Mutual Funds’ Top Cop Leaves Clean Beat : Market Watch
On Kathryn McGrath’s final day last week as the nation’s top mutual fund cop, the Securities and Exchange Commission paid her a fitting tribute: It voted for a sweeping public review of the 50-year-old federal law that created the modern mutual fund industry.
For 36 million fund shareholders, the SEC review will offer an opportunity for comment on how well the funds serve investors and how the industry can be improved in the 1990s. The review also will allow the funds themselves to suggest rule changes that could enhance competition and create new investment products for the ‘90s.
As head of the SEC’s investment management division since 1983, the 45-year-old McGrath presided over the mutual fund industry’s go-go years. Now, as she returns to private law practice, she leaves an industry whose assets have ballooned to $1 trillion from $300 billion in 1983. The number of stock, bond and money market funds has rocketed to 3,037 from 653.
Perhaps even more remarkable, the industry has grown at that meteoric rate while remaining generally free of scandals, fraud and bankruptcies--no small victory, considering the bombs that have exploded in other financial services industries.
“The funds sell trust and most of them realize it,” said McGrath, sitting in her spacious office at the SEC’s headquarters in northwest Washington. “I have to say they’ve maintained pretty high standards.”
And where McGrath felt the standards weren’t high enough, she was quick to make her point with the funds. Her critics within the industry complain that she spent too much time picking fights and that her views on a few topics kept her from bigger victories. Some also criticize her combative style, arguing that it alienated even some co-workers.
But her supporters say McGrath was the right kind of cop for what became a decade of dangerous excess in many investment areas. “She was always pressing in the right direction--for more disclosure and full disclosure,” said John Bogle, chairman of the Vanguard Group of mutual funds.
McGrath faced a Herculean task in the past decade: how to keep the SEC’s relatively small investment management staff (now 216 people) on top of the burgeoning mutual fund industry while monitoring an even bigger group, the pension funds and private money-management firms that invest $4.6 trillion in assets.
McGrath says she decided early on to follow a two-track approach: Peeling back unneeded regulation so that the fund industry could grow more easily with investor demand, while at the same time re-regulating the funds where potential abuses threatened investors.
For example, McGrath allowed the industry to shorten the often lengthy and boring prospectuses that potential shareholders are supposed to read before they buy fund shares.
Meanwhile, she was particularly tough on fund advertising and fee disclosure. In the mid-1980s, some funds tried to lure shareholders by stretching what McGrath felt was the outer limit of truthful advertising. So she formed a “Bad Ad Squad” and threatened funds in writing when they overstepped her boundaries.
A simple threat, McGrath found, “was a lot faster way to stop things than cranking up an enforcement action,” which takes up SEC time and money.
Likewise, she oversaw the standardization of yield quotes in fund advertising, so investors could compare apples to apples when shopping for funds. Left to their own devices, many funds had quoted whatever number made them look best: annualized yields, monthly yields, 7-day yields, compounded yields, etc.
McGrath joined the SEC as a staff attorney in 1970. She left the agency for private practice in 1979, only to be lured back by former Chairman John S. R. Shad in 1983 to take over the investment management job.
Her decision to leave this time, she said, was colored by her need to boost her earnings, with two sons--ages 15 and 7--looking ahead to college. (McGrath’s husband also is an attorney, practicing in suburban Washington.) McGrath earned $83,600 a year at the SEC, which she said might be “a lot compared to other peoples’ standards, but not compared to what I used to earn.”
She leaves many issues for her as-yet-unnamed successor to pick up anew, as the commission’s plan for a full-scale review of fund regulation begins this summer.
In fund advertising, for example, “I don’t think the industry has done a very good job of pointing out the risks in bond funds--particularly U.S. government bond funds,” McGrath says. The use of the word “guarantee” in bond fund ads annoys her because investors have come to believe that means their principal can’t disappear. In fact, Treasury bond values fluctuate wildly and so do bond fund share prices.
Fund fees are also an area of deep concern, McGrath said--not fee levels, but how they’re charged and disclosed. “I don’t think we should be regulating what people pay. The market will take care of that,” she says. But she has long been at odds with the funds over so-called Rule 12b-1 fees.
Under 12b-1 regulations, funds can charge shareholders an annual fee to cover such costs as marketing and advertising. The fee is automatically deducted from fund assets, so shareholders don’t see it unless they look. Nonetheless, if a fund is spending 1% of its assets on marketing, that’s a 1% penalty on its return to shareholders yearly.
Added to general fund management fees, which can eat up 1% to 3% of assets, 12b-1 fees become a significant expense.
As more fund companies began billing shareholders via 12b-1 fees in the 1980s, McGrath felt the industry was trying to hide the charges. She forced the funds to disclose the fees clearly in a table in fund literature.
McGrath also pushed for the National Assn. of Securities Dealers to come up with its own self-policing rules on 12b-1 fees to make sure the fees wouldn’t get out of hand. The NASD now is working on proposals for capping those fees.
Despite her objections to some fund practices, McGrath gives the industry high marks for its competence and service to investors. And after the various tales of abuse from Wall Street in the 1980s, to review how clean the funds have remained is almost astounding, she said.
The extent of illicit thrills in the mutual fund industry, she jokes, is “when all of these fund people show up with their spouses (at fund conventions), and they think they’re getting away with something because they serve Dove Bars at the breaks instead of cheap ice cream.
“I don’t know how you bottle that attitude,” she laughs.
