- Fund Regulation
- Retirement Security
- Trading & Markets
- Fund Governance
- ICI Comment Letters
Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,
Committee on Financial Services,
United States House of Representatives
On “Mutual Fund Industry Practices and Their
Effect on Individual Investors”
Paul G. Haaga, Jr.
Executive Vice President
Capital Research and Management Company
Investment Company Institute
James S. Riepe
T. Rowe Price Funds
T. Rowe Price Group, Inc.
March 12, 2003
Table of Contents
I. Executive Summary
II. Oral Statement of Paul G. Haaga, Jr.
III. Oral Statement of James S. Riepe
IV. Written Statement—Introduction
V. Benefits of Disclosure and Regulation of Mutual Fund Fees
VI. Benefits of a Strong Regulatory Scheme
I. Executive Summary
- The last several years have been challenging ones for investors, including mutual fund investors, market conditions and corporate and accounting scandals have shaken investor confidence.
- Throughout these difficult times, the comprehensive regulatory scheme under which mutual funds operate has served the interests of fund investors well.
- The disclosures that mutual funds are required to provide to investors are unmatched by those of any other financial product. Every investor must receive a prospectus, which contains key information about a fund to help an investor make an investment decision. This includes information about fund fees and expenses.
- Mutual fund fees and expenses are clearly and prominently disclosed in a standardized, easy-to-read fee table at the front of every fund prospectus. Performance information in mutual fund advertisements must be presented net of fees. Fees also are subject to substantive regulation under the Investment Company Act of 1940 and NASD rules.
- The broad availability of information about mutual fund fees and expenses has helped promote price competition in the industry. Recent government and industry studies support the conclusion that competition is working in the interests of fund investors. Among the findings are that the average total cost of purchasing mutual funds has declined steadily and significantly since 1980, that mutual fund investors benefit from economies of scale, and that the overwhelming majority of investors buy and own funds with lower than average expenses.
- The SEC continues to improve disclosure of mutual fund fees and other costs, as demonstrated by various new and pending disclosure requirements, including proposed expense disclosure in mutual fund shareholder reports, proposed disclosure in fund performance advertisements directing investors to the prospectus for information about fund fees and expenses, and standardized disclosure of after-tax returns.
- In addition to disclosure and substantive regulation of fund fees and expenses, mutual funds are subject to comprehensive regulation under the Investment Company Act that has been effective in protecting investors and helping the industry avoid major scandal. The fact that many of the central tenets of mutual fund regulation—including independent boards, mark-to-market accounting, prohibitions on complex capital structures, prohibitions on self-dealing, and direct oversight by the SEC—are now being extended to other businesses (e.g., through the Sarbanes-Oxley Act of 2002) serves as a strong endorsement of the mutual fund regulatory system.
II. Oral Statement of Paul G. Haaga, Jr.
Thank you Chairman Baker, Ranking Member Kanjorski, and members of the Subcommittee. I appreciate the opportunity to testify before you today.
My name is Paul Haaga. I am Executive Vice President of Capital Research and Management Company. I am the Chairman of the Investment Company Institute’s Board of Governors and a member of the Institute’s Executive Committee.
My firm is the investment adviser to the American Funds, which manages $350 billion on behalf of about 12 million mutual fund investors. We are the third largest family of mutual funds in the United States.
We appreciate the opportunity to continue our work with Chairman Oxley, who first chaired a hearing on the mutual fund industry in 1998, Chairman Baker and their staff as the Committee examines additional ways to bolster investor confidence in our financial markets. With half of all American households owning mutual funds, fund companies can play a key role in helping millions of middle-income American investors regain confidence in long-term investing. Following today’s hearing, the ICI and the fund industry look forward to addressing any questions or concerns members of the Committee may have as we continue to reinforce our commitment to meeting the needs of 93 million individual mutual fund investors.
You asked us how the mutual fund industry is serving the individual Americans who invest in the stock, bond and money market funds we manage. We believe the answer to the question is clear.
At a particularly difficult and challenging time in the history of the nation’s financial markets, we believe we are serving 93 million investors quite well. Mutual funds provide more useful information, investment options, and services to our shareholders—at much lower cost—than ever before.
We believe that the cost of mutual funds, and the services they provide to investors, are lower—in fact, far lower—than any of the other financial services used by most Americans.
A major part of the reason why mutual funds are effectively serving investors is the fact they are strictly regulated by the SEC. Virtually every aspect of a mutual fund’s operations is governed by detailed regulations. These rules
- limit a fund’s name,
- restrict its advertising,
- cap its sales charges and distribution fees,
- prohibit certain investments and investment strategies,
- specify how daily prices and performance statistics are calculated,
- specify the composition of the board of directors and board committees,
- restrict the personal investment practices of among fund personnel, and
- prohibit self-dealing transactions among fund affiliates.
In 1999, Investor's Business Daily published an article describing the regulation of mutual funds. The author wrote: "You might think that the fund industry would chafe under what some think is the most pervasive regulatory environment” in the financial services industry. But we don’t chafe under this system; we thrive under it.
As we have for many years, the mutual fund industry views strict federal regulation as an asset rather than a liability. Under the SEC’s watchful eye, and accompanied by effective oversight by independent directors, mutual funds have remained free of major scandal for more than sixty years. We don’t think it’s an accident that historically, mutual funds have enjoyed unusually high levels of trust and support from fund investors.
This hearing occurs as we approach the 37th month of one of the worst bear markets in modern history. Our memory of costly accounting scandals and corporate abuses is also still vivid. Most individuals investors holding stocks and stock mutual funds have lost money during the last few years. Some have also lost confidence.
While stock mutual funds were not the cause of the scandals or abuses – our responsibility to serve and protect the interests of millions of individual investors makes it imperative that we work to devise and support solutions. For this reason, we strongly supported the Sarbanes-Oxley Act and many other reforms to our financial reporting and oversight system.
Let me now turn to the issue of mutual fund fees.
It is frequently reported that the average stock mutual fund charges fees at an annual rate of about 1.6 percent of assets. By itself, that statistic is essentially true. But by itself, that statistic is also hugely misleading.
Although the average stock mutual fund charges 1.6 percent for its annual fees, an overwhelming majority of stock fund investors pay far less. As of the end of 2001, the average investor’s stock mutual fund had annual fees of 0.99 percent.
As illustrated in a chart we’ve brought with us, 79 percent of all shareholder accounts are in lower-cost stock mutual funds—funds that all charge less than the industry average. These lower cost accounts hold 87 percent of all stock fund assets.
At first, it may not seem apparent that an average investor could pay less than the average fund charges. But consider a business that has two cars for sale, one for $20,000, and the other for $40,000. The “average” selling price is obviously $30,000.
But if 80 people buy the less expensive car, and only 20 choose the more expensive car, the typical buyer clearly does not pay the average price charged by the seller. The typical buyer pays $24,000. This is 20 percent less than the $30,000 average price charged by the seller.
The Committee expressed interest in the trend in mutual fund fees and expenses. Since 1998, major fee studies have been completed by the ICI, the General Accounting Office and the Securities and Exchange Commission. My written testimony points out that these studies share many common conclusions. Perhaps the single most important shared conclusion is the finding that as mutual funds grow, their fees generally decline, with the sharpest reductions apparent at the funds that grew the most.
The ICI study looked at 497 stock funds representing nearly three quarters of stock fund assets. 74 percent of these funds lowered their fee levels as they grew, with the average reduction amounting to 28 percent. Many of the funds that had not lowered their expense ratios were older funds with rock bottom fees to begin with.
The GAO study came next. It looked at the 46 largest stock funds. It found that 85 percent of them had reduced their fee levels. The average reduction was 20 percent. The GAO, in particular, “found that the largest reductions in expense ratios generally involved funds with the greatest growth in assets.”
The SEC fee study presents the most recent analysis. It reviewed the management contracts of the 100 largest stock and bond funds as of the end of 1998. It found that 76 of these contracts included provisions that automatically reduce mutual fund fee levels as the fund grows beyond certain size thresholds. In addition, the SEC found that stock funds that had grown to exceed $1 billion in assets had fee levels that were substantially lower than smaller funds.
In fact, the SEC found specifically that “as fund assets increase, the operating expense ratio declines.” This is the essence of economies of scale. To understand fee trends in the mutual fund industry accurately, it is essential to recognize that the industry’s overall growth does not produce industry-wide cost savings.
If any one of us decided to start a mutual fund tomorrow, we would derive no cost benefit from the fact that the industry we were joining had grown quite large. Indeed, the prospect of competing successfully against so many large and experienced firms would likely lead to much higher start-up costs than when the industry was smaller. Cost savings from mutual fund asset growth can be realized only by the individual funds or fund companies that realize that growth. We are very pleased that all three studies on this subject—by the ICI, GAO and SEC—recognized this, while also confirming that the overwhelming majority of funds and fund companies that grew significantly reduced their fee levels along the way.
It is important to recognize that some of the automatic fee reductions that are triggered by economies of scale when assets grow can be lost when a fund’s assets decline. While a declining market may cause the benefits of some automatic fee reductions to be lost—hopefully temporarily—over longer periods these fee schedules have been hugely beneficial to millions of fund investors. They result in huge savings from economies of scale that are shared with investors. The SEC fee study pointed out that about three-quarters of stock fund shareholders own funds with assets of more than $1 billion.
It is equally important to understand that mutual fund fee levels, which frequently include lower rates as assets grow, cannot be increased without three separate actions being taken. First, the fund’s board must approve a fee increase. Second, the board’s independent directors must separately approve the fee increase. And third, the fund’s shareholders must approve the increase in a shareholder vote. This is a key governance mechanism that helps protect and serve the interests of millions of mutual fund shareholders.
Because of continuing interest in mutual fund fee trends, the Institute recently looked at the fee level of all mutual funds purchased by shareholders over the course of five years, from the beginning of 1997 until the end of 2001, the last year about which we have full data.
As illustrated on the chart on the side of the room, we found that over this five-year period, 82.8 percent of all stock funds purchased by shareholders had expense ratios below the industry’s average.
The Committee expressed interest in the effect of industry practices on individual shareholders. In our view, examining the practical needs and concerns of typical individual mutual fund shareholders—including fees but not limited to them—is exactly the right focus.
The fact that the typical shareholder who holds mutual funds today is paying far less than the average fund charges is compelling evidence that our industry’s practices – the funds we offer, the services we provide, and the fees we charge—are serving tens of millions of fund investors faithfully and effectively. In particular, it is apparent that the market readily enables investors to find lower cost mutual funds.
I would close by reemphasizing two points.
The evidence about the decisions actually made by fund investors and fund companies speaks powerfully. Nearly 83 percent of all stock funds purchased by investors from 1997 until 2001 had expense ratios below the industry average. At least 74 percent of all stock funds that experienced significant growth reduced their expense ratios as they grew. We are pleased and gratified by both of these developments.
This positive news hardly means our job is complete. This is especially true in the wake of the corporate scandals and abuses that have been revealed over the last 18 months. The challenge of educating investors—about diversification, asset allocation, various types of risk, the impact of fees and taxes, the need for realistic expectations and a long-term focus—is a constant responsibility and an essential element of reinforcing confidence in our markets.
Thank you very much.
* * * * * * *
III. Oral Statement of James S. Riepe
Thank you Chairman Baker, Chairman Oxley, Ranking Member Kanjorski, and all the other members of the Subcommittee. T. Rowe Price is a Baltimore-based investment management firm. We manage some $141 billion in assets, $87 billion of which is in mutual funds. Personally, I have been in the fund management business for about 34 years, and am happy to be here with you today to talk about this important subject.
Before I start, I want to note that as you conduct your review of the mutual fund industry, it is important to remember that stock funds, although they get all the headlines—particularly, after 3 years of a severe bear market—represent less than one half of mutual fund industry assets—about 41 percent, specifically. The balance are in fixed-income funds and money funds. And when we look at just the equity fund portion of the industry, less than one-fifth of those assets are in aggressive growth funds—again the ones that get the most headlines. So that means when we look at total mutual fund industry assets, only about 6-7 percent of the entire industry is in the aggressive end which enjoyed the upward volatility of the late 90’s and now suffered the downward volatility of the last three years. So the context for your review is that this is much more than just a growth stock business. It also means that the vast majority of investors have benefited from mutual funds in a very substantial way when one considers all the other types of funds in which they are invested.
Individual investors do not typically trust all their assets to just one fund or even one manager. The average T. Rowe Price investor, for example, owns at least three of our funds and also owns funds offered by two or three other fund managers as well. So clearly, investors understand the idea that diversification is important—not only diversification within funds and among funds, but among managers, as well.
That is also evident in the defined contribution side of the business. Again using our example, our typical 401(k) participant has seven different investment accounts and about 50 percent of these assets are in equities, some in company stock and the remainder in fixed income options. So as a result, the 401(k) investor has done relatively well in terms of his or her risk-adjusted performance during this recent down period and did well during the later years of the bull market as well.
Our panel has covered a range of subjects today, and I just want to touch on a few of them. Several issues we are a bit uncertain about and others we view with some certainty.
With respect to disclosure, I don’t know if mandating more disclosure is the answer. I think we need to work harder in determining what disclosure is illuminating to the investor and what disclosure is obfuscating. As an industry, we are committed to educating investors—and I think the evidence is very clear that we have done that both collectively and as individual firms. And we have done it, quite frankly, because it is in our self-interest to have investors who understand their investment. But disclosure for the sake of disclosure is not good. I would reference the example of “owners manuals.” Studies show that people simply do not read owners manuals. One of their problems is that the first 10 pages tend to be filled with disclaimers and warnings and, of course, the books are too thick. If we do the same to mutual funds, then we are going to turn away the average mutual fund investor. So we need good, useful, focused disclosure; we do not need simply more disclosure.
When we get into the world of trading cost evaluations, you can tell from listening to a couple of the comments here that it is incredibly complex and very difficult to measure. There are multiple ways to measure transaction costs, but there is no consensus on which is best. And all the measurement models are at their base speculative. I think we can be comforted in the fund industry that however such costs are measured, we know that the fund investor’s return is net of all costs—and I think that is very important.
There are, fortunately, some things that we do know. The fundamental qualities of mutual funds—diversification, professional management, relatively low cost—have proven their merit during this bear market. Being able to gain access to a diversified portfolio is critically important for investors. When they invest in individual stocks, they do not have such diversification. Morningstar and all the critics have agreed on the value of fund investments from a diversification perspective.
Mutual funds also provide better and much more useful and more transparent disclosure than any other financial product or service. As Mr. Gensler suggested, the disclosure always could be better. But let’s compare mutual funds to other financial services. If I buy a certificate of deposit at my bank, they tell me I’m going to get 3 percent; they don’t tell me that they are going to lend that money out at 8 percent, use 400 basis points to cover their expenses and keep 100 basis points of profit. That is the reason, ironically, that you could not have hearings on the expenses of those products in the way you can have hearings on mutual funds. Because funds spell out all of the expenses that investors incur and they spell out the bottom line, which is the net return the investor receives after those expenses.
I think, too, there is an impression being left that mutual fund investors panic easily, that they are skittish, etc. One has to look under the aggregate redemption numbers to find that most fund investors are long-term investors. There are certainly those investors who follow trends, investors who think they can out-guess the market. They are not the majority. They are not even in many cases a significant minority, but they trade often enough that they affect the overall redemption numbers. So I think it is misleading, frankly, to look at aggregate numbers and try to draw conclusions about 95 million investors. Mutual fund investors are intelligent when they make their investments, and they hold their investments longer than aggregate redemption ratios might indicate.
Unlike many other financial relationships, and in contrast to Mr. Bogle’s suggestion, the interests of mutual fund companies and mutual fund investors are in my view very well aligned. Investors and fund managers want good performance. We all want good performance—that’s how as managers we thrive and prosper. We want good service. We have to have good service to be competitive, and we are in an incredibly competitive industry. We also need to provide helpful guidance. Investors select us on the basis of the type of guidance and intelligent advice we can give them. And they want all of that at a reasonable cost.
As to the suggestion that almost no one beats “the index,” nearly 80 percent of T. Rowe Price equity funds beat their competitive Lipper Group and the S&P 500 over the last five years. Almost two-thirds have beaten the market index over the last 10 years. So the fact is that there are many funds out there that have been successful in beating the indices. There are also many investors who would rather bet on health care, or on financial services, or on technology than buy an index fund that is going to provide them with the overall market performance. Having said that, T. Rowe Price manages billions of dollars of index funds along with our actively-managed products. This is not about religion. This is a matter of choice. Selection depends on an investor’s objectives and how he or she believes they can best achieve them. Index funds are out there for all those investors who want them.
Let me just say very quickly a word on governance. Sarbanes-Oxley adopted governance practices that have existed for mutual funds for many years. So we feel the corporate world is being brought closer to where we are now and not vice versa. And fund investors do not invest in boards of directors. They invest in a fund manager, a company they know, a company they’ve talked with their friends about, a company they have read about in Morningstar, Lipper, or Money Magazine. And they do not expect directors, whom they do not know and who do not necessarily have an investment expertise, to decide to replace the manager they have picked. What they do expect directors to do is to monitor the fund’s results while also making sure the manager has adequate resources and always acts prudently in a manner which is consistent with the fund’s policies. And if there are funds that they believe have not performed up to reasonable standards, then they should urge the management to make appropriate changes. But the idea that independent directors should start replacing managers and putting out to bid contracts when the investor has already made the decision to invest with that company, I think is neither appropriate nor expected.
In closing, when you ask about the effects funds have had on investors, the answer is that the mutual fund—as an investment vehicle for individual investors—has been arguably the most successful financial service in the 20th Century. It has succeeded for one reason—because investors see value in it as an investment vehicle. Funds have provided tens of millions of investors with diversified and professionally managed access to stock, bond, and money market securities invested around the globe in every way, shape, and form that they could want. And mutual funds have succeeded without incurring any major scandals or frauds during their long history—a statement that not many industries could make, and certainly not other financial services. That success, in my view, is attributable to a number of factors, including the intensive regulatory scheme under which funds operate. But most important to their success is the transparency which our panel has talked about and which is inherent in mutual funds. And that transparency has been critical in creating trust between tens of millions of investors and the managers responsible for investing their hard-earned dollars in these funds. It is a trust that all of us in the business know could be lost very easily if we do not continue to earn that trust every single day.
What you see is what you get in a mutual fund. The net return on a fund is just that, return net of all expenses—whether they are the measurable ones or the more difficult ones to measure. In fact, our funds are measured every single day. The results are posted in the paper and are seen by everyone. And the evidence clearly indicates that investors value this combination of transparency, diversification, and professional management—all at a relatively low cost.
Thank you very much for the opportunity to express my views, and I look forward to your questions.
IV. Written Statement
My name is Paul G. Haaga, Jr. I am Executive Vice President and Chairman of the Executive Committee of Capital Research and Management Company, the investment adviser to the 29 funds in The American Funds Group, with more than $350 billion in assets under management. The American Funds Group is the third largest mutual fund group in the United States and the largest group distributed exclusively through unaffiliated financial intermediaries. I also serve as Chairman of the Board of Governors of the Investment Company Institute, the national association of the American investment company industry, and I appear here today on behalf of the Institute. The Institute’s membership includes 8,929 open-end investment companies ("mutual funds"), 553 closed-end investment companies and 6 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.322 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.
I am pleased to appear before the Subcommittee today to discuss how Securities and Exchange Commission (SEC) disclosure requirements and substantive regulation have provided mutual fund investors with a sound basis for making informed investment decisions, fostered competition in the mutual fund industry, and shielded the industry from major scandal.
The last two to three years have been challenging ones for all investors, including mutual fund investors. Because mutual funds themselves are investors in the securities markets, they have felt the impact of market downturns. In addition, the egregious corporate and accounting scandals that have surfaced during this period have broadly impacted investor confidence.
In these difficult times, when so many Americans have entrusted their hard-earned dollars to mutual funds, it is entirely appropriate to conduct this review of mutual fund industry practices and their effect on individual investors. My testimony will describe how fund shareholders benefit from the current system of SEC mutual fund regulation.
First, I will describe mutual fund disclosure requirements, especially the requirements governing disclosure of fund fees and expenses. The availability of clear and prominent fee disclosure has served to create a basis for informed investment decisions. It also has promoted price competition in the industry, which has the beneficial effect of limiting costs to fund shareholders. Recent industry and government studies of mutual fund fees confirm the existence of competition. Moreover, in recent years, the SEC has adopted and proposed changes to further enhance fund disclosures.
Second, I will discuss key elements of the strong system of substantive regulation that has protected funds from the scandals that have shaken investor confidence in corporate America. In fact, in the aftermath of these scandals, many of the central tenets of mutual fund regulation—including independent boards, mark-to-market accounting, prohibitions on complex capital structures, prohibitions on self-dealing, and direct oversight by the SEC—are being extended to other industries through the provisions of the Sarbanes-Oxley Act of 2002 and other regulatory initiatives.
V. Benefits of Disclosure and Regulation of Mutual Fund Fees
A. Clear and Prominent Fee Disclosure Is Provided to Investors
The disclosures that mutual funds are required to provide to investors are unmatched by those of any other financial product. Each investor receives a prospectus at or before the time of buying fund shares. The prospectus provides detailed information about a fund’s investment objectives and policies, risks, returns, fees and expenses, the fund manager, and how to purchase and redeem shares. In 1998, with strong support from the fund industry, the SEC adopted changes designed to improve the quality and usefulness of information in fund prospectuses in order to promote the primary purpose of the prospectus—to help an investor make an informed investment decision. One of the innovations adopted by the SEC at that time is the requirement for a standardized “risk/return summary” at the beginning of every fund prospectus that lays out concisely and in a specified order information about the fund’s investment objectives, strategies, risks and performance, as well as its fees and expenses.1
Reflecting their importance as part of the information that investors and their professional advisors should consider when deciding whether to invest in a fund, fund fees and expenses are disclosed in a straightforward, standardized fee table. The fee table presents fund fees in two broad categories: shareholder fees (such as sales charges paid to compensate financial professionals who provide investment advice and other services) and annual fund operating expenses. The fee table shows annual fund operating expenses broken down into specified categories. These include, for example, the “management fee” that the fund’s investment adviser charges to manage the fund and the “distribution (12b-1) fee,” if any, that the fund pays to cover costs such as compensating broker-dealers, financial planners and other financial professionals for services they provide directly to investors. Each type of annual operating expense is expressed as a percentage of the fund’s average net assets. The fee table also shows total annual fund operating expenses as a percentage of average net assets (sometimes referred to as a fund’s “expense ratio”).2
One distinction between shareholder fees and annual fund operating expenses is that shareholder fees are paid directly by investors, whereas annual fund operating expenses are paid out of the fund’s assets (and, thus, indirectly by investors) to cover the ongoing costs of running the fund and other services. Notably, investors often have the option of paying for the assistance and ongoing services of their financial advisers, including administrative services related to maintaining shareholder accounts, in more than one way. These payment options could include a direct fee (i.e., a sales charge), a payment made from the fund’s assets over time (i.e., a 12b-1 fee), or a combination of both. Most investors use these services; thus, most funds have sales charges and/or ongoing fees to cover these costs. Indeed, Institute data show that the vast majority (approximately 80 to 85 percent) of mutual fund purchases are made by investors through financial intermediaries, including both financial advisers and employer-sponsored retirement plans.3 In other words, in most cases, investors are receiving professional advice or other services from financial intermediaries when investing in mutual funds. To provide investors with a choice of how to pay for these services, many funds offer various classes of shares that provide a variety of different payment options.4
The American Funds Group provides a good example of this. Our funds are sold exclusively through third parties, primarily retail broker-dealers. We have adopted a multiple class structure that, by providing choices, seeks to satisfy the different needs of the different types of customers we serve. The overall expenses of our share classes vary based largely on two important factors: (1) the level of compensation paid by the fund on behalf of its shareholders to financial intermediaries; and (2) the level of administrative services supported by the share class.5
In addition to listing a fund’s fees and expenses, the prospectus fee table includes an example that illustrates the effect of fund expenses on a hypothetical investment over time. The example is designed to enable investors to readily compare the costs of two or more funds because the invested amount and time periods are standardized. The total is an “all-in” figure, expressed as a single dollar amount, that takes into account both sales charges and annual operating expenses.6
The required disclosures of mutual fund fees are reinforced by SEC rules governing mutual fund performance advertising. Under current SEC rules, funds that advertise performance information must provide standardized total return data for prescribed periods. Importantly, all standardized performance numbers must be presented net of fees. Thus, when investors review and compare fund performance data, the effect of all fees has already been taken into account.
Taken together, the foregoing disclosure requirements provide investors and their professional advisers with the information needed to make decisions about the value that a particular fund can offer.
B. Substantive Regulation of Fees Further Protects Fund Investors
In addition to the wealth of information about fees and expenses that is available to mutual fund investors and their professional advisors, there are a number of substantive regulatory protections that apply to mutual fund fees.
First, NASD rules place limits on mutual fund sales charges and 12b-1 fees.7
Second, fund boards of directors oversee all expenses and have specific review, approval and oversight responsibilities with respect to the most significant components of ongoing fund expenses—the investment advisory fee and any 12b-1 fee.8
For example, both the board as a whole and a majority of the fund’s independent directors must review and approve any investment advisory contract entered into by a fund on an annual basis, after an initial term of no more than two years. Fund directors are required to request, and the adviser is obligated to provide, information reasonably necessary to review the terms of the contract, including the advisory fee.9 My firm, Capital Research and Management Company, prepares extensive information for this purpose and provides it to the directors of The American Funds and their independent legal counsel approximately two weeks in advance of a meeting of the contracts committee of independent directors that is convened for the purpose of considering renewal of the investment advisory contract, the 12b-1 plan (discussed further below) and other key agreements between the funds and the investment management organization. Every committee meeting includes an executive session involving the independent directors and their legal counsel outside the presence of fund management.
Pursuant to Rule 12b-1 under the Investment Company Act, any payments by a fund for distribution-related expenses must be in accordance with a written plan approved annually by the fund’s board of directors, including a majority of the independent directors. The fund’s directors must review, at least quarterly, the amounts spent under a 12b-1 plan and the reasons for the expenditures.
In addition to the specific limits on fund fees and the board review, approval and oversight requirements described above, another level of investor protection is provided through requirements that shareholders must approve any material changes to the advisory contract (including any proposed fee increase) and any material increase in a fund’s 12b-1 fee. Thus, funds cannot unilaterally raise these fees, nor may the board alone approve a fee increase.
C. Transparency of Fee Disclosure Has Helped Foster Competition
The broad availability of information about mutual fund fees and expenses has helped promote competition in the industry. Individual investors, as well as the intermediaries who assist investors in making their investment decisions, have access to and use this information. When the Institute testified on price competition in the fund industry in 1998, a central theme of the Institute’s testimony was that competition in the mutual fund industry is working effectively in the interests of investors.12 As evidence of this, we noted: (1) that mutual funds compete for investor dollars; (2) that there are low barriers to entry into the fund business; (3) that the industry is not concentrated; (4) that the total costs of investing in mutual funds are declining; (5) that mutual fund investors are benefiting from economies of scale; and (6) that a substantial majority of fund shareholders own equity funds that charge lower fees than the industry average. Each of these points remains valid today and several have been reinforced by developments since 1998.
1. The Market Structure of the Fund Industry Promotes Active Competition. In its 2000 report on mutual fund fees,13 the United States General Accounting Office (GAO) described the mutual fund industry as one that features a large number of competitors, low barriers to entry, and product differentiation on the basis of performance, quality and services. The GAO Report noted that both the number of funds and the number of fund families rose significantly during the period of 1984 to 1998 and that the industry was not concentrated.14
2. Mutual Fund Fees Continue to Decline. The Institute’s 1998 testimony discussed several studies indicating that the total purchase cost of investing for mutual fund shareholders had steadily declined over time.15 Additional studies of trends in mutual fund fees have been conducted more recently. These studies all reach the same conclusion: total costs of purchasing mutual fund shares have continued to fall.
According to Institute research, the average total cost that investors incurred when purchasing mutual funds16 as declined steadily and significantly since 1980. From 1980 to 2001, the total cost of equity funds fell by 43 percent, the total cost of bond funds decreased by 41 percent and the total cost of money market funds decreased by 35 percent.17
The SEC’s Division of Investment Management published its own study of mutual fund fees in 2000.18 The SEC looked at both expense ratio trends and total ownership costs. According to the SEC study, the weighted average expense ratio for all fund classes declined in three out of the last four years that the SEC studied (from 0.99 percent in 1995 to 0.94 percent in 1999). While the SEC found an increase in the weighted average expense ratio from 0.73 percent in 1979 to 0.94 percent in 1999, it explained that this increase was due to the shift from use of front-end sales charges (which are not included in a fund’s expense ratio) to finance distribution, to the use of 12b-1 fees (which are included in the fund’s expense ratio). When examining the total ownership costs of “load classes,”19 the SEC found a decline of 18 percent between 1979 and 1999.
3. Fund Investors Continue to Benefit from Economies of Scale. Some critics have suggested that the mutual fund industry has not passed economies of scale on to investors. These critics usually rely upon a fundamental misconception—that economies accrue to an industry that has grown. Economies do not accrue to an industry but rather only to individual funds or fund families as they grow. In fact, evidence shows that mutual fund investors have benefited from economies of scale.20 Institute research shows that the expense ratios of large equity funds were lower than those for smaller funds and that expense ratios declined as funds grew.21
The findings in the GAO Report are consistent with the Institute’s research. For example, the GAO found that between 1990 and 1998, 85 percent of the equity funds included in its study reduced their expense ratios, with an average decline of 20 percent.22 Another more recent empirical study of mutual fund advisory contracts provides further support for the proposition that mutual fund investors are benefiting from economies of scale. This study found that fee rates in mutual fund advisory contracts are lower for advisers of large funds and members of large fund families, leading the author to conclude that these results “are consistent with economies of scale being passed along to investors—suggesting a competitive environment.” 23
My own experience backs this up. Like many other fund groups, The American Funds have management fee schedules that provide a series of breakpoints at specified asset levels. As a result, our funds’ shareholders have benefited greatly from economies of scale. For example, as a result of the amount of assets in our oldest and largest fund, Investment Company of America, the current advisory fee is 24 percent.
4. Most Investors Buy and Own Lower Cost Funds. In 1998, the Institute testified that the overwhelming majority of both shareholders’ equity fund accounts and equity fund assets were in mutual funds that charged annual fees below the simple average. More recent Institute data indicate that this is still true. In fact, in 2001, 79 percent of equity fund accounts and 87 percent of equity fund assets were in share classes with a below average expense ratio. Institute research also shows that the percentage of new sales attributable to share classes with a lower than average expense ratio was at least 80 percent in each year from 1997 through 2001, when it reached 86 percent.24
D. The SEC Continues to Improve Mutual Fund Disclosure
As discussed above, existing mutual fund fee disclosure requirements provide a high degree of transparency that has played a significant role in fostering competition in the mutual fund industry. The SEC continually seeks ways to further improve disclosure of mutual fund fees and other costs, as evidenced by various new and pending SEC disclosure requirements.
1. Shareholder Report Disclosure. Mutual funds are required to furnish to shareholders on a semi-annual basis reports containing the fund’s financial statements and additional financial and other information. The SEC recently proposed changes to simplify and improve the disclosure in fund shareholder reports. Among other things, the proposals would allow mutual funds to provide summary portfolio schedules and require funds to provide graphic presentations of their portfolio holdings. The Institute strongly supports most of the proposed changes, which build on earlier SEC disclosure initiatives such as fund prospectus simplification. 25
As part of its shareholder report disclosure improvement initiative, the SEC has proposed to require new disclosure concerning fund expenses in shareholder reports. Specifically, the SEC has proposed that fund shareholder reports disclose the cost in dollars of a $10,000 investment in the fund, based on the fund’s actual expenses and return for the reporting period. The proposed disclosure is intended to enhance investor understanding of ongoing fund expenses and allow investors to estimate the costs they bore over the reporting period.
The Institute supports this proposal. It should enhance investors’ awareness of the importance of fees by reminding them about the impact of expenses on their investment return and will also assist them in comparing the expenses of different funds. The proposed disclosure would complement the extensive fee and expense disclosure that funds currently provide.
In making its proposal, the SEC noted that it had considered an alternative approach that would require every quarterly account statement delivered to an investor to disclose the actual dollar amount of fees paid with respect to each mutual fund held by that investor during the last quarter. The SEC expressed concerns about the cost and logistical complexity of such a requirement. For example, in many cases, fund shares are held by broker-dealers, financial advisers, and other third-party financial intermediaries. In order to calculate and timely report personalized expense information for each fund held in an account each quarter, not only funds but also each intermediary would have to implement new systems, which would be extremely burdensome.26 Based on these concerns, the SEC determined not to propose such an approach.27
Individual expense disclosure in account statements also would have other disadvantages. For example, it would not provide any context for an investor to assess the expenses paid in a meaningful way or to make comparisons with different funds. If an account statement reflected investments in several different funds, it is likely that the amount invested in each one would be different, thus making it difficult to make a fair comparison. The SEC’s proposed approach uses a standardized investment amount ($10,000), which is specifically designed to facilitate comparisons. Also, account statement disclosure of fund expenses could be misleading because there could be other investments reflected on the same statement that would not include similar disclosure. This could create the mistaken impression that mutual funds are the only type of investment that involves costs, which might lead to ill-informed investment decisions.
2. Disclosure in Fund Advertisements. As discussed above, standardized quotations of fund performance are calculated in a manner that takes fund fees and expenses into account. The SEC has proposed amendments to the rules governing fund advertisements. Among other things, the proposed amendments would require a legend in fund performance advertisements to direct investors to additional information about fees and expenses in fund prospectuses. This proposed change will call further attention to fund fees and expenses and their impact on returns.
3. Disclosure of After-tax Returns. As part of the SEC’s continuing efforts to improve mutual fund disclosure of costs, in early 2001, the SEC adopted rules requiring most mutual funds to disclose in their prospectuses returns on an after-tax basis.28 This disclosure is presented in a standardized format and included as part of the risk/return summary required at the front of the prospectus. Significantly, to our knowledge, no other financial product is subject to a similar disclosure requirement. Nevertheless, the Institute generally supported the rules because we agree that it is relevant for investors to understand the impact that taxes can have on returns.29
4. Disclosure of Brokerage Costs. Questions have arisen concerning the disclosure of brokerage costs (commissions) that a fund pays in connection with buying or selling portfolio securities. Information about brokerage commissions paid by mutual funds is included in a fund’s Statement of Additional Information, which is available to investors for no charge upon request.30 The SEC previously required disclosure of average commission payments in fund prospectuses, but eliminated this requirement as part of its 1998 prospectus simplification initiative.31
The industry would welcome ideas for ways to better disclose these costs. One suggestion that has been raised—requiring that they be included in the fund’s expense ratio—would not improve disclosure of brokerage costs. There are several reasons for this. For example, including brokerage commissions in a fund’s expense ratio could confuse investors, distort expense ratios and make fair comparisons across funds more difficult, because the expense ratio would include commissions paid for securities that trade on an agency basis but would not include the spread for securities traded on a principal basis. As a result, it might appear that a fund that holds securities that trade on a principal basis would have lower trading costs and lower overall expenses than a fund that pays commissions, when this might not be the case. Other components of trading costs (e.g., market impact) also could not be included in the expense ratio. By including some, but not all costs associated with trading, the expense ratio would no longer serve its primary function—allowing investors and others to compare ongoing fund expenses in a consistent manner. Finally, the level of brokerage costs can fluctuate significantly, sometimes as the result of a one-time occurrence, such as a change in the fund’s portfolio securities in connection with the assignment of a new portfolio manager. This could lead to volatility in the fund’s expense ratio that may confuse investors by appearing to indicate changes in the cost of providing fund services to investors.
VI. Benefits of a Strong Regulatory Scheme
The disclosure and substantive regulatory requirements governing fund fees and expenses and the other disclosure requirements discussed above represent just some of the ways in which mutual fund regulation informs and protects investors. Mutual funds are subject to a comprehensive regulatory scheme under the federal securities laws that has worked extremely well for over 60 years. Their operations are regulated under all four of the major federal securities laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940 and, most importantly, the Investment Company Act of 1940.
The Investment Company Act goes far beyond the disclosure and anti-fraud requirements characteristic of the other federal securities laws and imposes substantive requirements and prohibitions on the structure and day-to-day operations of mutual funds. Among the core objectives of the Investment Company Act are to: (1) insure that investors receive adequate, accurate information about the mutual fund; (2) protect the physical integrity of the fund’s assets; (3) prohibit or restrict forms of self-dealing; (4) prohibit unfair and unsound capital structures; and (5) insure fair valuation of fund purchases and redemptions.
The strict regulation that implements these objectives has allowed the industry to garner and maintain the confidence of investors and also has kept the industry free of the types of problems that have surfaced in other businesses in the recent past. An examination of several of the regulatory measures that have been adopted or are under consideration to address problems that led to the massive corporate and accounting scandals of the past several years provides a strong endorsement for the system under which mutual funds already operate.32
For example, under the Investment Company Act, mutual funds—unlike any other financial product—are governed by a board of directors that is required to have at least a certain percentage of directors who are independent from fund management. In early 2001, the SEC adopted new requirements designed to enhance the independence and effectiveness of independent fund directors, and to “reaffirm the important role that independent directors play in protecting fund investors.”33 As a result, funds that rely on any of several key exemptive rules under the Investment Company Act (which includes the vast majority of funds) are subject to the following requirements: (1) independent directors must constitute a majority of their boards of directors; (2) independent directors must select and nominate other independent directors; and (3) any legal counsel for the independent directors must be an “independent legal counsel” as defined by the SEC.34
Recognizing the significant role that independent directors can play in protecting investors, the New York Stock Exchange and other self-regulatory organizations are considering adopting board independence requirements for listed companies.35
Fundamental provisions of the Investment Company Act—affiliated transaction prohibitions, restrictions on capital structure and daily mark-to-market accounting—contribute greatly to the transparency of mutual fund operations. Perhaps more importantly, they prevent the types of conduct and practices of corporate issuers (e.g., loans to insiders or “creative” accounting practices) that have caused millions of Americans to lose not only significant amounts of money but also their confidence in the capital markets.
The extensive regulatory scheme that applies to mutual funds has been effective in protecting investors and helping the industry avoid major scandal due, in large part, to another important aspect of mutual fund regulation—direct SEC oversight and regular examinations of funds. The Institute has always strongly supported adequate funding of the SEC to ensure that it can fulfill these roles effectively, and we are pleased that the SEC’s latest budget increase recognizes the importance of a strong, well-funded SEC.36 We note that Section 408 of the Sarbanes-Oxley Act, which provides for regular and systematic SEC review of certain disclosures made by corporate issuers, affirms the value of direct SEC oversight and regular examinations.
In these challenging times that we all face—where public confidence has been shaken and weak market performance continues—it is clear that investors have benefited from the stringent regulation of mutual funds. The disclosure and substantive regulatory requirements imposed upon mutual funds have enhanced competition and helped the industry avoid major scandal.
1At the same time that the SEC proposed these changes to fund prospectuses, it also proposed a rule, which the Institute supported, designed to prevent misleading fund names. The SEC adopted the “fund name rule” in 2001. It requires any fund whose name suggests that the fund invests in certain investments, industries, countries or geographic regions to have a policy of investing, under normal circumstances, at least 80 percent of its assets in a manner consistent with its name.
2 A variety of other readily available sources of information about mutual fund fees supplement the SEC’s fee disclosure requirements. These sources include brokers and financial advisers, newsletters, newspapers and magazines. They also include the SEC itself, which in recent years has developed and made available on its website (www.sec.gov) both an interactive mutual fund cost calculator designed to assist investors in comparing the costs of different funds and other educational materials about investing in mutual funds. The Institute and many individual fund groups also offer educational resources and tools for investors to help them better understand fees and expenses as well as other important aspects of mutual fund investing.
4 In a multiple class structure, each class of shares invests in the same portfolio of securities. Different classes may be sold through different distribution arrangements (e.g., retail broker-dealers, employer-sponsored retirement plans, etc.) and may have different expense levels that reflect their customization.
5 For example, we offer five share classes designed for use exclusively by retirement plans. These share classes have a broad spectrum of expense levels. The expense differences reflect the fact that some retirement plan sponsors wish to have the fund pay for all expenses of financial intermediaries and plan administration, while others prefer to pay most of these expenses directly and outside of the fund.
7 See NASD Conduct Rule 2830. NASD rules limit total front-end and/or deferred sales charges to no more than 8.5 percent of the offering price, although most funds charge far less than the maximum. The rules also limit 12b-1 fees. These fees are limited to a maximum of 1.00 percent of the fund’s average net assets per year, which may include a service fee of up to 0.25 percent to compensate intermediaries for providing services or maintaining shareholder accounts. NASD rules also subject the aggregate amount of 12b-1 fees to a lifetime cap, based upon a percentage of fund sales.
In addition to these fee limits, NASD rules impose suitability requirements on broker-dealers with respect to securities that they recommend, including mutual funds. The NASD has provided guidance reminding its members that, in determining the suitability of a particular fund, a member should consider the fund’s expense ratio and sales charges as well as its investment objectives. The NASD also has issued specific guidance concerning the application of suitability principles to sales of mutual funds that offer multiple classes. See, e.g., NASD Regulation, Inc., “Suitability Issues for Multi-Class Mutual Funds,” Regulatory & Compliance Alert, Summer 2000.
9 While fund directors have a responsibility to make sure that advisory fees are reasonable in light of all relevant facts and circumstances, they are not required to engage in a competitive bidding process or to award the advisory contract to the adviser offering the lowest rates. Either of these approaches would, inappropriately, ignore the fact that the fund’s shareholders have chosen the fund and the fund family in which they wish to invest. In the words of former SEC Chairman Arthur Levitt, “Directors don’t have to guarantee that a fund pays the lowest rates. But they do have to make sure that fees fall within a reasonable band.” Remarks by Chairman Arthur Levitt, U.S. Securities and Exchange Commission, Investment Company Institute, Washington, D.C. (May 15, 1998).
10 Section 36(b) of the Investment Company Act of 1940. A mutual fund also enters into a number of contracts with other service providers, such as the fund’s principal underwriter, administrator, custodian, and transfer agent. As part of its overall responsibilities, the board of directors oversees the performance of these service providers. If the service provider is the investment adviser or an affiliate of the adviser, the fund board must review and approve the contract with the service provider to ensure that any compensation paid thereunder meets the standards of Section 36(b).
11 See, e.g., Kalish v. Franklin Advisers, Inc., 928 F.2d 590 (2d Cir. 1991); Gartenberg v. Merrill Lynch Asset Mgmt., 694 F.2d 923 (2d Cir. 1982).
12 Statement of Matthew P. Fink, President, Investment Company Institute, before the Subcommittee on Finance and Hazardous Materials of the House Committee on Commerce on “Improving Price Competition for Mutual Funds and Bonds,” September 29, 1998.
13 United States General Accounting Office, “Mutual Fund Fees: Additional Disclosure Could Encourage Price Competition” (June 2000) (“GAO Report”).
14 GAO Report at 58-59.
15 These studies included: (1) Erik R. Sirri and Peter Tufano, “Competition and Change in the Mutual Fund Industry,” in Financial Services: Perspectives and Challenges, edited by Samuel L. Hayes, III, Cambridge, MA, HBS Press, 1993; 92) Steve S. Savage, “Perspective Amid the Debate Over Mutual Fund Expenses,” AIA Investor News, published by the American Investors Alliance, February 1993; (3) Lipper Analytical Services, Inc., “The Third White Paper,” September 1997; and (4) “Advisory Fee Contracts,” Strategic Insight Overview, May 1998, p.ii.
16 To properly measure the total cost of investing in mutual funds, it is important to consider both (1) the sales charges paid by investors directly to compensate financial professionals who provide investment advice and other services, and (2) the annual operating expenses that are paid out of the fund’s assets to cover the costs of running a fund and other services. Unlike annual operating expenses, sales charges are one-time charges. Thus, to measure total shareholder cost accurately, it is necessary to “annualize” the sales charge, i.e., convert it into the equivalent of an annual payment paid by the investor over the life of his or her investment.
19 The SEC defined “load classes” as classes with 12b-1 fees higher than 25 basis points, classes with 12b-1 fees and contingent deferred sales charges, and classes with traditional front-end sales charges.
20 The term “economies of scale” refers to the expectation that a growing fund should be able to spread certain fixed costs across a larger asset base, resulting in a declining expense ratio. In fact, the fee structures of many funds have been specifically designed to pass along economies of scale by means of management fee “breakpoints,” which refer to a specific level of asset growth, and provide that when this level is achieved, the management fee rate will be reduced by a predetermined amount (e.g., 5 or 10 percent).
21 John D. Rea, Brian K. Reid, and Kimberlee W. Millar, “Operating Expense Ratios, Assets, and Economies of Scale in Equity Mutual Funds,” Perspective, Vol. 5, No. 5, December 1999.
22 The GAO examined expense ratios, asset growth rates, and related data for the 46 largest equity funds and 31 largest bond funds as of December 31, 1998 that had been in existence since January 1, 1990.
23 Daniel N. Deli, “Mutual Fund Advisory Contracts: An Empirical Investigation,” The Journal of Finance, Vol. VII, No. 1, Feb. 2002, at 110.
24 The experience of bond funds has been similar: 74 percent of bond fund accounts and 85 percent of bond fund assets were in share classes with below average expense ratios in 2001. The percentage of new sales of bond funds attributable to bond fund share classes with lower than average expenses increased from 79 percent in 1997 to 85 percent in 2001.
26 The American Funds, for example, are sold through approximately 2,000 dealer firms.
27 An ICI survey of various industry participants conducted in late 2000 confirmed that the costs and burdens of providing individualized expense disclosure on quarterly account statements would be substantial. ICI Survey on GAO Report on Mutual Fund Fees (January 31, 2001).
28 Certain types of funds, such as money market funds and funds used as investment options for 401(k) plans and other types of retirement plans, are exempted from these requirements.
29 We continue to have concerns with some of the specific aspects of the rule, however. The most significant concern is that the rules require funds to use the highest marginal tax rate in computing after-tax returns. This rate is much higher than the rate applicable to the majority of mutual fund shareholders. We believe that using the rate applicable to the average fund investor would provide more useful information by presenting a more realistic measure of after-tax returns.
30 Funds also include this information in Form N-SAR, which is filed with the SEC. (Both documents are available on the SEC’s EDGAR system.)
31 In eliminating the requirement, the SEC stated that “a fund prospectus appears not to be the most appropriate document through which to make this information public.” SEC Release No. IC-23064 (March 13, 1998), 63 Fed. Reg. 13916, 13936 (March 23, 1998).
32 Mutual funds also are subject to most of the requirements that apply to corporate issuers under the Sarbanes-Oxley Act of 2002, including the following: (1) mutual fund shareholder reports must be certified by the fund’s principal executive and principal financial officers; (2) mutual funds must disclose whether their audit committee includes at least one member who is an “audit committee financial expert,” and if not, why not; (3) mutual funds must disclose whether they have adopted a code of ethics that covers specified fund officers and other personnel and if not, why not; (4) mutual funds must comply with the new auditor independence requirements, including the requirement to periodically rotate auditors; and (5) legal counsel to mutual funds (which the SEC has interpreted to include legal counsel to the fund’s investment adviser, for this purpose) must comply with new requirements governing attorney conduct. Congress excluded mutual funds from some of the Act’s provisions where existing law already prohibits the conduct in question. For example, because Section 17(a) of the Investment Company Act prohibits most transactions with affiliates, mutual funds were exempted from Section 402 of the Sarbanes-Oxley Act, dealing with issuer loans to insiders.
33SEC Release No. IC-24816 (January 2, 2001), 66 Fed. Reg. 3734 (January 16, 2001).
34Even before the SEC issued its fund governance proposals, the Institute formed an industry Advisory Group, on which I served, that issued a report recommending that fund directors consider adopting a series of fifteen “best practices”—which go beyond legal requirements—to enhance the independence of independent directors and the effectiveness of fund boards as a whole. Investment Company Institute, Report of the Advisory Group on Best Practices for Fund Directors: Enhancing a Culture of Independence and Effectiveness (June 24, 1999).
35 See, e.g., Report of the New York Stock Exchange Corporate Accountability and Listing Standards Committee (2002).
36 Congress recently passed a spending bill for fiscal year 2003 that earmarks $716 million for the SEC, an increase of approximately 47 percent above the amount the SEC spent in fiscal 2002. The SEC has announced plans to make significant additions to its examination staff and restructure its current mutual fund examination process.