Reforming Mutual Funds: Start at the Top

The lawyers at the Securities and Exchange Commission have spent two years thinking about how to reform the mutual fund industry. The result is a red-jacketed, 525-page report with enough footnotes to fill Santa Monica Bay.

But the reforms that could mean the most to the majority of fund shareholders don’t take more than two minutes of thought--if only fund executives would consider what their increasingly sophisticated customers really want and need in the 1990s: A better product at lower cost.

The SEC report, released Thursday, deals mostly with how funds are governed and marketed. The study doesn’t suggest there’s anything inherently wrong with the fund industry. Indeed, the funds are perhaps America’s greatest financial success story of the last decade. The industry now holds $1.4 trillion of investors’ savings, yet has remained remarkably free of fraud and failure.

In the 1980s, millions of individual investors learned to trust the mutual fund concept. In a fund, your dollars are pooled with those of other small investors and invested in a diversified portfolio of stocks, bonds, money market instruments or other securities. The fund manager takes a small piece of that portfolio as an annual fee, and the rest of the return goes to shareholders. Simple and honest, and it works.

In the course of the industry’s explosive growth, however, many mutual fund firms have come to treat shareholders with a certain detached attitude. Some critics even suggest that the industry has become condescending toward small investors.

It’s as if some funds are essentially saying to the public now: “Just give us your money. Call our 800 phone number any time, but don’t ask a lot of questions about what we’re doing with your investment, how much we’re charging you, or whether we could do better for you, for lower fees. Just trust us--everyone else does.”

That approach may have worked in the 1980s, when most investors were new to the funds. But as those same investors grow more knowledgeable and discerning in the ‘90s, chances are they will hold the fund industry to ever-higher standards. As consumers, we already put every other business through the competitive wringer. The funds’ turn will surely come.

Yet instead of trying to anticipate this, many funds fight change.

Take, for example, the issue of disclosure. In the literature a fund sends potential shareholders, there’s a lot of boring general explanation. But rarely is there any discussion of the individual portfolio manager--the person who’s actually managing your money.

How old is the manager? How much experience does he or she have? How much is the person paid? And how much of the manager’s own money is in the fund (i.e., does he/she have a stake with you)? If your fund tells you any of this, consider yourself lucky.

Repeatedly over the last two decades, the SEC has attempted to force the funds to do a better job of giving background information on portfolio managers in their shareholder literature. And repeatedly, the industry has beaten back those proposals.

The industry says details about the individual managers aren’t important. Too much emphasis on that person would obscure the contributions of analysts and others on the fund team whose input is key, the industry argues.

Well, so what? The funds can describe their team approach in any way they choose, as long as shareholders get more details about who’s really calling the shots. Big pension funds demand no less when they hand their dollars to private investment managers. Don’t individuals deserve the same?

Ironically, the fund managers themselves appear to favor such disclosure, says Jonathan Pond of Boston-based Investment Management Information Inc. His firm surveyed 200 fund managers a year ago on pay and disclosure issues, and found that 62% favored giving shareholders more biographical information.

The obstacle, it appears, isn’t the managers, but rather fund-company senior executives and owners--the people who have been most enriched by the industry’s boom. They are a private lot, to be sure, and many seem to believe that shareholders would only be confused by greater disclosure.

Don Phillips, publisher of Mutual Fund Values newsletter in Chicago, argues that fund executives are all wet. “The industry shouldn’t be so patronizing toward shareholders,” he says. “They should let shareholders decide how much importance to place on that information.”

Likewise, Phillips notes, the fund industry has become increasingly defensive about its fees, which have risen consistently at many funds since 1980.

The funds make money off the fees assessed to run a portfolio. The average stock fund now takes 1.6% of assets as a management fee each year, versus less than 1% a decade ago. (Any sales fees are additional.)

To many shareholders, 1.6% may still seem like a bargain. What aggravates Phillips and other fund watchdogs, however, is that there is such a wide disparity of annual management fees in the industry--from 0.20% to 4% or more.

In any other industry you can name, that kind of price disparity would become a major marketing point: The low-cost producers would stress that attribute, potentially increasing investor awareness and putting pressure on other funds to cut fees.

Yet in the $1.4-trillion fund industry, Vanguard Group of Valley Forge, Pa., has almost been alone in its table-pounding advocacy of low-fee funds that don’t sacrifice service or return.

Charles Trzcinka, a finance professor at State University of New York at Buffalo who has long studied mutual fund fees, contends that “there isn’t the same kind of price disparity in any other product category in America. It’s a strong indication of an imperfect market.”

The point is, it doesn’t require an act of Congress or even the SEC for mutual funds to get serious about lowering their expenses so that shareholders take home more of the profits.

What will make that happen? Just this: Fund shareholders have to become far more aware of who’s managing their money, what they’re paying for that expertise, and how their returns stack up next to other funds. And when fees are up while returns are down, shareholders have to make noise--just as they would when any other product or service fails them.

In the ‘90s, many fund-watchers believe that shareholders will increasingly take that stance. They’d better--it’s their money.

Do You Know Your Fund Manager?

Many mutual fund investors get little information about the people actually managing their funds because fund companies often refrain from disclosing much. But a 1991 survey of individual fund managers shed light on two key issues--pay and ownership:

What fund managers earn

Under $50,000: 9%

$50,000-$100,000: 25%

$100,000-$250,000: 46%

$250,000-$500,000: 16%

$500,000+: 3%

Do managers own their own fund’s shares?

Some, but not largest single investment: 54%

Largest single investment: 27%

No ownership: 19%

Source: Investment Management Information Inc.

MAIN STORY: A1