Commentary: Time for Mutual Funds to Bare All

By Amy Borrus

Last year's Sarbanes-Oxley Act reforms beefed up the accountability rules for Corporate America but overlooked a key player: mutual-fund companies. While the fund industry is not scandal-ridden, neither is it as investor-friendly as it likes to think. Funds still withhold crucial information about accounts from their shareholders. The Securities & Exchange Commission is trying to prod them in the right direction by proposing that mutual funds give shareholders more information on what investments the funds hold and how they vote them.

But with the climate favorable for reform, the SEC should push for even more disclosure. "It's time to pierce the veil" of mutual-fund management, says John C. Bogle, founder and ex-chairman of Vanguard Group Inc.

Few of Bogle's peers agree with him. Fund executives, who demand all manner of disclosure from companies they invest in, balk at divulging similar information to their own investors. Nevertheless, in the next few months, the SEC is expected to adopt both proposals now on the table.

First, it wants to require funds to say how they vote the shares they hold in corporate proxy contests. The funds are fiercely opposed, saying it would be costly to compile and distribute this information and might politicize the voting. But the measure has support from key lawmakers on Capitol Hill, and the overwhelming majority of the 7,500 letters submitted during the comment period are in favor. The move would unmask conflicts of interest that cause funds to rubber-stamp management policies. Since corporations hire fund companies to administer pension and 401(k) plans, funds are loath to bite the hand that feeds them by opposing management in proxy contests.

Less controversial is the SEC's call for funds to reveal their portfolio holdings every three months, instead of twice a year. Already, about 70% of funds tell fund trackers what's in their portfolios at least quarterly. Under this proposal, shareholders also would get more useful fee data. Funds would be required to report semiannually how much investors paid in fees during the previous six months for a hypothetical $10,000 account. Stating fees in dollars instead of as a percentage of assets would make investors more aware of what they actually pay funds. That could encourage funds to curb expenses.

With the wind at its back, the SEC shouldn't stop there. Requiring funds to reveal their trading costs, portfolio managers' pay, and the factors affecting investment performance would give fund shareholders an even clearer picture of how their money is being managed.

After management fees, trading costs are the biggest expense, but they aren't included in the expense ratios that funds must make public. Funds pay brokerage commissions and bid-ask spreads that range from 0.5% to 0.75% of assets, so it's not surprising that academic studies show that the more a fund manager trades, the worse the fund performs. Fund portfolios turn over an average of 110% a year. So if fund managers had to disclose their trading tabs, they might switch to lower-trading strategies. "Turnover would drop drastically," says Mercer Bullard, president of shareholder advocacy group Fund Democracy Inc.

It's also time to draw back the curtain on portfolio managers' compensation. Fund directors now tell customers the overall fee they pay for advisory services, but they don't break out what--or how--individual portfolio managers are paid. If, for example, compensation is based on pretax returns, why would a fund manager take care not to run up a big capital-gains-tax bill, which investors, not the fund, pay? "It's hypocritical of funds not to disclose this, since it's information they routinely look at" when investing in companies, says Don Phillips, managing director of fund-tracker Morningstar Inc.

In addition, funds need to do a better job of telling investors what's happening to their money. The "management discussion" sections of shareholder reports often are boilerplate summaries that don't explain the key factors that drove portfolio performance. An SEC checklist of points to highlight--industry exposure, best- and worst-performing stocks, changes in investing strategy--would be a good start.

The likely new SEC chairman, William H. Donaldson, hasn't hinted at his priorities. But if he wants to show that he's an investors' advocate, he needs to back vigorously the two proposals now in the works--then promise to keep on going.

Borrus covers financial regulation in Washington.

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