Preview of Rep.'s Dec. Issue: "The World's Largest Skimming Operation"

The House has overwhelmingly approved a bill aimed at curbing mutual fund market timing and other investor-harming abuses. (The legislation would ban short-term trading by mutual fund insiders, ratchet up reporting requirements surrounding so-called soft-dollar arrangements and call for more fund oversight from independent directors.) With the legislation ready to move to the Senate, a conversation

The House has overwhelmingly approved a bill aimed at curbing mutual fund market timing and other investor-harming abuses. (The legislation would ban short-term trading by mutual fund insiders, ratchet up reporting requirements surrounding so-called soft-dollar arrangements and call for more fund oversight from independent directors.)

With the legislation ready to move to the Senate, a conversation between Registered Rep. contributing editor Ann Therese Palmer and Senator Peter Fitzgerald (R-Ill.), a champion of investor's rights, takes on new importance. We've excerpted the conversation below. A more expansive version of this interview will appear in Rep.’s Dec. issue.

Sen. Peter Fitzgerald, a first-term Republican from Illinois, chairs the only Senate committee investigating mutual fund trading abuses—the Governmental Affairs Subcommittee on Financial Management, the Budget and International Security.
As such, his thoughts matter mightily to the investment community. Unfortunately, those thoughts right now are not pretty.

Rep.: Why did you describe the mutual fund industry as "the world's largest skimming operation--a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings"?
Fitzgerald: The industry has grown from $115 billion in 1980 to $7 trillion at the end of 2002. Until now, no one has really taken a look at what kind of fees are being charged to manage that $7 trillion pot of money. While the mutual funds industry's assets have grown 60 times since 1980, the fees have grown 90 times. I called that a skimming operation because in most industries, there is an economy of scale. As assets under management increase, you would expect fees to go down.

Rep: How does this affect the average investor?
Fitzgerald: At our [Nov. 3rd] hearing, the SEC disclosed that 50 percent of the mutual funds in America appear to have given market-timing capacity to select investors. That's half! And, 25 percent of the broker/dealers in this country had assisted clients in making illegal trades after the market closed. We're talking about widespread, wholesale criminal activity.

Rep.: How do you define market-timing as opposed to late-trading? What's wrong with trying to time asset classes? Do you intend to outlaw it or limit it?
Fitzgerald: When a fund gives some investors a peek at the investments the fund has, or selectively discloses material non-public information about the funds’ assets and then gives that investor market-timing capability that it doesn’t give its other fund shareholders, I’d call that market timing. It hurts the other investors in the fund because they’re incurring transaction costs and being deluded as market timers trade in and out of the fund. Mutual funds say in their prospectuses that they treat all shareholders equally. If a fund is giving an investor market-timing capability and not its other investors, it's not treating everyone equally.

The SEC would argue that in certain circumstances market timing could already be illegal, as when select disclosure of non-public information is made and then those investors are allowed to trade, based on that select disclosure.

I personally think market timing should be illegal. The mutual fund industry seemed to agree with this at the Sub-Committee hearing when they proposed establishment of a mandatory 2 percent redemption fee to discourage market timers. Vanguard has a similar fee.

Rep.: Do you think retail financial advisors are complicit in any alleged wrongdoing?
Fitzgerald: Many mutual funds pay brokers for order flow. Where a broker puts a client into a mutual fund, not because it’s a good investment for client, but because the broker is going to get a kickback from the mutual fund, then the broker has made a mistake. The broker has arguably violated his fiduciary duty to clients. I think brokers who do that sort of thing are engaging in a mixture of the unethical and illegal.

Rep.: What's been proposed to resolve these problems?
Fitzgerald: Sen. [Daniel] Akaka (D-Hawaii) and I would require that brokers disclose mutual fund commissions in written confirmations to their clients, just as they do with stocks and bonds sales. If a broker steers a client into a mutual fund and gets a fee from the fund, he should have to disclose that fee. That's one of the main things that our bill does.

We would also require boards of mutual funds to be comprised of 75 percent independent directors. That means independent of the outside fund manager, too. The chairman of the fund would also have to be independent. If we had independent boards, we wouldn't be seeing the problems we’re seeing today.

The mutual fund industry is very powerful. They will fight reform. But I do think there will be a law enacted on enhanced disclosure of fees. It won't happen this year. But I predict it will pass next year. Let me tell you one thing that the mutual fund industry doesn’t want disclosed. When a fund wants to do radio, television or newspaper advertising, they debit everyone's account to pay for the ads. It's called 12(b)1 fees. They can pay for all of their marketing costs. I think that's absolutely outrageous.

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