Commentary: Mutual Funds: Investors Are Still in the Dark

By Geoffrey Smith

For an industry that handles $7 trillion of America's savings, the mutual-fund business is remarkably opaque. Most funds tell shareholders what stocks they own only twice a year. Many won't announce when a hot manager leaves or say why they keep a money-losing one. As for a good explanation of why a fund's fees are so high--one of investors' biggest beefs--good luck.

Indeed, the industry has an impressive track record of dodging efforts to make it more responsive to investors. Case in point: Former Securities & Exchange Commissioner Arthur Levitt Jr.'s reforms, the first major ones in a decade, which went into effect on Jan. 31. The main goal was to give independent fund directors more power and make them more accountable. One key new rule requires fund boards, which ostensibly represent investors, to tell the SEC why they renewed a fund management company's annual contract. A second forces directors to disclose financial ties to the fund companies and their affiliates.

It's already clear that the new rules are having little effect. Directors are filing boilerplate explanations of their decisions despite specific SEC instructions to the contrary. And a provision for which the industry lobbied, to exempt from disclosure payments to directors of less than $60,000 a year, potentially opens the door to abuse. The SEC should close that loophole and force directors to explain their decisions better.

But the bigger problem is that today's regulation is aimed at an industry that doesn't exist any more. Fund regulation as we know it was born 62 years ago with the Investment Company Act of 1940. It's based on the assumption that each mutual fund operates as a separate entity with its own board of directors. Fund companies administer the funds, appoint managers, and propose fees for their services under a contract with the fund. And the board decides each year whether to renew the contract.

That made sense back then when most fund companies ran one or two funds. No longer. In a world of giant fund families, regulation is out of kilter with the economic reality of business. These days, whatever the formal rules may say, it's the family that effectively decides whether to open or close a fund, what fees it will charge, and who will manage its portfolio. And the independent directors are often on the boards of so many of the funds in the same family that it's hard to distinguish them from full-time employees.

One prominent industry figure believes that the SEC should simply abandon rules such as the director's approval of advisory contracts and the mandatory mailings of printed prospectuses to investors. "The SEC, the fund's adviser, and the fund's board would enhance investor protection if they could patrol for the real abuses and not waste their time with rituals," says Marianne K. Smythe, an attorney and former head of investment management at the SEC, who now represents fund companies.

But giving directors a free pass on many of their present responsibilities is as absurd as not reforming accounting in Enron's wake. Needed are rules focusing on the fund families as much as on the individual funds they operate. That means giving investors information that's easy to find and simple to understand.

A starting point would be to put details of the average fees a fund charges in a place where investors will read it: in big type, right on their regular statements--just like the health warnings on cigarette packs. How independent fund directors can be contacted should be printed on statements, too. And when a manager--hot or not--leaves, the fund family should be required to announce it promptly and repeat it on the next shareholders' report.

Aren't these steps rather basic? Yup. But the industry will find them harder to evade than earlier reform efforts. Once investors have this important, albeit simple, information, they'll be better able to judge whether to buy, sell, or hold. The market will take care of the rest.

Smith covers mutual funds from Boston.

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