How to Fix the Mutual Funds Mess

Hidden fees, lax boards, and now scandal. Here's what has to be done

Used to be, the worst you could say about a mutual fund was that it lost money. Nowadays, there's worse: losing money dishonestly. Thanks again to the crusading efforts of New York State Attorney General Eliot Spitzer, some mutual-fund managers have made the growing list of investment-industry professionals willing to sacrifice investors' best interests for the sake of profits.

On Sept. 3, Spitzer tore the veneer from the almost pristine, 79-year-old fund business. In a $40 million settlement with hedge fund Canary Capital Partners, he outlined a series of improper practices in the trading of mutual-fund shares. Not only were four blue-chip companies implicated -- Bank of America (BAC ) Bank One (ONE ), Janus Capital Group, and Strong Capital Management -- but dozens of others, Spitzer suggested, schemed to bilk investors of billions each year. "Looks like they are taking advantage of investors like everyone else on Wall Street," says James Punishill, an independent analyst with Cambridge (Mass.)-based Forrester Research (FORR ) Inc.

Spitzer's is just the first salvo. Since then, the U.S. Attorney for the Southern District in New York, James B. Comey Jr., launched his own fund-trading investigation. Representative Richard H. Baker (R-La.), the author of a mutual-fund reform bill watered down after pressure from industry lobbyists earlier this year, is sharpening his pencil. And the Securities & Exchange Commission -- already miffed over negligent boards, hidden fees, and conflicts plaguing both the mutual and hedge-fund businesses -- plans a rulemaking push in coming weeks. It has now requested details from large broker-dealers, transfer agents, and the 80 largest U.S. mutual-fund families on their trading practices.

At stake is the reputation of an industry entrusted with nearly $7 trillion of the public's money. More than 95 million ordinary folks rely on funds to finance the American dream: a house, college tuition for the kids, and a comfy retirement.

All of those goals are a little further off, thanks to a vicious bear market. The average stock fund lost 12% a year in 2000, 2001, and 2002, yet funds paid $62 billion in fees just for stock-picking services alone over the same period, says consultant Max Rottersman of FundExpenses.com. Worse, funds pay another $100 billion a year just in transaction costs -- according to online trading outfit for fund managers, LiquidNet -- partly the result of high commissions, poorly executed buy and sell orders, and unnecessary trading.

Who's watching out for you? Certainly not the fund's board of directors. Most rubber-stamp management's recommendations, and few bother to negotiate lower fees. The largest mutual funds, in fact, pay money-management advisory fees that are more than twice those paid by pension funds.

Investors' best hope of reform lies with the SEC. So far, the agency has mostly tinkered with the rules under the widely shared assumption that the industry was largely clean. That may be changing. BusinessWeek has learned that the SEC is planning within weeks to push through stricter rules on deceptive ad practices and timeliness of portfolio reports, and to propose new rules on disclosure of fees and revenue-sharing deals with brokers.

Still, that's not likely to be enough. The industry itself needs to overhaul its practices. And shareholders have to be more vigilant themselves. Here is a blueprint for regulators, fund companies, and shareholders to refurbish a business that's too big and too important to fail us.

CORPORATE GOVERNANCE

Where were the directors? At the fund families implicated in the latest scandal, there apparently wasn't much oversight -- and no wonder. A. Max Walker, the 81-year-old chairman of Bank of America's Nations Funds, sits on the board of 85 funds. At another, Janus, the chairman is a director for 113.

Unusual? Not really. While many governance experts recommend corporate directors sit on no more than five boards, fund directors typically sit on dozens. By law, each fund must have a board. Most fund families use the same set of directors for every fund in their stable. It's more efficient, they reason, because funds operate similarly. Some 277 of Fidelity Investments' funds, for example, share a common board.

The SEC requires that a majority of those busy directors be independent. But many so-called independent fund directors have ties to the fund managers. The legal definition of "independence" is squishy: The statute lets relatives of fund managers serve as independent directors as long as they aren't members of the immediate family. Former employees of the fund's investment adviser may also serve as independent directors just two years after retirement. It's a nice perk: In 2002, the median total pay for directors at the big fund groups was $113,000, according to consultants Management Practice Inc.

Little surprise that directors rarely exert their authority to challenge the fund's adviser. Many routinely approve management contracts at fees that are twice what pension funds pay for stock-picking services. And they are slow to insist that investment advisers cut loose portfolio managers with lousy records. It took the boards of Putnam Vista Fund and Putnam's OTC & Emerging Growth Fund three years to replace managers in each fund, after losses that averaged 24% and 44% a year through 2002, respectively, ranking both at the bottom of their peer group. Fund governance is "fundamentally broken," says Gary Gensler, co-author of The Great Mutual Fund Trap. "Directors too often think of the fund company -- not the real investors in the funds -- as their client."

It's time to shake up fund governance the same way that the 2002 Sarbanes-Oxley Act gave corporate boards a wake-up call. To start, Congress must tighten the definition of independence so fund companies can't use board positions as retirement benefits for their executives. And the SEC should require directors to seek the best investment adviser, based on cost and performance, and to justify the selection to shareholders annually. Directors should closely monitor the performance of their investment adviser year after year.

The fund industry, for its part, must limit directorships. Many funds in the same category operate similarly, so allowing directors to sit on 10 or even 20 boards may be viable. But directors who oversee 50 or more risk becoming lapdogs instead of watchdogs. Outside directors must take control of meeting agendas. To shake up the clubby culture, they might insist that meetings be held offsite. Boards should require that compliance officers report to them -- and adhere to a zero-tolerance policy for violations of fund rules.

Investors must make their voices heard, too. If they think performance is weak or fees too high, they should look at the prospectus for the independent directors and call them to demand an explanation. Directors are well-paid; let them work for that money.

DISCLOSURE

Mutual-fund managers demand all sorts of disclosures from the companies they invest in. Yet funds keep their own shareholders in the dark about expenses that lower their returns.

Take the cost of trading stocks in a portfolio, one of a fund's biggest expenses. It isn't broken out or included in the expense ratios that funds report. Funds do tell investors how often they turn over stocks, but the ratio -- 110%, on average -- is buried in the prospectus and may not mean much to shareholders. (It means that a $100 million fund will make $110 million worth of trades in a year.) If they saw what that frenetic activity was costing them in dollars, says University of Mississippi law professor and ex-SEC lawyer Mercer E. Bullard, they might demand that funds trade much less. That would benefit investors: Studies show that higher-trading strategies yield lower returns.

Soft-dollar payments aren't disclosed, either. Soft dollars are created when fund managers pay their brokers a higher commission than they have to. Those extra dollars work like frequent-flier miles, with fund managers using them to get research reports, data feeds, and other aids for picking stocks. But the practice can create conflicts of interest. Managers may churn their accounts to generate more soft dollars in order to buy services such as stock research that investors shouldn't have to pay for.

Fund managers' compensation is also a tightly held secret. But investors need to know what the manager's incentives are. Is the pay based on pretax returns or aftertax returns, beating an index or just beating the fund peer group, or returns for the quarter or longer term?

Lastly, most funds report their holdings to shareholders only twice a year, not enough for investors to gauge whether they're overexposed to a sector or stock. And too often, their quarterly reports offer broad summaries that don't explain key stock-picking decisions that affect returns. "It's very difficult for even a well-educated investor to have a comprehensive understanding to compare funds," says Baker, chairman of the House capital markets subcommittee.

The SEC has already proposed rules for mutual funds to report their holdings quarterly and give investors more useful data on fees every six months. It's likely to adopt these rules within weeks. It should further insist that funds calculate transaction costs so investors can see whether managers are engaging in rapid-fire trading despite pledges to "buy and hold." In addition, the agency should trim the list of services that funds may buy with soft dollars, and demand they tell investors what is purchased.

Funds must start telling investors how they compensate portfolio managers -- or at least what performance measures they use.

Investors who aren't satisfied with the information they get must speak up. The fund industry is a lobbying juggernaut and will fight hard to squelch most new disclosure requirements. Only by making their views known to the SEC and lawmakers can investors overcome the industry's self-interest.

FEES

One of the fund industry's favorite parlor games is debating detractors who argue that fund fees are too high. The Investment Company Institute, the mutual-fund trade group, says the majority of stock-fund investors pay only 0.99% of total assets a year in fees. But because that doesn't include such costs as brokerage commissions, one of a fund's largest expenses, Vanguard Group founder and industry critic John C. Bogle thinks the ICI's number is off by a mile.

Whether fees are up or down, investors should understand this immutable truth: High fees, like weights on a runner's ankles, reduce performance. The difference between a 0.5% and 1.5% fee may seem minuscule, but on a $10,000 investment returning 5% over 10 years, the lower fee puts $1,489 more in the investor's pockets. Or look at a recent Lipper Inc. study of money-market mutual funds. The study of 263 funds over the last five years shows that investors could have increased their income by 51% simply by investing in one of the 25 lowest-cost funds.

In the long run, fees can make the difference between investment success and failure. Problem is, it's almost impossible for investors to calculate what a fund's total costs are. And the industry, with the SEC's backing, seems to prefer it that way. There are one-time transaction costs, such as sales loads and redemption fees, that don't appear in the expense ratio -- the measure of costs that most investors focus on.

And the expense ratio -- which includes recurring costs such as management and marketing fees -- can be inscrutable because investors never get a bill. Instead, the costs are deducted from the fund's assets and expressed not in dollars but as a percentage of total assets. In other words, what you personally pay is near invisible. That's a boon for the industry, quips ex-SEC lawyer Bullard: "More fee information would make funds more competitive, and that in turn would drive down fees."

That should be the goal. The SEC must require that funds disclose the cost of owning a fund -- in dollar terms, not as a percentage of assets -- in a personalized quarterly statement. Shareholders should see how much of their money went in and out of a fund, much like a brokerage account.

Some fees should just be eliminated. The SEC should ask Congress for authority to ban marketing charges that funds are foisting on shareholders. Also called 12(b)-1 fees after the 1980 rule that created them, such fees were supposed to be temporary, to help new funds defray distribution costs. Today, they are used to pay brokers and financial planners who sell the bulk of funds. Why shoulder the burden of selling your fund to other investors?

While the SEC agrees that more fee disclosures would help, it's not pushing for individual dollar figures, nor is it asking funds to reveal trading costs. And while it suggested three years ago that 12(b)-1 rule changes were overdue, the SEC has not acted. Just ask any investor: Fees are too confusing. The SEC, with the help of industry, could do a lot to bring about some order.

SALES PRACTICES

With almost as many equity mutual funds as actively traded stocks, the industry has become a marketing machine. Today, most funds have given up selling directly to investors and turned to brokerage firms and financial planners to distribute their products. But such intermediaries now hold all the aces and are extracting ever-higher fees -- which investors pay.

What's worse, this new landscape is littered with sales practices that are sloppy at best and deceptive at worst. In July, the SEC settled a case against Prudential Securities Inc. alleging that head office managers improperly supervised brokers' mutual-fund sales. Prudential did not admit or deny guilt. A few months earlier, a study by regulators of 43 brokerage firms concluded that fund customers were routinely being cheated out of volume discounts. And studies show that brokers are boosting their pay by herding investors into funds' so-called B-shares, those that levy marketing fees for up to six years instead of a one-time sales charge.

Revenue-sharing is probably the biggest worry. This involves fund companies paying brokerage firms -- $1.5 billion a year by some estimates -- to guarantee they're on a select list of funds. Brokers almost never reveal to clients that they are being paid more to place clients in certain funds. And while funds reveal in prospectuses if they have such arrangements, they don't say who gets paid or how much.

In August, the NASD said it would propose rules to clamp down on shelf-space fees, but it didn't go far enough. The NASD would require brokers to tell clients about revenue-sharing deals but not the amounts being paid to the firm or individual broker. This is crucial information to customers, who deserve to know that their broker earned that 5% sales charge and didn't just choose a fund, Chinese-menu-style, off a list.

The NASD also must work harder to close numerous loopholes in existing brokerage rules. It can start by banning all broker sales contests and quotas -- inducements that can result in brokers pushing inappropriate funds on unsuspecting investors. Regulators should also ban granting higher commissions to brokers selling the firm's own funds, which often have lower returns. And the NASD must regulate branch managers' compensation. Because many branch honchos are paid a bonus based on how many select-list funds their offices sell, they can place undue pressure on brokers to bend the rules.

Another common selling practice: Funds increasingly offer multiple classes of shares, each with different up-front or backend sales charges. The array of classes is baffling to most investors. The PIMCO Total Return Fund, for instance, has seven share classes. The fund industry, on its own, could end the confusion. Not only are there too many classes, but for some classes there are no common definitions. Thus, what may be the best class for the investor at one company may be the worst at another.

The industry also can do more to restore its image as a steward of other people's money. Fund companies should act sooner to deny entrance to new investors once a fund reaches a critical size. More funds should take their cues from Wasatch Advisors, a small-cap fund manager in Salt Lake City that just turned off the spigot to six funds; one was closed to additional investors after it took in $65 million on its opening day. While that limits Wasatch's management fees, it shows the company is putting investors first. Small-cap funds must keep total assets fairly low to be effective. There are only so many good investment opportunities in that sector, and buying indiscriminately merely to put tons of money to work is likely to lead to mediocre returns -- or worse.

With most fund groups hungry for money, Wasatch is turning it away. That's the kind of competitive advantage all funds should strive for.

PRICING

The law that governs mutual funds was adopted in 1940, and in one respect, the industry thinks it's still back in the '40s. Fund companies price their shares no more than once a day. And with rare exceptions, they sell and redeem shares at prices set at 4 p.m. New York time.

This sets up a huge opportunity for sharp traders in U.S. funds full of European or Asian stocks that stopped trading in their home markets hours earlier. Buying these funds at lower prices ahead of overseas gains almost assured by rallies in the U.S., traders divert $4 billion a year from other fund customers, estimates Stanford University business professor Eric Zitzewitz.

Fund companies and the SEC did little about this until scholars began calculating the damage in the late 1990s. Even now, only half of international funds have taken serious steps to stop it. The most common response is to penalize traders who sell within weeks of buying. But that's hard to enforce because orders are often bunched together by brokers. It also hurts customers who must sell for legitimate reasons. Worse, the penalties can be waived, as Attorney General Spitzer noted, for favored customers.

One answer: Follow the lead of the Guinness Atkinson Funds, which stops taking orders on Asia funds when U.S. markets open at 9:30 a.m. But the best solution is for the SEC to press the funds to do, in essence, what the traders do: Update the fund's price according to what U.S. markets do after overseas exchanges close. This "fair-value pricing" can virtually eliminate the chances for exploitative trading. Zitzewitz, who started moonlighting for a pricing service after his research drew attention, says about two dozen fund companies -- representing one-third of assets in international funds and including Vanguard, Fidelity, and T. Rowe Price -- already use fair-value updates.

Mutual-fund companies have had three years of watching their stock portfolios plunge, and fees along with them. That has tempted some to get creative about enhancing their profits, which has gotten them into hot water with regulators. "Salesmanship and not enough stewardship" rule the day, quips Vanguard's Bogle. While no credibility crisis is well-timed, this one strikes just as investors are returning to the fold, encouraged by the market rally. After yanking a record $27 billion out of equity funds in 2002 -- the biggest pullback in 15 years -- investors are now channeling in more than they have in almost four years. The speedy restoration of integrity will ensure buy-and-hold investors will keep doing just that.

By Mara Der Hovanesian and David Henry in New York, and Amy Borrus and Paula Dwyer in Washington, with Anne Tergesen in New York

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