When the dust settles from the mutual-fund scandals, average investors will be better off.
At the very least, controversial trading techniques - used by some big traders to the detriment of small, long-term investors - will be banned. That reform should put a few extra dollars in the hands of some shareholders. The big question is whether the shakeup will push fundamental reform in the mutual-fund industry, especially in the area of fees.
If it does, long-term investors could see a small but significant increase in the annual returns of many of their funds.
But don't hold your breath. Those reforms face big opposition.
The mutual-fund industry, which manages $7 trillion in assets, and its lobbying organization "are clever, well-heeled, driven, and used to getting their way," holds John Freeman, a University of South Carolina Law School professor. He worries that Congress will leave reform to regulators at the Securities and Exchange Commission, and that the SEC will remain in a friendly partnership with the industry's lobbyist, the Investment Company Institute (ICI). The end result: only a little reform and the half of American households that own fund shares continuing to be overcharged some $20 billion per year in various fees and expenses, he says.
Not so, counters Matthew Fink, ICI president. He claims such estimates are based on faulty studies. In reality, the costs of investing in stock funds have actually decreased by 43 percent since 1980, he claims.
In any case, the pressure is on fund companies to trim their fees, thanks to the unfolding "late trading" and "timing" scandals revealed by New York Attorney General Eliot Spitzer last fall.
Late trading involves buying or selling mutual-fund shares after the 4 p.m. stock-market close, the time when the net asset value or share price is set for the next day. The SEC proposes that in the future any mutual-fund transaction must reach the fund, or another SEC-registered entity, by 4 p.m. to be valid for that day's price. Late traders either used dodges or got permission from fund officials to escape the regulation.
Timing is the quick purchase and sale of fund shares during trading hours to take advantage of news events. It is not necessarily illegal, but it often violates a provision in a fund prospectus promising to discourage this from happening. The SEC proposes charging a 2 percent redemption fee on any sale of fund shares within five days of their purchase. That would probably make timing unprofitable.
The agency also wants mutual-fund groups to appoint a compliance officer to report regularly on the group's adherence to laws and regulations to the "independent" directors on a fund's board.
Only a year ago, Mr. Fink of the ICI bragged to Congress that the industry's governance and investor-protection standards could serve as a blueprint for corporations in other industries. Today he admits to being totally surprised - like regulators and people in Congress - by the "breach of trust" to shareholders of a minority of the nation's 400 or so mutual-fund groups.
True, the cost to each shareholder was in tens of dollars - not thousands, Fink points out.
But pocketing tiny slices of investor value can add up when so many shareholders are being taken. "Skimming" is the term used by Sen. Peter Fitzgerald (R) of Illinois, who has been chairing hearings on mutual funds.
Now the SEC is asking investors to comment on a proposal requiring broker-dealers "to disclose more information about costs and conflicts of interest to investors who purchase or sell interests in mutual funds."
Professor Freeman also wants more disclosure. "We need the mutual-fund industry to be put on a rigorous, detailed disclosure regime," he says. Every expense should be clearly defined so the information can be standardized and examined by academics, Wall Street analysts, and journalists. He also wants revenues and profits after expenses reported.
While in favor of "better disclosure," Fink may disagree with Freeman on important details of these reforms. But their key clash is over fund expenses and fees.
Freeman, together with Stewart Brown, a finance professor at Florida State University, produced a 2001 law journal article comparing the cost of portfolio management paid by pension plans with those of mutual funds. "Mutual-fund shareholders are being gouged," says Freeman.
The charge alarmed the industry, especially since Mr. Spitzer has been using Freeman's study, and the SEC has won huge fee reductions in relation to fund scandals.
Late last month, Putnam Investments announced it would cut fund fees by $35 million a year, hoping to stanch shareholder defections. Massachusetts Financial Services Co., a Boston neighbor of Putnam, agreed with regulators to cut fees by $125 million over five years. Alliance Capital Management Holding settled on a 20 percent management-fee reduction over the next five years, or about $350 million.
To Freeman, fund acceptance of such reductions offer some proof that fees are excessive. Alliance, he notes, charges its mutual funds a management fee of 0.93 percent of assets, while charging a Wyoming pension fund only 0.1 percent for "the same service."
Fink denies that the services provided to pension funds are the same. He charges that Freeman is making an unfair "apples-to-oranges comparison." He adds that Spitzer is basing his conclusions about excessive fees on "a grossly flawed methodology."
Freeman calculates that funds' advisory fees are still excessive by $9 billion, andthat the 12b-1 fees many funds charge are "a marketing boondoggle" that costs investors another $9 billion.
Fink replies that most 12b-1 fees justly reward brokers and others who sell shares to investors.
This battle is likely heat to up as the investigations continue - a good sign for small investors.