Pennsylvania Investment Observer

Mutual Fund Reforms

by Daniel J. Nestlerode

On Wednesday, June 23rd, the Securities and Exchange Commission (SEC) will tackle the issue of reforming the $7.4 trillion dollar industry. The main issue now is whether the chairman of a mutual fund must be independent from the fund management and or the fund distribution company. The proposed rule would also require that 75% of fund directors also be independent.

Since New York State's Attorney General Elliott Spitzer took on the mutual fund industry and a number of "scandals" have emerged, the SEC has been scrambling to once again take the lead in mutual fund regulation. At issue is the independence of fund directors, late trading, market timing, and the rapid turnover of fund shares among other issues. Further the SEC wants funds to hire compliance officers and develop codes of ethics. All of these issues are somewhat important to the brokers who sell the mutual funds and the investors who place their money with the funds hoping to earn better returns than are available at their local bank. The bigger issue in my estimation is not being addressed and probably won't be address until some competitive pressures force the mutual funds to change their practices.

The mutual fund industry is largely a monopoly with little price competition between competing firms. While there are load and no load funds, giving investors the option to pay a sales charge to buy their fund or avoid it altogether, every fund charges management and trading fees from their gross returns on their investment operations. Buried deeply in the prospectus and statement of additional information are most of the facts and figures related to costs charged to investors, but not all of them. A knowledgeable investor can fathom the management fees for a particular mutual fund, however, he/she cannot find out how much it costs the mutual fund to trade the investments within the mutual fund portfolio. Furthermore, the funds do not report to shareholders or potential shareholders special arrangements they might have with certain brokerage firms to showcase particular funds with the payment of money from the funds to the brokerage firms and individual brokers. Finally, on top of these fees the average investors needs to understand that the investment management business is one the most lucrative businesses in the world. After tax profit margins run about 20% at one large well known mutual fund management company.

Mutual Funds are sold based on the hope of future performance often argued from past performance. To this end, the ongoing costs of mutual fund ownership are almost never discussed between the selling broker firm, its representative and the buying investor. Further, the mutual fund itself rarely has any contact with its shareholders, since the point of contact is usually the representative of the broker. The bottom line is that with this distribution system in place, mutual funds have no incentive to reduce costs and cut fees in order to improve investor performance. Indeed, mutual funds always have an out in explaining that the investment performance would be better if only the stock market in general was performing better. In the end, conversations about the cost of investing involve up to three percent per year, compared to potential mutual fund performance of gains over twenty percent in a good year. In other words, until a viable alternative investment product becomes widely available to investors and investors start moving their money away from mutual funds, do not expect any major change in the practices and cost structures of mutual fund organizations. So the bottom line is that the mutual fund industry looks like and acts like a monopoly, with precious little reason to engage in any price (cost) competition.

Spitzer and the SEC might nip around the heels of the industry and proclaim victory including "major" changes in the regulation of mutual funds. The real change that would benefit all mutual fund investors however, is in my opinion, a long ways off. Mutual funds will not be induced to change their business as usual practices until a major credible competitor appears on the investment scene or until investors sell massive amounts of mutual fund and reduce sharply the management and other fees earned by the mutual fund management and distribution companies.

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