Industry Leader Reflects on Causes of Scandals, Remedies
The scandals that have rocked the $7.5-trillion mutual fund industry since September have put Paul G. Haaga Jr. on the hot seat. He chairs the board of governors of the Investment Company Institute, the industry’s chief trade group.
Haaga’s full-time job is executive vice president of Los Angeles-based Capital Research and Management Co., parent of the American Funds group, the third-largest U.S. fund company.
A former marathon runner and a father of two, Haaga, 55, is a lawyer by training who began his career with the Securities and Exchange Commission’s investment management unit, which regulates mutual funds.
In an interview, Haaga discussed the scandals and how the industry is addressing what went wrong.
Question: Do you think the public has lost faith in the mutual fund industry, given the revelations of the last 10 months?
Answer: I’m not sure whether the public has lost faith or trust in the industry. But I think we need to govern our activities as though we do need to regain trust. Whether we lost it or not we ought to act as though we need to regain it. I think we’ll come out well if we do that.
Q: Until the scandal broke, the fund industry enjoyed a reputation as a place where small investors would always be treated fairly. Now we find that some fund companies allowed favored big investors to engage in fast-paced market timing and other abusive trading, at average shareholders’ expense. What went wrong?
A: I don’t think you can isolate one root cause. When you have several hundred thousand people working in an industry, regrettably, not everybody is going to “get it.”
I think several things happened. One was that we didn’t ask ourselves enough questions. For example, everybody was chanting over and over again that market timing is bad because it makes portfolio counselors [fund managers] sell securities that they wouldn’t have otherwise sold. That’s half the story. The other half of the story is that at any level it causes dilution of existing shareholders and therefore creates harm.
The problem was that people only talked about one side, so then some said, “Well, if the only harm of market timing is that it makes you sell portfolio securities, I’m going to go ask my portfolio counselors how much market timing they can handle before they have to start selling securities.” And if the counselors said 2% [of assets], then maybe I make another error by thinking “it’s my 2% that I get to give away.”
I think some people thought they weren’t harming the funds. Plain and simple. They thought, “If the portfolio counselors aren’t complaining, I’m not harming.”
Q: “People” meaning fund-company marketing people?
A: “People” meaning some of the executives who cut these deals. I haven’t searched their souls, but I think some of them may have been more stupid than venal.
Q: On the issue of late trading, fund companies have long allowed retirement plans and other intermediaries to send in buy or sell orders after the 4 p.m. end of market trading each day because the intermediaries needed time to consolidate orders from their own investors. Did anyone in the senior ranks of the fund industry ever see the potential for late-trading abuses under this system?
A: Yes and no. When you allowed somebody like a 401(k) record keeper to send you trades after 4 p.m., we understood that there was the potential for them coming in late. We put in clauses in the agreements with them, requiring them to only send us trades that they got before 4 p.m. from their investors. So we were alert to the need to enforce that rule.
I think what we missed was understanding the incentives and possible benefits of trading late. What we didn’t realize was that, with [stock-index] futures trading in some of the non-U.S. markets, that those things were sending such clear signals about the next day’s [U.S.] markets.
Q: So someone could surmise from foreign-market trading after 4 p.m. how U.S. markets might move the next day, and try to sneak in a buy or sell order at the last U.S.-market price, after the fact?
A: Yes. And the other thing we could have thought better about was hedge funds’ investment in mutual funds. They don’t need to have “sure things” [in their trading] or make a lot of money on every trade. They just need to be doing it enough times, and putting down enough money, and they’ll make money in the end. We didn’t properly evaluate the attractiveness of [market-timing] to other people.
Q: The SEC now is considering reforms to make sure late trading can’t occur. What has the industry proposed?
A: The essence of our recommendation is to do something that slams the door and is technically foolproof. Whether that means literally that all orders have to be in by 4 p.m., or have to be in some system with some kind of time-stamp verification that you can’t fool with, we’re flexible on that.
Q: The SEC also has proposed a number of governance reforms for the fund industry. What is the industry’s view of the proposals overall?
A: Very favorable. First of all, in a matter of a few months the SEC got all of the reforms out for the proposal stage. That required an enormous amount of work. In terms of the ideas overall, probably 85% or 90% of the things that have been proposed we agree with. Some of them were things we actually suggested and in several cases had been suggesting for some time.
Q: But the fund industry did not support the SEC’s idea that the chairman of each fund’s board of directors should be independent, meaning not affiliated with the fund management company.
A: Our view was that fund directors ought to retain the right to choose whom they want as a chairman. But the SEC approved the rule change, and we will make it work. .
Q: Some industry analysts have suggested that the cost of the new post-scandal regulations on funds could far exceed what investors lost because of market timing and other abuses. Is that valid?
A: I wouldn’t add up those two numbers and say, as soon as they’re equal we stop doing one or the other. What I do worry about in any new regulation is the impact on small fund groups -- and on the ability of people to get into the industry. It has been small fund groups and new entrants that have really brought a lot of the useful innovation to mutual funds over the years. Tiny start-ups were the ones who invented money market funds; it wasn’t the old established people who did that, for example.
So I think we should always worry about discouraging innovation. That doesn’t dictate that you stop regulating where regulation is appropriate. It dictates that you stop and think and not just enact more regulation just so you can say you did something.
Q: Does the industry believe that New York Atty. Gen. Eliot Spitzer, who uncovered the trading scandals, has a legitimate role in saying that fund management fees are too high?
A: There is a very robust, detailed and, I think, effective mechanism for setting fees, and it existed long before Spitzer came on the scene. There is a great deal of disclosure of, and attention to, fund fees, and there is a requirement that independent fund directors approve fees for their fairness.
Most important is that shareholders are very well aware of what the fees are, and they have shown by and large that they choose funds that charge lower-than-average fees. So they aren’t exclusively focused on fees but they’re acting as though they’re very aware of them and are very sensitive to them.
So all of that suggests to me that we didn’t need state attorneys general to come in and add themselves to the mix.
Q: Regulators are looking at some long-standing fund industry practices involving revenue-sharing and sales-incentive agreements with brokerages -- so-called pay-to-play practices. Is the industry’s view that these practices do not, and have not, involved wrongdoing by fund companies?
A: I prefer to call it “cost sharing” because that better describes the actual practice. There are three potential issues involved here, two relating to disclosure and one involving the broker’s “suitability” obligation.
First, if any amounts are paid by a fund sponsor to a dealer firm, rules require general disclosure of the practice either in the fund’s prospectus or in the dealer’s confirmation.
The second disclosure issue does not involve specific rules but the general legal principle that the potential purchasers of securities must receive all information material to their investment decisions. Under this standard, disclosure would be required only if payments to dealer firms or to individual brokers were sufficiently material and varied among fund groups that a purchaser might reasonably expect that it would have a substantial effect on the broker’s recommendation.
Third, brokers have an obligation to select suitable investments for their customers, and no amount of disclosure will excuse an unsuitable recommendation.
Obviously, I can’t say whether every single fund group and every single dealer has complied with all three of these obligations, but my sense is that most have done so.
