Speech by SEC Commissioner:
Remarks Before the Mutual Fund Directors Forum Seventh Annual Policy Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
April 12, 2007
Thank you very much Paul for those kind remarks. I am very pleased to be speaking to you today and appreciate the efforts of David Ruder, Allan Mostoff, Susan Wyderko, and others to bring me here. Although I certainly miss having Susan's wise counsel at the Commission, I can see that the Forum is thriving, and I am confident that she will continue to play a vital role in its future growth.
The Forum has been successful at hosting interesting and informative conferences and other events, and from a look at your agenda for the next two days, this conference will be no exception. I am sure that you will be well-rewarded for taking time out of the National Cherry Blossom Festival to attend. As you may know, in 1912, the Mayor of Tokyo gifted 3,000 cherry trees to the city of Washington to celebrate the close relationship of the American and Japanese people.
The United States reciprocated this kind gesture three years later with a gift of flowering dogwood trees, and in 1981, Japanese horticulturalists came to take cuttings from our trees to replace Yoshino cherry trees in Japan destroyed by a flood. And just a few years ago we planted a new generation of cuttings from a famous Japanese cherry tree reputed to be over 1,500 years old. Over one million people visit Washington each year to admire the trees and participate in the festival that heralds the beginning of spring in our nation's capital, and I hope that you have the opportunity, after the conference of course, to be among them.1
Similar to the relationship commemorated by these gestures, the relationship between the Commission and independent mutual fund directors promises to be close and cooperative. Our nation's mutual fund investors are relying on us to work together to protect their interests.
In fact, independent mutual fund directors and the Commission play important complementary roles that form the foundation of our regulatory structure governing fund fees and expenses. At base, our focus is on effective fund governance and disclosure as the two key elements. We have a regime that is designed, through the efforts of fund boards, to ensure that advisers act in the best interests of investors and that fees and expenses are kept in check. It is also dependent on an effective disclosure and transparency program administered by the Commission that arms investors with useful information to enable them to make rational investment decisions.
Today, I will discuss our efforts concerning both fund governance and transparency, and then focus on what additional steps I believe are necessary, at a minimum, to address market inefficiencies that are evident notwithstanding our ongoing efforts.
Before I get too far along though, please let me remind you that my remarks represent my own views, and not necessarily those of the Commission or my fellow Commissioners.2
As you know, the growth of the U.S. mutual fund industry in the last 25 years or so has been extraordinary. In 1979, assets under management stood at nearly $135 billion. Now, they amount to more than $10 trillion.3 The industry shows no signs of slowing down, as mutual funds continue to be the vehicle of choice for individual investors, whether baby boomers or their progeny, to invest for their futures. In fact, the percentage of U.S. households investing in mutual funds has increased dramatically over time, from roughly 6% in 1980, to 48% in 2005.4
The rise in popularity of mutual funds among individual investors has brought into greater focus the level and transparency of mutual fund fees and expenses. These fees and expenses include the transaction costs of buying and selling mutual funds, such as commissions and sales loads, and ongoing fund costs, such as advisory and 12b-1 fees.
It is clear that investors can have a difficult time understanding mutual fund costs. For example, notwithstanding the information appearing in the fee table, many do not understand terms like "12b-1 fees." Further, long prospectuses may cover multiple mutual funds and generally contain a wealth of information that may be hard for investors to absorb. Perhaps this is one reason why many seem to make investment decisions based more on the advice of friends or co-workers than on current fund disclosure documents. Investors also tend to focus intently on the past performance of mutual funds rather than giving proper weight to the effect of fees and expenses on that performance.5 In fact, fund expenses are critically important in determining an investor's return over time. A 1% annual fee, for example, will reduce an ending account balance by 18% on an investment held for 20 years.
Given the importance of fees and expenses, it is no surprise that much of our regulatory focus has been on making these costs more transparent and strengthening the ability of the board, through its independent directors, to address these issues more effectively.
Thus our oversight regime contemplates the Commission and independent directors having mutual interests in protecting investors with respect to mutual fund costs. Independent directors are the backbone of the procedural safeguards put in place to keep fees and expenses in check, while the Commission is primarily charged with ensuring that prospective investors have sufficient disclosure regarding costs in order to make investment decisions.
Mutual Fund Governance
The first leg of the current regulatory framework governing mutual fund costs involves having independent directors in place to reduce the conflicts of interest that could lead to inappropriate or inflated fees.
Congress and the Commission have taken a number of steps to facilitate your ability to do this. In doing so, we have reaffirmed the important role that you play in protecting fund investors, strengthened your hand in dealing with fund management, and reinforced your independence.
For example, the Investment Company Act requires that a majority of a fund's independent directors approve the initial investment contract between the investment adviser and the fund, as well as any renewals. During this process, fund directors evaluate relevant information, such as the advisory fee paid by the fund, the services provided by the adviser, and the profitability of the fund to the adviser.
Congress strengthened the ability of independent directors to carry out their responsibilities to review and approve advisory contracts in 1970. Among other things, this included adding Section 36(b) to the Investment Company Act to provide that advisers have a fiduciary duty regarding all compensation that they receive from mutual funds.
The Commission, for its part, has ensured that independent fund directors are in place to police conflicts of interest between a fund and its affiliates regarding the use of fund assets to finance distribution. Under rule 12b-1, a fund may adopt a plan to provide for the payment of distribution expenses from its assets, but among other things, a majority of the fund's independent directors must approve the payments annually. They must also decide whether there is a reasonable likelihood that the plan will benefit the mutual fund and its shareholders.
Also, in 2001, the Commission adopted amendments to require that, for mutual funds relying on its exemptive rules, independent directors constitute a majority of their boards, independent directors select and nominate other independent directors, and any legal counsel for the independent directors also be independent.
Due in part to the Commission's continued concerns about fund governance, in 2004 we took steps to increase the percentage of independent fund directors to 75% and to require mutual fund boards to have independent chairs. Although these efforts were ultimately overturned after a court challenge, our actions evidence the reliance that we place on the role of independent directors.
Also in 2004 we took action to encourage fund boards to engage in vigorous and independent oversight of advisory contracts by improving the disclosure regarding how they evaluate and approve, and recommend shareholder approval of, investment advisory contracts.
The Commission has taken other steps that have impacted this audience directly. In 1999, for example, Chairman Levitt announced the creation of the Mutual Fund Directors Education Council in order to improve fund governance. As you may know, Chairman David Ruder chaired that group, which just a short time later grew into what is now this very Mutual Fund Directors Forum. I believe that the Forum has made great strides towards fulfilling its mission of promoting vigilant, dedicated, and well-informed independent directors and serving as their advocate on policy issues.
Also, most independent board members have taken their responsibilities very seriously and have done all that is within their power to satisfy their fiduciary obligations. In fact, boards are focused more than ever before on many material aspects of fund operations, including best execution analyses and soft dollar oversight.
The second leg of our mutual fund oversight effort relates to transparency. You undoubtedly know that whenever an SEC official talks about transparency, he or she takes on the tone of a religious zealot. That is unavoidable. Transparency and disclosure are imbedded in our statutory mandate and we truly believe in their benefits. Transparency is embodied in virtually all of our regulatory initiatives and this area is no exception. And with good reason. Effective transparency leads to more informed investor behavior and better markets. It is that simple. Thus, we have had a long history of trying to get it right on the transparency side of the mutual fund equation.
Going back to 1983, the Commission introduced an innovative approach to mutual fund prospectus disclosure by adopting a two-part format that permitted a mutual fund to provide investors with a simplified prospectus containing essential information about the fund and to place more detailed information in the SAI, which investors could obtain upon request. Under this layered approach, the more essential information would be found in the prospectus, with the SAI providing additional details for those who wanted it. Also, the Commission later required funds to disclose their fees in a uniform fee table.
As the fund industry continued to grow, and the complexity and sophistication of fund operations and investments along with it, the Commission recognized that the prospectus was becoming less helpful in meeting the informational needs of investors.
As a result, starting in 1998 we permitted mutual funds to use a new disclosure document called a "profile," which provided investors with key information about the fund, including its investment strategies, risks, performance, and fees, in a concise, standardized format. We also undertook a major overhaul of the prospectus disclosure requirements for mutual funds in order to provide investors with clearer and more understandable information. This included a requirement that every prospectus contain a risk/return summary that would provide investors with a type of "executive summary" of key information about the fund, including its fees.
The Commission crafted these two initiatives to promote more effective communication of information about funds to investors without reducing the amount of information provided to them. The initiatives also reflected the Commission's strong belief that the primary purpose of the disclosure in a fund's prospectus is to help an investor make a decision about investing in the fund. Consistent with this belief, the objective was to provide investors with prospectus disclosure that presents clear, concise, and understandable information.
More recently, the Commission has made other changes to improve the transparency of mutual fund disclosure regarding fees and expenses by adopting amendments requiring disclosure of a fund board's basis for approving an existing advisory contract and the effect of taxes on the performance of mutual funds.
Also, in response to specific concerns raised about the degree to which investors understood the nature and effect of the ongoing fund fees, the Commission required funds to provide disclosure in their shareholder reports about expenses borne by shareholders. This disclosure was important because it permitted investors to estimate their actual costs, in dollars, and provided a basis for comparing the ongoing costs of different mutual funds.
The Commission also banned directed brokerage in part because the practice had migrated beyond what the Commission had originally intended, and because of a concern that it might harm investors by diminishing the transparency of fund distribution costs and the ability of investors to understand them.
All of these efforts were thoughtful attempts to improve the disclosure that is available to investors. The question, though, is whether these regulatory measures have been successful in achieving the desired results. We remain concerned, notwithstanding all of these efforts and the diligence of fund boards, that mutual fund fees remain elusive and poorly comprehended by investors. The result is arguably a failure of market forces to constrain fees adequately or a failure of current disclosure to enable investors to make rational decisions that are in their economic best interests.
It should be apparent from my comments to this point that I continue to support efforts to enhance disclosure and assist independent directors in constraining fund costs under the current regulatory framework.
But the results have been far from perfect. We have known for some time, for example, that many investors are not currently using fund disclosure documents when they make investment decisions. We made significant efforts in 1998 to address these very issues when we overhauled the mutual fund disclosure regime and permitted funds to use a profile. Despite its early support and a role in the development of the profile, the fund industry has not widely used it. A large part of the reason for this relates to funds' concerns over liability.
It is my hope that we will have the opportunity to consider further reform of the mutual fund disclosure regime in the near future. Our staff is currently undertaking a project to recommend to the Commission a streamlined, short-form disclosure document that would be delivered to mutual fund investors, with a more detailed document available on the Internet or delivered in paper upon request. The staff envisions that the streamlined document could include key information necessary for investors to make investment decisions, such as fees and expenses, risks, investment objectives and strategies, and historical returns.
I believe that fund disclosure reform is necessary to improve further the transparency of fund costs for investors. Simply put, we need a disclosure document that prospective mutual fund investors can use when they make investment decisions, and we know that the current prospectus is not serving them well.
This means that we need to get fund disclosure into the hands of prospective investors when they are most likely to use it. We know from experience that this is not with a confirmation statement, but instead at the point of sale. Although the Commission currently has outstanding a proposal regarding point of sale disclosure, I think it would make sense for us to revisit and recalibrate it in conjunction with mutual fund disclosure reform. Consequently, I believe that it makes sense to consider whether broker-dealers should be required to provide a streamlined prospectus, along with broker-specific cost and conflict information, to prospective investors at the point of sale.
The Commission's efforts regarding XBRL should also help to improve the transparency of mutual fund costs. As you may know, the Commission recently proposed to extend its interactive data voluntary reporting program to include mutual fund risk/return summary information. The tagging of key information could help streamline the delivery of mutual fund information and provide investors with improved tools to compare funds based upon costs.
In addition to taking steps to improve transparency regarding mutual fund costs, the Commission should also find ways to tackle, or better yet, take steps to enable market forces to tackle, the fees themselves. For example, we should take a hard look at 12b-1 fees and at a minimum, determine whether distribution costs for mutual funds should be priced more explicitly. Although they are currently disclosed, investors do not appear to understand the nature or extent of the charges, partially because they are paid through reduced returns. The more explicit the pricing of distribution expenses, arguably the more sensitive that investors will be to these charges, and the more market discipline will be imposed in the process.
Also, the Commission should consider asking Congress to amend Section 22(d) of the Investment Company Act to end mandatory retail price maintenance. Among other things, it appears that developments in the industry since 1940 have eliminated the rationales that apparently prompted the enactment and retention of this provision. For example, riskless trading by fund insiders to the dilution of other shareholders was eliminated with rule 22c-1 and "forward" pricing. Also, and importantly, eliminating this provision would have a positive effect on mutual fund costs, as it would introduce price competition among dealers.
After taking these steps, we should take the time to evaluate our progress and determine the effect that these steps have had on mutual fund fees and expenses. If they have not had the desired results, we should look further to structural or other possible responses. The mutual fund industry is too important, and the effect of costs on returns too large, for the Commission to be complacent in this area.
I am optimistic that we can continue to rely on the thoughtful assistance of independent directors as we consider further reforms in the mutual fund area.
I very much appreciate the opportunity to be with you today and share my thoughts and I look forward to an ongoing dialogue with you on these important issues.