Industry reforms: first steps on a long road

Mutual funds and regulators are taking the right steps to deal with the trading scandals that surfaced last fall, but they have a long way to go.

That's the assessment of two well- regarded veterans of the industry: John Brennan, chairman of the Vanguard Group in Valley Forge, Pa., and Don Phillips, managing director of Morningstar Inc. in Chicago. In separate interviews, they outlined steps the industry needs to take on the road to reform.

Regulations proposed by the Securities and Exchange Commission, including one that would prohibit late trading, are important, Brennan says. But simply uncovering these abuses may be just as valuable. "Highlighting activities that are deleterious to the shareholder is a huge positive outcome," he says.

Brennan also believes the 4:00 p.m. deadline should be firm for all investors. "The 4:00 close is more than a detail," he says. "The idea of protecting the sanctity of that transactional price is critically important." The scandal erupted because some funds allowed preferred customers to buy or sell shares after the close at prices that had been set several hours earlier.

He also agrees with proposals to make mutual-fund boards more independent. The SEC, for example, has discussed a proposal to increase the number of independent directors from one half of the members to three-quarters and require that the chairman not be affiliated with the fund company.

Since the trading abuses came to light, some fund companies have added redemption fees as high as 2 percent for certain fund shares sold within 30 days after they were purchased. Brennan expects more companies to impose such fees to discourage market timing (the rapid in-and-out trading of fund shares). "Transactional fees are clearly a huge impediment to market timing," he says. "You simply shouldn't be able to free-ride on the back of long-term shareholders."

"What was missing in the industry for the last decade was checks and balances," says Mr. Phillips of Morningstar. "Regulators stopped asking tough questions. If you don't have that, any industry is going to run astray eventually."

While he believes the industry will become more accountable as a result of the scandals, other steps would help boost investor confidence. For example:

• Disclose fund managers' and executives' incentives and compensation. While people who own stocks have access to the compensation and holdings of senior executives and others at the companies, fund investors do not have the same information about the managers of their funds, Phillips notes. For example, he argues, shareholders should be able to find out if a portfolio manager's bonus was linked to short-term, quarterly, annual, or five-year returns.

• Increase communication between fund directors and shareholders. Fund directors are, in theory, supposed to represent the interest of the shareholders. But at most companies, directors have far more contact with managers and executives than with shareholders. At the same time, there is no mechanism for shareholders to individually or collectively communicate with directors.

• Change the system for reporting fund costs. Currently, Phillips points out, funds state costs in percentage terms, not dollars, and they show these costs as a percentage of assets being managed. For example, he says, an investor with $300,000 in a bond fund may be told his expense ratio is 1.5 percent. But if an investor receives a 5 percent annual return while he owns the fund, that 1.5 percent actually reflects a 30 percent reduction on his return. If investors were told, in dollar terms, what the fees and charges actually cost each year, they might seek out funds with competitive returns - but lower costs.