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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Success and Survival of the Mutual Fund Industry in a Changing World

Remarks by

Paul Roye

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

Before the ICI General Membership Meeting
Washington, D.C.

May 19, 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.

Thank you and good morning. It is always a pleasure to be at the ICI General Membership Meeting.

I hope those of you from out of town have had the chance to see some of the sights. The month of May usually is a very nice time of year, although from the recent weather we have been having it is not clear whether we are suffering from global warming or a return of the ice age. After the conference sessions, you can always go see a movie if the weather does not cooperate. I saw a sign on the way over here that indicated that the new Disney movie, Dinosaur, opens today. If you have kids, I am sure that at some point you will be forced to see it.

My son tells me that there is supposed to be some factual basis for the movie. There is a giant crater in the Yucatan peninsula of Mexico measuring around 150 miles across, which scientists think was formed when a meteor about the size of Mount Everest hit the earth. They speculate that the meteor caused the equivalent of a nuclear winter that resulted in the extinction of thousands of species. The impact of the meteor sent huge quantities of dust into the atmosphere that blocked out the sun. When the plants weakened and died, the entire food chain collapsed. Imagine that you are a dinosaur living in what is today New York City. Two thousand miles away a meteor falls to the earth. You do not feel the earth tremble. You do not feel a thing. But life, as you know it, has just changed forever.

We have, in our lifetimes, experienced a technological transformation that has had as great an impact on the business world as that meteor had on the physical world, millions of years ago. This morning I would like to discuss the new competitive environment confronting the mutual fund industry and offer some thoughts on how the industry and the SEC should respond to this new environment, brought about in large measure by technological change.

In 1975, a company called Micro Instrumental and Telemetry Systems Inc. started selling a kit for a thing called the MITS Altair 8800. It was the first personal computer. It had no monitor, no printer, one kilobyte of memory and you had to have a soldering iron to put it together. That same year, a couple of high school buddies, one living in New Mexico and the other in Boston, decided to form a company to write programs that could run on the Altair 8800. They called their company Microsoft.

Twenty years ago "state of the art" in word processing meant an IBM Correcting Selectric typewriter. Ten years ago there was no such thing as the World Wide Web. Five years ago approximately 12 million American households had computers with modems; about half of those were connected to a commercial on-line service. At the end of last year an estimated 67 million U.S. households had access to 56 million websites. The velocity of innovation and consequent change has truly been astonishing.

Technological Changes Have Been Embraced by the Industry

The changes that personal computers and the commercialization of the Internet have brought about, in large measure have been very good for the economy and the mutual fund industry.

The mutual fund industry has embraced the new technology. A 1997 study by the ICI found that about half of the fund companies surveyed had a website, and two thirds of those without websites, planned to launch one by the year 2000. Today, there probably is not a person in this room that works for a fund group without a website. Funds use the Internet to communicate with and educate their investors, and to reach out to prospective investors. Funds use the Internet for everything from making disclosures about their portfolio holdings, to electronic proxy voting. An investor can enter a website, check the market, read about investing for retirement, order a paper copy of a prospectus, use a calculator to evaluate asset allocation, review recent press releases, purchase shares in one portfolio and redeem shares in another -- all before breakfast.

A recent study found that more than 60 percent of investors use the Internet to research investments and gather information and news. While most investors who enter mutual fund websites are using them to check share prices, many investors quickly embrace new electronic tools as they become available. In light of the explosive growth in individual use of computers and Internet technology, we can anticipate that as consumers become more comfortable with the Internet and the level of security afforded their Internet transactions, and as their privacy concerns are addressed, they will increasingly rely on the Internet to manage their finances.

Recognizing that the securities laws were written in an era when documents were drafted on manual typewriters and copied using carbon paper, we realize that we cannot be blinded by our paradigms and that we must keep up with the needs of those affected by our regulations. Electronic Communication Networks are challenging traditional stock exchanges. 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.

We know that we have to respond to changes in technology and the markets for the fund industry to evolve and compete. Fortunately, sixty years ago, the wise drafters of the Investment Company Act gave the SEC the mechanisms to respond to changing circumstances and innovation. We are firmly committed to the task of removing barriers to electronic commerce while continuing to protect investors. As part of this effort, the Commission last month issued a release discussing the application of the federal securities laws to electronic media, updating earlier guidance on the issue of electronic delivery of prospectuses, annual reports and proxy materials, and providing additional guidance on online offerings and website content. We recognize, however, that continuing guidance will be necessary in this area, as the use of electronic media and technology will continue to evolve. For that reason, the latest release seeks comment on specific issues that we should address in the future.

Changes in the Environment Yield Changes in the Participants

The meteor in the Yucatan changed the global environment. Those that could adapt survived and flourished; those that could not, perished. And while no one, certainly no one in this room, would compare today's mutual fund industry to the dinosaurs, technology has changed the environment in which financial service companies do business, spawned significant changes in the fund industry and in its competitors, as participants in the financial services industry struggle to adapt and thrive in the new environment.

Many of your competitors aggressively question the benefits of mutual fund ownership and are trying to lure fund investors with new products. On-line trading has made it cheaper and easier for individual investors to buy stocks on their own, and perhaps has led some investors to believe that they are better off day-trading securities, rather than pursuing a traditional buy and hold mutual fund strategy. A long-running bull market makes choosing individual stocks look easy, although recent market volality may have tempered the enthusiasm of some and melted the wings of more than a few high flyers.

Broker dealers are offering brokerage accounts with asset-based fees or other alternative pricing structures and are developing products that compete with, and are alternatives to, mutual funds.

Separately managed accounts that can be opened with as little as $100,000, have become competitive with mutual funds. Today, investment managers routinely have access to personal computers that are more powerful than the computer originally used to send men to the moon. Better software and portfolio management systems make it feasible for a manager, who in the past would only take institutional accounts with a minimum of $5 million or higher, to take on much smaller accounts, including retail accounts.

Financial advisers increasingly are attracting investors from funds by offering customized portfolios. They offer services over the Internet to enable individuals to create and manage their own portfolios or create a virtual mutual fund on-line; tailor-made portfolios that reflect the investor's risk tolerance, time horizon and tax situation. Technology has made customization on a large scale possible.

The growth in exchange traded funds also presents a challenge for the rest of the fund industry. There is an increasing variety of these funds investing in everything from the total U.S. stock market to particular industrial and Internet sectors. Assets in exchange traded funds listed on the American Stock Exchange, where almost all of these funds are traded, have increased significantly, from $2.4 billion in assets only three years ago to over $38 billion today. 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, can be sold short, and have more predictable tax consequences.

Simultaneously with the emergence of these new industry participants, we have seen explosive growth in the number of traditional funds. With some 8000 funds for investors to choose from, mutual fund companies, in order to stay competitive, have been striving for "name-brand recognition". Fund groups have been creating and marketing new types of funds, such as Internet funds, tax-managed funds, market-neutral funds, and stable-value funds. While some funds offer novel benefits to their investors, it seems that others merely offer gimmicks, sacrificing sound investment principles for clever marketing appeal.

As tempting as it may be to promote a mutual fund as if it were laundry detergent, it is important to remember that mutual funds are attractive to investors because they offer transparent daily pricing, diversification, economies of scale, access to professional money management and the ability to redeem or exchange shares when circumstances dictate. In the short-term, it may be possible to generate investor interest by flooding the market with new products and by adding enhancements to existing products. Indeed, some of these innovations may prove themselves as significant steps in the evolution of the mutual fund industry. Ultimately, however, funds will have to demonstrate that they can provide value, service and performance at competitive fee levels.

Increased Focus on Fund Fees

Competition among funds, and from other financial products is going to force funds to become more sensitive to the fees that they charge. Investors, who now have more information about fund costs and expenses readily available, are becoming more sophisticated. They have more options available to them and will want assurance that the value added by fund ownership is worth its cost.

Focusing investor attention on the impact of fund fees and costs has been a priority for us for some time. 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 fundís total return is lost each year to taxes, an amount significantly in excess of average expense ratios for these funds. In 1998, mutual funds distributed approximately $166 billion in capital gains and $134 billion in taxable dividends. The Commissionís proposal is designed to facilitate investor understanding of the impact of taxes on mutual fund returns, through a standardized formula comparable to the formula currently used to calculate before tax average annual total returns. A recent MIT study claims that there is evidence that investors currently are avoiding mutual funds that are not tax efficient.

In the coming months, fund fees will probably be the subject of further debate. At the request of Congress, the General Accounting Office is in the process of completing a study of mutual fund fees and expenses and the Division of Investment Management is completing its own study of mutual fund fees. The GAO has indicated that its study will be released soon, and our study should be released this summer. The Division's report is intended to provide objective data that may be useful to Congress and the Commission in overseeing the mutual fund industry, and to others who are focusing on the effect of mutual fund fees and expenses on investor returns. A representative of the GAO has said that its report will examine issues surrounding the fee-setting process for funds, including the SEC's oversight role, the role that funds' boards of directors play in setting fees, whether there are economies of scale in the fund industry, and whether the industry is sufficiently competitive. These reports will contribute to the ongoing dialogue regarding the appropriate level of fund fees and expenses, in the light of the growth of the industry.

Some argue that costs of fund ownership are too high. They say that industry growth has produced economies of scale that have not been passed on to investors in the form of reduced fees and expenses. Others counter that shareholders today are getting more for their money -- more services and more investment options -- which justify the current level of fund fees. The SEC has no desire to become the arbiter of the appropriate level of fund fees. Whether fees are too high or too low is a question that we believe is best answered by competition in the marketplace, not by us.

The Investment Company Act envisions a two-pronged regulatory approach to investor protection with respect to fund fees and expenses. First, the Act prescribes regulatory safeguards and standards designed to reduce conflicts of interest that could result in excessive charges. Second, the Act requires full disclosure of fees and charges so that investors can make informed decisions. We support the use of disclosure and regulatory safeguards to keep mutual fund fees and expenses within the range of reasonableness, rather than the use of fee caps or other forms of more direct, regulatory intervention. We remain committed to this regulatory structure and have been working on rule proposals and other initiatives that promote investor protection on both fronts.

The fund governance proposals issued by the Commission last fall were designed to enhance the effectiveness of independent directors. We want to give fund directors greater power to act independently and in the best interests of shareholders in their many areas of responsibility, including their review of the reasonableness of fund fees. The proposals to mandate a majority of independent directors, have them be self-nominated and advised by independent counsel, are important steps in this process. We received many thoughtful comments on this initiative that will enable us to improve on the proposed rules. We are in the process of analyzing these comments so that we may forge the best possible regulatory framework for fund directors and the investors that fund directors are duty bound to protect. We applaud the leadership of the ICI in taking significant steps to strengthen the mutual fund governance framework. The Report of the Advisory Group on Best Practices for Fund Directors, which was endorsed by the ICI Board of Governors, sets forth laudable recommendations and policies that, if widely adopted by the fund industry, will measurably improve the governance framework that safeguards the interests of investors.

We recently reaffirmed our position that the scheme of the Investment Company Act places independent directors of investment companies in a key role in safeguarding the interests of fund shareholders in an amicus brief filed in the Second Circuit in New York. This case involves a group of closed-end investment companies in which shareholders complain, in an action under Section 36(a) of the 1940 Act, that the management company and the directors breached their fiduciary duty by failing to take steps to open-end the funds or otherwise reduce the discount from net asset value at which the funds were selling in the market.

The district court found that the action was derivative in nature (i.e., brought on behalf of the funds) and that a demand on the directors was required or a showing that demand would be futile. Having failed to make the demand or show that demand would be futile, the court dismissed the action and the plaintiffs appealed.

Our brief takes the position that the requirement for a demand in a shareholder action is not inconsistent with the policy or provisions of the Investment Company Act. Since independent directors have a crucial role in protecting fund shareholders under many provisions of the Act, there is no reason to prevent them from considering a shareholderís demand to bring an action under Section 36(a).

Needless to say, I hope that independent directors of investment companies, when considering such a demand, will rely on independent counsel to assist them in their determination. Which brings me, of course, to our proposed rule on the necessity for independent counsel for fund directors. We probably have had more comment on that proposal than any other in the fund governance package. Let me just say that we are reviewing the scope of that proposal, but it is important to note that courts have repeatedly recognized the value of independent counsel in actions when fees or other matters involving possible conflicts with fund management are involved.

Along with the Commissionís efforts to strengthen the fund governance structure, an important safeguard regarding fund fee levels, the Commission has also worked to make fees and costs more transparent and educate investors about the relationship between fees and mutual fund returns. Fund prospectuses are required to include a standardized table listing all of the fees charged by the fund, and are also required to include an example showing in dollar terms how much of an investment would be given up to fees over a period of time. And as I mentioned previously, after-tax returns disclosure would provide another perspective on the cost of owning mutual fund shares. We have also added a cost calculator to our website, and taken other steps to alert investors to the significant impact that costs can have on long-term fund performance.

We at the SEC will do our part to help funds reduce shareholder costs. The Division of Investment Management is working on proposals to revise the shareholder report and financial statement requirements to streamline them and to make the prospectus and the shareholder reports work together to provide information that investors need, when they need it, in a useful format. We are also exploring ways to eliminate the need for funds to annually deliver updated prospectuses to existing shareholders. Because a current prospectus must be delivered either before or simultaneously with a confirmation of sale, most funds annually deliver updated statutory prospectuses to all of their shareholders in order to avoid having to keep track of who has and who has not been sent an updated prospectus. We are exploring whether a profile could serve as an annual updating document. This could be a more effective way of communicating information to shareholders than delivering an entire new statutory prospectus, and could result in significant savings for funds and their shareholders.

We are also considering whether we can reduce regulatory burdens on funds by amending Rule 482 to eliminate the requirement that the substance of the information contained in a fund's advertisements be derived from its statutory prospectus. Eliminating this requirement should result in funds being able to provide investors with better and more timely information.

I want to be clear though, that this particular initiative should not be seen as a signal that unfettered fund advertising is the order of the day. To the contrary, any proposal regarding Rule 482 will, first and foremost, seek to promote balance and responsibility in fund advertisements.


It is important that funds not respond to the new 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 those numbers are sustainable.

Although prior performance is only one of many factors that an investor should consider when deciding whether to invest in a particular fund, many investors do consider performance to be one of the most significant factors when selecting an investment. Although it is repeatedly said that prior performance is not necessarily an indicator of future performance, it remains a key element in many fund advertisements. The omission of important information when advertising performance is unacceptable. The misuse of performance information to mislead investors is intolerable. We have tried to send a message in this area with our recent enforcement actions. Last week, the Commission settled an administrative proceeding with a major mutual fund company and one of its former portfolio managers. The Commission found that over the course of a new aggressive growth fundís early operating history, the portfolio manager allocated securities purchased in initial public offerings Ė specifically "hot" IPOs Ė in a way that had the overall effect of favoring this fund over other funds managed by the portfolio manager. This practice was inconsistent with prospectus disclosures that investment opportunities would be allocated equitably among funds in the family. The Commission found that the firm did not review the portfolio managerís IPO allocations to assess their fairness. The Fund achieved exceptional returns in its first year, in large part because of the investments in IPOs and increased its net assets from $2 million to over $154 million in eight months. The huge impact of the IPOs was not disclosed, even through it was questionable whether the Fund could replicate its prior performance through investing in IPOs as the Fund grew larger. The firmís advertisements regarding the fund did not mention the huge impact that IPOs had on the fundís performance. There are a number of important messages in this action, but perhaps the most important is that the Commission will not tolerate the misuse of performance information to mislead investors. The penalties associated with this action, $1 million, along with $2 million to settle with the New York Attorney General, demonstrates that we are indeed serious about this issue.

Along with the Commission, the National Association of Securities Dealers is also concerned about marketing practices that cross the line between "aggressive" and "misleading". The NASD issued a notice to its members reminding them of their responsibility to base their communications on principles of fair dealing and good faith and to avoid statements that are exaggerated, unwarranted, or misleading. It cautioned its members that if they choose to present extraordinary performance information for funds, they should do so in a manner designed to lessen the possibility that investors will have unreasonable expectations concerning future performance. For our part, Chairman Levitt has asked the Division of Investment Management and the SEC's Office of Compliance Inspections and Examinations to conduct a special review of fund marketing -- including fund websites, sales literature, and advertisements -- to determine whether funds' portfolio performance and investment strategies are consistent with their website statements, advertising and prospectus disclosure. I strongly urge you to keep in mind the "tradition of integrity" that is the theme of this year's conference when formulating your marketing materials.

This is another area where the ICI has shown leadership. In February, the ICI issued a series of public service advertisements in major newspapers that cautioned investors not to place too much emphasis on mutual fund performance. We applaud the actions of the ICI through its public service advertising and those funds that have attempted to place 1999ís extraordinary returns into proper perspective through communications with their investors. Indeed, we applaud the ICIís efforts regarding investor education in general. The ICI is a key participant in the Facts on Saving and Investing Campaign, along with the SEC and nearly 50 other governmental agencies, consumer organizations and business groups. Just yesterday, the ICI Education Foundation announced a partnership with the National Urban League that is designed to increase awareness among minorities of sound investing principals. Through a series of brochures, articles, videos and seminars, the "Investing for Success" Campaign hopes to help investors reach their economic goals. We commend the ICI and the Urban League for this important investor education initiative. We are pleased that there is recognition that educating investors is a responsibility not just for the Commission, but for the mutual fund industry as well.


The fund industry has done more than perhaps any other participant in the financial services industry to offer solid products that meet the real financial needs of millions of Americans. You have helped them to achieve their dreams of retirement, college educations for their children, homes for their families. Your "tradition of integrity" has served you well and will continue to serve you in the coming years. As you work to respond to changing investor needs in a changing world, we at the Commission are committed to working to provide a sensible regulatory environment that encourages innovation and growth, while maintaining the highest standards for investor protection. We are engaged in an effort to strengthen the fund governance structure in anticipation of having to place greater reliance on independent directors in adapting the mutual fund regulatory regime to changing circumstances brought about by technology and competition. Next week, the SEC will host a roundtable to discuss how we should modernize the investment adviser regulatory framework. We recognize that we must respond to change.

There are often different responses to change. Some are energized by it while others are unnerved by it. None of us can afford to ignore it. Unlike the dinosaurs, I am confident that together we will adapt and the fund industry and its investors will thrive.

Thank you.