged 0.28
    percent, which it stated were the lowest in the
    industry. In 1998, the average fund fee was 1.25
    percent. Vanguard's average expense ratio is also
    lower because it operates several index funds,7
    which have among the lowest ratios of all fund
    types.

    Although this structure appears to minimize the
    conflict of interest between the typical mutual
    fund and its adviser, it is not a structure that
    has been widely replicated within the industry.
    According to SEC officials, one other fund company
    had an organizational structure similar to that of
    Vanguard's but later changed its structure to
    resemble the third-party ownership structure used
    by most firms in the industry. The third-party
    structure that is most prevalent does allow the
    firm that initially provides its own capital to
    create a mutual fund to earn a return on the
    investment it put at risk. In addition, it can use
    that capital to subsidize the fund in the event
    that the fund needs an influx of capital, as
    occurred for several money market funds that
    incurred losses on structured notes investments in
    1994. In contrast, having the fund adviser owned
    by the fund shareholders, as is the case for
    Vanguard, is more analogous to the structure of a
    credit union, whose depositors and borrowers are
    the owners of the institution. However, credit
    unions may be more prevalent because the services
    they provide are more generically required by the
    public and the affiliated groups that tend to
    create such institutions than are mutual fund
    services.

    Mutual Fund Directors Have Specific
    Responsibilities Regarding Fees
    Because of the conflict of interest inherent in
    the organizational structure of a typical mutual
    fund, fund directors have been tasked by law to
    oversee fees charged to shareholders. These
    responsibilities regarding fees are derived from
    both state and federal law. The primary federal
    statute governing mutual fund activities, the
    Investment Company Act of 1940, tasks fund
    directors with specific duties to review and
    approve the fees their funds charge. Concerns over
    the level of fees led to amendments of the act in
    1970 that imposed additional responsibilities on
    fund directors, placed a fiduciary duty on fund
    advisers, and granted investors the right to sue
    advisers for charging excessive fees. A series of
    court cases interpreting this duty has served to
    clarify the information that fund directors review
    to determine if fees are excessive.

    Federal and State Laws Provide Responsibilities
    for Mutual Fund Directors
    Because mutual funds are typically organized as
    corporations, the laws of the states where the
    funds are incorporated also place various general
    duties on fund directors. These duties generally
    require them to act in the best interests of the
    shareholders they represent.8

    In addition to the general duties imposed by state
    law, federal law provides specific
    responsibilities relating to the composition and
    duties of a fund's board of directors. The
    Investment Company Act of 1940 is the primary
    federal statute governing mutual fund operations,
    and it establishes various requirements and duties
    for mutual fund directors.9

    Under the act, a mutual fund's board of directors
    is generally entrusted with protecting the fund
    shareholders' interests and policing conflicts of
    interest that might arise in connection with
    payment for services to the fund. Under section
    15(c) of the act, the terms of any advisory
    contract and its renewal must be approved, in
    person, by a vote of a majority of the independent
    directors. The section also specifies that fund
    directors are to obtain and consider any
    information necessary to evaluate the terms of
    both advisory and underwriting contracts and that
    fund management must furnish this information to
    the directors. The requirement that directors
    obtain and review such information was added as a
    result of amendments in 1970 to the Investment
    Company Act of 1940.

    In addition to the requirement that they approve
    the overall advisory contract and its fees, a
    mutual fund's directors are also required to
    review distribution fees. A fund is prohibited
    from using fund assets to pay for the sale and
    distribution of its shares unless it adopts a plan
    of distribution approved by the directors-known as
    a rule 12b-1 plan. Such plans must be approved by
    a majority of both (1) all of a fund's directors
    (both the interested and independent directors)
    and (2) the independent directors separately.

    Fund Adviser Responsibilities Increased After
    Concerns Over Fees
    Congress also tasked mutual fund advisers with
    additional fee-related responsibilities in 1970.
    The impetus for the 1970 amendments to the
    Investment Company Act arose primarily from
    findings of two studies of mutual fund operations
    done in the 1960s. One of the studies was by the
    Wharton School of Finance in 1962,10 and SEC
    prepared the other in 1966.11 The Wharton study
    found that mutual fund shareholders lacked
    bargaining power relative to the adviser, which
    resulted in higher fees.

    In its study, SEC found that litigation by fund
    shareholders had been ineffective as a check on
    fund advisers because of the difficulty in proving
    that the adviser was charging excessive fees. The
    standard being used by most courts at the time was
    whether the fees charged by advisers represented a
    flagrant misuse of fund resources. Because of the
    difficulty of proving that fees charged met such a
    standard, SEC recommended that the Investment
    Company Act be amended to impose a reasonableness
    standard on fund advisers regarding the fees they
    charge. SEC noted that such a standard would
    clarify that advisers would charge no more than
    what would be charged if fees were negotiated on
    an "arm's-length" basis (i.e., as if between
    unrelated parties).12

    However, the amendments to the Investment Company
    Act of 1940 did not contain SEC's reasonableness
    standard after objections to it were raised by
    industry participants, who feared that courts
    would substitute their judgment over that of fund
    directors. As a compromise, the legislation
    instead placed a fiduciary duty on the fund
    adviser regarding the fees it receives.
    Specifically, section 36(b) of the act13 imposes on
    the adviser a fiduciary duty with respect to
    compensation or material payments the adviser or
    its affiliates receive from the fund. The statute
    does not further define the fiduciary duty
    imposed. Typically, under state common law, a
    fiduciary must act with the same degree of care
    and skill that a reasonably prudent person would
    use in connection with his or her own affairs.

    Section 36(b) also granted investors and SEC the
    right to bring claims in federal court against the
    adviser, the directors, officers, and certain
    other persons14 for breach of fiduciary duty
    regarding the compensation or payment they receive
    from the fund. Investors have a 1-year period in
    which to bring suit, and damages are limited to
    fees received by the advisers within the prior
    year. 15 In reviewing such cases, section 36(b)
    directs the courts to give consideration as is
    deemed appropriate under all circumstances to
    board approval and shareholder ratification of the
    compensation or advisory contract.

    Court Decisions Have Shaped Directors
    Responsibilities
    Court decisions have played an important role in
    shaping the role of mutual fund directors
    regarding fees. Since 1970, various cases were
    filed under section 36(b), and the resulting
    decisions have served to provide specific
    guidelines for fund directors. These guidelines
    arise primarily from a Second Circuit Court of
    Appeals case decided in 1982.16

    After the Investment Company Act was amended to
    give investors the right to sue advisers for
    charging excessive fees, a series of cases was
    brought under this new section of the act.
    However, section 36(b) of the act, which provides
    investors with the right to sue a fund adviser for
    breach of fiduciary duty regarding fees, does not
    contain specific standards for determining when
    such a breach has occurred. Instead, the federal
    courts adjudicating the claims brought by
    investors under 36(b) have developed standards for
    making such determinations. These standards focus
    on assessing whether a payment is excessive.

    The key case that established the standard for
    determining whether a fund's fee is excessive was
    Gartenberg v. Merrill Lynch Asset Management Inc
    (Gartenberg). The shareholders in Gartenberg sued
    the investment adviser for breach of fiduciary
    duty with respect to its compensation. The
    shareholders of this money market fund claimed
    that given the fund's size and growth, the
    adviser's profits were excessive due to its
    disproportional fee. In Gartenberg the fee
    schedule called for payment of 0.50 percent (1/2
    of 1 percent) of the fund's average daily value of
    net assets under $500 million and for various
    intermediate percentages as the value of the net
    assets increased down to 0.275 percent for assets
    in excess of 2.5 billion. 17 In dismissing the
    investors' claim of excessive profits, the
    district court emphasized that the principal
    factor in determining whether the adviser breached
    its fiduciary duty to the fund with regard to fees
    is to compare a fund's fees to the fees charged by
    other funds in the industry.

    In upholding the district court's decision, the
    Second Circuit Court stated that to be guilty of a
    violation under section 36(b), the fee must be "so
    disproportionately large that it bears no
    reasonable relationship to the services rendered
    and could not have been the product of arm's-
    length bargaining." The Second Circuit Court
    disagreed with the district court's suggestion
    that the principal factor to be considered in
    evaluating a fee's fairness is the price charged
    by other similar advisers to funds they managed.
    The court stated that "the existence in most cases
    of an unseverable relationship between the adviser-
    manager and the fund it services tends to weaken
    the weight to be given to rates charged by
    advisers of other similar funds." The court
    further stated that since a fund cannot move
    easily from one adviser to another, advisers
    rarely compete with each other on the basis of
    fees and advisory contracts.

    The court thus reasoned that although fund
    directors may consider the fees charged by similar
    funds, it indicated that other factors may be more
    important in determining whether a fee is so
    excessive that it constitutes a breach of
    fiduciary duty. These include

    �    the nature and quality of the adviser's
    services,
    �    the adviser's costs to provide those
    services,
    �    the extent to which the adviser realizes and
    shares with the fund economies of scale as the
    fund grows,
    �    the volume of orders that the manager must
    process,
    �    indirect benefits to the adviser as the
    result of operating the fund, and
    �    the independence and conscientiousness of the
    directors.

    Since Gartenberg, additional cases have been
    decided that continue to apply the standards
    established by the Gartenberg court.18 The court
    decisions in Gartenberg and the cases that
    followed it, therefore, have served to establish
    the current expectations for fund directors
    regarding fees. As a result, regulators expect
    mutual fund directors to review the types of
    information the courts identified as important
    when assessing whether the fees their fund pays to
    its adviser are excessive. As noted above, among
    the information to be considered by directors is
    how their fund's fee structure compares to those
    of similar funds. Under such standards,
    independent directors are not required to seek the
    lowest fee. For example, SEC's chairman
    characterized these duties by stating that
    "[d]irectors don't have to guarantee that a fund
    pays the lowest rates. But they do have to make
    sure that the fees fall within a reasonable band"
    of other funds' fees.19

    Standards Criticized as Lacking Specific Guidance
    For Assessing Fees
    Opinions on Boards' Effectiveness in Overseeing
    Fees Vary
    Opinions on mutual fund boards' effectiveness in
    overseeing fees varied. Some fund adviser
    officials depicted directors as assertive in
    reviewing fees, even seeking reductions and
    resisting fee increases. However, other industry
    participants expressed various criticisms of
    directors' effectiveness in overseeing the fees
    mutual funds charge, including that directors lack
    sufficient independence and that legal standards
    governing their actions are flawed. To address
    concerns over a potential lack of independence
    among mutual fund boards, SEC and others have
    various initiatives under way, but they are not
    likely to have a significant impact on fees
    because most funds already have them in place.

    Fund Officials Say Boards Are Effective in
    Lowering Fees
    Mutual fund adviser officials indicated that their
    boards of directors follow rigorous review
    processes when reviewing their funds' fees.
    Officials at several of the 15 mutual fund
    advisers we contacted described a rigorous process
    of review that their independent directors use to
    evaluate the investment management contract and to
    review fees. For example, officials at one fund
    adviser said that their board members are
    successful businessmen and women who are very
    knowledgeable about how the funds operate. The
    officials said that these directors obtain expert
    advice, when needed, with which to make their fee-
    related decisions.

    Adviser officials told us that their fund
    directors often obtain data from independent
    sources, such as the industry research
    organizations Lipper and Morningstar, Inc. They
    told us that their directors also actively seek
    out other materials they need to help them do a
    thorough job of reviewing fund costs. Several
    indicated instances where fees were lowered or fee
    raises were denied at the board's insistence.

    Adviser officials we contacted indicated that
    their fund directors meet several times a year,
    and a committee of independent directors typically
    meets at least annually to discuss the investment
    adviser's contract and related fees. They said
    that they provide directors large amounts of
    information relevant to the investment management
    contract and fee schedule, and they include
    comparative fees paid by similar funds for these
    services. According to the adviser officials,
    independent directors typically review and
    deliberate on the information provided by the
    adviser before meeting with fund officials,
    consult with independent counsel on the terms of
    the proposed contract, and compare the fees they
    are being asked to approve with those of peer
    groups of funds. Adviser representatives depicted
    their funds' independent directors as tough
    negotiators who scrupulously review available
    information and then lower fees or refuse fee
    hikes when they feel such actions are warranted.

    SEC examinations we reviewed cited few
    deficiencies relating to directors' role in
    evaluating fees. According to an SEC official, SEC
    examines all mutual fund families within a 5-year
    cycle. In our review of SEC examinations of 16
    fund advisers conducted between 1995 and 1999, we
    found 3 instances citing deficiencies related to
    the directors' role in reviewing fees. Two stated
    that minutes of board meetings failed to indicate
    that certain factors had been reviewed or
    discussed, and one found that the directors for
    two funds in a particular family had not received
    information on certain expense information when
    they approved their investment advisory
    agreements.

    Some Officials Criticized Directors' Effectiveness
    in Overseeing Fees
    Various industry participants criticized mutual
    fund directors' effectiveness in overseeing fees
    charged for operating their funds. A primary
    criticism of mutual fund directors is that they
    lack sufficient independence and knowledge to
    effectively oversee the fund adviser's activities
    and fees. Such allegations have appeared in
    various press and magazine accounts. In addition,
    some of the industry participants we contacted
    raised similar criticisms. A private money manager
    told us that because a fund's investment adviser
    or an affiliate usually manages the fund, its
    independent directors cannot be truly autonomous
    in negotiating adviser fees and contracts.
    According to an industry analyst, a general lack
    of experience with mutual fund operations prevents
    independent directors from being as effective as
    they could be in keeping fees down. Because of
    their inexperience, the independent directors will
    often defer to the opinions of the interested
    directors, who are also employees of the adviser,
    during the deliberations of the board.

    Critics have also indicated that the legal
    standards applicable to directors' oversight of
    fees are flawed. One factor that directors
    consider is how their fund's fee compares to those
    charged by other similar funds. However, a private
    money manager stated that directors have no basis,
    therefore, for seeking a lower fee if their fund
    is charging fees similar to those of other funds.
    An industry analyst indicated that basing a fund's
    fees on those charged by similar funds results in
    fees being higher than necessary. He stated that
    although it is a safe way to set fees, in light of
    the Gartenberg standards, such practices do not
    contribute to lower fees.

    SEC and ICI Proposed Reforms to Increase Director
    Independence and Knowledge
    In response to criticism that independent
    directors on mutual fund boards may not be
    sufficiently independent of the adviser, SEC and
    ICI took steps to examine ways in which
    independent directors might be more autonomous.20
    In February 1999, SEC conducted 2 days of public
    discussions, with various industry participants
    and critics evaluating independent directors'
    responsibilities and ways in which they could more
    effectively carry them out. Shortly thereafter,
    ICI assembled an advisory group to identify and
    recommend best practices for fund boards to
    consider adopting.21 In addition, in response to
    the SEC chairman's call for improved fund
    governance, a Mutual Fund Director's Education
    Council, chaired by a former SEC chairman and
    administered by Northwestern University, has been
    formed. The Council intends to foster the
    development of programs to promote independence
    and accountability in fund boardrooms.

    In October 1999, SEC promulgated proposed rules to
    enhance the independence of certain mutual fund
    boards. SEC noted in its introduction to the
    proposed rules that in order to truly enhance the
    effectiveness and independence of all fund
    directors, the Investment Company Act would need
    to be amended, but SEC's recent attempts to
    achieve such changes by legislation were never
    enacted. As a result, SEC's proposal applies to
    funds that rely on exemptions granted by SEC of
    certain statutory conflict of interest
    prohibitions.22 According to SEC officials, almost
    all funds rely on one or more of these rule
    exemptions, and thus the proposal would apply to
    virtually all funds.

    Under SEC's proposal, funds relying on any of
    these exemptions would be required to have
    independent directors who constitute either a
    majority or a super-majority (two-thirds) of their
    boards and who select and nominate other
    independent directors. In addition, if the
    independent directors use legal counsel, such
    counsel would be required to be separate from that
    used by the fund's adviser.

         SEC's proposed rule amendments also would
    require funds to provide additional information to
    investors about fund directors. Under the
    proposal, funds would be required to provide
    investors with basic information about the
    identity and business experience of the directors,
    the extent to which the directors own shares of
    funds within the fund family, and any potential
    conflicts of interest.

    These proposed rule amendments may not
    significantly affect the level of fees in the
    mutual fund industry. First, the rule proposals
    focused on enhancing director effectiveness and do
    not specifically address fees. SEC officials
    acknowledged that most funds already have a
    majority of independent directors on their boards.
    Officials at the 15 fund advisers we contacted
    also told us that the requirements they place on
    their boards already meet SEC's proposed changes.
    Most of them indicated that a majority of their
    boards are independent directors, they set their
    own compensation, and they nominate and select new
    independent members. In addition, they have
    separate outside counsel and advisors to help them
    evaluate the fees and contracts they are
    responsible for negotiating in the shareholders'
    best interests.

    Others argue that even though many funds have
    these requirements in place, they should be
    required for all funds so that all investors have
    consistent protections. Some commenters to the
    proposed rule amendments stated that the proposed
    changes are burdensome and that SEC is attempting
    to do by regulation what it has been unable to
    achieve through legislation. Others claim that the
    proposal is a necessary measure to provide
    investors consistent protection. As of May 16,
    2000, the amendments in the proposal had not yet
    been adopted.

    _______________________________
    1 In some cases, the adviser may contract with
    other firms to provide investment advice, which
    then act as subadvisers to the fund.
    2 Investment Company Amendments Act of 1970, S.
    Rep. No. 91-184, 91st Cong., 2d Sess. (1970),
    reprinted in [1970] U. S. Code Cong. & Ad. News
    4897, 4901 (1970).
    3 Proposed Rule: Role of Independent Directors of
    Investment Companies, Rel. Nos. 33-7754; 34-42007;
    IC-24082, 64 Fed. Reg. 59825 (Oct. 15, 1999) (to
    be codified 17 C.F.R. parts 239; 240; 270 & 274).
    4 Although the Investment Company Act of 1940 does
    not dictate a specific form of organization for
    mutual funds, most funds are organized either as
    corporations governed by a board of directors or
    as business trusts governed by trustees. When
    establishing requirements relating to the
    officials governing a fund, the act uses the term
    "directors" to refer to such persons, and this
    report also follows that convention.
    5 Independent fund directors cannot be affiliates
    of a fund's investment adviser, be immediate
    family members of an affiliated person of an
    adviser, have beneficial interests in securities
    issued by the adviser or the principal underwriter
    or any of their controlling persons, be registered
    broker-dealers or affiliated with broker-dealers,
    or be affiliated with any recent legal counsel to
    the funds.
    6 About 30 of the 100 Vanguard funds use the
    services of independent investment managers, which
    provide portfolio selection and advice services
    for these funds. These firms receive a subadvisory
    fee paid out of fund assets. However, the Vanguard
    Group, Inc., and not the investment manager,
    provides all other administrative services for
    these funds.
    7 Index funds invest in the securities represented
    in a broad-based index such as the Standard &
    Poor's Index.
    8 Under state law, directors are typically bound
    by duties of care and loyalty to the shareholders
    they represent. The duty of care requires
    directors to carry out their responsibilities in
    good faith and to exercise the degree of skill,
    diligence, and care that a reasonably prudent
    person would exercise in the same circumstances in
    the management of his or her own affairs. The duty
    of loyalty prohibits directors from benefiting
    personally from opportunities rightfully belonging
    to the company. This requires the directors to
    place the interests of the corporation above their
    own individual interests. State common law
    provides the "business judgement rule." This rule
    provides that directors will not be found liable
    for their actions, provided that they act
    reasonably and in good faith for the best
    interests of the corporation, even if their
    decisions turn out to be wrong.
    9 This discussion focuses on mutual fund
    directors' specific responsibilities regarding the
    fees their funds charge. The law also places
    various other responsibilities on fund directors
    that exceed those of the directors of a typical
    corporation. These additional responsibilities
    include approving the contracts between the fund
    and the adviser and the other service providers,
    approving trading practices, and monitoring
    investments in derivatives as well as other
    duties.
    10 A Study of Mutual Funds: Prepared for the
    Securities and Exchange Commission, Wharton School
    of Finance and Commerce, University of
    Pennsylvania (Philadelphia, PA: 1962).
    11 Public Policy Implications of Investment Company
    Growth, SEC (Washington, DC: 1966).
    12 SEC also recommended that application of the
    reasonableness standard not be affected by
    shareholder or director approval of the advisory
    fee and that recoveries be limited to excessive
    compensation paid in the 2 years prior to
    commencement of an action.
    13 15 U.S.C. 80a-35(b).
    14 Section 36(b) authorizes excessive fee claims
    against officers, directors, members of an
    advisory board, investment advisers, depositors,
    and principal underwriters if such persons
    received compensation from the fund.
    15 Courts have held that section 36(b) is an
    equitable claim; therefore, plaintiffs do not have
    the right to a jury trial.
    16 Gartenberg v. Merrill Lynch Asset Management,
    Inc., 694 F.2d 923 (2d Cir. 1982), cert. denied,
    461 U.S. 906 (1983).
    17 Gartenberg v. Merrill Lynch Asset Management
    Inc., 528 F. Supp. 1038 (S.D.N.Y. 1981), aff'd ,
    694 F. 2d 923 (2d Cir. 1982), cert. denied, 461
    U.S. 906(1983).
    18 Schuyt v. Rowe Price Prime Reserve Fund, 663 F.
    Supp. 962 (S.D.N.Y.), aff'd, 835 F.2d 45 (2d Cir.
    1987), cert. denied, 485 U.S. 1034(1988); Krinsk
    v. Fund Asset Management, 715 F. Supp. 472
    (S.D.N.Y. 1988), aff'd, 875 F. 2d 404 (2d Cir. ),
    cert. denied, 493 U.S. 919 (1989); Kalish v.
    Franklin Advisers, 742 F. Supp. 1222 (S.D.N.Y.
    1990), aff'd , 928 F. 2d 590 (2d Cir.), cert.
    denied, 502 U.S. 818 (1991).
    19 May 15, 1998 remarks before the Investment
    Company Institute, Washington, DC. See also Krinsk
    v. Fund Asset Management, 715 F. Supp. at 502-03 .
    20 In 1992, SEC staff conducted a study of the
    regulation of investment companies to determine
    whether existing regulations imposed unnecessary
    constraints on funds and whether there were gaps
    in investor protection. As a result of this study,
    the staff recommended that the act be amended to
    require that the minimum proportion of independent
    directors be increased from 40 percent to a
    majority, that independent director vacancies be
    filled by the remaining independent directors, and
    that independent directors be given the authority
    to terminate advisory contracts. Notwithstanding
    the SEC staff recommendations, the legislation was
    never enacted.
    21 Enhancing a Culture of Independence and
    Effectiveness, ICI (Washington, DC: Jun. 24, 1999.
    22 Examples of these exemptive rules include Rule
    12b-1, which permits the use of fund assets to pay
    distribution expenses; Rule 17a-8, which permits
    mergers between certain affiliated funds); and
    Rule 18f-3, which permits funds to issue multiple
    classes of voting stock.

    Chapter 7
    Conclusions and Recommendations
    Page 99            GAO/GGD-00-126 Mutual Fund Fees
    Conclusions
         Because of the unavailability of
    comprehensive data on costs advisers incurred
    operating mutual funds, we were unable to
    determine to what extent the growth in mutual fund
    assets during the 1990s provided advisers the
    opportunity to reduce fund expense ratios. We
    found that many large funds had reduced their
    operating expense ratios between 1990 and 1998,
    with the average fee among the largest stock funds
    declining by 20 percent. However, not all funds
    reduced their fees, including some that had grown
    by more than 500 percent during that period.
    These results also reflect the largest funds,
    whose advisers were most likely to have
    experienced economies of scale that would have
    allowed them to reduce these funds' expense
    ratios. In addition, our sample consisted
    primarily of the largest and fastest growing funds
    in the industry and thus may not reflect the
    characteristics and the trend in fees charged by
    other funds.

         We also found certain limitations in the
    mechanisms that regulators currently rely on to
    influence fee levels. As with other financial
    products, regulators rely on competition as means
    of setting prices for products and services.
    However, competition in the mutual fund industry
    is not generally price-based and thus may not be
    strongly influencing fee levels.

    Regulators also rely on fee disclosures to inform
    investors of the fees that funds charge. The
    information that is disclosed in mutual fund
    prospectuses and annual reports allows investors
    to compare the relative fees and expenses charged
    by differing funds. However, while mutual fund
    statements show the dollar amounts of any
    transaction fees deducted from shareholder
    accounts, they do not disclose the actual dollar
    amounts of each investor's share of the fund's
    operating expenses. Some officials we interviewed
    acknowledged that such information would reinforce
    the fact that investors are paying for mutual fund
    advisers' services. Including the dollar amount
    paid in fees along with each investor's account
    value would also put mutual fund statements on
    comparable footing with that of other financial
    services whose specific charges also routinely
    appear in confirmation and account statements.
    Fees stated in dollar terms, considered in
    conjunction with other relevant information such
    as investment goals, could spur investors to
    evaluate the services they receive from their
    funds in exchange for the fees being charged and
    to compare their funds' services and fees with
    those of other funds with similar investment
    objectives. Prominently and regularly disclosing
    to investors the specific dollar amount of
    operating expense fees each investor pays could
    also encourage more fee-based competition among
    fund advisers, as has occurred with brokerage
    commissions and other financial services.

    To produce such information, fund advisers may
    have to make changes in their account management
    systems to collect and calculate information that
    is not currently maintained. Advisers and certain
    broker-dealers whose customers invest in mutual
    funds would also incur both one-time and ongoing
    costs. However, estimates for these costs did not
    appear to be inordinately high-with some estimates
    generally indicating that such costs might be a
    few dollars or less per investor. In addition,
    industry participants have already identified
    alternative, less costly, ways of calculating the
    dollar amount of fees paid by individual fund
    investors, such as by multiplying a fund's share
    value by its expense ratio and an average of the
    number of shares held by an investor during the
    prior period rather than by maintaining
    information on each investors actual daily share
    of expenses.

    Another alternative means of disclosing dollar
    amounts of operating expense fees paid on
    individual investor statements would be to provide
    the dollar amount of fees paid for preset
    investment amounts, such as $1,000, which
    investors could use to estimate the amount they
    paid on their own accounts. In determining how
    such disclosures could be implemented, regulators
    will have to weigh the costs that the industry may
    incur to calculate fees for each investor against
    the burden and effectiveness of providing
    investors with the requisite information and
    having them be responsible for making such
    calculations on their own.

    Regulators also rely on mutual fund boards of
    directors to serve as a check on the fees charged
    by the funds they oversee. Currently, fund
    directors annually review the fees of the funds
    they direct and, among other things, generally
    maintain their funds' fees within a reasonable
    range of fees charged by other funds. Opinions
    about fund directors' effectiveness varied, and
    regulators are taking steps to increase directors'
    independence from their funds' advisers. However,
    these steps are not likely to have a significant
    impact on fees because most funds already have
    many of the proposed reforms in place and their
    purpose is to generally enhance director
    effectiveness and did not specifically address
    fees. Our analysis of the largest funds' fees,
    which showed higher fee funds migrating to lower
    fee levels while lower fee funds generally
    retained their levels, is consistent with
    assertions that mutual fund directors are choosing
    to keep fees at a level comparable to those of
    other funds. Whether this level is appropriate for
    the industry is not known.

    Recommendations
    To heighten investors' awareness and understanding
    of the fees they pay on mutual funds, we recommend
    that the Chairman, SEC, require that the periodic
    account statements already provided to mutual fund
    investors include the dollar amount of each
    investor's share of the operating expense fees
    deducted from their funds. This disclosure would
    be in addition to presently required fee
    disclosures. Because these calculations could be
    made in various ways, SEC should also consider the
    cost and burden that various alternative means of
    making such disclosures would impose on (1) the
    industry and (2) investors as part of evaluating
    the most effective way of implementing this
    requirement. Where the form of these statements is
    governed by NASD rules, SEC should require NASD to
    require the firms it oversees to provide such
    disclosures.

    Agency and Industry Comments and Our Evaluation
    We requested comments on a draft of this report
    from the heads, or their designees, of SEC and
    NASDR. In addition, we requested comments from the
    mutual fund industry association, ICI. Each of
    these organizations provided us with written
    comments, which appear along with our responses to
    individual comments in appendixes I through III.
    Additional technical comments from SEC were
    incorporated into this report as appropriate.

    Overall, each of the commenting organizations
    agreed that our report raised important issues and
    contributed to the public dialogue on mutual fund
    fees. In his letter, the director of SEC's
    Division of Investment Management indicated that
    SEC staff agreed that investors need to be aware
    of and understand the fees that mutual funds
    charge. The letter also indicated that the SEC
    staff welcomed the report's recommendation and
    intended to consider it carefully. The vice
    president of NASDR's Investment
    Companies/Corporate Financing Department agreed in
    his letter that investors should consider fees,
    expenses, and other issues in addition to
    performance in making investment decisions.

    However, the letters from the SEC, NASDR and ICI
    officials raised several issues about our report.
    ICI's letter notes that although promoting
    investor awareness of the importance of fund fees
    is a priority for ICI and its members, ICI
    officials had reservations about the account
    statement recommendation that investors
    periodically receive information on the specific
    dollar amounts of the fees deducted from their
    mutual fund accounts. Their concern was that this
    requirement could erode the value of the fee
    information currently provided in the prospectus
    and thus impede informed assessments of fee levels
    at competing funds, which could paradoxically
    diminish rather than enhance investors' overall
    understanding of fund fees.

    We agree with ICI and the other commenters that
    the current disclosures made by mutual funds,
    which provide fund expense ratios expressed as a
    percentage of fund assets and include an example
    of the likely amount of expenses to be incurred
    over various holding periods for a hypothetical
    $10,000 account, are useful for investors in
    comparing between funds prior to investing. The
    additional disclosure we recommend is intended to
    supplement, not replace, the existing disclosures,
    and should serve to reinforce to investors that
    they do pay for the services they receive from
    their mutual funds as well as indicate to them
    specifically how much they pay for these services.

         SEC, NASDR, and ICI also commented on our
    observation that other financial products and
    services disclose specific dollar amounts for the
    fees charged to their users, but mutual funds do
    not. In their comments, these organizations
    generally indicated that not all charges are
    disclosed for other financial products and
    services; thus, the disclosures for mutual funds
    are not that dissimilar. For example, SEC noted
    that funds disclose to investors specific dollar
    charges subtracted from their accounts, such as
    for sales loads or account fees, but do not
    disclose the specific charges that are levied
    outside the account. SEC stated that this is
    similar to banks not disclosing the spread between
    the gross amount earned by the financial service
    provider on customer monies and the net amount
    paid to the customer.

         We do not agree with the commenting
    organizations that mutual funds' lack of
    disclosure of the specific operating expenses to
    individual investor accounts is comparable to the
    practices of banks or other businesses that do not
    disclose the difference between their investment
    or operating earnings and the amounts they pay to
    the individuals who provided those operating or
    investment funds. Investors in mutual funds have
    in essence hired the adviser to perform the
    service of managing their investment dollars for
    them. The fees that the advisor and the other
    service providers deduct from the fund's assets
    represent the price of the services they perform.
    Although such fees are deducted from the fund
    overall, each individual investor's account is
    ultimately reduced in value by their individual
    share of these deductions. However, the specific
    amount of these deductions is not disclosed in
    dollar terms to each investor. In contrast,
    customers and users of other financial services,
    such as private money managers, banks, and
    brokerage firms, are told of the specific dollar
    amounts subtracted from their individual assets or
    accounts.

         Customers who place money in savings
    accounts, bank certificates of deposit, or bonds
    are not purchasing investment management or
    financial transaction services as are mutual fund
    investors. Thus, customers placing money in those
    other investment or savings products are generally
    told what the nominal returns will be, regardless
    of how the firm providing the product will use the
    customer's capital to conduct investment or
    operating activities intended to produce
    sufficient income to provide the promised rate of
    return to the customer. In such cases, customers
    are not entitled to the residual returns earned by
    their capital but instead are promised and paid a
    fixed return.

         Furthermore, the fact that not all financial
    products provide information on all their charges
    to account holders does not reduce the likely
    usefulness of such information to the millions of
    mutual fund investors. Instead, independent
    evaluations of the usefulness of providing such
    information for those other products would be
    necessary to determine if similar disclosures
    would also benefit the users of those other
    products.

    All three commenting organizations also generally
    questioned our finding that mutual funds do not
    compete primarily on the price of their services.
    SEC noted that although an argument could be made
    that more price competition should occur in the
    mutual fund industry, it is not completely absent.
    ICI emphasized that because funds report
    performance on an after fees and expenses basis,
    mutual funds do compete on the basis of their
    fees. NASDR stated that our draft report did not
    address the fact that mutual funds present
    performance net of expenses.

    Our report notes that a mutual fund is required to
    disclose its performance net of fees and expenses;
    its performance is the primary basis upon which
    funds compete. However, competition on the basis
    of net returns may or may not be the same as
    competition on the basis of price. Separating the
    fee from the return would remind investors that a
    fee is embedded in their net returns. In addition,
    our report also notes that when customers are told
    the specific dollar amounts of the fees or
    charges, such as they are for stock brokerage
    transactions or bank checking accounts, firms in
    those industries appear to more frequently choose
    to compete directly on that basis, resulting in
    greatly reduced charges for such services.
    Implementing our recommendation to have such
    information provided to mutual fund investors
    could provide similar incentive for them to
    evaluate the services they receive in exchange for
    the fees they pay. Disclosing such information
    regularly could also encourage more firms to
    compete directly on the basis of the price at
    which they are willing to provide mutual fund
    investment services.

    SEC and ICI also questioned the legal accuracy of
    some of the statements made by individuals we
    interviewed regarding the role of mutual fund
    directors in overseeing fees. The individuals we
    quoted were critical of the director practice of
    setting their funds' fees only in relation to the
    fees charged by other funds; however, both SEC and
    ICI indicated that fund directors, by law, are
    required to review a wide range of information
    when assessing the fees charged by their fund
    advisor and other service providers.

         We have added text to the report to indicate
    that comparing one fund's fees to those charged by
    other funds is not the only factor that directors
    are required to consider when evaluating fees.
    However, in the opinion of the individuals whose
    comments we cited, directors are primarily
    emphasizing such comparisons over the other
    factors they are also required to consider as part
    of their fee reviews. As a result, these
    individuals see directors as maintaining fee
    levels, or at least allowing fees to be lowered
    only to the extent that other funds are taking
    similar actions.

         Furthermore, we recognize that a firm's
    comparison of the prices it charges with those its
    competitors charge is a legitimate and perfectly
    acceptable means for firms to evaluate their own
    business strategies. However, in the mutual fund
    industry, which competes indirectly on the basis
    of such charges, such comparisons may serve to
    maintain fees at a consistent level or allow them
    to be reduced only by amounts similar to those of
    other funds' reductions, as the individuals we
    interviewed stated. Although we did find that fees
    for many mutual funds have declined, we also noted
    in chapter 2 of our report that we were unable to
    determine if the growth in fund assets would have
    provided advisers the opportunity to reduce fees
    by even more.

    Appendix I
    Comments From the Securities and Exchange
    Commission
    Page 110           GAO/GGD-00-126 Mutual Fund Fees
    Note: GAO comments supplementing those in the
    report text appear at the end of this appendix.

    See comment 1.

    See comment 2.

    The following are GAO's comments on the Securities
    and Exchange Commission's May 10, 2000, letter.

    GAO's Comments
    1. The Securities and Exchange Commission (SEC)
    described various changes since the 1980s to the
    fee disclosures that mutual funds are required to
    make. To acknowledge this, we have added a
    footnote to our discussion of the currently
    required disclosures that describes some of the
    changes made to these disclosure requirements over
    time.

    2. SEC stated that our report should note that the
    current disclosure does provide investors with
    access to information on an annual basis that
    enables them to assess and understand the fees
    they bear and to effectively compare fees. We
    agree that disclosure of such information is
    currently required, and we have added additional
    language to our report to clarify that these
    disclosures are made annually. However, these
    disclosures present fund expense ratios as a
    percentage of fund assets and include an example
    of the likely amount of expenses to be incurred
    over various holding periods for a hypothetical
    $10,000 account. Furthermore, these reports are
    provided to investors only semiannually. Although
    investors can use this information to compare
    among funds, the additional disclosure we
    recommend is intended to supplement, not replace,
    the existing disclosures, and should serve to
    reinforce to investors the fact that they do pay
    for the services they receive from their mutual
    funds. The specific dollar amounts we recommend
    that funds disclose should also have the added
    immediacy of being unique to each investor and his
    or her account. By disclosing these additional
    dollar amounts on investors' quarterly account
    statements, funds will provide fee disclosures to
    investors more frequently than they currently do.

    Appendix II
    Comments From the National Association of
    Securities Dealers Regulation, Inc.
    Page 115           GAO/GGD-00-126 Mutual Fund Fees
    Note: GAO comments supplementing those in the
    report text appear at the end of this appendix.
    Now on p. 97.
    Now on p. 96.

    Now on p. 27; see comment 4.
    See comment 3.
    See comment 2.
    See comment 1.

    Now on p. 74; see comment 7.
    Now on p. 42; see comment 6.
    Now on p. 29; see comment 5.
    See comment 4.

    The following are GAO's comments on the National
    Association of Securities Dealers Regulation's May
    8, 2000, letter.

    GAO's Comments
    1. The National Association of Securities Dealers
    Regulation, Inc. (NASDR) commented that our draft
    report assumed that mutual funds impose ongoing
    fund operating expenses, such as Rule 12b-1 fees
    and advisory fees, at the account level. NASDR
    stated that, instead, funds impose these expenses
    at the entity level. In addition, it noted that
    NASD member broker/dealers are generally required
    to send all customers, at least quarterly, account
    statements that detail, among other things, all
    charges and debits imposed at the account level.

    We have added language to both the Executive
    Summary and chapter 5 that clarifies that
    shareholder account statements do show amounts
    deducted directly from shareholder accounts, such
    as transaction charges and sales loads. However,
    the statements do not show in dollars each
    investor's share of the operating expenses that
    were deducted from the fund. In chapter 5 we
    mention that NASDR rules require quarterly
    statements.

    2. NASDR stated that our recommendation may be
    difficult, if not impossible, to implement. It
    stated that mutual funds do not perform the
    shareholder-level accounting envisioned by the
    proposal and that many broker/dealers would not
    have access to the information about the mutual
    fund's expenses necessary to comply with these
    rules.

    From discussions with operational staff at various
    mutual fund advisers and broker dealers, we
    learned that although such information is not
    currently calculated, compiling and making the
    calculations necessary to report to individual
    investors is feasible. As we discussed on page 79
    of chapter 5, producing such information will
    require some additional programming and will
    entail some development and ongoing costs to fund
    advisers and broker dealers, but the estimated
    costs did not appear to not be prohibitive. On the
    basis of these discussions, we believe that SEC
    and NASDR can determine a cost-effective way for
    funds and others who maintain shareholder accounts
    to provide this information to shareholders.

    3. NASDR commented that if our recommendation
    results in investors focusing solely on
    identifying funds with low expenses, such
    investors may sacrifice the performance that they
    might obtain if they were to consider other
    factors, such as a fund's investment objectives
    and the quality of the fund adviser's investment
    management.

    As we stated in the conclusions to this report,
    investors should evaluate a fund's expenses in
    conjunction with their own investment goals and
    objectives. A reasonable approach may be for
    investors to first determine what types of funds
    they wish to invest in on the basis of the their
    tolerance for risk and the types of markets or
    securities invested in by the fund. After
    determining a desired fund category type, the
    investors could then evaluate the relative fees,
    expenses, and services provided by funds within
    each investment category.

    Adequate disclosure is one of the primary goals of
    the securities laws. Withholding such specific
    information from investors because it could
    potentially be used inappropriately would not be
    consistent with the spirit of these laws. We would
    anticipate that funds would likely include
    explanatory materials with the disclosures we
    recommend to better ensure that investors evaluate
    the specific operating expense fee dollar amounts
    in context with their investment objectives and
    other information relevant to the fund.

    4. We have changed the language noted in chapter 1
    to clarify that NASDR regulates broker-dealers and
    not the funds. We also added footnotes stating
    that maximum permissible sales loads vary
    depending on certain factors, such as whether the
    fund imposes an asset-based sales charge or
    service fee; and stating the required conditions
    for a no load mutual fund.

    5. We corrected the effective date of the
    applicable Gramm-Leach-Bliley Act provisions to
    May 12, 2001.

    6. We calculated our estimates of fund adviser and
    service provider revenue by multiplying fund
    expense ratios by fund assets. These estimates
    used the net expense ratios reported by the funds
    in our sample, which exclude the amounts of any
    fund operating expenses that may be waived by the
    fund adviser.

    7. In chapter 5, we corrected the table number to
    table 5.2 and changed wording in the sentence to
    reflect that direct sales are made by a fund,
    either through an internal or external sales
    force, and not the fund adviser.

    Appendix III
    Comments From the Investment Company Institute
    Page 121           GAO/GGD-00-126 Mutual Fund Fees
    Note: GAO comments supplementing those in the
    report text appear at the end of this appendix.
    See comment 1.

    See comment 3.
    See comment 2.

    See comment 4.

    The following are GAO's comments on the Investment
    Company Institute's May 3, 2000, letter.

    GAO Comments
    1. The Investment Company Institute (ICI) notes
    that our report indicates that mutual funds
    compete primarily on the basis of investment
    performance but gives less prominent attention to
    the fact that mutual funds disclose their
    performance after fees and expenses have been
    deducted. ICI states that as a result, investors
    who consider performance are indirectly taking
    into account the impact of fees on returns. ICI
    also states that this indirect consideration
    appears to be highly relevant to shareholder
    investment decisions because, as of year-end 1999,
    more than 78 percent of shareholder accounts and
    86 percent of shareholder assets were invested in
    equity mutual funds that charged less than the
    industry average. Finally, ICI states that by
    competing on the basis of net performance, funds
    have an incentive to keep fee levels as a low as
    possible because small differences in performance
    can affect a fund's competitive standing.

    At the beginning of each discussion of how funds
    compete, our report notes that funds are required
    to disclose performance net of fees. However,
    competition on the basis of net returns may or may
    not be the same as competition on the basis of
    price, and such indirect competition may not
    result in the same level of fees as could likely
    result from more direct fee-based competition. As
    we noted in chapter 5 of the report, the charges
    associated with other financial services, such as
    bank checking accounts and stock brokerage, which
    are generally disclosed in dollar terms to the
    users of these services, have been subject to
    vigorous competition directly on the basis of
    these costs, which has resulted in lower charges
    for many consumers. In addition, we noted that
    loads, which are disclosed in investor statements,
    have also declined over time. In addition, because
    past performance is not an indication of future
    returns, relying on such disclosures alone would
    not be sufficient for ensuring that adequate
    competition is occurring on that basis.

    The statistics that ICI cites in its letter
    regarding the majority of mutual fund shareholders
    invested in funds charging fees lower than the
    industry average is based on a calculation of the
    simple average fees charged by funds in the
    industry. As we note in chapter 3 of our report,
    calculations using simple averages of mutual fund
    fees are biased upwards by the growing proportion
    of new funds, funds investing in foreign
    securities, and other funds that tend to have
    higher expense ratios than older funds investing
    in domestic securities. Therefore, finding that
    most investors are invested in funds charging less
    than such an average is not sufficient evidence to
    indicated that fund investors overall are highly
    fee-conscious, particularly in light of surveys we
    reviewed that indicated that investors generally
    considered fees to be less important than other
    factors in making their investment decisions. In
    addition, although ICI's studies reported that
    some investors are increasingly investing in lower
    fee funds does not obviate the need for more
    explicit disclosure of fees and the increased
    competition that could result.

    2. ICI noted that our draft report assumed that
    total fee revenues were the same as the revenues
    of fund investment advisers. ICI states that the
    expense ratios deducted from fund assets include
    amounts that are used to compensate not only the
    fund adviser but also other entities for
    shareholder servicing, marketing (12b-1 fees), and
    other services. ICI's letter also notes that
    adviser fees now typically account for 50 to 60
    percent of fund expense ratios. It further states
    that the report suggests that the growth rates of
    fund assets and adviser revenues have been similar
    in the 1990s. ICI indicates that a more accurate
    finding would be that advisers' revenues have
    grown more slowly than both overall fund expenses
    and assets.

         Although our report previously acknowledged
    that the expense ratio includes fees charged for
    various purposes, we have added additional text
    where appropriate to indicate that the fees
    deducted from fund assets represent revenue to
    more entities than just the fund advisor. However,
    all fees, regardless of which entities receive
    them as revenue, are deducted from investor
    assets; thus, our overall conclusion that such
    fees and assets grew at comparable rates remains
    accurate.

         3. ICI commented that the duties that mutual
    fund directors have regarding the fees funds
    charge exceed those of typical corporate
    directors. ICI emphasized that these duties are
    unique and were specifically designed to provide
    safeguards for fund shareholders. ICI notes that
    one of the individuals with whom we spoke about
    mutual fund directors appears to have suggested
    that mutual fund directors' activities may be
    serving to increase fees by evaluating a fund's
    fees in light of those charged by other funds. ICI
    states that directors, as fiduciaries, are legally
    required to act on shareholders' behalf and to
    consider a broad range of specific factors when
    reviewing fees. ICI indicates that the
    individual's claim is also contradicted by various
    studies, including our own, that found fees have
    declined.

         ICI has identified various duties placed on
    mutual fund directors that exceed those of the
    directors of a typical corporation, and we have
    added a footnote in chapter 6 to acknowledge these
    additional responsibilities. However, as our
    report points out, these additional duties,
    particularly those related to the approval of the
    advisor's contract and its fees, arise because of
    the potential conflicts of interest between fund
    shareholders and the adviser. As a result, the
    independent directors are required to review and
    approve the fund's contract and fee arrangement
    with the adviser.

         Congress intended that the independent
    directors of mutual funds serve as a check on the
    adviser because of the conflicts between the
    interests of the adviser and fund shareholders.
    However, the critics of fund directors whose
    comments we cited are of the opinion that
    directors are placing primary emphasis on
    comparing their funds' fees to those of other
    funds rather than the other factors that directors
    are required to consider as part of their fee
    reviews. Therefore, these individuals see
    directors as maintaining fee levels, or at least
    allowing fees to be lowered only to the extent
    that other funds are taking similar actions.
    Although we did find that fees for many mutual
    funds have declined, we also noted in chapter 2 of
    our report that we were unable to determine if the
    growth in fund assets would have provided advisers
    with the opportunity to reduce fees by even more
    than they had. Furthermore, a firm comparing the
    prices it charges its customers to those charged
    by competitors is a legitimate and perfectly
    acceptable means for such firms to evaluate their
    own business strategies. However, in an industry
    that only indirectly competes on the basis of such
    charges, such an activity may serve to maintain
    fees at a consistent level or allow them to be
    reduced only to the extent that other funds reduce
    theirs, as the individuals we interviewed stated.

         4. ICI commented that the assertion in our
    report that unlike mutual funds, most other
    financial services disclose the specific dollar
    amounts of all fees paid is unsupportable. As an
    example, ICI states that no bank it is aware of
    discloses to depositors the amount of the spread
    that the bank earns on a depositor's balances in
    checking or savings accounts. ICI states that the
    fee disclosures required of mutual funds are the
    most comprehensive and understandable in the
    financial services world. It also notes that these
    disclosures have been recently made simpler by the
    Securities and Exchange Commission.

         We agree with ICI that the currently required
    disclosures are comprehensive and reasonably
    understandable. In response to this comment by ICI
    and others on the draft report, we have added a
    footnote that discusses some of the recent changes
    to the disclosures we describe in our report.

         Although the disclosures that mutual funds
    make are comprehensive and useful for investors in
    comparing the relative fees charged by different
    funds, the information in them discloses fees in
    percentage terms and uses hypothetical examples,
    which are less direct indications of the specific
    prices charged to any one investor. In our report,
    we cite five examples of other common financial
    services or transactions with which most mutual
    fund investors are also likely to be familiar,
    such as checking accounts, stock brokerage, or
    bank trust services. These services disclose in
    periodic statements the specific fees in dollars
    charged to customers. As we point out, mutual
    funds do not similarly provide specific dollar
    amounts of charges on the periodic statements they
    provide to individual investors.

    Appendix IV
    GAO Contacts and Staff Acknowledgments
    Page 125           GAO/GGD-00-126 Mutual Fund Fees
    GAO Contacts
    Thomas J. McCool, (202) 512-8676
    Cody J. Goebel, (202) 512-7329

    Acknowledgments
         In addition to those named above, Michael
    Burnett, Suzie Bright, Melvin Thomas, Darlene
    Wall, and Desiree Whipple made key contributions
    to this report.

    *** End of Document ***