- Fund Regulation
- Retirement Security
- Trading & Markets
- Fund Governance
- ICI Comment Letters
Congressional Hearing on
Mutual Fund Industry
Telecommunications and Finance Subcommittee of the Committee on Energy and Commerce
U.S. House of Representatives
Table of Contents
Characteristics of Mutual Funds
Growth of the Mutual Fund Industry
Economic Role of Mutual Funds
Regulation of Mutual Funds
Recommendations for Improving Investor Protection
July 22, 1993
I am Matthew P. Fink, president of the Investment Company Institute, which is the national association of the mutual fund industry. We appreciate the opportunity to appear before you today.
Mutual funds are a great American success story. Starting in 1940 with 68 funds with less than $500 million in assets, the industry has grown to over 4,000 funds with $1.7 trillion in assets. One in four American households owns mutual fund shares. It should also be noted that over 36% of fund assets are held by institutional investors, rather than by individuals.
Mutual fund growth in recent years has been due both to appreciation of portfolio securities and to new sales. Over the last nine years, 43% of growth was due to appreciation and 57% to new sales. A number of factors have contributed to the popularity of mutual funds: new types of funds; improved shareholder services; increased investment in mutual funds by retirement plans and by institutional investors; new channels of distribution; a shift by individuals from direct investment to existing fund shareholders. But the most critical reason for the industry's success is public confidence in the industry, which is based on the strict regulatory regime to which funds are subject.
In the words of former SEC Chairman Ray Garrett, Jr. "No issuer of securities is subject to more detailed regulation than mutual funds." Mutual funds are regulated under four of the federal securities laws: 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 is a great Congressional success story. The Act's main purpose is to safeguard "other people's money." Unlike the other securities laws, which are designed to protect investors primarily through disclosure, the Investment Company Act also imposes detailed substantive requirements on the structure and day-to-day operations of mutual funds.
For example, the Act prohibits or restricts transactions between a mutual fund and any person affiliated with the fund; requires that fund officers and employees be bonded; specifies stringent requirements for custodianship of fund assets; and requires that funds mark all of their assets to market every day. Investor protections are furthered by requirements that at least forty percent of a fund's board of directors be independent of the fund's adviser, and that every investor receive extensive prospectus disclosure, including information regarding the fund's investment objectives, risks and all fees and charges.
The mutual fund industry supported the enactment of the Investment Company Act of 1940, and we have worked with Congress and the SEC over the past half century to enhance investor protection. Our written testimony enumerates some of the legislative and regulatory changes which we believe should be made to meet new and anticipated investor needs.
However, by far the most critical need is to ensure that the SEC is provided with adequate resources to oversee the industry in the future. From 1983 to 1992, the number of investment companies increased by 133%, and assets by 344%; yet SEC staff devoted to investment company regulation increased by only 74%. As the SEC recently testified, the situation is "ironic given that last year the SEC collected over $80 million in fees from mutual funds . . . [but was] only allowed to use $18 million of these fees, with the $62 million balance diverted to pay for other federal spending." Thus, mutual fund are paying far more in fees that the SEC spends on mutual fund regulation.
For these reasons, we strongly support efforts to provide the SEC with greater resources to oversee the mutual fund industry in the future.
In an effort to be responsive to two issues raised in your letter inviting us to testify—investor education and market volatility—let me make the following comments.
Mutual funds have strong interest in seeing to it that fund shareholders have realistic expectations about their investments. Industry compensation is based on assets under management, rather than transaction fees, and shareholders can redeem their shares at any time. Therefore, individual fund organizations and the Investment Company Institute are engaged in ongoing efforts to educate existing and prospective shareholders about the risks, as well as potential rewards, of investing in mutual funds. In this connection, I should note that the early evident indicates that most of the new money going into mutual funds is coming from people who already own fund shares, rather than from first time investors. For example, over the last two years, fund assets increased by 30% due to sales, whereas the percentage of households owning funds only increased by 4%.
As to volatility, recent studies indicate that increased activity by mutual funds (and other investors) has helped decrease stock market volatility. Moreover, an analysis of the 1987 stock market break indicates that mutual funds were able to meet most shareholder redemptions from their cash reserves, rather than through the sale of portfolio securities. Thus, mutual funds are able to act as "shock absorbers," helping to cushion against sharp price charges.
We thank you for the opportunity to testify. I would be happy to respond to any questions.
July 22, 1993
My name is Matthew P. Fink. I am President of the Investment Company Institute, the national association of the American investment company industry. The Institute's membership includes 4,116 open-end investment companies (mutual funds), 336 closed-end investment companies, and 13 sponsors of unit investment trusts. Our mutual fund members have assets of over $1.7 trillion, accounting for approximately 95 percent of total industry assets, and have over 38 million individual shareholders. I am pleased to be here today to discuss the mutual fund industry.
Mutual funds are the most popular and well known type of investment company, representing approximately 86 percent of all investment company assets.1 Mutual funds pool the money of many investors and invest it in a wide range of stocks, bonds, or money market instruments, consistent with the investment objectives of the fund. Mutual funds are professionally managed, thereby allowing investors to delegate investment decisions—such as which securities to hold, when to buy, and when to sell.
Investors own shares of the mutual fund, each of which is a security representing a proportionate ownership in all of its underlying securities. Dividends, interest and capital gains produced by these securities are paid out to investors in proportion to the number of shares owned. Thus, investors who invest a few hundred dollars get the same investment return per dollar as those who invest hundreds of thousands.
Mutual funds are unique in that they offer redeemable securities, which permit an investor to sell his or her shares back to the funds at any time at their current net asset value.
Types of Mutual Funds
Today, there are mutual funds designed for many different investment objectives. To meet those objectives, funds invest in a wide range of securities, including common stocks; bonds issued by corporations, the federal government, or state and local governments; and, short-term money market instruments, such as bank CDs, the commercial paper of major corporations, and U.S. Treasury bills and federal agency notes.
For many years, mutual funds concentrated in common stocks of American companies. As recently as 1971, 94 percent of industry assets were in equity funds. However, in response to changing investor needs and changes in the marketplace, the industry broadened its product lines in the 1970s and 1980s, and introduced new types of funds, such as money market funds, municipal bond funds and international equity funds. Today, mutual fund assets are distributed in approximately equal amounts among the three broad categories of fund types: equity funds, bond and income funds, and money market funds.
Distribution of Mutual Fund Assets by Type of Fund
Organization and Operation
Mutual funds are generally organized under state laws as corporations or business trusts. They are usually externally managed by a separate entity, which means that they do not have employees of their own and all their operations are conducted by third parties. The structure of a typical mutual fund organization is depicted below.
Mutual Fund Organization
Board of Directors/Trustees
Funds that are established as corporations have directors, while funds established as business trusts have trustees. The duties of directors and trustees are essentially identical. The role of directors and trustees in policing conflicts of interest is central to the regulatory scheme to which mutual funds are subject. Directors and trustees are required to oversee the management and operations of the fund, to provide policy guidance, and to protect the interests of fund shareholders in conflict of interest situations. The duties imposed on mutual fund directors and trustees are in addition to those imposed by state law.
Federal law generally requires that at least 40 percent of the fund's board be comprised of persons who are not affiliated with the fund, its investment adviser, or its principal underwriter. These independent directors serve as watchdogs over the shareholders' interests and provide a check on the investment adviser and other persons affiliated with the fund.
The investment adviser is responsible for selecting portfolio investments for the fund in accordance with the fund's investment objectives and policies. The investment adviser is usually paid for these services through a fee based on the value of the fund's net assets. Many investment advisers also provide administrative services to the fund, and may, for example, oversee the activities of the other companies that provide services to the fund to assure that the fund's operations comply with applicable federal and state requirements.
Principal Underwriter, Custodian and Transfer Agent
The principal underwriter arranges for the distribution of the fund's shares to the public.
Mutual funds are limited in their ability to hold their own assets and therefore generally place their assets in the custody of a third party. Most mutual funds use a bank custodian, whose functions include safeguarding the fund's assets, making payments for the fund's purchases of securities, and receiving payments for the fund when securities are sold.
The transfer agent performs shareholder recordkeeping services. It maintains shareholder account records, issues new shares, cancels redeemed shares, and distributes dividends and capital gains to shareholders.
As stated above, mutual funds issue redeemable securities, which permit a shareholder to sell his or her fund shares back to the fund at any time at the net asset value of the shares. The fund must send the shareholder the redemption proceeds within seven calendar days. Current per-share values are required by law to be calculated at least daily based on the market value of the fund's portfolio securities. Per-share values change as the values of the fund's portfolio securities move up or down. Mutual fund share purchase and redemption prices are published each day in the financial sections of most major newspapers.
Methods of Distribution of Mutual Fund Shares
Since mutual fund shares are redeemable, most mutual funds continuously offer new shares to the public.2 Mutual fund shares are generally purchased by investors in two ways—they may be purchased from a member of a sales force or directly from a fund. These two distribution channels are frequently referred to as "sales force distribution" and "direct marketing," respectively. Most sales force distributed funds charge a sales commission and are commonly referred to as "load" funds; most direct marketed funds do not charge a commission and, thus, are usually referred to as "no load" funds.
Sales of Equity, Bond, and Income Funds by Distribution Method — 1992
*Variable annuity, funds not offering shares
Sales Force Distribution
Sales force distributed funds sell their shares through securities firms, financial planners, life insurance organizations, and depository institutions. Sales force representatives can help investors analyze their financial needs and objectives and recommend appropriate funds. For these professional services, investors are charged a sales commission expressed as a percent of the total purchase price of the fund shares. Under rules set out by the National Association of Securities Dealers, Inc. (NASD), the maximum charge for these services is 8.5 percent of the initial investment. This initial sales charge is called a "front-end" load, as it is payable when shares are first purchased. Today, most funds charge less than the maximum permitted front-end load. Institute data show that as of 1991, the average front-end load charged for new sales was 3.5 percent.
Some funds have an "asset-based" sales charge, commonly referred to as a 12b-1 fee (after a rule under the Investment Company Act of 1940). A 12b-1 fee is an annual fee taken out of fund assets to pay for distribution-related costs. As of July 7, 1993, 12b-1 fees are subject to the NASD's maximum sales charge rule. The purpose of this rule is to limit aggregate sales charges (including 12b-1 fees) to the economic equivalent of the maximum legally permitted front-end sales charge.
Many funds that have 12b-1 fees impose "back-end" loads when shares are redeemed. By far the most common type of back-end load is a contingent deferred sales charge (CDSC), which is payable if shares are redeemed during the first few years of ownership. A CDSC may be expressed as a percentage of either the original purchase price or the redemption proceeds. Most CDSCs decline over time, and are not imposed if the shareholder remains in the fund for a specified period of time (typically six years). The NASD's sales charge rule noted above also applies to the aggregate amount of 12b-1 fees and CDSC that a fund may impose, limiting it to the economic equivalent of the maximum permitted front-end load.
Direct marketed funds are used by those investors who prefer to make investment decisions themselves. These funds typically market their shares through advertising and/or direct mail. Because there is no sales force involved, many of these funds charge either a low sales commission or none at all. Some direct-marketed funds have 12b-1 fees to cover the costs of distribution, which include advertising and other promotional methods.
SEC-Required Disclosure of Sales Charges
Mutual funds are required by the SEC to disclose all charges imposed in connection with the purchase of their shares. These charges are included in the fund's fee table, which is a uniform, tabular presentation of all fund expenses. The SEC requires that the fee table be included immediately after the cover page of the fund's prospectus. Set forth below is the fee table required by the SEC of all mutual funds.
Mutual Fund Fee Table
|Shareholder Transaction Expenses|
|Maximum Sales Load Imposed on Purchases (as a percentage of offering price)||_____%|
|Maximum Sales Load Imposed on Reinvested Dividends (as a percentage of offering price)||_____%|
|Deferred Sales Load (as a percentage of original purchase price or redemption proceeds, as applicable)||_____%|
|Redemption Fees (as a percentage of amount redeemed, if applicable)||_____%|
|Annual Fund Operating Expenses(as a percentage of average net assets)|
|Total Fund Operating Expenses|
|Example||1 year||3 years||5 years||10 years|
|You would pay the following expenses on a $1,000 investment, assuming (1) 5% annual return and (2) redemption at the end of each time period:||$_____||$_____||$_____||$_____|
|You would pay the following expenses on the same investment, assuming no redemption:||$_____||$_____||$_____||$_____|
The Mutual Fund Shareholder
Mutual fund shareholders include individuals and institutions (e.g., bank trustees and other fiduciaries, business corporations, retirement plans, insurance companies, and foundations, etc.). The majority of mutual fund assets (63.6%) belong to individuals. In addition, many institutional shareholders own mutual fund shares on behalf of individual investors (e.g., trust beneficiaries, participants in retirement plans, etc.).
Individual and Institutional Assets, All Mutual Funds — 1992
(billions of dollars at yearend)
Because mutual funds have proved to be a way by which middle-income individuals and families can receive the same benefits of professional money management and diversification of investments as wealthy individuals, funds have played a significant role in opening the securities markets to millions of Americans. By 1992, 27% of U.S. households owned mutual funds. According to Institute data, the number of individual mutual fund shareholders as of the end of 1992 was approximately 38.2 million; the median age of fund shareholders is 46; mutual fund shareholders have a median household income of $50,000, average financial assets of $114,000 (excluding real estate and assets in employer-sponsored retirement plans), and an average of $43,500 invested in mutual funds.
The first mutual fund began in Boston in 1924. Since the passage of the Investment Company Act of 1940, enacted to regulate the structure and day-to-day operations of mutual funds, the mutual fund industry has grown substantially, from 68 funds in 1940 to over 4,000 funds in 1993, and from assets of $448 million in 1940 to over $1.7 trillion today. The steady growth of the mutual fund industry attests to the success of the mutual fund concept and of the strict regulatory system that governs the structure and day-to-day operations of mutual funds in a manner designed to achieve the core objective of protecting mutual fund investors.
Assets of All Mutual Funds
(millions of dollars at yearend)
For years 1975-92, assets of short-term funds are included.
Reasons For Mutual Fund Growth
Capital Appreciation of Portfolio Securities
The growth in mutual fund assets is attributable in significant part to the capital appreciation of portfolio securities owned by mutual funds due to increases in stock and bond prices. For example, during the period from January 1984 to present, mutual fund assets increased by $1.3 trillion. The increase in assets of equity and bond and income funds over this period was $938 million, of which 43% was due to capital appreciation of portfolio securities and the remaining 57% was due to net sales of fund shares.
Components of Mutual Fund Asset Growth
(billions of dollars)
New Products and Services
As discussed above, for many years most mutual funds invested in common stocks of American companies. But as investor needs changed during the past two decades, the mutual fund industry responded by introducing new types of funds. For example, taxable money market funds were developed in 1972; tax-exempt money market funds were introduced in 1979; and, during the 1980s, international funds, precious metal funds, Ginnie Mae and government income funds were developed.
The industry improved existing services and created many new services to meet shareholders' needs. These services include 1) toll-free (800) telephone numbers, 2) 24-hour telephone access, 3) touchtone telephone access to account information and transactions, 4) consolidated account statements, 5) shareholder newsletters, 6) shareholder cost basis information, 7) exchanges between funds, 8) automatic investments, 9) automatic reinvestment of fund dividends, and 10) automatic withdrawals.
Retirement Plan Market
The retirement plan market has played an important role in mutual fund growth. Recent data indicate the popularity of mutual funds as a vehicle through which to invest retirement dollars. By the end of 1992, retirement assets accounted for 21 percent of total mutual fund assets.
The largest share of the fund industry's retirement plan assets are held in Individual Retirement Account (IRA) assets. Mutual funds held $211 billion, or 29 percent, of the $724.7 billion IRA market at the end of 1992. As demonstrated below, mutual funds are the most popular funding mechanism for IRAs, followed by self-directed IRAs, commercial banks and thrifts.
Shares of IRA Market — 1992
*Includes only those self-directed IRAs not included in other categories; does not represent the entire self-directed universe for IRAs
As many companies switch from defined benefit plans (where the employer makes investment decisions) to defined contribution plans, such as 401(k) plans, more individual employees are selecting their own investments. The growth of these defined contribution corporate retirement plans has been dramatic. In 1975, only 11.2 million participants were covered by corporate defined contribution plans as compared to the 27.2 million participants covered by corporate defined benefit plans. By 1990, however, approximately 38.5 million employees were covered by corporate defined contribution plans as compared to only 28.8 million employees in corporate defined benefit plans. It is anticipated that by the year 2000 corporate defined contribution plans will have 52.3 million participants with assets of $2.258 trillion, while corporate defined benefit plans will have 29.7 million participants and assets of $1.847 trillion.
Private Pension Coverage
(millions of employees)
Private Pension Assets
(billions of dollars)
With their multiple investment options, daily pricing and wide range of shareholder services, mutual funds are becoming an increasingly popular investment medium for defined contribution plans.
While the majority of mutual fund assets belong to individuals, institutional investors (such as bank trustees and other fiduciaries, business corporations, retirement plans, insurance companies, and foundations) now own a significant portion of mutual fund assets. The value of institutional assets invested in mutual funds rose from about $1.8 billion in 1960 to $582.7 billion at the end of 1992.
New Channels of Distribution
Historically, mutual funds were sold primarily by full service broker-dealers. Today, funds are offered directly, and through a variety of channels, including insurance agents, financial planners, discount brokers and, most recently, banks. The availability of mutual funds through banks has increased dramatically since 1990. Banks can sell both funds advised by entities unaffiliated with the bank ("nonproprietary funds") or funds in which the bank or its affiliate acts as the fund adviser ("proprietary" funds). Bank distribution is accomplished through both direct marketing and sales force distribution.
The Institute recently completed the first comprehensive survey of mutual fund sales through banks. The findings indicate that during 1991 banks accounted for over $28 billion, or 13 percent, of total sales of equity and bond and income funds. Of these sales, 55 percent were of nonproprietary funds, while 45 percent were of proprietary funds. The results for the first half of 1992 were quite similar. During the first six months of 1992, banks accounted for over $23 billion, or 14 percent, of sales of equity and bond and income funds. Similarly, 60 percent of these sales were of nonproprietary funds, while 40 percent were of proprietary funds. It is important to note that a significant portion of the sales of proprietary funds are the result of banks investing trust and custody assets under their management in their proprietary funds, rather than retail sales.
Shift From Direct Investment in Securities and CDs
Some of the growth of the fund industry also is attributable to an historical trend in which investors have shifted from direct ownership of individual stocks and bonds to ownership of mutual funds. The shift is due to, among other things, the attractiveness of professional management and diversification offered by mutual funds.
In addition, yields on bank certificates of deposits (CDs) in recent years have prompted many CD investors seeking better returns on their investments to shift their money into securities, including mutual funds. Indeed, many banks have entered into the securities and mutual fund businesses in order to be able to offer their customers alternative investment vehicles.
Additional Purchases By Existing Shareholders
Much of the growth in the industry is due to additional purchases by existing shareholders, and not to purchases by first-time investors. While there has not been an in-depth study of this issue, available evidence indicates that most of the new money going into mutual funds is coming from people who already own mutual fund shares. For example, in the last two years (March 1991 to March 1993), there was a 30 percent increase in mutual fund assets (not including growth attributed to capital appreciation of portfolio securities), whereas the percentage of U.S. households owning mutual fund shares only increased about 4 percent. The small increase in households owning mutual funds compared to the much larger increase in total mutual funds assets for the same period indicates that most of the increase in mutual fund assets was due to additional purchases by existing shareholders. In addition, a recent Institute survey of mutual fund sales by banks purchased during 1991 and the first half of 1992 shows that only 5 to 10 percent of purchasers of mutual funds through banks were first-time mutual fund purchasers.
Finally, as described in Section V below, the strict regulatory regime to which mutual funds are subject has played a vital role in the growth of the mutual fund industry. Mutual funds differ from most other companies in that they are subject to detailed, substantive regulation. As a result of this regulatory system, there is a high level of public confidence in mutual funds.
Challenges Arising From Growth
Education of Investors
Because of the rapid growth in the ranks of fund shareholders, one of the industry's foremost challenges is the education of fund investors. Indeed, the industry is engaged in a variety of efforts to explain to the public the nature of investing in mutual funds, the risks involved, and how certain fund investments might perform in various market environments. For example, the Institute and many of its members have published brochures and other literature specifically designed to educate and inform current and prospective bond fund shareholders about the impact of interest rate changes on the price of bond funds.
These educational efforts are undertaken not only because it is the right thing to do, but also because it is in the industry's best interest to maintain investor satisfaction. Since the industry's compensation is based on assets under management rather than on volume of transactions, and given the ease with which shareholders can redeem their fund shares if they become dissatisfied, it is important to the industry that investors do not have unrealistic expectations when they purchase mutual fund shares.
Education of Industry Employees
As a result of the growth of mutual funds, there has been an influx of new personnel at existing as well as at new mutual fund organizations. It is important that these new employees are properly trained. Therefore, the Institute and its members have enhanced their education and training programs for employees. This past year, the Institute sponsored conferences, seminars and workshops with over 7,000 attendees from the industry. In addition, the Institute is developing a self-paced basic training program for fund employees.
Disclosure in the Retirement Market
The shift in the retirement plan market from defined benefit plans to defined contribution plans, such as 401(k) plans, presents another challenge since more individual employees are now selecting their own investments. Therefore, it is essential that steps be taken to ensure that these employees are provided with adequate information about the available investment medium in a format that is easy to understand. As discussed below in Section VI, in order to achieve this objective the Institute recommends that (1) all pooled securities funds offered to participants in defined contribution plans be required to register with the SEC and provide prospectuses to employee participants and (2) funds be permitted to utilize a summary prospectus, which would set forth all key information about a mutual fund in a concise manner.
Adjustments to Mutual Fund Regulation
As discussed in Section VI below, it also is essential that the regulatory system governing mutual funds be adjusted continuously to respond to the changes and growth within the industry and to meet new investor needs. In recent years, the Securities and Exchange Commission has promulgated new rules designed to enhance investor protections (e.g., to permit the use of simplified prospectuses, to require uniform yield formulae for advertising by mutual funds, and to tighten the investment restrictions on money market fund portfolios and require disclosure that such funds are not federally insured). In its 1992 study on investment company regulation (discussed below in Section V), the SEC and its staff proposed further regulatory and legislative changes designed to meet new and anticipated conditions. The mutual fund industry itself has strongly supported these measures, and, most importantly, has urged that the SEC be provided with adequate resources to oversee the mutual fund industry.
Mutual funds play an important and positive role in the U.S. securities markets. Recent studies show that the increased activity of mutual funds and other institutional investors have helped decrease market volatility.3 During the period from 1964 to 1989, when institutional investor participation in the marketplace increased significantly, market components not attributable to changes in fundamental asset values (what is commonly referred to as "noise") actually declined. Thus, institutional investors, such as mutual funds, through their ability to gather and analyze information have probably increased the informational efficiency of the marketplace. As a result, mutual funds and other large institutional investors mitigate the informational advantage of insiders and contribute to lower bid-ask spreads and reduced "noise".
In addition, an analysis of the 1987 market break indicates that equity funds are capable of satisfying an extraordinarily high volume of shareholder redemptions largely from their cash reserves, without having to resort to a forced liquidation of portfolio securities. Thus, mutual funds are able to act as a buffer or "shock absorber" in the marketplace, protecting against sharp stock price changes that would have otherwise occurred.
Mutual Funds' Role in the Economy
The mutual fund industry contributes to U.S. economic growth through its effect on overall capital formation and on capital markets. Mutual funds are an important source of capital for American business. For example, mutual funds were the largest institutional buyer of corporate equities in 1992, purchasing more than double the amount of the next largest purchaser—state and local government retirement funds. In particular, the expansion of aggressive growth and growth funds has stimulated the financing of many new equity issues by making it easier and cheaper for emerging companies to issue their stock. In this regard, more and more funds have been organized to invest primarily in securities issued by smaller companies. For example, as of December 1992, there were at least 57 small company growth mutual funds with aggregate assets of over $19 billion. Further, in 1992, mutual funds purchased approximately one quarter of all corporate bonds issued in the U.S., second only to life insurance companies.
In addition, the development and growth of money market funds and municipal bond funds have contributed significantly to the tax-exempt municipal bond market, helping to supply money to build schools, highways, bridges, and other elements of America's infrastructure.
The mutual fund industry also bolsters the American economy by providing shareholders with additional income. Earnings in the form of capital gains and dividend distributions provide consumers with money to spend on goods and services, contributing to the country's overall economic growth.
Capital Gains and Dividend Distributions to Shareholders —
All Types of Mutual Funds
(billions of dollars)
|Net Realized Capital Gains||Dividend Distributions|
Additionally, the fund industry employs thousands of people who are involved in day-to-day fund operations and management, including employees of fund/management companies, custodian banks, transfer agent and shareholder communications functions, and sales force distribution.
VII. Regulation of Mutual Funds
A. Mutual Funds are Subject to Stringent, Substantive Regulation
The growth of the mutual fund industry is attributable, in large part, to the fact that it is stringently regulated under the federal securities laws. This regulatory scheme has fostered a high level of investor confidence. As noted by former SEC Chairman Ray Garrett, Jr., "No issuer of securities is subject to more detailed regulation than mutual funds." Mutual funds are regulated under the following federal securities laws.
Shares of mutual funds must be registered under the Securities Act of 1933, which requires a fund to provide potential investors with extensive prospectus disclosures about the fund, including information about the fund's investment objectives and policies, investment risks, and all fees and expenses.
The distributors of mutual funds are regulated as broker-dealers by the SEC under the Securities Exchange Act of 1934, and also are subject to regulation by the National Association of Securities Dealers, Inc.
Investment advisers to mutual funds must be registered with the SEC under the Investment Advisers Act of 1940.
Finally, and most importantly, mutual funds must register with the SEC as investment companies under the Investment Company Act of 1940.
The Investment Company Act is a model of effective legislation, drafted by the staff of the SEC and strongly supported by the industry. At the August 23, 1940 signing ceremony, President Franklin D. Roosevelt, commending this achievement, stated that, "The investment trusts have themselves actively urged that an agency of the federal government assume immediate supervision of their activities."4
Unlike the other federal securities laws, which are designed to protect investors primarily through disclosure, the Investment Company Act imposes detailed, substantive requirements and prohibitions on the structure and day-to-day operations of mutual funds. 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 regulate forms of self-dealing; (4) restrict unfair and unsound capital structures; and (5) insure fair valuation of investor purchases and redemptions. In order to achieve these objectives, the Investment Company Act, among other things, prohibits or restricts transactions between a mutual fund and affiliated persons of the fund, requires that mutual fund officers and employees with access to fund assets be bonded against larceny and embezzlement and specifies stringent requirements for the custodianship for mutual fund assets. Investor protections are also furthered by the requirement under the Investment Company Act that at least forty percent of a fund's board of directors must be independent of the fund's adviser.
One of the most important requirements under the Investment Company Act is that mutual funds must sell and redeem their shares at their current net asset value, which must be determined at least daily. The daily mark-to-market requirement under the Act imposes a discipline upon mutual funds to which other financial institutions are not subject.
In addition to regulation under the Investment Company Act, Subchapter M of the Internal Revenue Code requires that a fund:
meet various asset diversification rules;
distribute 90 percent of its ordinary income; and
limit the amount of income the fund may receive from short-term holdings.
Mutual funds also are subject to NASD requirements in connection with their distribution and advertising activities. Finally, mutual funds are regulated under state securities laws.
B. The Investment Company Act Provides the SEC with Significant Regulatory Authority
While the Investment Company Act imposes very strict controls on mutual funds, it also provides the SEC with broad regulatory authority to meet new conditions. Some of the significant recent developments, which exemplify the SEC's regulatory authority, include: (1) adoption of amendments to the advertising rules to require the use of standardized performance data in advertisements; (2) adoption of a two-part registration statement for mutual funds to permit the use of a simplified prospectus; (3) adoption of amendments to the rule governing money market funds to tighten the restrictions on money market fund portfolios and to require disclosure of the non-federally guaranteed status of these funds; (4) adoption of the fee table in mutual fund prospectuses, requiring that investors be provided with a uniform, succinct, plain English summary of all fees and charges; and (5) adoption of a rule to allow the assets of mutual funds to be maintained in foreign custody, facilitating the ability of mutual funds to invest in foreign securities.
C. SEC Staff Study on Investment Company Regulation
On the fiftieth anniversary of the Investment Company Act, and in recognition of the growth and changes in the investment company industry, former SEC Chairman Breeden requested the SEC Division of Investment Management to examine the existing regulation of the investment company industry. In May, 1992, the staff of the Division issued a study entitled "Protecting Investors: A Half Century of Investment Company Regulation" (the "Study"). The Study includes the Division's legislative and regulatory recommendations for changes to the Investment Company Act, the rules thereunder and provisions of other federal securities laws regulating investment companies.
The Study generally concluded that the Act and the regulations thereunder have worked well for the past 52 years and that there is no need for changes in the core investor protection provisions that have served mutual fund shareholders for over half a century. At the same time, the Study recommended certain legislative and regulatory modernizations, most of which the Institute generally supports.
VIII. Recommendations for Improving Investor Protection
The Institute believes that the regulatory scheme to which mutual funds are subject is working well. However, there are steps that should be taken to ensure that the high level of investor protection continues.
A. The Need to Ensure Adequate Resources for the SEC
The SEC's diligent and effective regulation of the mutual fund industry has contributed to a high level of investor confidence in the integrity of the industry. The Institute has for years supported increased funding for the SEC (and the Division of Investment Management in particular) so that the highly effective regulation that the mutual fund industry has experienced to date will be assured in the future.5 The Institute notes this Committee's dedication to such an effort and supports H.R. 2239, the SEC reauthorization bill reported earlier this month.
An examination of the growth rate of the mutual fund industry, as compared to the growth of the SEC's resources devoted to regulation of the industry, illustrates the need for increased funding to assure the SEC's continued ability to provide effective oversight of the industry in the years ahead. For example, from 1982 to 1992, the number of registered investment companies increased by 133% and the assets under management of such companies increased by 344%. In contrast, the staff of the Division of Investment Management grew by only 74% over that period.
The resources available to the SEC have been adequate to date; if the industry continues to grow, the SEC's resources must keep pace. We note that if the SEC's resources are not adequately increased in the coming years, several important functions of the SEC, such as the review of mutual fund prospectuses, the adoption of new rules, and the ability to bring enforcement actions, could come under considerable pressure.
Another important function that could come under increased pressure is the granting of exemptive relief from provisions in the Investment Company Act. While the Investment Company Act contains very detailed provisions and prohibitions governing the structure and day-to-day operations of mutual funds, it also grants the SEC broad authority to grant individual exemptions. The exemptive process has permitted the development of innovative products and services designed to meet changing investor needs. Much of the benefit of the exemptive process hinges upon the industry's ability to respond quickly to changing market conditions and the SEC's corresponding ability to process requests for exemption in an expeditious manner. Yet the time required for processing applications will only increase if there are staffing shortfalls.
Inspections are another important area that requires adequate funding. The SEC's staff inspects mutual funds to determine the accuracy of disclosure in registration statements and the adequacy of compliance with regulatory requirements. To ensure that problems in the industry do not go undetected, the SEC staff assigned to inspect mutual funds must keep pace with the growth of the industry. Thus, former Commission Chairman Richard Breeden stated in testimony on the SEC's proposed budget for fiscal year 1994 that "... the extremely rapid growth of mutual funds makes an increase in the number of examiners absolutely imperative."6
Additional resources also would enable the SEC to improve the efficiency and efficacy of mutual fund inspections. In this regard, we would recommend more frequent examinations of fund complexes of various sizes instead of focusing primarily on the 100 largest complexes (which currently are inspected on an annual basis), since factors other than size are more determinative of the risks involved.
In addition to the SEC's regulatory activities that are specifically directed towards mutual funds, as major investors themselves in the U.S. securities markets, mutual funds have a strong interest in the SEC's continued fulfillment of its many other regulatory responsibilities. These include ensuring the integrity of the securities markets generally, monitoring the quality of disclosures made by corporate issuers, and overseeing self-regulatory organizations. Moreover, changes in the markets due to technological developments and growing internationalization are likely to increase the demands on the SEC in these areas.
Ironically, the gap between the size of the mutual fund industry and SEC resources available to regulate the industry threatens to grow despite the fact that mutual funds pay substantial registration fees to the SEC. For example, in 1992, investment companies paid filing fees to the SEC totaling approximately $80.9 million. In contrast, however, the amount which the SEC expended to regulate investment companies was only approximately $18.4 million, less than 23% of the amount paid. Thus, mutual fund shareholders pay far more in fees than they get back in terms of federal regulatory oversight. Moreover, the Administration has proposed an increase in the rate of registration fees paid by issuers of securities, including investment companies, from 1/32 of one percent of the amount offered to 1/24 of one percent.
The Institute firmly believes that the revenues that the SEC collects from the entities it regulates must be used to assure that a fully adequate level of regulation is provided by the SEC for the protection of investors. Therefore, we strongly support legislation that would allow the SEC to use revenues generated from registration fees to regulate the entities paying those fees. This would seem to be the fairest and most logical way to ensure that the SEC is able to maintain an appropriate level of regulatory oversight over the mutual fund industry as it continues to grow.
B. All Pooled Investment Vehicles Should Be Subject to Full Regulation Under the Federal Securities Laws
The Institute is pleased that one of the major legislative recommendations in the staff's Study on investment company regulation is an amendment to the Securities Act to repeal the exemption for interests in bank collective trust funds and insurance company separate accounts in which participant-directed defined contribution plans invest. This change would ensure that participants in such plans receive prospectuses containing the information necessary to make informed investment decisions with respect to their retirement savings.7
The original rationale for the exemption under the Securities Act was that these products, which are publicly offered securities pools just like mutual funds, were sold to sophisticated corporate employers to finance their defined benefit plans, plans in which the employer made the investment decisions and bore the investment risks. As noted above, this is clearly no longer the case. Today these pools are being sold to millions of individual employees to fund their 401(k) plans and other types of employee-directed defined contribution plans, plans in which employees make the investment decisions and bear the investment risks.
The decision as to how to invest for retirement may be the most important investment decision that an individual will make during his or her lifetime. As such, an employee making this decision should be entitled to receive the same degree of disclosure, subject to the same liability standards, as he or she does with respect to other purchases of securities.8 Unfortunately, due to the absence of general disclosure requirements governing investment media for defined contribution plans, "plan participants get little information—and what they do get is often unintelligible."9 Therefore, we strongly support the SEC staff's recommendation to repeal the exemption under the Securities Act for bank collective funds and insurance company separate accounts used to fund participant-directed defined contributions plans.
In addition, the Institute believes these investment vehicles should be required to register under the Investment Company Act. Not only would this further the goal of functional regulation, it would ensure that all investors in these products receive the full benefits of the stringent protections under the Investment Company Act.10
C. Regulatory Modernizations to Accommodate New Entrants
As discussed above, one source of the growth in mutual fund assets has been the entry of commercial banks into the business. Today, it is estimated that between 10 and 15 percent of all mutual funds assets are represented by funds advised by banks or bank affiliates.
Bank-sold mutual funds, like other mutual funds, are subject to regulation under the federal securities laws. Bank-sold funds must register under the Investment Company Act and shares of bank-sold funds must be registered under the Securities Act. Most banks establish separate broker-dealer affiliates (either subsidiaries of the bank or separate affiliates of the bank holding company) to sell the securities products offered by the bank, and these affiliates (as well as the fund's own distributor) are regulated as broker-dealers under the Securities Exchange Act and the Rules of Fair Practice of the National Association of Securities Dealers, Inc.11 Finally, investment advisers to nonproprietary funds and separate bank affiliates that advise proprietary funds must register as investment advisers under the Investment Advisers Act.
However, the current regulatory structure did not envision bank advised mutual funds. For example, while bank affiliates that advise mutual funds or sell mutual fund shares must register under the Investment Advisers Act and the Securities Exchange Act, banks that themselves engage in these activities are exempt from registration under both Acts. In addition, the Investment Company Act does not contain provisions specifically addressing mutual funds advised by banks.
In recent years, Congress has considered financial services reform legislation. This Committee, when it passed H.R. 6, the "Financial Institutions Safety and Consumer Choice Act of 1991," which grants banks full mutual fund powers, also recognized the need for amendments to modernize the federal securities laws to accommodate bank entry into the fund business. The Institute strongly supports this approach. If properly crafted, such amendments will ensure effective protection for investors in all mutual funds, without imposing unnecessary regulatory burdens on bank funds.
The federal banking regulators12 also have begun to review their policies concerning the sale of bank mutual funds and other uninsured products.13 In order to assist the federal banking regulators and to encourage greater uniformity in the regulations that they issue, the Institute is preparing proposed guidelines that the Institute will submit to the various banking agencies. The guidelines will address a broad range of issues, including disclosure and sales practices, training, and compensation. The Institute hopes that the banking regulators will adopt regulations that provide adequate protection to investors without unduly limiting legitimate sales activities.
D. Regulatory Recommendations
As noted above, the Investment Company Act gives the SEC broad authority to adopt rules to improve existing regulation to better protect investors. We would like to briefly mention two regulatory items that we believe should be a priority for the SEC in the coming months.
1. Summary Prospectus
The SEC has proposed to permit the purchase of mutual fund shares from a summary prospectus. Summary prospectuses14 are intended to present key information about a mutual fund in a concise, easy-to-read format, which would be short enough to be used as an advertisement or a direct mail piece.
The SEC's proposal would fully maintain all existing investor protections. The summary prospectus would be a prospectus under the federal securities laws. Thus, mutual funds would be held liable under the Securities Act for any material misstatement or omission. In addition, the SEC proposal would require that all summary prospectuses contain specified information about the fund's investment policies, risk factors, and all fees and expenses. Moreover, the prospectuses would have to be filed with the SEC and/or the NASD, where they would be reviewed to ensure compliance with the new rule. Finally, all investors would continue to receive the full prospectus with the confirmation of any purchase and would have to be given the option in the summary prospectus of receiving the full prospectus before making any purchase.
While maintaining the strong investor protections noted above, the new summary prospectus would offer many benefits. First, the summary prospectus would provide information in a concise, easy-to-read format that will make it easier for investors to assess a particular mutual fund and to compare several different mutual funds. Second, the use of a summary prospectus would provide a special benefit to participants in defined contribution retirement plans, where employees are required to choose among a number of mutual funds and other investment vehicles.15 Finally, it would eliminate unnecessary delays and burdens on shareholders who today must go through two steps in purchasing shares of directly distributed funds.
2. Tax-Exempt Money Market Funds
The Institute recommends that amendments be adopted to Rule 2a-7 under the Investment Company Act to impose restrictions on tax-exempt money market fund portfolios similar to those adopted for taxable money market funds in 1991.
The Institute has two primary concerns with respect to the internationalization of the mutual fund industry. First, we strongly believe that the U.S. should negotiate to secure better access for U.S. mutual fund managers seeking to enter foreign markets. Second, the Institute would oppose any changes to the Investment Company Act which would permit foreign funds to be distributed in the U.S. without complying with the basic investor protections applicable to U.S. funds.
A. U.S. Mutual Fund Managers Need Better Access To Foreign Markets
Foreign investment managers enjoy far greater access to the U.S. market than that which is available to U.S. mutual fund managers in almost all foreign markets. Foreign advisers are able to register under the Investment Advisers Act and sponsor and advise U.S.-registered mutual funds. As of March 31, 1993, approximately 312 entities with foreign business addresses from 42 countries were registered under the Advisers Act. A number of these foreign advisers operate U.S.-registered mutual funds.
By contrast, U.S. mutual fund managers have limited access to major foreign markets. In certain markets, such as Japan and Korea, no U.S. investment managers sponsor and advise domestic mutual funds. Korea does not permit U.S. managers to apply for a license to manage mutual funds, and Japan imposes discretionary licensing standards under which no U.S. firm has been granted a license to manage Japanese investment trusts (mutual funds).
The Institute believes that the U.S. should negotiate to secure better access for U.S. management firms seeking to enter foreign markets. In this regard, the North American Free Trade Agreement ("NAFTA") represents a breakthrough for U.S. fund managers. Under current Mexican law, a U.S. investment manager is prohibited from managing Mexican mutual funds, and Mexican persons or entities must own the majority of any Mexican mutual fund management company. However, following implementation of NAFTA, U.S. mutual fund managers will be permitted to sponsor, advise and distribute Mexican mutual funds. We urge the U.S. representatives to continue to push for other market access liberalizations for U.S. mutual fund managers through ongoing trade negotiations, such as the GATT Uruguay Round.
B. U.S. Investor Protection Standards Should Apply to Foreign Funds Offered in the U.S.
Foreign investment advisers are effectively barred under Section 7(d) of the Investment Company Act from selling foreign funds in the United States. However, Section 7(d) does not in any way preclude foreign advisers from establishing U.S.-registered mutual funds and publicly offering them in the United States. In its Study on investment company regulation, the SEC Division of Investment Management recommended that Section 7(d) be amended to make it possible for a foreign fund to be offered in the U.S., even though the fund may not be in full compliance with all of the provisions of the Act. The Institute opposes any such change to the Act that would permit a foreign fund to be marketed in the U.S. without complying with the same investor protection standards applicable to a U.S. fund. For example, to avoid conflicts of interest arising from the purchase and sale of securities or other property between a fund and the fund's adviser, such transactions are prohibited under the Investment Company Act. In contrast, these types of affiliated transactions are a common practice in other nations. We believe that core provisions of the Act, such as the prohibitions on affiliated transactions, are so fundamental to the U.S. securities laws that they should not be compromised.
The mutual fund industry has experienced significant change and growth over the past half century. The industry has grown from 68 funds in 1940 to over 4,000 funds in 1993, and from assets of $448 million in 1940 to more than $1.7 trillion today. The reasons for growth include: capital appreciation of portfolio securities, new products and services designed to meet changing investor needs, the growth of the retirement plan market, increased investment by institutional investors, new distribution channels, a shift from direct investment to investment through mutual funds, but, most importantly, the stringent regulation imposed upon mutual funds by the Investment Company Act of 1940. The mutual fund industry supported the enactment of the Investment Company Act 53 years ago, supports modernization of the regulatory system today, and remains committed to stringent and well-funded SEC regulation of the industry in the years ahead.
We thank you for this opportunity to present our views and look forward to working with this Subcommittee on issues relating to the mutual fund industry.
1The two other principal types of investment companies are unit investment trusts and closed-end investment companies. Unit investment trusts own a fixed portfolio of securities until the maturity of the trust, at which time the trust is dissolved and the proceeds are distributed to unit holders. In contrast, closed-end funds, like mutual funds, are managed on an on-going basis by an investment adviser. The distinguishing feature between mutual funds and closed-end funds is that closed-end fund shares are not redeemable (see discussion below). Instead, they are generally traded on one of the major stock exchanges or in the over-the-counter market.
2Some mutual funds stop selling new shares once their assets under management reach a certain level. One reason why funds stop selling new shares is the limited availability of the securities in which they invest (such as a sector fund investing in a particular industry).
3See, e.g., J. Lakonishok. A. Schleifer and R.W. Vishny, "The Impact of Institutional Trading on Stock Prices," Journal of Finance, 32 (1992), pp. 23-43; A. Kraus and H.R. Stoll, "Parallel Trading by Institutional Investors," Journal of Finance and Quantitative Analysis, 7 (1972), pp. 2107-2138.
4Statement by the President of the United States upon signing into law H.R. 10065, Aug. 26, 1940, 86 Cong. Rec. 5230-31 (1940)(Appendix).
5See Letter from Matthew P. Fink, President, Investment Company Institute, to Rep. Edward J. Markey, Chairman, Subcommittee on Telecommunications and Finance, dated May 18, 1993.
6See Testimony of Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, Concerning Appropriations for Fiscal Year 1994, before the Subcommittee on Commerce, justice, and State, the Judiciary, and Related Agencies of the House Committee on Appropriations, March 23, 1993.
7The Study also recommends that the federal securities laws be amended to require delivery of prospectuses for the underlying investment vehicles to employees who direct their retirement plan investments. While we strongly support this change, in many instances the issuer of the investment vehicles may not have access to the identity of individual plan participants. Therefore, we recommend that if this change is adopted, it be clarified that prospectuses can be furnished to intermediaries (e.g. employers), who will forward them to participants.
8The Department of Labor has issued regulations under Section 404(c) of the Employee Retirement Income Security Act (ERISA:) setting forth certain minimum standards for employers that wish to limit their fiduciary responsibility under ERISA, including certain disclosure requirements. The Institute does not believe the DOL regulations provide the protections equivalent to those that would be provided if the exemption for these vehicles under the Securities Act were repealed, as recommended in the Study. The reasons for this include (1) the regulations would not apply to retirement plans not covered by ERISA (e.g., governmental plans), (2) the regulations are not mandatory, but are only an optional safe harbor for each employer, (3) the disclosures required to be actually furnished to employees would not be as extensive as those required under SEC standards, and (4) the disclosures, unlike mutual fund prospectuses, would not be subject to review by a governmental agency.
9"Cloudy Sunset: A Grim Surprise Awaits Future Retirees," Barron’s, July 12, 1993, 8 at 34.
10While the Study did not recommend this change, it admitted that the "protections provided by the Investment Company Act probably are somewhat greater: than those applicable to collective funds and separate accounts. The staff, however, concluded that requiring these entities to register under the Investment Company Act would be "costly and disruptive." We do not believe this is necessarily true; in fact, we understand that many bank collective funds have voluntarily registered under the Investment Company act in recent years.
11Alternatively, some banks enter into contractual arrangements with independent broker-dealers under which the broker-dealers sell securities products on bank premises.
12The federal banking regulators generally are the Federal Reserve Board (which regulates bank holding companies and state banks that are members of the Federal Reserve System), the Office of the comptroller of the Currency (which regulates national banks), the Federal Deposit Insurance Corporation (which regulates insured state banks that are not members of the Federal Reserve System), and the Office of Thrift Supervision (which regulates savings associations).
13See, e.g., Comptroller of the Currency Banking Circular 274 (July 19, 1993); letter from Richard Spillenkothen, Director. Division of Banking Supervision and Regulation, Federal Reserve Board, to supervisory officers (June 17, 1993).
14See Release No. 33-6982 (March 19, 1993).
15As SEC Commissioner Beese has argued, many employee participants in defined-contribution retirement plans may make ill-informed investment decisions, in part because "most investors do not spend a great deal of time reading bulky prospectuses when they are filled with legalese." See Remarks of J. Carter Beese, Jr., Commissioner, U.S. Securities and Exchange Commission, Before the Investment Company Institute 1993 pension Conference (March 30, 1993).