In early September of 2003, several mutual fund firms were investigated for allowing large investors to profit from practices that were either illegal or actively discouraged by their own published policies.
The practices for which they were investigated, “late-trading” and “market-timing,” involved attempts to capitalize on “stale prices” – mostly in international stocks. Trading in Europe and Japan, for example, ends many hours before the 4 p.m. deadline and, in the interim, events may occur that could lift prices the next day. Through stale-price-arbitrage, an investor can, in effect, bet on a horse after the outcome of the race is known.
Regulation. Congress and the SEC had been examining major changes in the structure and regulation of mutual funds, and, after the scandals, a flood of legislation was introduced, including three major bills in the Senate in the space of 20 days in November. Regulations consider broadening disclosures to investor and specifically addressing late-trading and market timing.
Regulation may Curtail Competition. Some in the industry, such as James Glassman, who testified before the Senate Banking Committee, worry that this increasing regulation in areas such as fees, board composition, and disclosure, runs the risk of limiting choices and raising costs for small investors. The argument is that the mutual fund industry is highly decentralized, competitive, and – despite the scandals and the three year market decline – continues to offer attractive investment opportunities. It has both provided capital for businesses and increased the net worth of families. But, “weighed down by dozens of new counterproductive rules, it could lose its robust character.”
The theoretical underpinning of this argument is that if a mutual fund were to run a dirty shop and investors learn of this deception, the investors will sell their mutual fund shares. Thus, the market punishes this bad behavior without requiring any government intervention.
In fact, this characterization is true. Looking at funds with and without allegations of impropriety, those accused (i.e. Putnam, Janus, Amvescap/Invesco, and Alliance) have faced combined net outflows of $54 billion in their funds. That’s a loss of at least $540 million in revenues in the first year alone, as these funds typically charge between 1% and 1.55% in annual expense ratios. Furthermore, since typical client keep their accounts for five years, funds may lose five times this amount when considering the average account. In addition, , in many cases, there is a 5.25% up front fee, or load that would have added directly to the fund’s bottom line. Simply, when confidence is shaken, “investor discipline is harsh.”
This argument has some appeal to it, though its short-comings, too, cannot be overlooked. First, the fact that mutual fund returns have not been decimated by the alleged improprieties and investors are still investing and making money does not mean that all is well and should be forgiven. All shareholders are entitled to all their returns and should not have any of it diluted or taken by other unscrupulous managers, brokers, or institutional investors.
Second, competition and decentralization, in and of itself, is insufficient to indicate that the market will stamp out any and all bad behavior. The argument that the mutual fund market is decentralized and highly competitive masks that fact that where investors have only imperfect access to information, the market of mutual fund buyers and sellers cannot reach its equilibrium. Clearly, the competition and market forces are at work in the empirical example cited above. However, a precondition for the argument to apply is that investors learn about the wrong-doing. But for government allegations of impropriety, the market may not have known of them and the market would not have self-corrected.
The rebuttal to this critique is that various independent analysts and financial commentators encouraged investors to sell their shares. By doing so, they help make the market for mutual funds more efficient without requiring government intervention and all its related inefficiencies. Furthermore, once the government started making allegations about particular funds, investors responded.
Regulating Trading Activity. Though admittedly, there are systematic problems, proposed regulation prohibiting late trading and market timing will likely hurt the many mutual funds that did not act wrongfully. These ramifications will trickle down and likely result in higher fees and lower returns for investors.
If the SEC or Congress regulate trading activity, funds will have to adopt policies such as an over-shortened trading deadline to prevent any remote possibility of late-trading (i.e. due to a backlog of orders that may be placed before 4 P.M. but would have been filled afterward) and high short-term exit fees to discourage market timing. These regulations will have the side-effect of punishing those having to sell their funds quickly in emergency situations and will discourage managers from selling stock at inopportune times when they need to raise cash. It will discourage innocent investors’ trading, increase transactions costs, and limit fund managers’ ability to capture the best rewards for their investors. Funds’ assets would therefore fall, disadvantaging their investors, who benefit from funds’ economies of scale. If the SEC would allow the funds to self-regulate, some funds will likely cater to the investors who are willing to forgo some returns and economies of scale for the stability of these policies. Otherwise, “the SEC would be dampening competition among funds and providing all of them with serendipitous income in case of emergency.”
Proponents of such regulation would argue that if investors are not sophisticated or informed enough to know the difference between which funds are self-regulating and which are not, even those seek a self-regulating fund may accidentally end up in one that is not.
However, in a competitive market, mutual funds that would cater to this audience will go out of their way to advertise to and educate such investors about the differences as a way to generate new business – thereby fostering competition. Also, as long as the government engages in serious investor education, this criticism will likely dissolve away.
Regulating Disclosures. Another one of the SEC’s main proposals to address these wrongs, going forward, is more verbose disclosures. These disclosures would be in addition to the myriad disclosures that the SEC already requires. One key disclosure would be the cost per $1000 for the mutual fund.
While such a disclosure would be helpful, there are three main criticisms. First, the funds will bear legal, printing and other expenses related to making these disclosures. They pass these costs along to their clients – investors – in the form of higher expenses, thereby reducing their returns. Second, funds already have an incentive to advertise low fees as a marketing tool. They are also required to do so in their prospectuses and “Statement of Additional Information.” Additional disclosures may therefore confuse small investors. Also, investor services such as Morningstar (that had previously been only available to the rich, but are now widely-accessible) already calculate such figures for curious investors. Moreover, the majority of investors who buy through brokerage houses can just ask their brokers about this information. Unsophisticated investors acting on their own probably should be doing so anyway. Catering policies to their needs would be needlessly pandering to the least-common denominator at the cost of inefficiency. Finally, investors are concerned more with returns rather than expenses. Even if an investor knew that XYZ was charging .50% more in fees than ABC, the investor would choose to invest with XYZ if he knew that XYZ was netting 1% more than ABC. The argument is that investors choose investments based on net returns (i.e. net of fees) anyway, so disclosures will not make a big difference in investing patterns of funds’ clients.
However, supporters of more disclosures would argue that these arguments merely contend that the reasons for more disclosures are not compelling. First, the expenses to create additional disclosures are likely to be relatively small, in orders of magnitude. Even so, investors are willing to pay these costs for better information about these funds (especially those who are so unsophisticated that they will not look at Morningstar reports).
Another problem with the stated argument is that most investors do not have the time or energy to search through long legal documents to find this information. Online trading is becoming increasingly popular and mutual funds are in the best position to communicate this information. It would save investors the expense of sifting through Morningstar reports and encourage Morningstar to offer even more services to make up for losing this rate-disclosure part of its business back to mutual funds. Funds with low fees have benefited from advertising them. However, the fact that many funds currently charge high fees indicates that they have had an incentive to tacitly collude and bury their fee disclosures, rather than advertise them. Furthermore, since most mutual funds, unlike hedge funds or more sophisticated financial instruments, produce average market returns, fees (as well as returns) are an important distinguishing factor between funds. The costs associated with disclosure are small; disclosure would fuel competition; ultimately, the investor would win.
No definite conclusion can be drawn regarding the proposed fee disclosures, but on the whole, it would appear that the benefits outweigh the costs and additional disclosures will be required by the SEC. However, government intervention would probably be more fruitful with initiatives focused on educating the investing public.
The Bully Pulpit, Technological Progress and Self-Regulation. Directly regulating trading activity will likely dampen competitive forces in the market. Disclosures, while important, do not address the problem of questionable trading practices that prompted investigations into the mutual funds in the first place.
These competitive forces are the principle means of disciplining the market. Since the government, by simply alleging wrongdoing, was so successful in triggering this market correction, it should take a bigger role in educating investors about general investing principles and improprieties.
The SEC has started acquiring new technology and employees to help bolster their regulatory efforts. The SEC can take the lead by implementing its own oversight of funds and perform both random and targeted checks of specific trading activity, similar to what it is considering requiring of the funds.
Requiring funds to perform their own oversight is finding support among policymakers. Some regulators believe that technological systems installed in mutual fund companies, but short of the over-sweeping regulations above, will help attack these problems in the industry. Once these systems will make trading more transparent, large investors will be more easily flagged for improper trading behavior. “Fund companies can use the same technology that market timers used to uncover arbitrage opportunities to protect their shareholders. This technology is available, and it needs to be applied to protect investors. Without that, we will end up with overly restrictive rules, like having a hard close of 4 p.m. for fund trading. That would cause a lot of hardship on individual investors.” Furthermore, more robust technological systems that will allow orders to be placed until 4 P.M. without a backlog would help allay the concerns expressed above.
By the government monitoring such self-regulatory efforts and aggressively exposing short-comings, the funds will have a great incentive in cleaning up their acts. It is clear that “investor discipline is harsh.” With all this government publicity, investors scrutinize their funds much more closely. In return, directors are under more pressure to comply with SEC regulations. Institutional investors that have been tagged with improprieties also have their reputations and financial futures on the line; they will be hard pressed to remove any semblance of illegal trading. With trillions of dollars at play, investors dollars count big in this calculus. Thus, the best acting the government can take is to closely analyze dishonest funds and prosecute them in front of the public’s eye.
Investor Education. Policymakers can also dramatically improve fairness in the mutual find market by focusing on investor education. As a part of a $50 million settlement for their improprieties, mutual funds will likely create a foundation dedicated to educating investors. The foundation will be run apart from the SEC and its executive director and chairman will be appointed by a judge overseeing the settlement. Such education is vital.
Even before this foundation was being formed, in December 2003, the National Association of Securities Dealers, the NASD, created the Investor Education Foundation. Its “mission will be to provide investors with high-quality, easily accessible information and tools to better understand investing and the markets.”[MAA The Foundation, with an initial endowment of $10 million has grown out of the NASD’s concern that investors have “fundamental questions and misunderstandings about important investment issues.” For instance, nearly 80 percent of investors responding to their surveys did not understand fully the meaning of “no load” (i.e. no upfront-fee) mutual funds. The NASD has developed and published Investor Alerts, brochures and online resource guides on such critical topics as mutual fund class shares and 401(k) and college savings plans that it distributes through its Web Site, printed materials and through Investor Forums that have been held in a number of different cities.
Finally, a working paper by two University of Chicago economists clearly depicts the kind of problems that investor education programs can and should address. The authors examined 85 funds mimicking the S&P 500 portfolio, which reflects 500 of the biggest and most successful public companies in the US economy. In mimicking the portfolio, no fund can have much of a strategic advantage, as they all have virtually the same composition. Shockingly, though, the economists found that “the highest-price S&P index fund in 2000 imposed annualized investor fees nearly 30 times as great as those the lowest-cost fund: 2.68% v. 0.095%. Even the 25th percentile and 75th percentile were considerably different, at 4.8 and 14.77 times the cheapest fund, respectively. Regardless of price, the funds command similar market shares. The cheapest commanded 1.4%, while the most-expensive got 1.1%.
The principal reason cited for this divergence in price is investor ignorance. With the dot-com boom of the late 90’s and the advent of online research and investing, investors became much more informed and efficient at deciphering between investments that suited them and those that did not. But this period also introduced a greater number of novice investors to the market. The more novice the investor, the greater his or her information cost (i.e. the value of his or her total time spent researching the best investment vehicle). Thus, even though general information costs for moderately skilled investors were falling (i.e. because of better research and technology by which to transfer it), with the “influx of high-information-cost investors,” funds could afford to charge novice investors higher fees without losing significant business. Such an example clearly demonstrates the importance of government efforts.
Conclusion. While disclosure and hard trading limits can protect novice investors, government should act in a way that will, at most, minimally harm investors. As a result, it should focus more on educating investors about improprieties and facilitating competition between funds. In a competitive market of funds, reputation will become a paramount selling point. Funds will learn that if news of their improper dealings will quickly hit the market (i.e. investors and potential investors), they will lose their greatest marketing asset. With more informed investors sifting through a field of funds that are on more or less equal-footing, funds will better self-regulate and investors will invest with greater confidence and reap greater rewards.
