Mutual Funds Brace for Rising Scrutiny, Regulation

At first glance, Sophia Collier and her colleagues would seem to be unlikely targets of what is fast becoming the latest government crackdown on corporate America.

Collier is president of Citizens Funds, a small mutual fund company based in the seaside city of Portsmouth, N.H., whose “socially responsible” investments eschew tobacco companies and those lacking diversity in upper management.

Citizens’ hometown is straight out of a Norman Rockwell painting. The firm is quartered in a refurbished brick building that once housed a power plant and, before that, a dairy. Collier’s office overlooks a 200-year-old naval shipyard and is a few blocks from a historic church where onetime Portsmouth resident Daniel Webster once addressed local citizens.

Collier, who moved her firm to New England from San Francisco 12 years ago to be closer to her home, speaks proudly of how mutual funds have been a positive force for investors and points out that the industry has never had a major scandal.

“We have done everything right,” she said. “To spend time scrutinizing what we’re up to, when the mutual fund industry has been an exemplar of what’s right in America, is a mistake.”

The Securities and Exchange Commission and some Congress members clearly disagree. Fresh from investigations of corporate miscreants and wayward Wall Street brokerages, they are turning the investigative spotlight on the mutual fund business.

Their prime concern: that mutual funds, despite painting themselves as investor champions, may be at odds with their shareholders’ best interests in key ways. And with 95 million Americans invested in mutual funds, such issues as how funds wield their vast influence in corporate elections and how much they charge to manage their customers’ money could be critical in reestablishing investor trust.

The result of mounting scrutiny could be significantly tightened oversight of an industry that has enjoyed largely hands-off treatment from regulators.

An indication that big changes may be brewing came last month when the SEC revealed it is considering the creation of a special organization devoted to monitoring mutual funds. The SEC already had proposed a battery of new rules in areas such as fund fees and disclosure of portfolio holdings.

The House Financial Services Committee also is homing in on the fund industry.

*

Hearings Planned

The latest signal came Friday when committee Chairman Michael G. Oxley (R-Ohio) told The Times he would hold hearings on the fund industry this year. That conjures up images of fund managers squaring off with congressional inquisitors, much as stock analysts and corporate executives did last year.

After scrutiny of stock analysts and accountants, “the natural progression is to take a serious look at mutual funds,” Oxley said. As a member of his staff put it: “This could be the year of the mutual fund.”

Regulators don’t expect to unearth the sort of scandals that have broadsided other segments of the business world. But “we don’t want problems creeping into the investment-management industry that we’ve seen elsewhere,” said Paul Roye, head of the SEC division that oversees funds.

The attention to funds comes partly from last year’s historic revamp of securities laws, known as the Sarbanes-Oxley Act for its two sponsors, Oxley and Sen. Paul Sarbanes (D-Md.).

The law imposed a variety of new corporate-governance mandates on companies, such as forcing chief executives to certify the accuracy of their financial statements. Funds must comply with the rules.

The scrutiny also is being driven by a growing concern that funds may not be monitored closely enough.

With fewer than 400 inspectors to oversee more than 9,300 stock funds, the SEC thoroughly reviews each fund company only once every five years, Roye said.

Better scrutiny of mutual funds is long overdue, according to critics.

The basic problem, they say, is that funds face an inherent conflict of interest -- between marketing and investing -- but have not been forthcoming about it.

Specifically, fund companies want to lure assets and the fees they generate. But huge funds can grow unwieldy and hurt performance for shareholders.

The industry is “driven by marketing rather than management, by salesmanship rather than stewardship,” said John Bogle, retired chief executive of Vanguard Group and a frequent industry critic.

The Financial Services Committee will focus in part on whether funds exacerbated the tech-stock bubble in the late- 1990s by launching scores of tech funds despite criticism at the time that doing so was not in investors’ best interests.

There are less visible conflicts, as well, some people say.

Two weeks ago, the SEC approved a rule requiring that funds disclose the positions they take in corporate proxy votes.

The industry -- led by giants such as Vanguard and Fidelity Investments -- vehemently opposed the measure as too expensive and useless for investors.

Critics say there is another reason behind the foot-stomping: Many fund companies derive big profits from managing the 401(k) and pension programs of U.S. corporations and don’t want to reveal a proxy vote against the management of a corporate client.

Another potential conflict, said Roy Weitz, an investor advocate who runs a Web site called FundAlarm.com from his Tarzana home, centers on the way funds handle their best investment picks.

Many fund firms operate private accounts that are not open to the general public. Which accounts get the benefit of the fund’s best investment picks?

“People are starting to wonder if the mutual fund industry is on their side or not,” Weitz said.

*

Fees Criticized

Also under scrutiny: the fees that mutual funds charge their investors, and whether these fees are properly disclosed. In the 1990s bull market, assets in stock mutual funds skyrocketed, but the average stock fund expense ratio rose as well. Because fund expenses are figured as a percentage of assets, critics say, the average expense ratio should have fallen as assets increased.

Industry missteps have inadvertently added to the scrutiny, some people say.

The industry lobbied in vain to be exempted from some Sarbanes-Oxley provisions. And its high-profile opposition to the proxy-vote proposal stirred anger, Weitz said.

Fund executives dismiss such notions.

For example, T. Rowe Price in Baltimore discloses all potential conflicts to its board, said Henry Hopkins, its chief legal counsel. No corporate client has ever complained about T. Rowe Price’s investment decisions on its stock, he said, and any that ever did would be rebuffed.

“Where is all the conflict?” he said. “You’re looking for problems that basically don’t exist.”

Fund companies worry that politicians and regulators will push measures that do little for investors but significantly boost their costs. The biggest opposition is to the idea of creating a separate organization to oversee the industry. Rather than reporting directly to the SEC, as fund companies do now, there would be a middleman clogging up the process, they say.

The effects could be acute at small companies such Citizens, Collier said. “It would be a huge headache for us.” About 30 of the company’s employees work in administrative areas such as compliance. Increased regulation could force her to switch people from researching stocks to “filling out compliance forms.”

“There are thousands of pages of rules already,” Collier said.

“My fear is that, despite the facts, some government officials want to show they’re tough on corporations and will go after the mutual-fund industry,” she added. Nevertheless, “if they do shine a spotlight on us, they’ll see a very good industry.”