Testimony 

Before the Subcommittee on Financial 

Management, the Budget and International 

Security, Committee on Governmental 

Affairs, U.S. Senate 

United States General Accounting Office 

GAO

For Release on Delivery 

Expected at 10:00 a.m. EST 

Tuesday, January 27, 2004 MUTUAL FUNDS 

Additional Disclosures 

Could Increase 

Transparency of Fees and 

Other Practices 

Statement of Richard J. Hillman, Director, 

Financial Markets and Community Investment 

GAO-04-317T 
Although mutual funds disclose considerable information about their costs 

to investors, the amount of fees and expenses that each investor specifically 

pays on their mutual fund shares are currently disclosed as percentages of 

fund assets, whereas most other financial services disclose the actual costs 

to the purchaser in dollar terms. SEC staff has proposed requiring funds to 

disclose additional information that could be used to compare fees across 

funds. However, SEC is not proposing that funds disclose the specific dollar 

amount of fees paid by each investor nor is it proposing to require that any 

fee disclosures be made in the account statements that investors receive. 

Although some of these additional disclosures could be costly and data on 

their benefits to investors was not generally available, less costly 

alternatives exist that could increase the transparency and investor 

awareness of mutual funds fees, making consideration of additional fee 

disclosures worthwhile.

Changes in how mutual funds pay intermediaries to sell fund shares have 

benefited investors but have also raised concerns. Since 1980, mutual 

funds, under SEC Rule 12b-1, have been allowed to use fund assets to pay 

for certain marketing expenses. Over time the use of these fees has 

evolved to provide investors greater flexibility in choosing how to pay for 

the services of individual financial professionals that advise them on fund 

purchases. Another increasingly common marketing practice called 

revenue sharing involves fund investment advisers making additional 

payments to the broker-dealers that distribute their funds’ shares. 

However, these payments may cause the broker-dealers receiving them 

to limit the fund choices they offer to investors and conflict with their 

obligation to recommend the most suitable funds. Regulators 

acknowledged that the current disclosure regulations might not always 

result in complete information about these payments being disclosed to 

investors. 

Under soft dollar arrangements, mutual fund investment advisers use 

part of the brokerage commissions they pay to broker-dealers for 

executing trades to obtain research and other services. Although industry 

participants said that soft dollars allow fund advisers access to a wider 

range of research than may otherwise be available and provide other 

benefits, these arrangements also can create incentives for investment 

advisers to trade excessively to obtain more soft dollar services, thereby 

increasing fund shareholders’ costs. SEC staff has recommended various 

changes that would increase transparency by expanding advisers’ 

disclosure of their use of soft dollars. By acting on the staff’s 

recommendations SEC would provide fund investors and directors with 

needed information about how their funds’ advisers are using soft 

dollars. 

Concerns have been raised over 

whether the disclosures of mutual 

fund fees and other fund practices 

are sufficiently fair and transparent 

to investors. Our June 2003 report, 

Mutual Funds: Greater 

Transparency Needed in 

Disclosures to Investors, GAO-03-

763, reviewed (1) how mutual 

funds disclose their fees and 

related trading costs and options 

for improving these disclosures, (2) 

changes in how mutual funds pay 

for the sale of fund shares and how 

the changes in these practices are 

affecting investors, and (3) the 

benefits of and the concerns over 

mutual funds’ use of soft dollars. 

This testimony summarizes the 

results of our report and discusses 

certain events that have occurred 

since it was issued. 

GAO recommends that SEC 

consider the benefits of requiring 

additional disclosure relating to 

mutual fund fees and evaluate ways 

to provide more information that 

investors could use to evaluate the 

conflicts of interest arising from 

payments funds make to brokerdealers and fund advisers’ use of 

soft dollars. SEC generally agreed 

with the contents of our report and 

indicated that it will consider the 

recommendations in this report 

carefully in determining how best 

to inform investors about the 

importance of fees and other 

disclosures. 

www.gao.gov/cgi-bin/getrpt?GAO-04-317T.

To view the full report, including the scope 

and methodology, click on the link above. 

For more information, contact Richard Hillman 

at (202) 512-8678 or hillmanr@gao.gov. 

Highlights of GAO-04-317T, a testimony to 

the Chairman, Subcommittee on Financial 

Management, the Budget and 

International Security, Committee on 

Governmental Affairs, U.S. Senate 

January 27, 2004

MUTUAL FUNDS 

Additional Disclosures Could Increase 

Transparency of Fees and Other 

Practices 
Page 1 GAO-04-317T Mutual Fund Disclosures 

Mr. Chairman and Members of the Subcommittee: 

I am pleased to be here to discuss GAO’s work on the disclosure of mutual 

fund fees and the need for other disclosures of mutual fund practices. The 

fees and other costs that mutual fund investors pay as part of owning fund 

shares can significantly affect their investment returns. In addition, 

changes over time in how mutual funds pay intermediaries to sell fund 

shares have also raised concerns. As a result, it is appropriate to debate 

whether the disclosures of mutual fund fees and fund marketing practices 

are sufficiently transparent and fair to investors. 

Today, I will summarize the results from our report entitled Mutual Funds: 

Greater Transparency Needed in Disclosures to Investors, GAO-03-763

(Washington, D.C.: June 9, 2003). Specifically, I will discuss (1) mutual 

fund fee disclosures and opportunities for improving these disclosures, 

(2) the potential conflicts that arise when mutual fund advisers pay 

broker-dealers to sell fund shares, and (3) the benefits and concerns over 

fund advisers’ use of soft dollars. I will also provide information relating to 

certain events that have occurred since our June 2003 report was issued. 

In summary: 

The results of our work suggest a need to consider ways to increase the 

transparency of mutual fund fees and other fund practices. Mutual funds 

disclose considerable information about their costs to investors, including 

presenting the operating expense fees that they charge investors as a 

percentage of fund assets and providing hypothetical examples of the 

amount of fees that an investor can expect to pay over various time 

periods. However, unlike many other financial products and services, 

mutual funds do not disclose to individual investors the specific dollar 

amount of fees that are paid on their fund shares. The Securities and 

Exchange Commission (SEC) has proposed that mutual funds make 

additional disclosures to investors that would provide more information 

that investors could use to compare fees across funds. However, SEC is 

not proposing that funds disclose the specific dollar amount of fees paid 

by each investor nor is it proposing to require that any fee disclosures be 

made in the account statements that inform investors of the number and 

value of the mutual fund shares they own. Our report recommends that 

SEC consider requiring mutual funds to make additional disclosures to 

investors, including considering requiring funds to specifically disclose 

fees in dollars to each investor in quarterly account statements. SEC has 

agreed to consider requiring such disclosures but was unsure that the 

benefits of implementing specific dollar disclosures outweighed the costs 
Page 2 GAO-04-317T Mutual Fund Disclosures 

to produce such disclosures. However, we estimate that spreading these 

implementation costs across all investor accounts might not represent a 

large outlay on a per investor basis. Our report also discusses less costly 

alternatives that could also prove beneficial to investors and spur 

increased competition among mutual funds on the basis of fees. 

The work that we conducted for our report also found that 12b-1 fees, 

which allow fund companies to deduct certain distribution expenses such 

as sales commissions from fund assets, can raise costs to investors but 

also provide additional ways for investors to pay for investment advice. 

Our work also found that mutual fund advisers have been increasingly 

engaged in a practice known as revenue sharing under which they make 

additional payments to the broker-dealers that sell their fund shares. 

Although we found that the impact of these payments on the expenses of 

fund investors was uncertain, these payments can create conflicts between 

the interests of broker-dealers and their customers that could limit the 

choices of funds that these broker-dealers offer investors. However, under 

current disclosure requirements investors may not always be explicitly 

informed that their broker-dealer, who is obligated to recommend only 

suitable investments based on the investor’s financial condition, is also 

receiving payments to sell particular funds. Our report recommends that 

more disclosure be made to investors about any revenue sharing payments 

their broker-dealers are receiving. On January 14, 2004, SEC proposed new 

rules and rule amendments designed to enhance the information that 

broker-dealers provide to their customers concerning conflicts of interest 

that arise from the sale of mutual funds. 

We also reviewed a practice known as soft dollars, in which a mutual fund 

adviser uses fund assets to pay commissions to broker-dealers for 

executing trades in securities for the mutual fund’s portfolio but also 

receives research or other brokerage services as part of the transaction. 

These soft dollar arrangements can result in mutual fund advisers 

obtaining research or other services, including research from third party 

independent research firms, that can benefit the investors in their funds. 

However, these arrangements also create a conflict of interest that could 

result in increased expenses to fund shareholders if a fund adviser trades 

excessively to obtain additional soft dollar research or chooses brokerdealers more on the basis of their soft dollar offerings than their ability to 

execute trades efficiently. SEC has addressed soft dollar practices in the 

past and recommended actions could provide additional information to 

fund directors and investors, but has not yet acted on some of its own 

recommendations. Our report recommends that more disclosure be made 

to mutual fund directors and investors to allow them to better evaluate the 
Page 3 GAO-04-317T Mutual Fund Disclosures 

benefits and potential disadvantages of their fund adviser’s use of soft 

dollars. 

Finally, since September 2003, federal and state authorities’ widening 

investigation of illegal late trading and improper timing of fund trades has 

involved a growing number of prominent mutual fund companies and 

brokerage firms. To address these abusive practices, regulators are 

considering the merits of various proposals that have been put forth. In 

addition, in November 2003, the House of Representatives acted on 

legislation that addresses abusive trading and various other mutual fund 

issues and legislation was introduced in the Senate. The House of 

Representatives passed H.R. 2420, the Mutual Funds Integrity and Fee 

Transparency Act of 2003. H.R. 2420’s purpose is to (1) improve 

transparency of mutual fund fees and costs and (2) improve corporate 

governance and management integrity of mutual funds. Also in November 

2003, three bills addressing mutual fund concerns were introduced in the 

Senate. The Mutual Fund Transparency Act of 2003, S. 1822, would require 

disclosure of financial relationships between brokers and mutual fund 

companies and of certain brokerage commissions paid by mutual fund 

companies. S. 1958, the Mutual Fund Investor Protection Act of 2003, was 

introduced to prevent the practice of late trading by mutual funds, and for 

other purposes. S. 1971, the Mutual Fund Investor Confidence Restoration 

Act of 2003 seeks to improve transparency relating to the fees and costs 

that mutual fund investors incur and to improve corporate governance of 

mutual funds. 

Although mutual funds already disclose considerable information about 

the fees they charge, our report recommends that SEC consider requiring 

that mutual funds make additional disclosures to investors about fees in 

the account statements that investors receive. Mutual funds currently 

provide information about the fees they charge investors as an operating 

expense ratio that shows as a percentage of fund assets all the fees and 

other expenses that the fund adviser deducts from the assets of the fund. 

Mutual funds also are required to present a hypothetical example that 

shows in dollar terms what investors could expect to pay in fees if they 

invested $10,000 in a fund and held it for various periods. It is important to 

understand the fees charged by a mutual fund because fees can 

significantly affect investment returns of the fund over the long term. For 

example, over a 20-year period a $10,000 investment in a fund earning 8 

percent annually, with a 1-percent expense ratio, would be worth $38,122; 

but with a 2-percent expense ratio it would be worth $31,117—over $7,000 

less. 

Additional Disclosure 

of Mutual Fund Costs 

Might Benefit 

Investors 
Page 4 GAO-04-317T Mutual Fund Disclosures 

Unlike many other financial products, mutual funds do not provide 

investors with information about the specific dollar amounts of the fees 

that have been deducted from the value of their shares. Table 1 shows that 

many other financial products do present their costs in specific dollar 

amounts. 

Table 1: Fee Disclosure Practices for Selected Financial Services or Products 

Type of product 

or service Disclosure requirement 

Mutual funds Mutual funds show the operating expenses as percentages of 

fund assets and dollar amounts for hypothetical investment 

amounts based on estimated future expenses in the 

prospectus. 

Deposit accounts Depository institutions are required to disclose itemized fees, in 

dollar amounts, on periodic statements. 

Bank trust services Although covered by varying state laws, regulatory and 

association officials for banks indicated that trust service 

charges are generally shown as specific dollar amounts. 

Investment 

services provided 

to individual 

investment 

accounts (such as 

those managed by 

a financial planner) 

 When the provider has the right to deduct fees and other 

charges directly from the investor’s account, the dollar amounts 

of such charges are required to be disclosed to the investor. 

Wrap accountsa Provider is required to disclose dollar amount of fees on 

investors’ statements. 

Stock purchases Broker-dealers are required to report specific dollar amounts 

charged as commissions to investors. 

Mortgage financing Mortgage lenders are required to provide at time of settlement 

a statement containing information on the annual percentage 

rate paid on the outstanding balance, and the total dollar 

amount of any finance charges, the amount financed, and the 

total of all payments required. 

Credit cards Lenders are required to disclose the annual percentage rate 

paid for purchases and cash advances, and the dollar amounts 

of these charges appear on cardholder statements. 

Source: GAO analysis of applicable disclosure regulations, rules, and industry practices. 

a

In a wrap account, a customer receives investment advisory and brokerage execution services from 

a broker-dealer or other financial intermediary for a “wrapped” fee that is not based on transactions in 

the customer’s account. 

Although mutual funds do not disclose their costs to each individual 

investor in specific dollars, the disclosures that they make do exceed those 

of many products. For example, purchasers of fixed annuities are not told 

of the expenses associated with investing in such products. Some industry 
Page 5 GAO-04-317T Mutual Fund Disclosures 

participants and others including SEC also cite the example of bank 

savings accounts, which pay stated interest rates to their holders but do 

not explain how much profit or expenses the bank incurs to offer such 

products. While this is true, we do not believe this is an analogous 

comparison to mutual fund fees because the operating expenses of the 

bank are not paid using the funds of the savings account holder and are 

therefore not explicit costs to the investor like the fees on a mutual fund. 

A number of alternatives have been proposed for improving the disclosure 

of mutual fund fees, that could provide additional information to fund 

investors. In December 2002, SEC released proposed rule amendments, 

which include a requirement that mutual funds make additional 

disclosures about their expenses.1

 This information would be presented to 

investors in the annual and semiannual reports prepared by mutual funds. 

Specifically, mutual funds would be required to disclose the cost in dollars 

associated with an investment of $10,000 that earned the fund’s actual 

return and incurred the fund’s actual expenses paid during the period. In 

addition, SEC also proposed that mutual funds be required to disclose the 

cost in dollars, based on the fund’s actual expenses, of a $10,000 

investment that earned a standardized return of 5 percent. If these 

disclosures become mandatory, investors will have additional information 

that could be directly compared across funds. By placing the disclosures 

in funds’ annual and semiannual reports, SEC staff also indicated that it 

will facilitate prospective investors comparing funds’ expenses before 

making a purchase decision. 

However, SEC’s proposal would not require mutual funds to disclose to 

each investor the specific amount of fees in dollars that are paid on the 

shares they own. As result, investors will not receive information on the 

costs of mutual fund investing in the same way they see the costs of many 

other financial products and services that they may use. In addition, SEC 

did not propose that mutual funds provide information relating to fees in 

the quarterly or even more frequent account statements that provide 

investors with the number and value of their mutual fund shares. In a 1997 

survey of how investors obtain information about their funds, the Investment 

Company Institute (ICI) indicated that, to shareholders, the account 

statement is probably the most important communication that they receive 

 1

“Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management 

Investment Companies, Securities and Exchange Commission,” Release Nos. 33-8164; 34-

47023; IC-2587068 (Dec. 18, 2002). 
Page 6 GAO-04-317T Mutual Fund Disclosures 

from a mutual fund company and that nearly all shareholders use such 

statements to monitor their mutual funds. 

SEC and industry participants have indicated that the total cost of 

providing specific dollar fee disclosures might be significant; however, we 

found that the cost might not represent a large outlay on a per investor 

basis. As we reported in our March 2003 statement for the record to the 

Subcommittee on Capital Markets, Insurance, and Government Sponsored 

Enterprises, House Committee on Financial Services, ICI commissioned a 

large accounting firm to survey mutual fund companies about the costs of 

producing such disclosures. 2

 Receiving responses from broker-dealers, 

mutual fund service providers, and fund companies representing 

approximately 77 percent of total industry assets as of June 30, 2000, this 

study estimated that the aggregated estimated costs for the survey 

respondents to implement specific dollar disclosures in shareholder 

account statements would exceed $200 million, and the annual costs of 

compliance would be about $66 million. Although the ICI study included 

information from some broker-dealers and fund service providers, it did 

not include the reportedly significant costs that all broker-dealers and 

other third-party financial institutions that maintain accounts on behalf of 

individual mutual fund shareholders could incur. However, using available 

information on mutual fund assets and accounts from ICI and spreading 

such costs across all investor accounts indicates that the additional 

expenses to any one investor are minimal. Specifically, at the end of 2001, 

ICI reported that mutual fund assets totaled $6.975 trillion. If mutual fund 

companies charged, for example, the entire $266 million cost of 

implementing the disclosures to investors in the first year, then dividing 

this additional cost by the total assets outstanding at the end of 2001 

would increase the average fee by 0.0038 percent or about one-third of a 

basis point. In addition, ICI reported that the $6.975 trillion in total assets 

was held in over 248 million mutual fund accounts, equating to an average 

account of just over $28,000. Therefore, implementing these disclosures 

 2

U.S. General Accounting Office, Mutual Funds: Information on Trends in Fees and Their 

Related Disclosure, GAO-03-551T (Washington, D.C.: Mar. 12, 2003). 
Page 7 GAO-04-317T Mutual Fund Disclosures 

would add $1.07 to the average $184 that these accounts would pay in total 

operating expense fees each year—an increase of six-tenths of a percent.3

In addition, other less costly alternatives are also available that could 

increase investor awareness of the fees they are paying on their mutual 

funds by providing them with information on the fees they pay in the 

quarterly statements that provide information on an investor’s share 

balance and account value. For example, one alternative that would not 

likely be overly expensive would be to require these quarterly statements 

to present the information—the dollar amount of a fund’s fees based on a 

set investment amount—that SEC has proposed be added to mutual fund 

semiannual reports. Doing so would place this additional fee disclosure in 

the document generally considered to be of the most interest to investors. 

An even less costly alternative could be to require quarterly statements to 

also include a notice that reminds investors that they pay fees and to 

check their prospectus and with their financial adviser for more 

information. In September 2003, SEC amended fund advertising rules, 

which require funds to state in advertisements that investors should 

consider a fund’s fees before investing and directs investors to consult 

their funds’ prospectus.4

 However, also including this information in the 

quarterly statement could increase investor awareness of the impact that 

fees have on their mutual fund’s returns. H.R. 2420 would require that 

funds disclose in the quarterly statement or other appropriate shareholder 

report an estimated amount of the fees an investor would have to pay on 

each investment of $1,000. S. 1958, like H.R. 2420, would require disclosure 

of fees paid on each $1,000 invested. S. 1971, among other disclosures, 

would require that funds disclose the actual cost borne by each 

shareholder for the operating expenses of the fund. 

SEC’s current proposal, while offering some advantages, does not make 

mutual funds comparable to other products and provide information in the 

 3

To determine these amounts, we used the operating expense ratios that ICI estimated in 

its September 2002 fee study—which reported average expense ratios of 0.88 percent for 

equity funds, 0.57 percent for bond funds, and 0.32 percent for money market funds. By 

weighting each of these by the total assets invested in each fund type, we calculated that 

the weighted average expense ratio for all funds was 0.66 percent. Using this average 

expense ratio, the average account size of $28,000 would pay $184 in fees. The additional 

expense of implementing specific dollar disclosures of 0.0038 percent would therefore add 

$1.07 to this amount. 

4

Final Rule: Amendments to Investment Company Advertising Rules, Securities and 

Exchange Commission, Release Nos. 33-8294; 34-48558; IC-26195 (Sep. 29, 2003). 
Page 8 GAO-04-317T Mutual Fund Disclosures 

document that is most relevant to investors—the quarterly account 

statement. Our report recommends that SEC consider requiring additional 

disclosures relating to fees be made to investors in the account statement. 

In addition to providing specific dollar disclosures, we also noted that 

investors could be provided with a variety of other disclosures about the 

fees they pay on mutual funds that would have a range of implementation 

costs, including some that would be less costly than providing specific 

dollar disclosures. However, seeing the specific dollar amount paid on 

shares owned could be the incentive that some investors need to take 

action to compare their fund’s expenses to those of other funds and make 

more informed investment decisions on this basis. Such disclosures may 

also increasingly motivate fund companies to respond competitively by 

lowering fees. Because the disclosures that SEC is currently proposing be 

included in mutual fund annual and semiannual reports could also prove 

beneficial, it could choose to require disclosures in these documents and 

the account statements, which would provide both prospective and 

existing investors in mutual funds access to valuable information about 

the costs of investing in funds. 

Academics and other industry observers have also called for increased 

disclosure of mutual fund brokerage commissions and other trading costs 

that are not currently included in fund expense ratios. In an academic 

study we reviewed that looked at brokerage commission costs, the authors 

urged that investors pay increased attention to such costs.5

 For example, 

the study noted that investors seeking to choose their funds on the basis of 

expenses should also consider reviewing trading costs as relevant 

information because the impact of these unobservable trading costs is 

comparable to the more observable expense ratio. The authors of another 

study noted that research shows that all expenses can reduce returns so 

attention should be paid to fund trading costs, including brokerage 

commissions, and that these costs should not be relegated to being 

disclosed only in mutual funds’ Statement of Additional Information.6

 5

J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, “Mutual Fund Trading Costs,” Rodney L. 

White Center for Financial Research, The Wharton School, University of Pennsylvania 

(Nov. 2, 1999). 

6

M. Livingston and E.S. O’Neal, “Mutual Fund Brokerage Commissions,” Journal of 

Financial Research (Summer 1996). 

Disclosures of Trading 

Costs Could Benefit 

Investors 
Page 9 GAO-04-317T Mutual Fund Disclosures 

Mutual fund officials raised various concerns about expanding the 

disclosure of brokerage commissions and trading costs in general. Some 

officials said that requiring funds to present additional information about 

brokerage commissions by including such costs in the fund’s operating 

expense ratios would not present information to investors that could be 

easily compared across funds. For example, funds that invest in securities 

on the New York Stock Exchange (NYSE), for which commissions are 

usually paid, would pay more in total commissions than would funds that 

invest primarily in securities listed on NASDAQ because the brokerdealers offering such securities are usually compensated by spreads rather 

than explicit commissions. Similarly, most bond fund transactions are 

subject to markups rather than explicit commissions. If funds were 

required to disclose the costs of trades that involve spreads, officials noted 

that such amounts would be subject to estimation errors. Officials at one 

fund company told us that it would be difficult for fund companies to 

produce a percentage figure for other trading costs outside of 

commissions because no agreed upon methodology for quantifying market 

impact costs, spreads, and markup costs exists within the industry. Other 

industry participants told us that due to the complexity of calculating such 

figures, trading cost disclosure is likely to confuse investors. For example 

funds that attempt to mimic the performance of certain stock indexes, 

such as the Standard & Poors 500 stock index, and thus limit their 

investments to just these securities have lower brokerage commissions 

because they trade less. In contrast, other funds may employ a strategy 

that requires them to trade frequently and thus would have higher 

brokerage commissions. However, choosing among these funds on the 

basis of their relative trading costs may not be the best approach for an 

investor because of the differences in these two types of strategies. 

To improve the disclosure of trading costs to investors, the House-passed 

H.R. 2420 would require mutual fund companies to make more prominent 

their portfolio turnover disclosure which, by measuring the extent to 

which the assets in a fund are bought and sold, provides an indirect 

measure of transaction costs for a fund. The bill directs funds to include 

this disclosure in a document that is more widely read than the prospectus 

or Statement of Additional Information, and would require fund 

companies to provide a description of the effect of high portfolio turnover 

rates on fund expenses and performance. H.R 2420 also requires SEC to 

issue a concept release examining the issue of portfolio transaction costs. 

S. 1822 would require mutual funds to disclose brokerage commissions as 

part of fund expenses. S. 1958 would require SEC to issue a concept 

release on disclosure of portfolio transaction costs. S. 1971 would require 

funds to disclose the estimated expenses paid for costs associated with 
Page 10 GAO-04-317T Mutual Fund Disclosures 

management of the fund that reduces the funds overall value, including 

brokerage commissions, revenue sharing and directed brokerage 

arrangements, transactions costs and other fees. In December 2003, SEC 

issued a concept release to solicit views on how SEC could improve the 

information that mutual funds disclose about their portfolio transaction 

costs.7

The way that investors pay for the advice of financial professionals about 

their mutual funds has evolved over time. Approximately 80 percent of 

mutual fund purchases are made through broker-dealers or other financial 

professionals, such as financial planners and pension plan administrators. 

Previously, the compensation that these financial professionals received 

for assisting investors with mutual fund purchases were paid by either 

charging investors a sales charge or load or by paying for such expenses 

out of the investment adviser’s own profits. 

However, in 1980, SEC adopted rule 12b-1 under the Investment Company 

Act to help funds counter a period of net redemptions by allowing them to 

use fund assets to pay the expenses associated with the distribution of 

fund shares. Rule 12b-1 plans were envisioned as temporary measures to 

be used during periods of declining assets. Any activity that is primarily 

intended to result in the sale of mutual fund shares must be included as a 

12b-1 expense and can include advertising; compensation of underwriters, 

dealers, and sales personnel; printing and mailing prospectuses to persons 

other than current shareholders; and printing and mailing sales literature. 

These fees are called 12b-1 fees after the rule that allows fund assets to be 

used to pay for fund marketing and distribution expenses. 

NASD, whose rules govern the distribution of fund shares by broker 

dealers, limits the annual rate at which 12b-1 fees may be paid to brokerdealers to no more than 0.75 percent of a fund’s average net assets per 

year. Funds are allowed to include an additional service fee of up to 0.25 

percent of average net assets each year to compensate sales professionals 

for providing ongoing services to investors or for maintaining their 

accounts. Therefore, 12b-1 fees included in a fund’s total expense ratio are 

limited to a maximum of 1 percent per year. Rule 12b-1 provides investors 

 7

Concept Release: Request for Comments on Measures to Improve Disclosure of Mutual 

Fund Transaction Costs, release Nos. 33-8349; 34-48952; IC-26313; File No. S7-29-03 

(Dec. 19, 2003). 

Changes in Some 

Fund Distribution 

Practices Likely 

Beneficial But Others 

Raise Potential 

Conflicts of Interest 
Page 11 GAO-04-317T Mutual Fund Disclosures 

an alternative way of paying for investment advice and purchases of fund 

shares. Apart from 12b-1 fees, brokers can be paid with sales charges 

called “loads”; “front-end” loads are applied when shares in a fund are 

purchased and “back-end” loads when shares are redeemed. With a 12b-1 

plan, the fund can finance the broker’s compensation with installments 

deducted from fund assets over a period of several years. Thus, 12b-1 

plans allow investors to consider the time-related objectives of their 

investment and possibly earn returns on the full amount of the money they 

have to invest, rather than have a portion of their investment immediately 

deducted to pay their broker. 

Rule 12b-1 has also made it possible for fund companies to market fund 

shares through a variety of share classes designed to help meet the 

different objectives of investors. For example, Class A shares might charge 

front-end loads to compensate brokers and may offer discounts called 

breakpoints for larger purchases of fund shares. Class B shares, 

alternatively, might not have front-end loads, but would impose assetbased 12b-1 fees to finance broker compensation over several years. Class 

B shares also might have deferred back-end loads if shares are redeemed 

within a certain number of years and might convert to Class A shares if 

held a certain number of years, such as 7 or 8 years. Class C shares might 

have a higher 12b-1 fee, but generally would not impose any front-end or 

back-end loads. While Class A shares might be more attractive to larger, 

more sophisticated investors who wanted to take advantage of the 

breakpoints, smaller investors, depending on how long they plan to hold 

the shares, might prefer Class B or C shares because no sales charges 

would be deducted from their initial investments. 

Although providing alternative means for investors to pay for the advice of 

financial professionals, some concerns exist over the impact of 12b-1 fees 

on investors’ costs. For example, our June 2003 report discussed academic 

studies that found that funds with 12b-1 plans had higher management fees 

and expenses. Questions involving funds with 12b-1 fees have also been 

raised over whether some investors are paying too much for their funds 

depending on which share class they purchase. For example, SEC recently 

brought a case against a major broker dealer that it accused of 

inappropriately selling mutual fund B shares, which have higher 12b-1 

fees, to investors who would have been better off purchasing A shares that 

had much lower 12b-1 fees. Also, in March 2003, NASD, NYSE, and SEC 

staff reported on the results of jointly administered examinations of 43 

registered broker-dealers that sell mutual funds with a front-end load. The 

examinations found that most of the brokerage firms examined, in some 
Page 12 GAO-04-317T Mutual Fund Disclosures 

instances, did not provide customers with breakpoint discounts for which 

they appeared to have been eligible. 

One mutual fund distribution practice—called revenue sharing—that has 

become increasingly common raises potential conflicts of interest between 

broker-dealers and their mutual fund investor customers. Broker-dealers, 

whose extensive distribution networks and large staffs of financial 

professionals who work directly with and make investment 

recommendations to investors, have increasingly required mutual funds to 

make additional payments to compensate their firms beyond the sales 

loads and 12b-1 fees. These payments, called revenue sharing payments, 

come from the adviser’s profits and may supplement distribution-related 

payments from fund assets. According to an article in one trade journal, 

revenue sharing payments made by major fund companies to brokerdealers may total as much as $2 billion per year. According to the officials 

of a mutual fund research organization, about 80 percent of fund 

companies that partner with major broker-dealers make cash revenue 

sharing payments. For example, some broker-dealers have narrowed their 

offerings of funds or created preferred lists that include the funds of just 

six or seven fund companies that then become the funds that receive the 

most marketing by these broker-dealers. In order to be selected as one of 

the preferred fund families on these lists, the mutual fund adviser often is 

required to compensate the broker-dealer firms with revenue sharing 

payments. 

One of the concerns raised about revenue sharing payments is the effect 

on overall fund expenses. A 2001 research organization report on fund 

distribution practices noted that the extent to which revenue sharing 

might affect other fees that funds charge, such as 12b-1 fees or 

management fees, was uncertain. For example, the report noted that it was 

not clear whether the increase in revenue sharing payments increased any 

fund’s fees, but also noted that by reducing fund adviser profits, revenue 

sharing would likely prevent advisers from lowering their fees. In addition, 

fund directors normally would not question revenue sharing arrangements 

paid from the adviser’s profits. In the course of reviewing advisory 

contracts, fund directors consider the adviser’s profits not taking into 

account marketing and distribution expenses, which also could prevent 

advisers from shifting these costs to the fund. 

Revenue sharing payments may also create conflicts of interest between 

broker-dealers and their customers. By receiving compensation to 

emphasize the marketing of particular funds, broker-dealers and their 

Revenue Sharing Raises 

Conflict of Interest 

Concerns 
Page 13 GAO-04-317T Mutual Fund Disclosures 

sales representatives may have incentives to offer funds for reasons other 

than the needs of the investor. For example, revenue sharing arrangements 

might unduly focus the attention of broker-dealers on particular mutual 

funds, reducing the number of funds considered as part of an investment 

decision−potentially leading to inferior investment choices and potentially 

reducing fee competition among funds. Finally, concerns have been raised 

that revenue sharing arrangements might conflict with securities selfregulatory organization rules requiring that brokers recommend 

purchasing a security only after ensuring that the investment is suitable 

given the investor’s financial situation and risk profile. 

Although revenue sharing payments can create conflicts of interest 

between broker-dealers and their clients, the extent to which brokerdealers disclose to their clients that their firms receive such payments 

from fund advisers is not clear. Rule 10b-10 under the Securities Exchange 

Act of 1934 requires, among other things, that broker-dealers provide 

customers with information about third-party compensation that brokerdealers receive in connection with securities transactions. While brokerdealers generally satisfy the 10b-10 requirements by providing customers 

with written “confirmations,” the rule does not specifically require brokerdealers to provide the required information about third-party 

compensation related to mutual fund purchases in any particular 

document. SEC staff told us that they interpret rule 10b-10 to permit 

broker-dealers to disclose third-party compensation related to mutual fund 

purchases through delivery of a fund prospectus that discusses the 

compensation. However, investors would not receive a confirmation and 

might not view a prospectus until after purchasing mutual fund shares. 

As a result of these concerns, our report recommends that SEC evaluate 

ways to provide more information to investors about the revenue sharing 

payments that funds make to broker-dealers. Having additional disclosures 

made at the time that fund shares are recommended about the 

compensation that a broker-dealer receives from fund companies could 

provide investors with more complete information to consider when 

making their investment decision. To address revenue sharing issues, we 

were pleased to see that a recent NASD rule proposal would require 

broker-dealers to disclose in writing when the customer first opens an 

account or purchases mutual fund shares compensation that they receive 

from fund companies for providing their funds “shelf space” or preference 

over other funds. On January 14, 2004, SEC proposed new rules and rule 

amendments designed to enhance the information that broker-dealers 

provide to their customers. H.R. 2420 would require fund directors to 

review revenue sharing arrangements consistent with their fiduciary duty 
Page 14 GAO-04-317T Mutual Fund Disclosures 

to the fund. H.R. 2420 also would require funds to disclose revenue sharing 

arrangements and require brokers to disclose whether they have received 

any financial incentives to sell a particular fund or class of shares. S. 1822 

would require brokers to disclose in writing any compensation received in 

connection with a customer’s purchase of mutual fund shares. S. 1971 

would require fund companies and investment advisers to fully disclose 

certain sales practices, including revenue sharing and directed brokerage 

arrangements, shareholder eligibility for breakpoint discounts, and the 

value of research and other services paid for as part of brokerage 

commissions. 

Soft dollar arrangements allow fund investment advisers to obtain 

research and brokerage services that could potentially benefit fund 

investors but could also increase investors’ costs. When investment 

advisers buy or sell securities for a fund, they may have to pay the brokerdealers that execute these trades a commission using fund assets. In 

return for these brokerage commissions, many broker-dealers provide 

advisers with a bundle of services, including trade execution, access to 

analysts and traders, and research products. 

Some industry participants argue that the use of soft dollars benefits 

investors in various ways. The research that the fund adviser obtains can 

directly benefit a fund’s investors if the adviser uses it to select securities 

for purchase or sale by the fund. The prevalence of soft dollar 

arrangements also allows specialized, independent research to flourish, 

thereby providing money managers a wider choice of investment ideas. As 

a result, this research could contribute to better fund performance. The 

proliferation of research available as a result of soft dollars might also 

have other benefits. For example, an investment adviser official told us 

that the research on smaller companies helps create a more efficient 

market for such companies’ securities, resulting in greater market liquidity 

and lower spreads, which would benefit all investors including those in 

mutual funds. 

Although the research and brokerage services that fund advisers obtain 

through the use of soft dollars could benefit a mutual fund investor, this 

practice also could increase investors’ costs and create potential conflicts 

of interest that could harm fund investors. For example, soft dollars could 

cause investors to pay higher brokerage commissions than they otherwise 

would, because advisers might choose broker-dealers on the basis of soft 

dollar products and services, not trade execution quality. One academic 

study shows that trades executed by broker-dealers that specialize in 

Soft Dollar 

Arrangements Provide 

Benefits, but Could 

Adversely Impact 

Investors 
Page 15 GAO-04-317T Mutual Fund Disclosures 

providing soft dollar products and services tend to be more expensive than 

those executed through other broker-dealers, including full-service brokerdealers.8

 Soft dollar arrangements could also encourage advisers to trade 

more in order to pay for more soft dollar products and services. 

Overtrading would cause investors to pay more in brokerage commissions 

than they otherwise would. These arrangements might also tempt advisers 

to “over-consume” research because they are not paying for it directly. In 

turn, advisers might have less incentive to negotiate lower commissions, 

resulting in investors paying more for trades. 

Under the Investment Advisers Act of 1940, advisers must disclose details 

of their soft dollar arrangements in Part II of Form ADV, which investment 

advisers use to register with SEC and must send to their advisory clients. 

However, this form is not provided to the shareholders of a mutual fund, 

although the information about the soft dollar practices that the adviser 

uses for particular funds are required to be included in the Statement of 

Additional Information that funds prepare, which is available to investors 

upon request. Specifically, Form ADV requires advisers to describe the 

factors considered in selecting brokers and determining the 

reasonableness of their commissions. If the value of the products, 

research, and services given to the adviser affects the choice of brokers or 

the brokerage commission paid, the adviser must also describe the 

products, research and services and whether clients might pay 

commissions higher than those obtainable from other brokers in return for 

those products. 

In a series of regulatory examinations performed in 1998, SEC staff found 

examples of problems relating to investment advisers’ use of soft dollars, 

although far fewer problems were attributable to mutual fund advisers. In 

response, SEC staff issued a report that included proposals to address the 

potential conflicts created by these arrangements, including 

recommending that investment advisers keep better records and disclose 

more information about their use of soft dollars. Although the 

recommendations could increase the transparency of these arrangements 

and help fund directors and investors better evaluate advisers’ use of soft 

dollars, SEC has yet to take action on some of its proposed 

recommendations. 

 8

J.S. Conrad, K.M Johnson, and S. Wahal, “Institutional Trading and Soft Dollars,” Journal 

of Finance (February 2001). 
Page 16 GAO-04-317T Mutual Fund Disclosures 

As a result, our June 2003 report recommends that SEC evaluate ways to 

provide additional information to fund directors and investors on their 

fund advisers’ use of soft dollars. SEC relies on disclosure of information 

as a primary means of addressing potential conflicts between investors 

and financial professionals. However, because SEC has not acted to more 

fully address soft dollar-related concerns, investors and mutual fund 

directors have less complete and transparent information with which to 

evaluate the benefits and potential disadvantages of their fund adviser’s 

use of soft dollars. 

To address the inherent conflicts of interest with respect to soft dollar 

arrangements, H.R. 2420 would 

• require SEC to issue rules mandating disclosure of information about 

soft dollar arrangements; 

• require fund advisers to submit to the fund’s board of directors an 

annual report on these arrangements, and require the fund to provide 

shareholders with a summary of that report in its annual report to 

shareholders; 

• impose a fiduciary duty on the fund’s board of directors to review soft 

dollar arrangements; 

• direct SEC to issue rules to require enhanced recordkeeping of soft 

dollar arrangements; and 

• require SEC to conduct a study of soft-dollar arrangements, including 

the trends in the average amounts of soft dollar commissions, the types 

of services provided through these arrangements, the benefits and 

disadvantages of the use of soft dollar arrangements, the impact of soft 

dollar arrangements on investors’ ability to compare the expenses of 

mutual funds, the conflicts of interest created by these arrangements 

and the effectiveness of the board of directors in managing such 

conflicts, and the transparency of soft dollar arrangements. 

S. 1822 would discourage use of soft dollars by requiring that funds 

calculate their value and disclose it along with other fund expenses. S. 

1971 also would require disclosure of soft dollar arrangements and the 

value of the services provided. Also, it would require that SEC conduct a 

study of the use of soft dollar arrangements by investment advisers. 
Page 17 GAO-04-317T Mutual Fund Disclosures 

Since we issued our report in June 2003, various allegations of misconduct 

and abusive practices involving mutual funds have come to light. In early 

September 2003, the Attorney General of the State of New York filed 

charges against a hedge fund manager for arranging with several mutual 

fund companies to improperly trade in fund shares and profiting at the 

expense of other fund shareholders. Since then federal and state 

authorities’ widening investigation of illegal late trading and improper 

timing of fund trades has involved a growing number of prominent mutual 

fund companies and brokerage firms. 

The problems involving late trading arise when some investors are able to 

purchase or sell mutual fund shares after the 4:00 pm Eastern Time close 

of U.S. securities markets, the time at which funds price their shares. 

Under current mutual fund regulations, orders for mutual fund shares 

received after 4:00 pm are required by regulation to be priced at the next 

day’s price.9

 An investor permitted to engage in late trading could be 

buying or selling shares at the 4:00 pm price knowing of developments in 

the financial markets that occurred after 4:00 pm, thus unfairly taking 

advantage of opportunities not available to other fund shareholders. 

Clearly, to ensure compliance with the law, funds should have effective 

internal controls in place to prevent abusive late trading. Regulators are 

considering a rule change requiring that an order to purchase or redeem 

fund shares be received by the fund, its designated transfer agent, or a 

registered securities clearing agency, by the time that the fund establishes 

for calculating its net asset value in order to receive that day’s price. 

The problems involving market timing occur when certain fund investors 

are able to take advantage of temporary disparities between the share 

value of a fund and the values of the underlying assets in the fund’s 

portfolio. For example, such disparities can arise when U.S. mutual funds 

use old prices for their foreign assets even though events have occurred 

overseas that will likely cause significant movements in the prices of those 

assets when their home markets open. Market timing, although not illegal, 

can be unfair to funds’ long-term investors because it provides the 

opportunity for selected fund investors to profit from fund assets at the 

expense of fund long-term investors. To address these issues, regulators 

are considering the merits of various proposals that have been put forth to 

 9

SEC rule 22c-1, promulgated under the Investment Company Act of 1940, prohibits the 

purchase or sale of mutual fund shares except at a price based on current net asset value of 

such shares that is next calculated after receipt of a buy or sell order. 

Various Scandals 

Involving Mutual 

Funds Surfaced in 

2003 
Page 18 GAO-04-317T Mutual Fund Disclosures 

discourage market timing, such as mandatory redemption fees or fair 

value pricing of fund shares.10

To protect fund investors from such unfair trading practices H.R. 2420 

would, with limited exceptions, require that all trades be placed with funds 

by 4:00 pm and includes provisions to eliminate conflicts of interest in 

portfolio management, ban short-term trading by insiders, allow higher 

redemption fees to discourage short-term trading, and encourage wider 

use of fair value pricing to eliminate stale prices that makes market timing 

profitable. S. 1958 would require that fund companies receive orders prior 

to the time they price their shares. S. 1958 would also increase penalties 

for late trading and require funds to explicitly disclose their market timing 

policies and procedures. S.1971 also would restrict the placing of trades 

after hours, require funds to have internal controls in place and 

compliance programs to prevent abusive trading, and require wider use of 

fair value pricing. 

In conclusion, GAO believes that various changes to current disclosures 

and other practices would benefit fund investors. Additional disclosures of 

mutual fund fees could help increase the awareness of investors of the 

fees they pay and encourage greater competition among funds on the basis 

of these fees. Likewise, better disclosure of the costs funds incur to 

distribute their shares and of the costs and benefits of funds’ use of soft 

dollar research activities could provide investors with more complete 

information to consider when making their investment decision. In light of 

recent scandals involving late trading and market timing, various reforms 

to mutual fund rules will also likely be necessary to better protect the 

interests of all mutual fund investors. 

 10Fair value pricing is a process that mutual funds use to value fund shares in the absence 

of current market values, such as for assets traded in foreign markets. 
Page 19 GAO-04-317T Mutual Fund Disclosures 

This concludes my prepared statement and I would be happy to respond to 

questions. 

For further information regarding this testimony, please contact Cody J. 

Goebel at (202) 512-8678. Individuals making key contributions to this 

testimony include Toayoa Aldridge and David Tarosky. 

Contacts and 

Acknowledgements 

(250180) 
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