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Consumer Groups Endorse Mutual Fund Reforms - But Want More

It is, not surprisingly, all about the money.

A year after New York State Attorney General Elliott Spritzer began exposing unfair trading practices at some of the nation's most prominent mutual fund companies, much has changed. Many fund companies have overhauled their trading policies and procedures. Some have pledged restitution to their shareholders. A few have agreed to lower their fees. And the Securities & Exchange Commission, which oversees the industry, has proposed a broad slate of reforms. Yet consumer advocates say more needs to be done to protect investors, particularly on the fee front. High on their complaint list: the industry's practice of allowing fund companies, rather than investors, to determine the compensation paid to the broker-dealers who sell their funds-through sales loads, 12b-1 fees and other sometimes obscure arrangements.

"When mutual funds set the brokers' compensation, brokers in too many cases end up recommending funds based on which offer them the most generous compensation, rather than on which are in their clients' best interests," says Barbara Roper, director of investor protection for the Consumer Federation of America. By allowing funds to compete for distribution by offering more generous compensation to brokers, she says, the industry drives costs to investors up, not down. "Right now," she says bluntly, "you basically have price fixing. I know it's counterintuitive to suggest we don't have a thriving competitive marketplace in the mutual fund industry when, in fact, we do. It's just not competition on terms that are beneficial to investors."

The SEC has taken some promising steps, Roper allows, such as proposing a ban on directed brokerage, in which fund companies send portfolio transactions to a particular brokerage firm to reward it for selling the company's funds. The SEC also has floated the idea of eliminating 12b-1 fees, or, at the least, changing the way they are assessed. "We would just like to see them push that farther," Roper says, "and do the kind of radical reform that, frankly, the commission staff has recommended on and off for years."

For now, however, most of the proposals set out by the SEC remain just that: proposals. Among the few that have been adopted are requirements that funds implement compliance policies and procedures and employ a chief compliance officer, disclose in their shareholder reports the fund expenses born by shareholders on a hypothetical $1,000 investment, report portfolio holdings on a quarterly basis to the SEC, and that of independent chairman of fund boards. They also must disclose their market-timing policies and procedures for shareholders who try to dart in and out of the market based on where they think prices are headed, and detail more prominently the breakpoint discounts on front-end sales loads that are available to investors as their account balances grow.

Still on the table are a slew of reforms that consumer groups generally consider to be more critical, including the proposed ban on directed brokerage, 12b-1 fee reform, and additional fee disclosures. On the latter point, the SEC has proposed that broker-dealers show customers the distribution-related costs of a fund purchase at the time of that purchase, either by referencing the value of the customer's actual transaction or a model investment of $10,000. Even more detailed disclosures would be required on the paperwork confirming a transaction, a proposal the fund industry is strenuously opposing on the argument that it would be costly and potentially confusing to investors.

Consumer advocates disagree. "The most important proposal on the agenda is the proposal to require point-of-sale and confirmation disclosure of fund costs," argues Mercer Bullard, a securities law professor at the University of Mississippi School of Law and founder and chief executive officer of Fund Democracy, an advocacy group for fund shareholders. Roy Green, senior lobbyist for financial services for the American Association of Retired Persons, concurs. "We think this is an important change," Green says. "There needs to be an effort to make these costs comprehensible to the ordinary investor-and they need to receive the information in advance so they can do a bit of comparison shopping." Opponents saw their case weakened recently when MFS Investment Management-one of the fund companies implicated in the scandals-announced that it will begin to provide detailed fee disclosures with their trade confirmations on a voluntary basis.

While consumer advocates are eager to see the SEC maintain its reform momentum, they are not particularly eager to see every SEC proposal enacted. One of the most inflammatory transgressions to surface in the fund scandals was the accommodation that some funds were making to allow certain big institutional customers to buy and sell funds at the market's 4 p.m. Eastern time closing price-after 4 p.m. Spritzer likened it to betting on a horse race after the horses had crossed the finish line. The SEC's proposed remedy is a so-called "hard close" at 4 p.m. Eastern time for all mutual fund trading. Critics, including the 401(k) industry, argue that for participants in retirement savings plans to enjoy same-day pricing on their plan transactions under the hard-close rule, plan administrators would have to collect trade orders much earlier in the day so they could be processed and forwarded to the fund companies by 4 p.m. Individual investors in western time zones would face a similar time crunch. Opponents of the hard close are calling instead for a system that would allow orders from retirement plan participants and western investors to be processed after 4 p.m., provided there was adequate documentation that their orders were entered prior to that time.

"I am very skeptical about the need for a hard 4 p.m. close, at least before other equally effective alternatives are explored," says Bullard. "In fact, the worst thing your typical mutual fund investor could do is worry about whether he is going to get that day's price. But as a practical matter, the SEC can't ignore the appeal that getting the same day price has for investors, be it in their interest or otherwise. This is primarily a matter of perceived fairness more than actual disadvantage."

The conundrum highlights the need, says the AARP's Green, for better cooperation between the SEC, which regulates the fund industry, and the Department of Labor, which oversees employer-sponsored retirement plans. The SEC has already warned that it does not believe it has the authority to oversee certain intermediaries in the retirement plan market who process mutual fund transactions. That could hamstring efforts to develop alternatives to the hard-close proposal.

Although consumer advocates are convinced that much remains to be done before the mutual fund playing field is level for investors-Bullard has even called for creating a "Mutual Fund Oversight Board" to supplement the SEC's efforts-they do not suggest that investors should steer clear of all mutual funds until then. "As a general rule, we think the SEC has done a pretty good job of addressing the specific abuses of both the sales practices and the trading practices uncovered by Elliott Spritzer," says Roper. "We also think they've had a pretty aggressive enforcement program, with tough sanctions, and I think they've been doing a lot of work on upgrading their inspection and oversight program, so that they'll be quicker to identify problems in the future."

Nonetheless, Roper worries that the abusive behaviors uncovered last year were so pervasive that they may reflect a consumer-unfriendly attitude that could lead to other types of abuses at later dates, even after the current set of problems is resolved. "I don't think mutual fund investors can afford to be complacent," she warns. "I think they need to be aware that not all mutual fund companies are created equal, and that there are some that were a lot more willing to sell out their shareholders interests than others."

Bullard is similarly cautious, and even more adamant than some of his peers that Congress, where several legislative initiatives are languishing, should act more aggressively to reform the fund industry. "The SEC hasn't adopted much at all thus far," he says, "so I think the jury is still out on whether their actions will have material long-term benefits to fund shareholders."

Failure, he and other consumer advocates suggest, would carry a price higher than consumers should have to bear.

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