Speech by SEC Staff:
Mutual Funds – A Century of Success;
Challenges and Opportunities for the Future

Remarks by

Paul F. Roye

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

The Securities Law Developments Conference
ICI Education Foundation, Washington, D.C.

December 9, 1999

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 the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

Thank you, Craig, and good morning. This December, your meeting takes place not just at the end of another year – we have come to the end of the 20th century. At the moment, for many of us the significance of this event is obscured by the efforts directed at our software or, for the lucky few, by the planning of millennium parties. But I think it is important to pause for a moment to consider the accomplishments in this century as they relate to the fund industry, as well as the significant lessons for the future. And I don't just mean making our computers Y10K compliant.

In the coming weeks, we will often be reminded through the media about the extraordinary achievements during the 20th century in almost every aspect of life. In the securities industry alone, we progressed from the paper ticker to electronic trading and from the Dow Jones at below 100 to around 11,000. The mutual fund industry, in particular, grew from a concept, to a $6 trillion dollar sector of the U.S. economy.

A Century in the Life of the Mutual Fund

It is not an overstatement to suggest that the 20th century, from the perspective of the American investor, was the century of the mutual fund. The changes that took place in the investment management industry over the past 100 years were dramatic.

At the turn of the century, the very idea of individuals investing in common stocks was novel. Indeed, it was illegal for a corporation to own shares of another corporation. According to the earliest Commission study on investment companies, "The concept of a company formed to invest in a cross section of securities . . . and to be supervised by professional managers, was an innovation to the public."¹

We all know that, today, half of all American households own mutual fund shares. There are many reasons for this success. I think we would all agree, however, that this could not have been accomplished without the regulatory framework that helped ensure the integrity of the industry.

In the 1920s and 30s, as the industry began to emerge, it was plagued by well-documented abuses embedded in the very concept of a pooled investment vehicle managed by an outside firm. Even as several billion dollars of the public's money poured into funds (most of which were closed-end) in the late 1920s, investors were in the dark about how that money was actually being invested and the self-dealing by some fund sponsors.

The Investment Company Act of 1940 is credited with establishing a legal framework that both allowed for creativity in the development of the industry and guarded against its inherent abuses. In the words of Hugh Bullock, a pioneer in managing mutual funds, the 1940 Act "cleared the atmosphere [and] codified the rules of the game. Public confidence began to return."² After enactment of the Investment Company Act, assets of mutual funds tripled between 1941 and 1945, in spite of a World War.

That confidence continues today and has revolutionized our financial markets. The fund industry has become a trustee of the nation's savings. At the same time, the influence of mutual funds on the securities markets continues to grow. Mutual funds, including 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.³ The size and importance of the fund industry has broad implications for the average investor, as well as the global economy. Commissioner Carey will touch upon one of these implications – the role of mutual funds as shareholders of their portfolio companies – today at lunch.

The Challenges to Come

What's next for the mutual fund and the industry? If changes in the fund industry will be as dramatic in the 21st century as they were in this century, then what we view as a mature industry today, will be perceived as primitive in the year 2099. We have already begun to see some of the directions in which the fund industry is heading.

1. Competition

The industry is experiencing a wave of consolidation so as to provide "one stop shopping" for the investor on a global scale. A 65-year old law, the Glass-Steagall Act, has been repealed, which may well bring a new era in banks' participation in investment management and securities activities. These developments are likely to affect competition within the industry, as well as give rise to new conflicts of interest that will have to be addressed by the funds and their advisers, as well as regulators.

The fund industry also is facing a variety of new – or returning – participants and competing products. Broker-dealers increasingly are offering brokerage accounts that charge an asset-based fee or use other alternative pricing structures. The Commission recently 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 registration requirements of the Advisers Act for broker-dealers using these pricing structures.⁴

Market-indexed CDs, an idea that dates back to the previous decade, are another product in which there is renewed interest.

Mutual funds also are facing increased competition from wrap accounts. According to a recent study, assets in consultant wrap account programs have more than doubled over the past three years to more than $200 billion dollars.⁵

2. New Products

The fund industry is responding to this competition with new approaches of its own. According to the same study, over $82 billion dollars are invested in mutual fund wrap accounts.⁶ The study also predicted an annual growth for this product of about 30% over the next two to five years. On this front, the Division recently issued a no-action letter permitting the type of flexibility for wrap fees that has been a staple of the fund industry.⁷

Another product that was made possible by a Commission exemptive order in the early 1990s, is the exchange-traded fund. Perhaps the most well known of these are SPDRS, WEBS and DIAMONDS. These and similar products currently account for nearly 50% of the total trading volume on the American Stock Exchange.⁸ We undoubtedly will see an expansion and evolution of these types of 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.⁹ The exemptive order allowing the unaffiliated fund of funds arrangement is subject to conditions carefully designed to assure that the abuses that plagued this product in years past are not repeated.

Lessons from History

Learning from the past is one of the keys to doing well in the future. If I have learned one thing over the past year as the IM Division Director, it is that the mutual fund industry is tremendously creative. During the past year, we have seen funds that are managed based on ideas generated by visitors to the fund's web site, funds that use technology and other devices for fund shareholders to monitor fund trading and to interact with portfolio managers and yes, funds that have no expenses.
As regulators, we must operate within the framework established by Congress set forth in the federal securities laws. When new products or ideas or even "gimmicks" come along, it generally is not our job to pass on the merits of those innovations. Rather our role is to ascertain whether the idea is permitted within the regulatory framework and make sure that investors have the proper information to make a reasoned judgment about the investment in the fund. As much as some in the fund industry may try to innovate or distinguish their funds from others with novel bells and whistles, and as much as the fund industry might change in the next century, certain of its fundamental attributes should remain.

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 to mutual fund investors is the transparency of daily mutual fund pricing and investors ability to redeem or exchange shares when circumstances dictate. As the fund industry seeks to innovate, it would be wise both for the industry and its regulators to remember and respect the framework and attributes that have enabled the mutual fund industry to become one of the major success stories of the twentieth century.

1. Conflicts of Interest

Since its early beginnings and throughout its history, the mutual fund has been managed for the benefit of its shareholders by an entity with its own shareholders and its own set of interests. The resulting conflicts of interest are well known to all of you. While it is virtually impossible to eliminate these conflicts, experience has shown that it is possible to keep them in check.

a. Independent Directors

The watchdog role of independent directors is fundamental to the framework established by the 1940 Act to address conflicts of interest. Going into the 21st century, strengthening that role is one of our key goals as regulators.

By now, you are probably well familiar with the comprehensive package of fund governance reforms that the Commission recently proposed.¹⁰ They include proposals to require at least a majority of independent directors on a fund's board, self-nomination of independent directors, and representation of fund directors by independent legal counsel. We also proposed enhanced disclosure to fund shareholders about their fund directors and the conflicts these directors might face.

A panel scheduled for later today will focus exclusively on the specifics of these proposals. Fundamentally, the proposals are designed to enhance the effectiveness of independent directors on a broad level and provide them the tools necessary to protect, and act as advocates for, fund shareholders. We look forward to receiving and evaluating your comments, as well as those of the independent directors.

I would note that our Chief Counsel's office just issued a letter to the ICI expressing the Division's views on fair value pricing – one of the key tasks performed by fund directors.¹¹ The letter discusses when market quotations for securities are "readily available," methods of determining "fair value," and the obligations of fund boards for fair value pricing securities and measures that boards may take, including delegation, when discharging their responsibilities. I urge you all to review this letter, and hope that it will provide valuable assistance to funds and their directors.

b. Affiliated Transactions

You probably would agree that the unique role played by a fund's independent directors has enabled the Commission to provide flexibility to the industry as it confronts the restrictions imposed by the 1940 Act. Historically, the Commission's exemptive rules and orders, particularly those permitting transactions between a fund and its affiliates, have relied to a significant degree on the oversight provided by the fund's board, and especially its independent directors.

This will become increasingly the case in the new millennium. As the financial services industry undergoes consolidation on a global scale, 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 the funds' independent directors. This underscores the importance of the Commission's fund governance initiative.

Just a couple of weeks ago, the Commission adopted rule amendments concerning shareholder approval of new advisory contracts following a merger or acquisition of the fund's adviser.¹² The rule acknowledges the difficulty in obtaining a shareholder vote in these circumstances, and permits fund shareholders to vote on the new advisory contract up to 150 days after consummation of the merger. The rule relies on the fund's directors to review the contract before the merger and monitor the services provided to the fund in the interim period.

The Division also intends to focus on a variety of projects relating to transactions between funds and their affiliates on a case-by-case basis and through rulemaking. For example, last week, the Commission issued a notice of an exemptive application permitting a group of closed-end funds to borrow money from a facility maintained by an affiliate of its investment adviser. The conditions to this relief, among other things, will require significant oversight by the funds' boards.¹³

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. Again, heavy emphasis would be placed on the fund's board to assure the fairness and appropriateness of the transaction.

Another area in which funds periodically request exemptive relief involves in-kind redemptions of fund shares by affiliated shareholders. Our Office of Chief Counsel is currently considering a no-action letter on this subject. We would expect that the letter, when issued, would significantly reduce the need to seek exemptive relief for such transactions. Here, too, the fund's board would be expected to play an oversight role.

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.

2. Disclosure

As important as the substantive regulation of mutual funds has been to their success, many would also agree that another reason for the fund industry's success in the second half of this century was that investors "knew what they were buying." Not surprisingly, many of our recent regulatory efforts have focused on fund disclosure. December 1st marked the final compliance date for the new Form N1-A and for fulfilling the "plain English" disclosure requirements for fund prospectuses.

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

We also 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 providing investors with better and more timely information. We are coordinating our efforts in this area with the NASD, which has principal responsibility for reviewing fund advertising. Last year at this conference, I indicated that performance advertising would be an area in which you could expect continued scrutiny from us. I indicated that we would not tolerate the misuse of performance information to mislead investors. Recent enforcement actions have confirmed that we were serious.

a. Shareholder Reports

We also are actively studying ways to improve the funds' periodic communications to shareholders. Specifically, we will recommend 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.

Later this month, new rules will become effective permitting "householding" of fund shareholders, to reduce the number of copies of prospectuses and annual reports delivered to investors sharing the same address.¹⁴ These rules are designed not only to save trees, and reduce costs to fund shareholders, but to deliver information to investors in quantities that are manageable and more likely to be actually read.

For those of you who remember that I talked about some of these projects last year and are wondering what happened, I would urge you to look around your firm; it probably includes a recent member of the Division's staff. I sometimes wonder whether I am the Dean of the SEC's graduate program in Investment Management law, rather than the IM Division Director.

b. Prospectus Delivery

We will continue to explore ways to reduce costs imposed on mutual fund investors. Chairman Levitt has made it clear to us that we should consider ways to reduce regulatory burdens and costs imposed on mutual fund investors if we can do so without sacrificing investor protection. Consequently, we are 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 shareholders who have not already received a current prospectus.

Is delivering an updated prospectus annually to existing shareholders an effective way to provide them information regarding material changes in the fund's operations? Some commentators have questioned the value of this approach; since shareholders do not know what information is new, they must read the entire prospectus to understand this new information. I suspect that few shareholders engage in this exercise. Consequently, our disclosure rulemaking office will be studying ways to eliminate the need to send an annual prospectus to existing shareholders.

They will explore the concept of an "annual prospectus update" which would be a concise document provided to fund shareholders annually that informs fund shareholders of material developments and changes in the fund's operations. In other words, funds would be deemed to have delivered a current prospectus to existing shareholders if they deliver to them an annual update. The annual update could include an updated fee table and expense examples, and any material changes affecting the management of the fund and the fund operations. This approach would assure that changes in essential information are not obscured and fund shareholders could focus on new information and changes in their fund's operations. This could be a more effective way of communicating this information to shareholders than delivering an entire new prospectus. Of course, any fund shareholder wanting the entire prospectus could request one from the fund.

While the financial printers may not like such a proposal, we estimate that such an approach could save mutual funds millions of dollars a year. More importantly, the annual update document would be a short, concise document that focuses investors on new essential information that they would be likely to read. Alternatively, this update information could be included in a fund's annual report and avoid the creation of a separate disclosure document. We would be interested in the reaction of investors and the industry to this type of approach.

c. Other Tools for Fund Investors

Even as our efforts to improve disclosure have continued, some critics have questioned whether investors really understand what they are buying when they purchase mutual fund shares. Providing investors with tools that help them to "really understand" is your task as well as that of the regulators.

An important aspect of understanding a mutual fund is understanding its fees and expenses. Earlier this year, we introduced the Mutual Fund Cost Calculator – the first of its kind – on the Commission's web-site.¹⁵ Its popularity seems to reach to all corners of the world – an article in The Irish Times recommended it to the Republic's financial regulators.¹⁶ We encourage fund groups to use their web-sites to provide investors with similar tools.

Understanding the effect of taxes on fund performance is another area in which investors could use some assistance. Many in the fund industry have recognized this need – at least one fund group offers a Tax Efficiency Calculator on its web-site, and several other fund groups provide similar information in their shareholder reports or web-sites. As you probably know, this issue has been taken up by Congress and supported by the fund industry. On our part, we have been examining how mutual fund disclosure requirements could be revised to provide investors with a better understanding of the tax consequences of holding and disposing of a fund, the relative tax efficiencies of different funds, and how much of a fund's reported pre-tax return will be paid out by an investor in taxes. We expect to present a proposal regarding after-tax returns to the Commission early in the new year.

3. Technology

The Commission and the fund industry have begun to use the Internet to educate and further empower investors. In the century to come, perhaps no other force will have a greater effect on all aspects of fund operations – as well as financial markets generally – than technology. Already, the Internet has virtually deleted geographic boundaries, redefined the ways in which consumers and businesses interact, and altered many long-standing market relationships.

We are entering the "e-century," which will present both opportunities and concerns for the fund industry and its regulators. The possibilities for new services and products that could be made available with the Internet technology probably are limitless. So are the possibilities for fraud, security breaches, and privacy violations. A complicating factor in all of these developments is the speed with which technology keeps changing and new issues arise.

a. Some Recent Developments

There is probably not a person in this room whose firm does not have a web-site. Fund groups also are beginning to offer investors the ability to do transactions on-line. Legislation currently pending in Congress would permit the use of electronic signatures, a development that could lead more fund groups to offer on-line services.¹⁷ As investors gain the ability to purchase and redeem fund shares with a few keystrokes, however, new pressures will be put on the funds' ability to plan for and meet redemptions.

The Commission, and we in the Division in particular, are committed to fulfilling our role of both facilitating innovation and assuring investor protection. The Division has been working with the Division of Corporation Finance on an interpretive release clarifying and expanding the releases issued in 1995 and 1996 concerning electronic delivery of information. We expect to have the release out very shortly. The release should provide guidance on telephonic and oral consent to receive information electronically, and will discuss the issues raised by hyperlinks. In addition, the release will address the propriety of "global consent" by an investor to a financial intermediary, which would allow electronic delivery of all documents of any issuer whose securities the investor owns through the intermediary.

b. Y2K

Of course, at the moment many of us are focused on the most immediate technological challenge – Y2K. Over the past year, we have monitored your preparations. We know that the fund industry has dedicated a lot of time and resources to assuring that the millennial calendar change is uneventful. Every indication is that the fund industry is ready. I assure you that the SEC is ready for Y2K. All the SEC's computer systems are fully Year 2000 compliant, including EDGAR.

At the heart of our contingency planning efforts is our focus on possible scenarios and responses in the unlikely event that disruption occurs. Working closely with the industry, we have analyzed a variety of possible Y2K scenarios – contingencies for which we need to be prepared, though we expect that they likely will not come to pass. In thinking about possible disruptions, we will favor responses which have the effect of keeping the industry up and running. In other words, we will expect funds – except in extraordinary circumstances – to remain open to price and process transactions. Doug Scheidt and Barry Miller will discuss Y2K issues later today.

Finally, SEC staff will operate a command and control center to gather critical status information from fund groups and others during the last week of this month and the first week of January. Moreover, there will be Division staff available throughout the "New Year's weekend" should you need to contact us. We stand ready to work with you should unexpected issues arise.

* * *

The mutual fund has had quite a century. While the past cannot be relied on to predict the future, I can assure you that we all will face new and exciting challenges in the century to come. As you make your professional "new millennium resolutions," I urge all of you, as lawyers, compliance officers and advisers to your organizations, whether it be a fund, an investment adviser, or a service provider, to stay ever vigilant. Whether you are a compliance officer or part of the legal department, as an adviser to your organization, you are, in effect, the gatekeeper. In your role at your organization, you will be asked by business and marketing people to pass on the legality (and hopefully the prudence) of many ideas. Just because a particular idea does not violate the federal securities laws or the rules thereunder does not mean that it is ethical or even smart.

Last month marked my one-year anniversary as Division Director. Over this past year, I have seen a number of products and proposals that pushed the envelope. Some of these products and proposals technically did not violate any law or rule. However, that does not mean that they were good for the industry, investors or even the organization that was proposing them.

Business and marketing people are paid to come up with innovative ideas. Compliance and legal people are paid, in part, to protect their organizations. Saying no to an idea that technically may not violate a rule or law, but is nonetheless problematic, takes courage and perseverance, and is part of what it takes to do a good job for your organization (even if you may not be the most popular person in your firm). I am here today to ask you to be vigilant in this area and to say no when need be. You should be in the forefront of assuring the integrity of the mutual fund industry so that the success of the past century can be multiplied in the next. We look forward to working with you in the coming years. Thank you.

¹Investment Trusts and Investment Companies, Report of the SEC, pt. 1, ch. 3, 37 (1939).

²Hugh Bullock, The Story of Investment Companies, Columbia University Press, 97 (1959).

³Federal Reserve Statistical Release Z.1, Flow of Funds Accounts of the United States, L.213 (Sept. 15, 1999).

⁴Certain Broker-Dealers Deemed Not To Be Investment Advisers, Investment Advisers Act Rel. No. 1845 (Nov. 4, 1999) (avail. at http://www.sec.gov/rules/proposed/34-42099.htm).

⁵Cerulli Assocs., Inc., The State of the Wrap and Managed Accounts Industry (1999); see also Frank Byrt, Mutual-Fund Wrap Programs' Growth Tied to Diversity, Dow Jones Newswires (Aug. 26, 1999); Paul J. Lim, Wrap' Plans Offer Convenience, But Be Sure You Know What You'll Get, Los Angeles Times, C-3 (Sept. 12, 1999).

⁶Id.