House fund investigation starts, with 12(b)-1 on the table

With Congress now zeroing in on mutual fund fees, financial advisers have a good reason to be nervous.

Some of the scrutiny is aimed at their pocketbooks, specifically 12(b)-1 fees, which are used to compensate advisers when they sell funds to clients.

That puts advisers between a rock and a hard place. Lower fees would benefit their clients, but at the same time, such fees are a source of income.

The seeming contradiction is just one of the issues facing advisers as Congress begins its investigation into mutual fund industry practices.

The Financial Planning Association, for example, “would be fighting for disclosure of expenses,” says Mark Johannessen, a member of the Atlanta- and Denver-based organization’s board of directors.

But the organization wouldn’t support banning the use of 12(b)-1 fees to pay advisers, he adds.

The fee is supposed to be only a temporary charge to help defray marketing and promotion costs for new funds.

setting standards

The House Financial Services subcommittee on capital markets two weeks ago held the first of what are likely to be several hearings into the issue, and provided a broad forum for critics to attack the industry over high fees and poor fund governance.

Although the subcommittee has yet to focus on 12(b)-1 fees, which make up a substantial part of advisory income, those fees are likely to be a subject of future attention.

Steve Murphy, a researcher for Morningstar Inc. in Chicago, calculates that about $8.1 billion in 12(b)-1 fees was collected by mutual funds in 2002, or about 0.5% of net assets.

Avi Nachmany, director of research at Strategic Insight Mutual Fund Research and Consulting LLC in New York, estimates that more than 95% of 12(b)-1 fees are paid to advisers who distribute the funds.

No figures are available on how much of advisers’ income comes from 12(b)-1 fees. However, Mark Hurley, chairman and chief executive officer for Undiscovered Managers LLC in Dallas, says it is “a lot.” Mr. Hurley, whose firm manages $500 million in mutual funds, has done research on advisory firms.

With investment sales down in the poor market, Mr. Hurley says, 12(b)-1 fees are what is “paying the light bill. [Advisers] are all trying to reinvent themselves into fee-based people.”

If such fees were to be prohibited, he says, “You’d have a lot fewer brokers in business.”

Whether advisers will get any sympathy from lawmakers is open to question. Committee members of both parties were critical of ever-rising fund fees and poor fund performance. Among those who testified at the subcommittee hearings, John C. Bogle, founder and former chairman of The Vanguard Group Inc. in Malvern, Pa., led the call for more and clearer disclosure of fund expenses.

Investors, he said, are entitled to know the actual dollar amount they are charged for fund expenses.

But not all advisers are as gung-ho on increased regulation.

“More disclosure is better to a point,” says Herbert Hopwood, senior vice president of West Financial Services Inc. in McLean, Va., which manages $425 million.

“The thing I get concerned about is, do people use [expense information] now?” he says. “Let’s not just generate more information for more information’s sake.”

Others think there should be more-stringent standards for funds.

Louis Stanasolovich, president of Legend Financial Advisors Inc. in Pittsburgh, wants monthly disclosure of portfolio holdings. “I realize that creates a problem for them, but everybody has to be a stand-up guy these days,” says Mr. Stanasolovich, whose firm manages $150 million.

He also suggests that shareholders hold at least half of fund board seats, and that independent directors make up another 25%.

He believes most fund directors are too cozy with fund managers. “That’s why you don’t see more fund management ousted,” he says.

Rep. Richard Baker, R-La., chairman of the capital markets subcommittee, said Democrats on the subcommittee would send a letter to the Securities and Exchange Commission to advise it on the issues raised at the hearing (see box on Page 3).The SEC has proposed disclosing expenses based on actual returns in shareholder reports, which the industry supports.

The agency also wants portfolio holdings disclosed quarterly rather than twice a year, as is now done. The industry has agreed to go along with the increased portfolio disclosure.

The SEC also has issued a report discussing the idea of setting up one or more self-regulatory organizations for fund and investment advisory industries. Advisers oppose that idea, and the fund industry is expected to do so as well.

In a telephone interview with InvestmentNews, Mr. Bogle called for a “two-pronged attack” to improve fund industry practices. Mr. Bogle said the dollar amount of expenses and estimated transaction costs should be reported with expense ratios at the front of fund annual reports. There is no requirement that transaction costs be reported, and fee tables are reported only in prospectuses.

The FPA’s Mr. Johannessen says that competition in the fund industry should determine fund’s fees. “Full disclosure of those fees,” he adds, is “the most important part.”

Mr. Bogle, however, contends “there’s nothing in the law to suggest that this should be left to competition,” and that requiring more independent directors and an independent chairman is “vital.”

“The boards have failed badly,” he said. “There’s no fee negotiation in this business. There should be. We don’t get into any barroom brawls.”

A new General Accounting Office report (see related story) calls attention to the problem, but industry executives are critical of its findings.

David Jones, vice president of Fidelity Management and Research Co. in Boston, which manages the largest fund complex in the country, says the GAO report is misleading.

Expenses for many of the largest Fidelity funds, he says, have increased because they contain performance fees. Performance fees rise when the fund outperforms the industry average. “We make no apologies for that,” Mr. Jones says.

“If you took out performance fees, expenses went down.”