SEC to funds: Don’t cut your compliance staffs

The mutual fund industry must resist the temptation to cut costs in this volatile stock market by letting go legal and compliance staff or risk a fate similar to the Titanic’s.

Paul Roye, director of the Securities and Exchange Commission’s division of investment management, delivered the warning Friday to attendees at the Investment Company Institute’s general membership meeting in Washington.

Mr. Roye also gave the mutual fund industry an update on where the SEC stands with regard to more-frequent portfolio disclosure and the regulation of synthetic funds and exchange-traded funds.

With regard to synthetic funds – baskets of stocks recommended by websites and traditional publishers – Mr. Roye signaled his disagreement with the ICI’s position that they should be regulated as mutual funds.

As for ETFs, he said, the SEC will publish a concept report on actively managed ETFs within the next couple of months.

Mr. Roye said the report would seek comment on how such products could work considering their holdings would be visible to all, making them prime targets for arbitrageurs and market timers.

But Mr. Roye’s comments on potential cuts in the legal and compliance staffs of mutual fund firms drew the most attention.

The mutual fund industry is now sailing through a treacherous stock market, and though some fund companies are experiencing outflows, they should be leery about making cuts to their legal and compliance departments, he said.

Like the Titanic, which sank after striking an iceberg, some mutual funds could find themselves without enough lifeboats if their lawyers lose their jobs, Mr. Roye said.

no examples

Mr. Roye said he had no examples of funds that are currently cutting legal departments. But company divisions that aren’t profit centers are usually the first to get squeezed to protect the bottom line.

That’s a mistake, he said, because it can lead to mistakes that can sink a company.

He pointed to Heartland Advisors in Milwaukee as an example of a company that could have benefited from more legal oversight.

The assets of three Heartland municipal bond funds were frozen by the SEC, which placed the fixed-income funds in receivership earlier this year after a valuation error caused the funds to plummet in value.

In addition to warning the fund industry about the pitfalls of cost cutting, Mr. Roye indicated that he may soon have even more unsettling news for the industry.

The industry opposes more-frequent disclosure of mutual fund holdings. But Mr. Roye said the SEC would balance the needs of the shareholders with the potential hardship that more frequent disclosure would place on the industry.

Asked whether such a hardship actually exists, considering that about 70% of all mutual funds already disclose their holdings to Morningstar Inc. of Chicago on a monthly basis, he said that that was something the SEC would have to consider.

duck or chicken?

Mr. Roye gave an even stronger indication that the SEC may not favor the ICI’s position that synthetic funds should be regulated as mutual funds.

He said the SEC must keep in mind two considerations when looking at the issue.

First, do synthetic funds constitute the creation of a security? The creation of a security means something that creates value for the investor.

The ICI’s position is that it does. Matthew Fink, ICI president, said that a synthetic fund is so similar to a mutual fund that “if it walks like a duck and quacks like a duck, it’s a duck.”

Mr. Roye, however, said that synthetic funds may actually be chickens.

The second issue the SEC needs to look at is whether companies that offer synthetic funds are in the advice business, Mr. Roye said. If so, they could be in conflict with the SEC’s rules.

Not everyone in the mutual fund industry agrees with the ICI. John Bogle, founder of the Vanguard Group in Malvern, Pa., and president of the Vanguard unit Bogle Financial Markets Research Center in nearby Valley Forge, Pa., said, “I felt obvious skepticism that these folio vehicles should be regulated as investment companies.”

He noted that investors control their own investments in folios. “If it’s not an investment company, it can’t be regulated as an investment company,” he said.