"Mutual Fund Reforms"
Saturday, February 12, 2005Lipper Senior Research Analyst Don Cassidy on KKZN AM-760 Thursday, February 12
TRANSCRIPT:
Q. Don, on Tuesday a major bill was filed in Washington in the hope of creating reforms in the funds industry...
A. Yes: the proposal is called the Mutual Fund Reform Act of 2004, and is sponsored by Sen. Fitzgerald of Illinois, Sen. Levin of Michigan, and Sen. Collins of Maine.
Q. What does it propose to do?
A. Well, it is quite sweeping in coverage. I think the size of the recent scandal concerning market timing (and late trading) in funds has opened the door to an "open season" for reforms, even if they are not related. It would:
- Abolish 12b-(1) fees
- Require disclosure of all costs including transaction costs
- Require independent board chairs and 75% of board members to be unconnected with the fund company
- Require disclosure broker compensation to be spelled out at the time of a fund sale to a customer
- Require disclosure of costs in dollar terms to the investor with each statement
- Require disclosure of portfolio managers' compensation, and their holdings of fund shares
- Require fair-value pricing
- Abolish soft-dollar, revenue sharing, and directed brokerage practices and several other things.
But it does not provide enough specifics to cure the trading problems we've been hearing about since September.
Q. Overall, what do you think? Personal opinions, of course....
A. Well, I'm afraid I once again come out not on the same page as the venerable John Bogle, who called it the "gold standard" and endorsed 100% of it. He has an understandable bias in favor of very low costs, and index funds against managed funds.
I think it will be very difficult to find and retain 75% of directors who are independent. I believe a majority would do. The chair, absolutely, yes!
I think portfolio manager compensation is hard for individual investors to relate to. They may reject investing in excellent funds because of envy of star managers' salaries. I DO think disclosing how bonuses are based is useful -- whether the incentives are short-term or long-term, and whether risk adjusted or raw performance is used. And I think knowing how much a portfolio manager owns in the fund is very interesting.
I think disclosing costs in dollar terms with every statement is overkill. If you own $15,000 of a fund and its expense ratio is 1.2% and you can't figure out for yourself that you are paying $180 a year, you need a lot of help with basic math. The programming to do this will be a big cost for little added benefit, and help with remedial math is not a burden the fund industry should pick up.
I DO strongly agree that full costs should be disclosed IN PERCENTAGE TERMS, and that means commissions paid by the fund. But "all costs" include spread and market-impact costs, which no one knows how to calculate precisely.
I do agree that abolishing 12b-(1) fees is a good idea. But investors should realize that loads will be increased to offset this hit on the brokers who sell the funds. 12b-(1) was to pay for ongoing service, including urging investors not to think short term. Clearly that has failed and the payments are just a stream of future commissions, or disguised loads. But the downside here is: if you cut brokers' income for keeping people IN funds, might they respond by pushing investors to move around more, thereby creating more load income??
I lean in the direction of getting rid of directed brokerage, revenue sharing, and especially 12b-(1). This will clean up the murky incentives behind why brokers recommend certain funds or groups. I believe funds should do their own research or buy independent research. However that may make it difficult for small fund shops to exist, and that would be unfortunate since it would reduce competition.
I think fair-value pricing should be allowed but not required. It applies to only certain situations. And the computer models are only about 75-80% reliable, so it is not a panacea.
Q. Talk some more about commissions... aren't those already disclosed, and included in expense ratios?
A. Commission dollars are usually disclosed, but they can be hidden in any of 3 places (annual report, Statement of Additional Information, or proxy), and they are NOT disclosed as a percentage of assets, which makes the information useless to an average investor. And no, they are NOT included in the total expense ratio, because as an accounting matter commissions are considered a part of the carrying cost of the stock held. It is a huge logic loophole and should be fixed.
Q. Are commissions a big drag on performance?
A. I think they are in some funds, and people do not realize it. There are several dozen funds where the commissions are more than the "total expense ratio" itself. There are nearly 200 funds where the trading commissions exceed 1% a year. So, looking at the so-called "total expense ratio" is looking at much less than the total drag on performance.
Q. Do you think this bill will pass?
A. I would bet anything it will not pass unchanged. And I suspect that with the elections coming it may get bogged down from here to July's recess. But it sounds good at a news conference to the people back home, and any objectors can be painted as against the little guy -- even though some of the proposals are extreme or unworkable. I think a much-amended, slimmed-down, version will eventually be adopted.
