My Yahoo!Mutual Funds, Heal Thyselves
NEW YORK - The Investment Company Institute, the trade association for 8,246 mutual funds managing $7 trillion in assets, rarely misses a chance to boast about its members' sparkling corporate governance. Sure, fund management firms such as Janus and Prudential had no problem offering up new tech stock or bond funds to appease fad-following investors, but at least they were upfront with investors on holdings and expenses, regardless of performance. Right?
New York Attorney General Eliot Spitzer, currently the financial world's toughest regulator, answered that question with a resounding "No!"
On Friday, a month into Spitzer's snowballing investigation of improper fund trading, ICI governors will convene a critical board meeting. While it is expected to take up issues such as soft dollars (the services-based financial backroads currency), advertising claims and stock-exchange governance, the board's most critical issue, in terms of the industry's self-preservation, is how ICI acts to fix member indiscretions.
Mutual funds, along with unit investment trusts, closed-end funds and exchange-traded funds, are regulated by the U.S. Securities and Exchange Commission under the Investment Company Act of 1940. Each individual fund is its own company, complete with operating expenses, assets and liabilities, guided by a majority independent board.
Spitzer's investigation into both illegal and discouraged trading privileges granted to a large investor exposed a gaping hole in that governance. Employees of management companies, such as Bank One (nyse: ONE - news - people ), Bank of America (nyse: BAC - news - people ) and Janus Capital (nyse: JNS - news - people ), allegedly subverted the democratic principle in which millions placed their trust. By investing their money in a mutual fund, "each investor shares in the returns from the fund's portfolio while benefiting from professional investment management." That's straight out of the ICI's 2003 fact book.
So what is the benefit--and the professionalism--in favoring one large investor over thousands of families? There is none.
It's no surprise, then, that fund management firms have started to clean house. Just this week, Alliance Capital Management (nyse: AC - news - people ), a unit of AXA (nyse: AXA - news - people ), suspended two employees for allowing certain trades. Prudential Securities, majority owned by Wachovia (nyse: WB - news - people ), booted 12 employees on similar violations. If more companies dismiss brokers and managers for infractions, confidence in mutual funds will continue to fall. Analysts at Morningstar, the largest mutual fund rating company, had no qualms pulling their recommendations on several funds implicated in the Spitzer probe.
"The investor shareholder is at the top of the food chain," says Don Phillips, a managing director at Morningstar in Chicago. Not just the biggest one or the most aggressive one, but everyone. The offending funds missed out entirely on the spirit of the Investment Company Act.
"Any mutual fund investor can have a visceral reaction to the allegations," says Daniel Sommers, a partner at Cohen, Milstein, Hausfeld and Toll in Washington, D.C. "Any whiff of abuse or fraud has to be addressed. It's just too much money. It's too important," he adds.
As the SEC, Congress and U.S. federal and state attorneys extend their tentacles to the inner workings of fund management firms, the ICI must become its toughest critic. Self-regulation, scarred by the recent flap at the New York Stock Exchange, is a non-starter. Regulation left to an overburdened SEC or a heavy-handed Congress, with a bill on the table after its Sarbanes-Oxley "victory," would go overboard, piling fees and expenses on fund managers and, thereby, fund shareholders.
Only the industry itself can map out the clearest and most cost-effective solution to eroding investor confidence. The following prescriptive measures may require opening the trench coat a little wider, but we're sure that investment banks and accountants can testify to this: Self-exposure hurts much less than having your clothes ripped off.
1. Get some skin in the game: Mutual funds should require that managers, advisers, staff and board members have significant holdings in funds they advise. Such holdings, and other 5% owners, should be revealed in fund annual reports.
2. Open up the boards: The ICI is calling for a greater fund voice at the New York Stock Exchange--to advance trading reforms and "represent the interest of investors." But what about letting their own constituents, largely middle-income investors, actually hold seats on fund boards?
3. Disclose actual costs: If fund costs are borne by every investor, then reveal the unique dollar amount of those costs, on both an actual and a percentage basis. If software can track the slightest change in portfolio risk, it should be able to tell investors the cost of that risk.
4. Use real money: Soft dollars, while exciting in theory, are prone to abuses.
These four are only a start. Covering distribution costs and mandating that brokers honor breakpoints on commissions for large purchases are also calling for a fix. The push is on "to restore the confidence of investors in the integrity of our financial system," said John Bogle, founder of low-cost fund company Vanguard, in a recent speech. But, Bogle says, the focus instead should be on "restoring the integrity of the system."
The ICI and many of its members, which have effectively ostracized the outspoken Bogle from its inner workings, should take it upon themselves to do just that.
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