MUTUAL FUNDS IN THE NEW MILLENNIUM: THE OPPORTUNITY TO INVENT THEIR FUTURE Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission 1997 ICI General Membership Meeting Washington, D.C. May 16, 1997 ==========================================START OF PAGE 1====== MUTUAL FUNDS IN THE NEW MILLENNIUM: THE OPPORTUNITY TO INVENT THEIR FUTURE-[1]- Signs of the new millennium are all around us. As we approach the year 2000, businesses throughout the world are positioning themselves for the new century: * Twentieth Century Fox has filed an application with the U.S. Patent Office to retain the right to the name "Twenty First Century Fox," although the company has yet to decide to change its name. * The Twentieth Century Funds and their investment adviser's holding company, Twentieth Century Companies, changed their names to "American Century." The change was costly: American Century spent $1 million notifying its account holders of the change. * Financial services and other companies worldwide are designing ways to respond to the impending computer glitch known as "the Year 2000 Problem," which will be much more expensive to fix than first anticipated. One report has estimated the cost to U.S. companies alone at $30 billion. More importantly, consider the anxiety cost to all of us if the problem is not fixed by midnight on December 31, 1999 -- computers will fail to recognize the new millennium and will insist that our credit card bills are 99 years overdue. Now is the time to look forward and think about big picture trends, questions and possibilities facing the mutual fund industry in the new millennium. We all should be trying to identify the issues that will confront the industry in the 21st century. Considering the new millennium inevitably raises the question of the validity of predictions. Everyone seems to have heightened respect for those in society who are adept at forecasting the future. How many articles have we seen describing the predictions of Wall Street gurus? The writings of Nostradamus, a 16th century prophet credited with having predicted many modern events, have drawn renewed interest recently. Did you know that he predicted that humans will visit Mars in the year 2000, and that aliens would be televised in the ---------FOOTNOTES---------- -[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. ==========================================START OF PAGE 2====== late 1990s? Gene Roddenberry, the creator of Star Trek, beat the prediction of televised aliens by a fair margin, and who knows, by now he may have reached Mars. When I try to imagine the future of the fund industry, I have to pause. After all, if I were making this same speech just ten years ago, would I or anyone else have predicted some of the events of the last several years? Consider the variety and complexity of instruments available today - such as 20 trillion dollars in notional value of derivatives outstanding, or 1.5 trillion dollars traded each day in world currency markets-[2]- - and the resulting challenges of adequately supervising that trading. Would anyone have predicted that the venerable Barings plc would be done in by derivatives? Could any fund industry participant ten years ago have foreseen the popularity of fund supermarkets, and the dramatic changes they have brought to traditional distribution channels? Would any of us here today have anticipated a decade ago the challenges facing the industry and Commission now? Would we have known that one of the most compelling questions of the waning days of this century would be whether some of the fundamental precepts of the securities laws are still valid? Probably not. Predicting the future is a difficult -- and a potentially embarrassing -- business, best left to the supermarket tabloids and infomercial psychics. Having said that, and knowing full well that we may all be looking back on this moment in twenty years - or maybe even just five - with a knowing smirk and the benefit of twenty-twenty hindsight, I would like to discuss some of the issues that I believe will confront the industry in the 21st century. I. Technological Developments Technology has revolutionized the fund industry and will continue to do so in the new millennium. Technology will create - and allow us to resolve - numerous challenges as we enter the Brave New World of the 21st century. * I anticipate that a new breed of mutual fund investors will appear on the scene in the next century. These investors will have access to more financial information at the click of a mouse than their parents did in a lifetime. But will they know how to use it? Will they be able to distinguish between hard data and "hype?" I'm not sure that all investors will be up to the task. It will be the responsibility of the industry, the regulators and investors ---------FOOTNOTES---------- -[2]- Bloomberg Financial Services (May 13, 1997). ==========================================START OF PAGE 3====== themselves to see that people do not drown in information, while becoming starved for knowledge. In short, investor education in the age of technology will not be a luxury, but an absolute necessity. * I foresee the potential for more market volatility, as these new investors react instantaneously to each new piece of information that comes their way. The challenge for the industry and the regulators is again to provide the knowledge to enable investors to use wisely the tools of technology. Our goal will have to be convincing investors of the need for a long-term investment vision in the face of computer advances that enable investors to buy and sell shares with just a few keystrokes. ==========================================START OF PAGE 4====== * I believe that technology can and should be used to provide investors with information in a more readily understandable manner, a key goal of the Commission's recent fund profile and simplified prospectus initiatives. I recently suggested that funds consider personalizing their investor statements so that shareholders can see their own performance, not just that of the fund over a particular period of time.-[3]- I've been told by many in the industry that this type of data would be too costly to generate and too hard for investors to understand. Technological advances may well afford the opportunity to address both of these concerns. * Technological advances will, in my view, force the industry to come to grips with an issue that seems to generate countless press articles and letters to the Commission but very little consensus among industry participants -- whether shareholders should be provided with more frequent updates about the securities held by their funds. To date, the issue has often been answered by pointing to costs many claim would be excessive. Technology is likely to render this response unconvincing. The debate, instead, will focus on questions such as whether investors want or need this information, and whether frequent reporting of the securities positions of funds compromises their investment strategies. The image that sticks in my mind as I consider these questions is a 20 to 30 page portfolio schedule of an index fund. Does that really help investors? * Technological developments enabling the fund industry to provide more and more information to investors is likely to accelerate the growth in the number of financial consultants, financial planners, broker-dealer registered representatives and the like whose business is to analyze information and advise investors. One challenge I can foresee is to ensure that these professionals meet basic levels of competence. To my mind, government regulation in this area should emphasize the fiduciary relationship between these advisers and their clients. Government is not well-suited to set competency standards for those who provide advice to clients. Establishing rules of conduct ---------FOOTNOTES---------- -[3]- "Fund Disclosure: The Sequel." Remarks by Barry P. Barbash, Director, Division of Investment Management, Securities and Exchange Commission, before the Mutual Funds and Investment Management Conference, Palm Springs, California (Mar. 17, 1997). See also M. Haltzik, "The `Personalized Returns' Issue: Why Can't Funds Do It?" Los Angeles Times, Apr. 15, 1997, at D4 & D8. ==========================================START OF PAGE 5====== and determining the elements of competency are both best left to industry self-regulators or professional associations. It's hard to recall a time when the pace of change in the markets has been so accelerated. Today's cutting edge is quickly made obsolete by tomorrow's innovation. We will have to adjust to a future marketplace we can barely envision, with market participants we can barely identify. ==========================================START OF PAGE 6====== II. Retirement Planning Another question mark on the millennium's horizon is the effect of retirement savings on the fund industry, and on the market as a whole. A recent Cerulli Associates, Inc. report indicates that Americans today have more than 2.9 trillion dollars invested in pension plans. Perhaps more importantly for the fund industry, the percentage of 401(k) assets invested in mutual funds has more than quadrupled during the last ten years. Although Cerulli predicts that this dramatic growth is peaking, funds will account for 45% of the 1.5 trillion dollar 401(k) market by the year 2001.-[4]- While these numbers are impressive, there is clearly more to be done by the industry and regulators. The Year 2000 Problem will seem very small indeed by the time we face the Year 2011 Problem. That's the year the first wave of baby boomers -- those 76 million Americans born between 1946 and 1964 -- will reach age 65 and begin retiring en masse. What will happen when the baby boomers driving much of the stock market run-up begin to withdraw their money? Answering this and other difficult questions about retirement savings is a significant undertaking that must be faced now if we are to enjoy the future. How do we convince younger workers struggling to pay education loans, buy a house, or simply pay the bills, to set aside money for the future? How do we teach all workers to weigh their choices carefully, in a world in which the number of choices is so rapidly increasing? Many in the fund industry have expended much time and money in working with investors to address these issues, and are to be commended for their efforts. Employers, often working with industry participants, have made tremendous strides in educating employees. Seminars, access to financial advisers, and enhanced choices all have contributed to the encouraging news that employees are investing more, and more knowledgeably, than ever before.-[5]- The actions of the private sector have been supported and supplemented by those of the regulators. Both the Commission and the Department of Labor have undertaken numerous initiatives designed to facilitate the education of plan investors. ---------FOOTNOTES---------- -[4]- The Cerulli-Lipper Analytical Report, The State of the Defined Contribution - 401(k) Market, 13-16 (1996) (the "Cerulli Report"). -[5]- E.g., K. Bergen. "401(k) Watch." The Houston Chronicle, 1 (Feb. 3, 1997). See generally Cerulli Report at 111-118. ==========================================START OF PAGE 7====== Investor education has been perhaps the most compelling retirement theme underlying actions of the fund industry and its regulators in the waning days of the 20th century. An ==========================================START OF PAGE 8====== equally important challenge for regulators in the new millennium will be reconciling regulation under the federal securities and federal pension laws. A seemingly constant refrain among many investment management industry participants, particularly compliance officers, is frustration with overlapping, inconsistent, overly burdensome or outdated regulations under ERISA and under the federal securities laws. Some point to inconsistent disclosure philosophies and requirements. Others complain that various types of securities transactions, such as cross trades between mutual funds under common management, are subject to different limitations under the securities and pension laws. Others point to different treatment under the federal securities laws of functionally similar pooled investment vehicles designed for retirement plan investors, and still others complain that the prohibited transaction provisions of ERISA impede the establishment of educational and investment programs that would be most beneficial to investors. The list never seems to end. The challenge for regulators of the investment management business in the new millennium will be to assess these claims responsibly and eliminate duplicative and inconsistent requirements that are detrimental to retirement plan investors. It is hardly risky to predict that, if the regulators fail to meet the challenge, Congress will step in. Indeed, I suspect that retirement concerns will, by sheer necessity, become one of the burning issues facing Congress in the near term. The resolution of these issues has the potential to redesign dramatically the landscape that has gradually evolved since the New Deal created social security. III. The Continued Effectiveness of the Commission The last two decades of the 20th century have been marked by tremendous prosperity in the mutual fund business. Many industry observers agree that this prosperity has been due, in part, to a strong and active Securities and Exchange Commission anticipating and addressing matters before they become problems. Investors and legislators alike have come to expect the Commission to be, in the words of former Commission Chairman and Supreme Court Justice William O. Douglas, the investor's advocate. Will the Commission be able to continue to meet these lofty expectations in the investment management area in the new millennium? If it has its intended effect, the Investment Advisers Supervision Coordination Act of 1996 should ensure that the Commission has sufficient resources to oversee the investment management business as we move into the 21st century. Under the 1996 Act and its implementing rules, which were adopted in final form by the Commission earlier this week, jurisdiction over the almost 23,000 investment advisers now registered with the ==========================================START OF PAGE 9====== Commission was divided between the Commission and the states. This sharing of oversight should reduce regulatory duplication and enable the Commission to examine registered advisers far more frequently than once every 44 years, as has been the case recently. As I gaze into the future, I worry that the Commission's ability to inspect participants in the investment management business during the new millennium may not be matched by its ability to regulate the conduct of those participants. Over the past two decades, in an attempt to respond to legitimate concerns of business, Congress has enacted more regulations applying to the regulators. Consider, for example, the Paperwork Reduction Act and the Small Business Regulatory Enforcement Fairness Act, both of which share the laudable goals of making the regulatory process more open and less burdensome to businesses. The Paperwork Reduction Act seeks to achieve this result by setting out procedures agencies must follow before obtaining information from ten or more members of the public; the Small Business Enforcement Act provides a special review period during which Congress can disapprove various agency rules. However well- intentioned, these Acts can limit the potential responsiveness of the administrative process by causing delays, restricting agencies' ability to collect important data and increasing regulatory uncertainty. These effects would seem likely to become exaggerated as technology advances and as the pace of change accelerates as we move into the 21st century. In commenting on the trend of regulating the regulators some 15 years ago, former SEC Commissioner, Roberta Karmel, questioned whether the "public interest [is] served by the imposition of elaborate and burdensome procedural requirements that further expand the federal bureaucracy and reduce the efficiency of the regulatory agencies. Just as there are many direct and indirect costs of government regulation of business, there are many costly burdens that accompany the benefits of regulating the regulators."-[6]- I hope that Commissioner Karmel's words do not prove as prophetic as those of Nostradamus. IV. Issues That Never Die The milestone of the new millennium acts like a deadline. It encourages us to confront and resolve existing problems so that we can face new challenges with a clean slate. As we approach the 21st century, the fund industry continues to be confronted by some issues that just never seem to go away. Two such issues making headlines recently are money market fund bailouts and performance advertising. ---------FOOTNOTES---------- -[6]- R. Karmel, Regulation by Prosecution (1982) at 81. ==========================================START OF PAGE 10====== A. Money Market Fund Bailouts Earlier this year, we witnessed what seems to be a recurring industry event, a bailout of a money market fund by its investment adviser. In this case, the fund found itself in jeopardy of breaking a buck as a result of holding the commercial paper of a finance company that announced, without any warning, that its published earnings were dramatically overstated. The adviser stepped up and, reportedly at some cost, purchased the commercial paper from the fund. That money market funds from time to time may have to face breaking the buck should not be surprising. After all, neither Commission rules nor all the disclosure in the world can offer ironclad protection from an issuer's unexpected default on an instrument appropriately held by a money fund. We have also seen enough adviser bailouts not to be surprised by the occurrence. What I find disconcerting about bailouts is that we and fund shareholders have come to expect them. As a financial columnist noted in the wake of the most recent bailout: "You aren't supposed to get something for nothing, but it sure seems like that's the way it works in the money market fund business."-[7]- After discussing the facts of the recent case, the writer concluded: What [the fund manager] proved, like dozens of fund companies before it, is that investors may as well own the highest-yielding money fund they can find, because in defiance of general investment principles there is not extra risk entailed in collecting that higher yield. So long as your fund management company's pockets are deep enough, your money fund's mistakes, if any, won't cost you.-[8]- In effect, the writer was suggesting that industry actions have caused money funds to be perceived to be guaranteed. I ask you: Do we really want investors to have a perception of money market funds that is so inconsistent with their basic design as an investment with the potential for some risk? I submit that the answer is a resounding "no." What then should be done? Surely, prohibiting bailouts would not be in the public interest. Disclosure also is not the answer -- all money market funds currently are required to disclose prominently that they are not guaranteed. ---------FOOTNOTES---------- -[7]- T. Petruno, "A Money Fund's Miscues Seldom Hurt Its Investors," The New Hampshire Sunday Monitor, Feb. 9, 1997 at F4. -[8]- Id. ==========================================START OF PAGE 11====== Should the Commission require investment advisers to money market funds to meet minimum capital requirements to enable them to have the financial wherewithal to bail out a fund? Wouldn't such a requirement only further reinforce the perception that advisers will take any actions necessary to prevent a loss? I would be loathe to follow in the footsteps of the banking regulators and move toward requiring management companies to maintain minimum amounts of risk-based capital. And I suspect that most here this morning would agree. Should money market funds or their management companies be required to obtain some form of insurance to cover the risks of loss from portfolio investments? Many express the concern that this type of insurance may be prohibitively expensive for most cost- and yield-conscious money market funds. To provide for more cost-effective insurance, one large fund complex is now seeking exemptive relief from the Commission to permit it to establish a mutual insurance company. We understand that at least one or two insurance companies are in the process of developing money market fund insurance. These proposals appear to be the first steps by the industry, on its own initiative, to avoid bailouts. But the proposals may not work for every mutual fund complex. We continue to think about various ways to address the bailout issue and encourage you to do the same. We simply can't afford the misperception of money funds to continue. B. Performance Advertising Responsible marketing and sales practices are essential to the fund 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 often, perhaps too often, make investment decisions based upon sales material, especially performance information. Investors want to know about the track record of the person with whom they entrust their money. And, most would agree that a prior record of a manager can be quite useful if it reflects an investment strategy that will be mirrored by the manager in the future. Acknowledging investors' desire for useful information, the Commission's staff confirmed through a series of letters over the past year or so that funds can include material in their prospectuses about the track record of their advisers or portfolio managers, so long as the material is not misleading or so cumbersome as to obscure other information that is required to be in the prospectuses. To date, we have been inundated by a variety of performance presentations that purport to rely on the letters. Some of them have been met by our just saying "no." Let me give you a couple of examples. Take the proposed ==========================================START OF PAGE 12====== prospectus summary of one fund called "the fund at a glance," which included performance information of another fund managed by the same adviser. In our view, this was not a glance at the first fund, but information impeding an understanding of the fund. In another case, a newly formed fund sought to include in its prospectus a track record of its portfolio manager. The record reflected the performance of a fund for which the portfolio manager served as one of three managers, although it was argued that the manager played the primary role in advising the fund. To our minds, the track record was not that of the portfolio manager and could not be included in the prospectus. These examples suggest that the industry is reading our letters more broadly than we intended or anticipated. Last December, when speaking at the ICI's Procedures Conference, I cautioned against overstating, overselling, and overdoing past performance. I characterized our position in our letters not as a green light, but as a yellow light of caution. The industry has an obligation to keep performance presentations balanced and clear so that prospective investors can evaluate them fairly. Showing the adviser's track record is one thing. Trying to substitute some other performance for that of a fund is something else. Industry participants would be ill-advised to operate under the impression that "anything goes" when it comes to presenting prior performance. We will be looking closely at prospectus disclosure and asking questions about presentations that seem to be unclear or misleading. Our examiners will be asking questions about how the information was derived, whether backup data exists to support performance claims, and whether important, but less favorable, information was omitted from presentations. Most importantly, we will be working with the industry and the NASD to consider the limits of performance presentations that can be used in fund prospectuses. This effort may well result in some performance presentations that are being used today disappearing from the scene tomorrow. Our recent experience with fund prospectuses showing performance makes me reflect on the conclusion reached by two authors in a recently published article entitled "Performance Games": It would be good [the authors said] if we would be granted a moratorium from performance games [played by fund managers] until we perfect a stopwatch by which to judge the winners. But a moratorium will never be granted; the race is too tempting, and the desire to declare a winner too strong. So individual investors will continue to jump from mutual fund to mutual fund in search of winners, and plan sponsors will continue to hire and fire money managers. All players ==========================================START OF PAGE 13====== will be exhausted, but the games will go on.-[9]- The statement could have been made at any time over the past 57 years -- it echoes some of the concerns of the drafters of the Investment Company Act of 1940, it captures the issues facing the Commission's staff today as it reviews fund prospectuses, and I'm afraid, it will have validity in the future. Nevertheless, I am not yet willing to abandon my high expectations of the fund industry. The industry should understand better than anyone the limits of performance information and act responsibly. Failing to do so risks damaging the excellent relationship that the industry has built in the 20th century with its shareholders. Acting responsibly will help ensure that the industry continues to prosper well into the 21st century. V. Conclusion Some believe that "futurism is not so much predicting tomorrow . . . as it is inventing it." The future presents us with many challenges, but with those challenges comes opportunity -- the opportunity to make our industry more efficient, more responsive to its shareholders, and with more educated investors than ever before. This is a particularly exciting time to be involved in the financial markets, whether as a participant or as a regulator. None of us should shrink from the challenge. Thank you. ---------FOOTNOTES---------- -[9]- John J. Bowen, Jr. and Meir Statman, "Performance Games," The Journal of Portfolio Management, Vol. 23, Winter 1997 at 15.