This Year in Funds: The Responsibilities of Prosperity Keynote Address Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission 1996 ICI Securities Law Procedures Conference Washington, D.C. December 3, 1996 This Year in Funds: The Responsibilities of Prosperity1 Introduction Thank you, Craig. In about a month or so, a sports magazine of some renown publishes its wrap-up issue called "The Year in Sports." Nineteen-ninety-six has been a remarkable year in the world of sports -- the United States hosted the Olympics and the U.S. women's gymnastic team won the gold in a dramatic victory, the Yankees won the World Series for the first time in 18 years (and gave me hope once again that the Red Sox could be next), and Michael Jordan inspired the older athletes among us by coming out of retirement to bring the NBA championship back to Chicago. This year in sports is only matched by this year in funds -- at least in my eyes. Throughout 1996, business conditions for the fund industry have been nothing short of spectacular. In the first nine months of this year alone, mutual funds of all types had net sales of almost $290 billion. This figure, when annualized, represents about 6.5 percent of personal income in the United States, and is a full percentage point higher than the nation's personal savings rate. If current trends continue, every single savings dollar produced by households in 1996 (and then some) will go into a mutual fund. Fund assets during the past year have increased by more than $600 billion -- the size of the entire fund industry only a decade ago. Stock fund assets now equal 17 percent of this country's gross domestic product -- in Japan the percentage is three percent, while in Germany it is only one percent. Just last week it was reported that, for the first time in history, stock funds themselves have taken in more than $200 billion in a single calendar year. Numbers alone do not reflect the extent of the good times for the fund industry. The recent enactment of the National Securities Markets Improvement Act of 1996 represents a significant milestone in the history of the mutual fund industry, and offers new opportunities for growth and innovation. Responding to concerns raised by the industry over the past decade, the 1996 Act seeks to rationalize the regulatory scheme by preempting state regulation of mutual funds. By reducing duplicative and costly regulation in this way, the Act could have a dramatic effect on the day-to-day operations of all funds. Fund marketing operations could be significantly improved by the 1996 Act's provision permitting the use of advertisements that are not tied to the contents of prospectuses. The 1996 Act also contains a number of other sections that could encourage fund sponsors to offer novel and improved investment products, ranging from more flexible funds of funds arrangements to enhanced insurance company products. In the midst of tremendous growth and legislative success, it would be most inviting for the fund industry simply to rest on its laurels. To do so, though, would not only be short-sighted, but also would be bad business. The industry's record of achievement has been built on a basis of public trust. Its ability to maintain investor confidence as it continues to evolve is the key to its future success. Investor confidence may easily erode without conscientious attention to areas of concern in the industry. My remarks this morning will focus on some of the issues that confront the fund industry as it looks toward the future. The remarks are not meant to cast a shadow on the industry's successes, but rather to highlight some of the challenges that remain. I. Internal Compliance/ Supervision The fund industry's stellar record this year overshadowed three disconcerting examples of improperly supervised portfolio managers. Early this year, the Commission brought enforcement proceedings against a portfolio manager, Thomas Rogge, and his employer, Van Kampen American Capital Asset Management, alleging that Mr. Rogge had mispriced securities held in a mutual fund advised by Van Kampen American.2 The Commission found that Mr. Rogge violated the securities laws by using his own higher valuations to misprice the securities and inflate the fund's NAV, after the broker-dealers from which the fund historically had obtained quotations ceased pricing the securities.3 In a related action against Van Kampen American Capital, the Commission found that Van Kampen failed to supervise Mr. Rogge sufficiently by giving him too much control over the pricing process with little or no oversight by anyone in a supervisory capacity.4 The Rogge case has much in common with two recent incidents involving foreign money managers and foreign securities regulators. In August, following a joint inquiry by British and Hong Kong regulators, Jardine Fleming, a Hong Kong bank linked to Robert Fleming, a British merchant bank, was ordered by Hong Kong officials to pay compensation of some $19 million to clients victimized by the abusive and unsupervised securities allocation practices of Jardine Fleming's chief fund manager and investment star, Colin Armstrong. Mr. Armstrong was reported to have engaged in a practice of delaying the allocation of securities transactions executed on behalf of Jardine Fleming clients in a manner that benefitted himself or a favored Jardine Fleming fund. This past September, trading in three British funds advised by the U.K. firm of Morgan Grenfell, a subsidiary in the Deutsche Bank group, was suspended pending review of the funds' holdings of an unusually large portion of unquoted Nordic technology stocks. The day after the suspension, Deutsche Bank paid approximately $280 million to purchase certain of these securities from the funds. British regulators have been reported to be investigating how the funds' portfolio mangers were allowed to build up large holdings in relatively unknown and risky firms, and whether those holdings were mispriced. A recent Economist article suggested that the Jardine Fleming and Morgan Grenfell incidents should make fund investors sleep a little less soundly.5 More importantly, cases such as these and Rogge should serve as a high decibel warning to the fund industry of the critical importance of strong internal compliance procedures covering sensitive areas such as pricing and allocation of securities. A fund's compliance procedures must restrict those who have conflicts of interest from playing a central role in the pricing and allocation processes, and implement safeguards to ensure accurate pricing of all fund assets. Funds also need to have effective systems of monitoring and supervision that specify permissible pricing sources, provide for routine checks on pricing, and, in the event of price overrides, provide for prompt review. Although these systems and procedures come at a cost, it's well worth the price -- otherwise, funds or their managers may find themselves paying the cost of losses resulting directly from inadequate compliance, the cost of lost business resulting from negative publicity, and quite possibly the cost of defending lawsuits or enforcement actions. II. Soft Dollars A practice that has, in the eyes of many, haunted the investment community (including funds) for close to 25 years is the use of soft-dollar payments. In announcing last month a special examination of soft-dollar practices of investment advisers, broker-dealers, and institutional investors, to be undertaken by the Commission's Office of Compliance Inspections and Examinations, Chairman Levitt said that he "personally abhor[s] the use of soft dollars" and that the Commission "intend[s] to review these arrangements to detect abuses . . . ."6 In a letter to Chairman Levitt, ICI President Matthew Fink, characterized the review as "timely and highly appropriate."7 Pending completion of OCIE's examination, fund managers, fund directors and trustees, and fund counsel would be well- advised to look carefully at existing fund soft-dollar practices and procedures. The types of services and products paid for in soft dollars, and the effect of these payments on the prices funds pay for executions of securities transactions, warrant special attention by fund management and board members. Fund counsel should be concerned with the legal basis or bases underlying fund soft-dollar practices, including the operation of Section 28(e) of the Securities Exchange Act of 1934. Counsel should also carefully review a fund's soft-dollar practices that fall outside the Section 28(e) safe harbor, such as directed brokerage arrangements, to ensure that the services obtained through these arrangements directly and exclusively benefit the fund. III. Management Fees As the fund industry has grown dramatically over the past decade, advisory fees, to the surprise of many, also have risen. Between 1988 and 1996, median advisory fees for general equity funds, for example, increased from 65 basis points to 73 basis points. According to a recent New York Times article, funds that began operations during the past two years charge an average of 72 basis points in management fees -- about 40 percent higher than the average management fee 50 years ago.8 As Morningstar Mutual Funds noted in a recent commentary, despite the industry's explosive growth, which might have been expected to lead to lower fees, fund companies are now charging their highest management fees ever.9 To date, the response of many in the industry to the increase in advisory fees is simply to explain it away or minimize its importance. I am not going to stand here this morning and assess the validity of the various explanations for higher fund management fees. Nor am I going to outline a major Commission initiative to drive fees down, although I would note that we are starting to take a hard look at whether the fees charged by certain funds meet the standards of Section 36(b) of the Investment Company Act. I am going to suggest, however, that industry participants, from fund sponsors to independent directors and trustees, take a forward-looking approach to the level of management fees. As the Morningstar commentary to which I referred earlier noted, the recent increase in advisory fees is hard to justify and ultimately would not seem to be sustainable by an industry that, to remain competitive, must provide better returns at lower costs than other investment options. Moreover, as we all seem willing to accept, the market's performance will have to come down at some time in the future, as will fund performance. Lower performance inevitably will lead to unhappy shareholders who will redeem their shares or start to look more carefully at fees and ask whether those fees are consistent with the provisions of the securities laws. Section 36(b) suits, whether brought by shareholders or the Commission, would likely not only mar the reputation of the funds against which they are brought, but likely would also cast a shadow on the industry as a whole. IV. Performance Advertising A Wall Street Journal article from last month described a recent industry survey that found that 85 percent of the mutual fund investors surveyed believed that the stock market, and presumably many mutual funds, over the next decade will match or exceed the 14 percent annual return for the ten years ended last December.10 The story continued by noting that this percentage is far above the long-run average and that achieving comparable returns will be difficult in the next decade.11 The Journal article suggests that the fund industry is far from winning the battle of educating the investing public about the limits of past performance in assessing funds' future results. I am particularly troubled that some funds don't seem willing to participate in the battle at all. I see too many funds over-emphasizing their short-term performance by, for example, claiming to be number one among a peer group of funds since an arbitrarily selected date or since the funds' inception. In many of these cases, the funds downplay that the performance results they are touting were achieved over a fairly short period, such as a year or less. Although the funds' advertising material may well meet the technical requirements of the federal securities laws, these funds strike me as being somewhat less than responsible in dealing with fund investors. Responsible marketing and sales practices are essential to the industry's long-term success. A fund's marketing and sales practices create the basis of the fund-shareholder relationship. We all know that investors frequently make investment decisions based on sales material. If a fund relies on exaggerated or less than straightforward sales pitches or sales literature to attract investors, it may well end up with unhappy shareholders who probably shouldn't have invested in the fund. On the other hand, if a fund employs an accurate, balanced presentation that shows both the potential rewards and the risks of investing in the fund, it will attract the right investors -- investors who are more likely to remain long-term investors. I am not suggesting that performance information is inherently bad or that it should be banned. I do believe it is imperative, though, that all funds that use performance information in their sales materials do so responsibly. This was the message the Division of Investment Management sought to send recently when we confirmed that a new fund can include in its prospectus past performance of other accounts similarly managed by the fund's investment adviser or portfolio manager. In taking this position, we emphasized that the performance information of the other accounts must not be presented in a misleading manner and must not impede understanding of information that is required to be in the prospectus. Some have portrayed our position as a "green light" for funds to present a greater array of past performance information in their prospectuses. To my mind, this is an overstatement. I would instead characterize our position as a "yellow light," contemplating the presentation of past performance subject to the caveat that it not be misleading. The past performance must be set out in a straightforward manner that does not imply that it is the fund's own performance. In addition, even if clearly distinguished from the fund's performance, the presentation of past performance information may nonetheless be misleading if it does not reflect significant differences between the way in which the fund is to be managed and the way in which the other accounts were managed. Will the fund, for example, be limited by restrictions not imposed on the other accounts? Will a portfolio manager have the same resources at her disposal in serving a new fund as she had in managing other accounts for another adviser? In short, disclosure regarding other accounts of the adviser or portfolio manager must provide sufficient information to permit an investor to understand what the performance information is, and what it isn't. In our review of disclosure documents and examinations of funds and broker-dealers, we have been, and will be, looking closely at the use of performance data to make sure that it passes this test. V. Prospectus Simplification Effective communication with investors is fundamental to the fund industry's continued ability to maintain public trust and inspire investor confidence. As the number of mutual funds continues to grow, and operations and portfolio investments become more sophisticated, investors crave straightforward information about funds and the risks of investing. Surveys show that investors would prefer to get that information from a fund's prospectus, but that they have trouble finding it there. More than ever, investors are placing a premium on good, clear disclosure -- they see added value in companies that produce informative, easy-to-read documents that help, rather than hinder, the process of making an investment decision. Recently, some fund companies have taken a hard look at their prospectuses and have put significant effort into reforming them. These funds have realized that good disclosure and frank communications with prospective and existing shareholders are vital to the funds' continued success. By improving communications about their investment objectives and strategies, risks, and costs, funds can educate today's investors and shape tomorrow's expectations. One would think that more funds would want to do everything they could to ensure that their shareholders have a good understanding of their investment and a realistic view of the future. Surprisingly, however, these companies are still in a decided minority. Over the past three and a half years, the Commission has worked steadily toward achieving better mutual fund disclosure: * With the Commission's support, the Division is working hard to make the disclosure review process a catalyst for change by encouraging the use of innovative disclosure formats to achieve better disclosure results. The Division has assisted those funds that have rewritten their prospectuses to speak more plainly to investors. These pioneers have inspired others to follow suit. * The Division has been working to develop a better form for the mutual fund prospectus. We have a good template in Form N-1A, but we have identified many ways in which it could be improved to elicit better information about a fund and how it is managed. * The Commission and the industry have worked together to create a new disclosure option for investors in the form of a fund profile. Many investors have told us that they find a short, standardized disclosure document to be a useful tool in sorting out the vast information available about a fund. We anticipate that, in the very near future, the Commission will publish for public comment a series of proposals designed to improve the prospectus, implement the fund profile as an additional information source for investors, and enhance risk disclosure. These proposals should help to promote more effective communication about funds without limiting the amount of information available to investors. If nothing else, all of these initiatives show the strong commitment of the Commission and the Division to achieve the most significant reform of mutual fund disclosure practice in over a decade. We are clearly on the disclosure bandwagon. The bandwagon will stall, however, if we are not joined by all industry participants. In the end, it is not the Commission or its staff that can deliver better disclosure documents. The challenge rests squarely on the shoulders of the fund industry. We are committed to giving the industry the framework and the flexibility it needs to do the job well. We expect that the industry, in turn, will meet its challenge and produce informative disclosure documents that communicate effectively to investors. Conclusion This is a time of great prosperity in the fund industry -- prosperity that has been built on the industry's reputation for integrity and trustworthiness. This record brings with it new challenges to achieve even greater success in the future. In going forward, the fund industry cannot afford to stop and reflect upon past achievements. Rather, in pursuing new opportunities, it must vigilantly and continually root out those practices that may threaten the industry's integrity and reputation. As that eminent philosopher, Satchel Paige, once said, "[d]on't look back. Something may be gaining on you." If the industry is able to look forward and address issues before they become crises, nothing will have a chance to gain on it, and it will retain its most valuable asset -- the trust of public investors. Thank you. _______________________________ 1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission. 2 In the Matter of Thomas M. Rogge, Investment Advisers Act Release No. 1472 (Feb. 22, 1995); In the Matter of Van Kampen American Capital Asset Management, Inc., Investment Advisers Act Release No. 1525 (Sept. 29, 1995). 3 Thomas M. Rogge, supra note 2. 4 Van Kampen American Capital Asset Management, Inc., supra note 2. 5 Funds of Disappointment, Economist, Sept. 7, 1996, at 72. 6 See Brett D. Fromson, SEC to Review Brokerages' Payments to Investment Advisers, Wash. Post, Nov. 5, 1996, at C1. 7 Letter from Matthew P. Fink, President, Investment Company Institute, to the Honorable Arthur J. Levitt, Jr., Chairman, U.S. Securities and Exchange Commission (Nov. 11, 1996). 8 Carole Gould, Management Fees: Defying Gravity?, N.Y. Times, Nov. 24, 1996, sect.3, at 8. 9 Amy C. Arnott, The Rising Tide, Morningstar Mutual Funds, Oct. 11, 1996, at S1. 10 Jonathan Clements, Keeping Perspective: Lower Expectations May Bring Happier Long-Term Results, Wall St. J., Nov. 26, 1996, at C1. 11 Id.