Taking Sides: Let the sun shine on fees charged by mutual funds

The mutual fund industry has enjoyed spectacular growth over the past decade thanks to an investing boom by the general public, driven in large part by the rise of 401(k) retirement plans, individual retirement accounts and similar savings plans.

At the same time, the industry has come under increased scrutiny, not only by public advocates but also by federal regulators. Both are concerned about maintaining public confidence amid rapid change in the industry and a growing sophistication among investors.

The mutual fund industry was created by the Investment Company Act of 1940, and that is a source of both its strengths and weaknesses.

Because it originated more than 60 years ago, the industry has a long and, for the most part, solid track record that does a lot to instill confidence. But some of the act’s provisions are archaic compared with the expectations of today’s investors.

Over the past two years, the Securities and Exchange Commission has been studying various aspects of the industry to improve the way it operates, and as the Clinton administration wound down, it finally began to adopt changes to accomplish that goal.

In one such effort – to increase the effectiveness of mutual fund directors – the agency has adopted rules that should help independent directors play more of a watchdog role on behalf of investors.

But in a second initiative – mutual fund disclosure – the SEC needs to take more aggressive action.

Disclosure is critical because it’s the basis by which the industry is supposed to be held accountable for the fees it charges. Instead of imposing government controls, regulators are essentially relying on informed investors to make decisions about how much they are willing to pay.

That’s not a bad strategy in theory, but critics have long complained that mutual fund companies don’t provide enough information to investors so they can make informed decisions. And the information they do provide makes it difficult to compare funds, or it’s not timely enough to make valid comparisons.

A long-awaited report from the SEC’s division of investment management and a recent report by the General Accounting Office both lay out the parameters of likely action by the commission. The most significant proposal calls on fund companies to report expenses in dollar amounts instead of percentages of assets.

That helps, but the report recommends requiring those disclosures only on an annual or semiannual basis.

That’s a cop-out. A better approach would be to require them quarterly. Every public company is required to release financial reports quarterly, and mutual fund disclosures should be the same.

The report also recommends limiting that information to those inscrutable annual fund reports that are filled with small print and mind-numbing legalese. Fund companies also should be required to publish that information in their advertising.

One of the goals suggested by the report is to increase investor awareness of the costs they are paying.

We agree. Too much emphasis is placed on performance and not enough on costs. Requiring such information in advertisements would not only make it more accessible, but it would increase investor awareness.

By the same token, fund companies should be required to disclose returns on an after-tax basis. We also support the report’s recommendation to study the way fund companies impose 12b-1 fees. As the report notes, the fees were authorized to pay for distribution and marketing expenses. But that provision is now 20 years old, and it needs to be modified to reflect the changes in today’s market.

As InvestmentNews reporter David Hoffman notes in his story this issue, the fees have been subject to abuse.

The Investment Company Act is a landmark law, but like many that have been on the books for awhile, it’s starting to show its age. The same goes for the industry. It needs to wake up and become more responsive to investors.