Scandal In Mutual Funds Ushering In Major Reform

In September 2003, when New York Attorney General Elliot Spitzer revealed he had found extensive trading abuses by Canary Capital, it sparked a mutual fund scandal that is still playing itself out. Dozens of fund companies have been accused of market timing, late trading, or both. But the ugliness exposed during recent months is having a positive outcome. Reforms now being discussed and implemented should benefit investors for years to come.

Proposals for fixing the industry have come from Capitol Hill, the Securities and Exchange Commission, the National Association of Securities Dealers, and others. Here are the changes to expect and how they are likely to help you.

A "hard" 4 p.m. close. Current rule: Get your order in by 4, and you get the current day's price; buy or sell a fund after 4, and you get it at tomorrow's closing price. But last-minute orders taken by brokerage firms and retirement plan administrators don't get processed until well after 4. That has made it harder to spot illegal late trades placed after the close. Proposed rule: All orders for mutual fund shares must reach fund companies, designated transfer agents, or registered clearing firms by 4. Period. You'll have to complete trades earlier in the day to be sure you beat that deadline.

Mandatory redemption fees of up to 2%. While most funds say they discourage short-term trading, many either lack redemption fees to penalize investors who make rapid-fire trades in and out of a fund or enforce their own rules prohibiting short-term trading only sporadically. A proposed 2% redemption fee on trades out of a fund you've been in less than 90 or 180 days could discourage improper market timing. However, it could also hurt legitimate trades if you use a short-term asset allocation strategy.

A ban on "directed brokerage." In this controversial sales practice, a fund company sends trades to brokerages that sell lots of its funds or gives the fund company access to research or initial public offerings, which gives the brokerage valuable commissions. Paul Roye, head of the SEC's mutual fund division, considers this business practice a serious conflict of interest and has recommended that it be outlawed.

Limits on other practices, and full disclosure. In so-called soft dollar arrangements, fund firms pay higher trading commissions in return for research and information tools-a market-data terminal, for example. Reforms call for restricting such set-ups to exchanges for proprietary research and disclosing the cost to investors.

Revenue sharing-here, a fund company gives a brokerage a cut of its profits in return for "shelf space" for its funds-will likely be allowed to continue, but brokers will have to disclose these arrangements when clients buy or sell mutual funds.

Annual 12b-1 fees, for "advertising and promotion," often compensate brokers and advisors, and are charged against fund assets. Proposals call for splitting out these costs and having individual investors pay them directly. This could eliminate the need for share classes and show clearly how much you're paying a broker for maintaining your account.

Better disclosure of trading costs. Currently, trading costs are listed as a dollar value in the fine print of fund documents. Proposals call for expressing a fund's total cost of buying and selling securities as a ratio of assets and prominently displaying it in the fee table at the front of the prospectus. Such disclosure could help drive down trading costs.

Requiring an independent board of directors and chair. This proposal-that the chair and at least two-thirds of a fund company's directors must come from outside the company-has gotten the most ink and may be the most overrated. Putnam Investments, which settled market-timing charges with the SEC, had a majority of independent directors and an independent chair. "This isn't a panacea," says Jeff Keil, a vice president at Lipper Inc., which provides analysis to fund boards. What could turn lapdog boards into watchdogs is access to an independent, well-funded staff, clearer guidelines on the board's duties to fund shareholders, and penalties for failing to uphold those standards, Keil says.

Hiring knowledgeable, experienced independent directors and providing staff support won't come cheap. But those additional costs could be more than offset by the downward pressure on expenses that better trade execution and more disclosure may exert. Most of these reforms, if adopted, should benefit mutual fund investors.

4/30/2004
©2004 AdvisorSites, Inc. All Rights Reserved.