Mutual Fund "Bad Apples" Haven't Spoiled the Barrel

The mutual fund industry enjoyed an excellent reputation for decades. It was untouched by the recent scandals in corporate America, which led to the bankruptcy of Enron, the indictment and demise of Arthur Anderson, and the adoption of the Sarbanes-Oxley Act.

Public Opinion Problems for Mutual Funds

This halcyon period came to a dramatic end in September 2003 with the Canary Capital case and subsequent developments. In just four months, the fund industry received more unfavorable publicity than it received in the preceding six decades. The SEC, the NASD, state attorneys general, and state securities commissions have launched investigations, and various reforms are being considered by the SEC and Congress. Mutual fund reform proposals have even found their way into the presidential race!

With this constant drumbeat of bad news, the typical investor might justifiably ask – should I continue to invest in mutual funds? The answer is a resounding "yes."

While the late trading and "market timing" violations manifested a serious breach of trust by a small number of fund insiders, the vast majority of fund personnel and funds have been untouched by these scandals. The negative dollar impact of these practices is minimal compared to the $7 trillion fund industry.

Several affected fund groups have already announced plans to reimburse fund shareholders who were hurt by these practices. Alliance Capital entered into a settlement agreement under which fund fees will be reduced by 20% for the next five years, and the MFS funds have tentatively agreed to cut management fees $125 million over the next five years.

Increased Oversight

It has been observed that "Sunlight is a great disinfectant." In response to the well-publicized scandals and enhanced scrutiny, even before the adoption of new SEC rules and new laws, fund groups are carefully scrutinizing their practices and those of financial intermediaries, to make sure there is no late trading or inappropriate market timing. Fund distributors are enhancing their procedures so that shareholders invest in appropriate classes and receive deserved sales load discounts.

In short, while important details of regulatory reform are unresolved, the mutual fund industry has already to a large extent "cleaned up its act." Fund insiders found guilty of illegal acts or egregious judgment have gone to jail, lost their jobs, or like the founder of the Strong Funds, been removed from fund involvement. Fund directors are asking harder questions of management. With the battering which some fund groups have received from regulators and the media (and the consequent loss of large investors such as retirement plans), fund management companies have learned that a highly effective compliance function is indispensable from both an ethical and "bottom line" standpoint.

The one SEC reform proposal which has already been adopted requires that funds have a chief compliance officer, who must be hired by and report directly to the fund directors. With this new requirement, the compliance process will be more robust.

Proposed Rules

The SEC has also proposed rules which will require that:

  1. 75% of fund directors be independent;
  2. fund boards have a chair who is independent of management;
  3. independent directors meet in separate "executive sessions" at least quarterly;
  4. independent directors be authorized to retain their own staff; and
  5. purchasers of fund shares receive the current day's price only if the fund, its designated transfer agent, or a registered securities clearing agency receives the order by 4:00 p.m. Eastern Time. This so-called "hard close" would eliminate the possibility of illegal late trading of fund shares by intermediaries.

Additional SEC action is likely to improve disclosure of mutual fund transaction costs (e.g., portfolio turnover and brokerage commissions), revenue sharing and "soft dollar" practices, and fund policies regarding market timing, disclosure of portfolio holdings and the use of "fair value" pricing.

Additional reform legislation is likely to be enacted. Senator John Kerry has introduced the "Mutual Fund Investor Protection Act" and recently, the House almost unanimously passed the "Mutual Funds Integrity and Fee Transparency Act of 2003." With the bewildering blizzard of proposed reforms emanating from the SEC and Congress, it is too early to speculate on the likelihood of any particular new legislation being adopted, or on the exact provisions of new SEC rules.

The typical fund investor can take comfort, however, from the fact that most funds and fund personnel were not touched by the well-publicized scandals, and that the industry "bad apples" are gone. The typical fund investor should not dwell unduly on the details of new rules and laws. Instead, investors should focus on the importance of maintaining an informed, rational, and disciplined investment approach which embraces such key principles as diversification and reasonable cost. The mutual fund industry will continue to offer products which are consistent with these key principles, and which will help investors meet their long-term investment goals.