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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Challenges for the Mutual Fund Industry
in the Competitive Frontier

Remarks by

Paul F. Roye

Director, Division of Investment Management
U.S. Securities & Exchange Commission

At the 2000 Mutual Funds and Investment Management Conference
Palm Desert, Calif.

March 27, 2000

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 herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

In following such distinguished speakers as Marianne Smythe and Matt Fink, I pondered long and hard what I could say that would be as profound and insightful as their remarks. After some thought, I determined that I would focus on what we might learn from the use of "pigeons," a much maligned bird, which I have often heard referred to as "rats with wings." I don't even think they have pigeons in Palm Desert – they can't afford the nests. But seriously, Nathan Rothschild, one of the greatest financiers in history, discovered that he could use carrier pigeons to obtain a higher quality of information, faster than anyone else. These carrier pigeons, which were like an early intranet, or a pre-electronic e-mail system, kept Rothschild hours, days, even weeks ahead of what his competitors were doing in the early banking days in Europe. As a result, he utilized that information to make better financial decisions.

You history buffs know that the battle of Waterloo was fought in June of 1815. In February of 1815, Napoleon escaped from Elba and assembled what was viewed as an invincible army. The Allies, having fought Napoleon's armies for fifteen years, were nearly bankrupt. The Allies, however, conscripted another rag-tag army and sent it to Belgium under Wellington's command to meet Napoleon's large and seasoned on-coming forces. But no one – including those in the financial markets – believed the Allied Army would defeat Napoleon.

Napoleon's victory seemed all too likely and the price of British government bonds reflected that prospect. Now we all know what the outcome of the Battle of Waterloo was – but so did Nathan Rothschild. As the story goes, flocks of carrier pigeons kept him apprised of the battle, allowing him to buy British government bonds at rock bottom prices, thereby enabling him to create another fortune when news of the victory arrived by normal means to Britain's shores. Rothschild realized that using the most advanced means available to quickly secure information was critical to success in the securities markets. Then, as now, innovation was key. But even the Rothschilds were overtaken by it. Their control over the flow of information through a network of couriers and carrier pigeons was so effective for a time, that Europe's heads of state relied on it. But after the telegraph rendered this network obsolete, James Rothschild, brother of Nathan, complained that now "anyone can get the news." It is clear that the mutual fund industry must innovate, embrace technology and use it to remain competitive.

We all are devoting a lot of our time and energy to keeping abreast of the technological revolution underway in the securities markets. Electronic Communication Networks, or ECNs, are challenging traditional stock exchanges. The nation's stock exchanges are considering shedding their long-held membership status. On-line trading has expanded the base of a powerful force in today's markets – the retail investor, and perhaps led some investors to believe that they are better off day-trading securities on-line, rather than pursuing a traditional buy and hold mutual fund strategy. Institutional trading has increased the demand for greater liquidity, anonymity, and even new trading venues. Market participants are demanding more: twenty-four hour trading, decimalization, immediate execution of orders and lower costs. In today's economy, all markets and all market participants must respond to new rules and new imperatives – not just to compete, but to survive. However, amidst the greatest technological revolution America's securities markets have ever seen, the fund industry must remain true to the fundamental keys to its success.

By any measure, the fund industry has enjoyed tremendous success in the last several decades. One need only look to the growth in this conference to appreciate the success the industry has enjoyed. The fund industry has become the principal trustee of the nation's savings, with 77 million investors having invested their hard earned dollars in mutual funds. Open and closed-end funds today own nearly 17% of the value of all equity securities trading in the United States – more than any other type of institutional investor. Clearly the growth of the industry to almost $7 trillion has not only been beneficial for the mutual fund industry, it also has been beneficial for the U.S. economy and fund investors. While the longest bull market in history has contributed to the success of the industry, it should also be recognized that this success has been achieved because of the confidence that investors have in the mutual fund industry. At the doorstep of the new millennium, we need to ask how the industry will continue this record of success, in an environment of increased competition.

Some industry observers are predicting a slowdown in the growth of mutual fund sales as the industry matures. These observers predict that fund sales will continue to grow, but not at the rapid pace they did in the 1990s. Indeed, the pace of fund sales slowed in 1999. Prior to that year, net sales had risen every calendar year of the decade except in 1994, when the Federal Reserve Board raised interest rates six times. In 1999, however, total cash inflows declined by one-third, to $36 billion a month. Observers have attributed the slowdown in fund sales to a variety of factors, including the popularity of on-line investing, profit-taking as stock indices fluctuated around their all-time highs, lackluster performance in the small-cap and value sectors, and lingering fears about investing in general due to the episodes of market volatility in 1998.

Given the pace of the changes in the markets and the press of competition, it is understandable if much of the thinking is short-term and reactive. But I want to challenge members of the industry to think in broader strategic terms about their responses to these pressures, just as we at the Commission must also. As we do, it is important to keep in mind some fundamental concepts.

Nature of Mutual Funds

I believe strongly that a large part of the mutual fund industry's past success has been its ability to present investors with the many straightforward benefits of having their money managed on a pooled basis by fund managers. These benefits include diversification, professional management, economies of scale, low initial minimum investments and the "redeemability" of fund shares.

Increasing Competition

However, while mutual funds have experienced unprecedented growth, many competitors today are aggressively questioning the benefits of mutual fund ownership and are trying to lure fund investors with new products. On-line brokerage ads promise fabulous riches. On-line trading has made it cheaper and easier for individual investors to buy their own stocks. While funds have benefited from the bull market, such a market also tempts some investors to try picking their own stocks even when they don't have the expertise to do so.

Broker-dealers increasingly are offering brokerage accounts with asset-based fees or use other alternative pricing structures, and are developing products that compete with, and are alternatives to, mutual funds. These asset-based pricing structures now are highly competitive with the costs of mutual funds.

Separately managed accounts also pose a threat to mutual fund sales levels, as a client can open a separately managed account with as little as $100,000. Thanks to technology, which has provided better software and portfolio management systems, investment managers who in the past would take institutional accounts with a minimum of $5 million or higher, are more willing to take much smaller accounts, including retail accounts. The major wire houses doubled their sales of separately managed accounts in 1998 but had only a five percent increase in mutual fund sales. According to the Money Management Institute, total assets in managed accounts jumped from $163 billion in 1996 to $321 billion at the end of 1998.

Additionally, wrap account costs are dropping, making these accounts more competitive with mutual funds. Those offering these products are moving away from the steep 3 percent fees charged in the early 1990s.

Financial advisers increasingly are attracting investors from funds by offering customized portfolios, and services over the internet that hold out the prospect that individuals will be able to create and manage their own portfolios or create a virtual mutual fund on-line, consistent with the investor's risk tolerance, time horizon and tax situations. In other words, technology is making mass customization more feasible.

The growth in exchange traded funds also presents a challenge for the fund industry. These non-traditional funds, with names like SPDRs, WEBs and DIAMONDS, have obtained exemptive relief from the Commission to facilitate secondary market trading in their shares. These funds have enjoyed tremendous growth. Assets in exchange traded funds listed on the American Stock Exchange, where almost all of these funds are traded, have risen from $2.4 billion three years ago to over $23 billion as of the end of last year. Promoters of these products assert that they offer the same type of diversification and low operating expenses that come with traditional index funds, but with the added benefit that they can be bought and sold at any time of the day and the shares can be sold short.

How Will Funds Respond?

How will the fund industry respond to these competitive pressures and rapid technological changes? To stay competitive, mutual fund companies are starting to create and market new types of funds. We are seeing an increasing number of internet funds, tax-managed funds, market-neutral funds and stable-value funds. We may also be seeing a revival of the fund of funds. As directed by Congress in NSMIA, the Commission recently permitted a fund of funds that makes significant investments in unaffiliated funds.

More broadly speaking, our Disclosure office is seeing new funds with some rather creative investment philosophies. Some funds offer novel benefits to their investors, others merely gimmicks. Still others sacrifice sound investment principles for clever marketing appeal. However, the rush to develop attractive products cannot come at the expense of products and services that offer investors real financial benefits and value. Nothing less than the long-term health of the industry is implicated.

Mutual funds are attractive to investors because of the benefits of diversification, economies of scale and the access to professional money management. But just as important is the transparency of daily mutual fund pricing and investors' ability to redeem or exchange shares when circumstances dictate. Indeed, it is the redeemability of open-end fund shares that rescued the fund industry after the stock market crash in 1929. Prior to 1929, most sales of fund shares were of closed-end funds. After the crash, not surprisingly, the supply of shares in these funds exceeded the demand, and closed-end fund shares began trading at a discount. This liquidity crisis precipitated the emergence of unit investment trusts and open-end funds. Shareholders recognized the advantage that these vehicles offered over closed-end funds, since they offered the ability to redeem shares for cash at the funds' net asset values. During the legislative hearings that led to the enactment of the '40 Act, David Schenker, one of the Act's draftsmen, stated: "Undoubtedly, the most important single attribute which induces purchases of the securities of open-end companies by the public is the so-called redemption feature' of such securities – that is, the assurance that the shareholder may tender his shares to the company and receive at once, or in a very short time, the approximate cash asset value of such shares as of the time of tender."

Consequently, the redeemable security definition in the '40 Act requires that a fund shareholder receive approximately his or her proportionate share of the fund's net assets upon redemption. A fee payable upon redemption may take the securities issued by the fund outside the definition of "redeemable security" in the Act and thus raises questions as to whether a fund should be regarded as open-end. The SEC staff has taken the position that a fund may impose a redemption fee of up to 2 percent without raising the redeemability issue if the fee is reasonably intended to compensate the fund for expenses directly related to the redemption of fund shares.

We recognize that redemption fees can have legitimate purposes, such as requiring investors to bear the costs of exiting the fund and deterring short-term trading. However, redemption fees should not be imposed at a level that imposes a penalty on an investor's ability to redeem out of a fund. In fact, we are told by representatives of various major fund groups, that a redemption fee of 2% or less is an effective deterrent against market timers. We have become increasingly concerned about this issue, particularly in light of the fact that last year's inflows into funds slowed and there may be increasing pressure to hold onto fund assets.

While we are committed to protecting the fundamental concept of redeemability reflected in the statute, we recognize that the Commission should be flexible in recognizing that there can be justifications for exemptions from the redeemability requirement. For example, the Commission has used its exemptive authority to permit the imposition of contingent deferred sales loads as an alternative means for an investor to pay for distribution-related costs.

As funds respond to increased competition, they face some fundamental choices in how they will compete and hold on to investors' dollars. Redemption fees at penalty levels are not the answer. Funds should be trying to eat the competition, not the franchise.

Investors are becoming increasingly aware of the significant, long-term effect of fund fees on their returns. If television advertisements are to be believed, on-line brokerage services have the power to attract investors in transcendental droves. Will funds also take full advantage of market developments that lower trading costs? Will mutual funds harness the power of the internet and other technological advances to operate more efficiently? Will they pass these savings on to shareholders in the form of lower fees?


One fear that we have is that funds will respond to the competitive environment with overly aggressive advertising. A number of funds achieved extraordinary triple digit returns in 1999. Few investment professionals, including the fund managers who achieved these returns, believe that these numbers are sustainable. Advertisements that lead investors to expect these returns are at best opportunistic; at most, they are misleading.

This is an area of particular concern to the Chairman. Chairman Levitt has asked the Division of Investment Management and our Office of Compliance Inspections and Examinations to conduct a special review of fund marketing – including fund websites, sales literature and advertisements. The purpose of the review is to determine whether a fund's actual portfolio performance and investment strategy are consistent with its website statements, its advertising and its disclosure in its prospectus. Are these funds telling the whole story in their marketing efforts to attract new investors? We have indicated that we will not tolerate the misuse of performance information to mislead investors.

Nevertheless, we will proceed with amending Rule 482 to eliminate the requirement that the substance of the information contained in the advertisement be derived from the statutory prospectus. Eliminating this requirement should result in funds being able to provide investors with better and more timely information. We will seek to promote in the rule, balance and responsibility in fund advertising. In this effort to modernize the advertising rules, we are working closely with the NASD, which has principal responsibility for reviewing fund advertising.


Let me turn to another factor which could significantly impact the fund industry, and that is the prospect of increasing consolidation in the industry. While the Commission recently proposed the privacy rules required by the Gramm-Leach-Bliley legislation, it remains to be seen how this financial services modernization legislation will impact the securities industry and the mutual fund industry in particular. Already, some middle-tier firms have been gobbled up by larger competitors. Will Citigroup, through the merger of banking giant Citicorp and the insurance behemoth Travelers Group, be the model for future consolidation?

How will these consolidated industries meet the needs and expectations of investors? What about compliance strategies in a mega-firm that suddenly finds itself more diverse, with divergent practices, conflicting cultures and increasingly complex affiliations?

As banks, insurance companies and securities firms merge, the boards and shareholders of mutual funds will be called upon to take action. For example, in a typical merger, a fund's board would be called upon to determine whether the transaction produces benefits for fund shareholders and is in the best interest of shareholders. A fund board generally must approve the adoption of a new advisory contract since, by law, the existing advisory contracts terminate. It is the responsibility of the fund's directors to reach a business judgment as to whether the new arrangement contemplated in the new advisory contract and/or distribution agreement is in the best interests of the fund and its shareholders, even in situations when the fund operations are a small part of a mega-merger.

We at the Commission also will be called upon to take action. The Commission strongly supported provisions in the legislation addressing conflicts of interest and other issues that arise when banks are investment advisers to mutual funds. Consequently, banks or divisions of banks will register with us as advisers, and our examination staff will for the first time be inspecting bank registered investment advisers to funds. These steps are necessary to ensure that the Commission has adequate information about bank investment advisers to inspect for trading violations such as front-running and illegal personal trading. We also will be considering the need for new rules and regulations governing circumstances under which banks serve as custodians or lend to affiliated funds.

Finally, these newly consolidated firms also will bear a great deal of responsibility in developing and implementing compliance programs that blend different cultures. The compliance structure of a bank traditionally has varied from that of an insurance company or a securities firm. An entity that combines two or more of these industries will have to find a way to craft a compliance program that addresses the unique conflicts of interest that can arise in each industry. Inconsistent personal trading policies, conflicting policies governing transactions between affiliates or how these policies are enforced are examples of the problems that may be created by these consolidations. One of our focuses will be to ensure that responsible oversight of compliance systems is a central component of these consolidations.

Issues for the SEC

Technological changes and issues raised by increasing competition, and industry consolidation undoubtedly raise important issues for the Commission. Many of the products and services competing with funds implicate one or both of the 1940 Acts, thereby raising fundamental questions such as the differences between a broker-dealer and an investment adviser. When broker-dealers began moving to an asset-based pricing structure for traditional brokerage services, issues were raised as to whether these broker-dealers were entitled to rely on the broker-dealer exclusion in the Investment Advisers Act. The Commission proposed a rule under the Advisers Act to clarify that the nature of the services provided, rather than the form of compensation, should be what triggers the requirements of the Advisers Act for broker-dealers using these pricing structures. I should note here that Chairman Levitt recently announced that on May 23, the Commission is going to hold a roundtable to discuss issues facing investment advisers today, including this broker-dealer issue, as the Commission undertakes efforts to modernize and improve the investment adviser regulatory regime.

The customized separate account portfolios being marketed on a retail basis raise issues under the Investment Company Act. Are these advisory programs providing individualized investment advice and do they fall within the safe harbor rule under the '40 Act or are these programs the equivalent of unregistered investment companies?

What about the evolution of exchange traded funds? These funds, which need SEC exemptive relief to operate, account for much of the trading volume on the American Stock Exchange. So far, the exemptive relief has been extended only to index funds, but not to managed funds. What about the public policy issues raised by a managed fund having a class of shares that is exchange traded? Would such a development further encourage fund investors to think of funds as something other than long-term investments and encourage short-term trading of mutual funds? Would the ability to sell the exchange traded class short have an adverse impact on the non-exchange traded classes? If it is necessary for these funds to make frequent disclosure of their portfolios, would this lead to front-running and other problems? These are just some of the issues that the Commission will have to consider as these products evolve.

With the growth in the internet and dot.com companies, we are being asked to deal with fundamental questions, like what types of entities should be regulated as investment companies. Do the traditional methods of analyzing investment company status questions under the '40 Act make sense for Internet Holding Companies or Internet "Incubator" Companies?

By facilitating rapid and widespread dissemination of information, the Internet has had a significant impact on how funds market and sell their shares and communicate with prospective investors and their existing shareholders. The Commission has issued guidance to investment companies and other issuers regarding the use of electronic media to deliver information to investors, including delivery of prospectuses, annual reports and proxy materials. The framework that the Commission established facilitates the significant benefits investors can gain from an increased use of electronic media. However, future guidance will be necessary. Shortly, the Commission will publish another release on the use of electronic media, updating previous guidance on the use of electronic delivery under the federal securities laws, online offerings and website content. We recognize that technological advances require that we reexamine our regulatory scheme as technology evolves. Our task is to remove regulations that pose increasing barriers to electronic commerce while continuing to protect investors. Soon the Commission will have to confront the issue of permitting a truly "electronic-only" offering. The 1995 release provided that an issuer, such as an investment company, could structure its offering as one that could be effected entirely through electronic media. However, it was contemplated that an issuer may have to provide the required documents in paper form if an investor revoked his or her consent before valid delivery was made. At some point, the Commission will have to abandon the paper back-up system and permit funds to offer "e-shares" for investors who agree to communicate only electronically. Perhaps such a class of shares could have lower expenses because of the cost savings attendant to electronic communication.

I believe strongly that the Commission must respond to the changes in technology and the markets in order to permit the fund industry to evolve and compete. The Division of Investment Management is very busy on several fronts to modernize the regulatory structure of funds and prepare for the challenges that lie ahead.

Corporate Governance

One of the more significant initiatives we have undertaken is the comprehensive package of fund governance reforms that the Commission recently proposed. As the financial services industry undergoes consolidation on a global scale, and wrestles with the issues brought about by technology and competition, the Commission will be called upon both to provide the flexibility needed to accommodate change, as well as to ensure investor protection. The Commission will have to rely, in no small part, on independent fund directors. We believe our governance proposals will offer fund boards greater power to act independently and in the best interests of shareholders. We received many thoughtful comments on this initiative that will enable us to improve upon the proposed rules. Specifically, many commenters felt that the disclosure requirements, especially as they related to directors' family members, went too far. It is likely that our recommendation to the Commission will be to scale back the proposed disclosures in several areas, particularly with regard to family members.

Many commenters also believed strongly that the proposal regarding independent counsel for directors was too paternalistic or that our definition of independent counsel was too rigid. We believe that encouraging the use of truly independent counsel by independent directors is one of the strongest pieces of our proposal. Independent counsel is a tool that can facilitate a director performing his or her duties in an informed, competent and diligent manner. We are encouraged by the formation of the American Bar Association task force to provide guidance to independent directors of funds regarding choosing and retaining legal counsel, as well as to counsel regarding their professional responsibilities when representing independent directors. Their recommendations should be helpful as we work through this issue in connection with the rule proposal. We are committed to thoroughly analyzing the comments on this proposal to forge the best possible framework for directors and the investors they protect. While there were a number of constructive suggestions to improve the proposal, which we will no doubt incorporate into the final rules, I urge critics of the proposal to embrace the goals of the proposal and look beyond the horizon to the challenges that are going to face funds and their boards in the future and recognize that it is vitally important that we strengthen the fund governance structure.

Affiliated Transactions

On another front, our rulemaking group is undertaking a review of rules that would permit certain affiliated transactions to proceed without the need for an exemptive order. One specific initiative relates to expanding Rule 17a-8 involving fund mergers. Heavy emphasis would be placed on the fund's board to assure the fairness and appropriateness of the transactions.

I assure you that we will continue through our rulemaking efforts and through the interpretative process if possible, to reduce burdens on funds and their affiliates, if we can do so without sacrificing investor protection.

Improving Disclosure

We will also continue our efforts to simplify and streamline mutual fund prospectuses, as we expect to proceed with further amendments to Form N-1A to address issues that we have identified in working with the new form over the last year.

The Commission adopted amendments to Form N-1A to focus investors on the most useful information as they compare funds. In this vein, the Commission recently proposed that funds disclose the effects of taxes on fund performance. The tax costs of investing in mutual funds are significant. Estimates show that over two and a half percentage points of the average stock fund's total return is lost each year to taxes, an amount significantly in excess of average expense ratios for these funds. In 1997, shareholders of stock and bond funds paid an estimated $34 billion in taxes on distributions by their funds. The next year, mutual funds distributed approximately $166 billion in capital gains and $134 billion in taxable dividends. The Commission's proposal is designed to facilitate investor understanding of the impact of taxes on their mutual fund returns. Under the proposal, funds would be required to disclose after tax returns based on standardized formulas comparable to the formula currently used to calculate before tax average annual total returns.

We are also working on revisions to the shareholder report and financial statement requirements. Our goal is to make the prospectus and the shareholder reports work together to provide information that investors need, when they need it, and in a format that is useful. In a shareholder report, fund management can tell the story of what it has done for shareholders. Our goal will be to facilitate getting that information from management to the fund's shareholders.

We are additionally exploring ways to eliminate the need for funds to annually deliver updated prospectuses to existing shareholders. Most funds deliver updated prospectuses to existing shareholders annually in order to avoid having to keep records of shareholders who have received updated prospectuses and deliver prospectuses throughout the entire year when new investments are made by these shareholders.

In this connection we are exploring whether the profile could serve the purpose of an annual updating document. In other words, funds would be deemed to have delivered a current prospectus to existing shareholders if they deliver to them the profile. This could be a more effective way of communicating updated information to shareholders than delivering an entire new statutory prospectus. Of course, any fund shareholder wanting the full prospectus could request one from the fund. Such an approach could result in significant savings to funds and their shareholders.


In conclusion, I want to emphasize my belief that the tremendous success the fund industry has enjoyed is due to the fact that, it has done more than any other financial services industry to offer investors solid products tailored to meet real financial needs, and marketed those products responsibly. We at the Commission are proud of our record of sensible regulation that has permitted fund products to evolve within a framework of the highest standards of investor protection. But we cannot ignore the fact that rapid changes and market pressures are challenging all of us. None of us can afford to remain "pigeonholed" by outdated thinking or antiquated business practices. If we keep our eyes on what's necessary to maintain the long-term health of the industry and investor protection, I am confident that we will sustain this record of success in the future. Thank you.