Is the Juice Worth the Squeeze?

The overhaul of the mutual fund industry spearheaded by Eliot Spitzer is widely viewed as a victory for investors, but some analysts are challenging that notion. In September 2003, Spitzer set off a firestorm, charging mutual fund companies with unfair trading. Since then, companies have paid nearly $2 billion in fines, and dozens of executives have walked the plank. Unsurpsingly, plenty of advisors

The overhaul of the mutual fund industry spearheaded by Eliot Spitzer is widely viewed as a victory for investors, but some analysts are challenging that notion.

In September 2003, Spitzer set off a firestorm, charging mutual fund companies with unfair trading. Since then, companies have paid nearly $2 billion in fines, and dozens of executives have walked the plank. Unsurpsingly, plenty of advisors think the enforcement effort will leave the industry better off.

“The industry is healthier, and that should give investors more confidence in mutual funds,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Wellesley, Mass.

But some analysts have mixed feelings. They say that new mutual fund regulations will saddle the industry with needless annual costs that will eventually be passed on to investors. The Securities Industry Association calculates that funds will face costs of more than $12 billion to comply with new rules requiring disclosure of loads and other commissions. Financial Research Corp. analysts predict that when the final costs of the reforms are totaled, net profit margins of fund companies will drop from the current level of 36 percent to 19 percent.

“The proposals would help stop abuses,” says John Benvenuto, director of mutual fund research for FRC. “But you have to wonder whether the costs of implementing the reforms are worth the benefits that shareholders will receive.”

Consider one of the first of the new rules instituted by the SEC, which requires every fund company to hire a chief compliance officer. During his first year, the new employee may be busy installing a compliance program. But after that, the officer should have little to do except preside over automatic systems, says Neil Hennessy, president of Hennessy Funds.

Whether or not the compliance officer fulfills a vital task, filling the job costs up to $500,000 a year in salary, benefits and software costs, Hennessy says. Big companies can easily handle the costs, but many small operators find the tab overwhelming, says Hennessy, who manages $1.25 billion in assets. For instance, say a fund with $50 million in assets charges 1 percent in annual management expenses. The cost of the compliance officer alone could eat up all revenues — before the company pays for rent, phones and other overhead.

The extra costs are forcing some small companies to close up shop or sell, says Hennessy, who recently acquired Lindner Funds, which had $300 million in assets. He believes the public could have less access to start-ups with new ideas. “A fund has to have at least $100 million in assets to break even, and people with $200 million will have a hard time,” says Hennessy.

Another big cost could come from redemption fees. Under a current proposal, investors who sell a fund within five days of buying would have to pay a redemption fee equal to 2 percent of the assets. The rule is meant to eliminate market-timing, the rapid trading that lay at the center of the scandals.

But implementing the redemption proposal would cost $1 billion annually in software and other costs, says TowerGroup, a financial researcher in Needham, Mass. The costly reforms might be prudent if they would eliminate a dangerous problem. But analysts question the value of the rules. TowerGroup figures that in the heyday of market-timing, the questionable trading cost shareholders $200 million a year, a fraction of the price tag for the reforms.

Instead of slapping on fees, regulators could simply bar short-term trading or use other relatively easy solutions. So far, cheap techniques have gained little support. And the possibility of more regulation still remains.

A recent SIA survey shows that, despite everything that has been done, investors remain unconvinced that the mutual fund problems have been adequately addressed, with 50 percent saying a poor job has been done, compared with 47 percent saying a good job has been done.

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