Testimony 

Before the Subcommittee on Capital Markets, 

Insurance and Government Sponsored 

Enterprises, Committee on Financial Services, 

House of Representatives 

United States General Accounting Office 

GAO

For Release on Delivery 

Expected at 10:00 a.m. EST 

Wednesday, June 18, 2003 MUTUAL FUNDS 

Additional Disclosures 

Could Increase 

Transparency of Fees and 

Other Practices 

Statement of Richard J. Hillman, Director, 

Financial Markets and Community Investment 

GAO-03-909T 
The work that GAO has conducted at the request of this Committee 

addresses several of the areas that are included in the recently introduced 

Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420). 

Mutual funds disclose considerable information about their costs to 

investors, but unlike many other financial products and services, they do not 

disclose to each investor the specific dollar amount of fees that are paid on 

their fund shares. Consistent with H.R. 2420, 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, which we 

estimate may result in minimal increases in fund expenses. Our report also 

discusses other alternatives that could also prove beneficial to investors and 

spur increased competition among mutual funds on the basis of fees but be 

even less costly to the industry overall. 

U.S. mutual funds have boards of directors who are charged with overseeing 

the interests of fund shareholders. Various corporate governance reforms 

have been proposed to improve the effectiveness of mutual fund boards. As 

a result of SEC requirements or industry best practice recommendations, 

many of these practices were already in place at many funds, but not all such 

practices were mandatory. H.R. 2420 would ensure that all mutual funds 

implement these practices. 

Mutual fund advisers have been increasingly making additional payments out 

of their own profits to the broker-dealers that sell their fund shares. 

Although allowed under current rules, these revenue sharing payments can 

create conflicts between the interests of broker-dealers and their customers 

that could limit the choices of funds that investors are offered. Under 

current disclosure requirements, however, 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. Consistent with H.R. 2420, our 

report also recommended that more disclosure be made to investors about 

any revenue sharing payments their broker-dealers are receiving. 

Under a practice known as soft dollars, 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. Although this research and 

other services can benefit fund investors, these arrangements could result in 

increased expenses for fund shareholders if fund advisers trade excessively 

to obtain additional soft dollar research. 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 all of its 

own recommendations. Consistent with H.R. 2420, our report recommended 

that more disclosure be made to mutual fund directors and investors. 

Concerns have been raised over 

whether the disclosures of mutual 

fund fees and other fund practices 

are sufficiently transparent and fair 

to investors. GAO’s testimony 

discusses (1) mutual fund fee 

disclosures, (2) the extent to which 

various corporate governance 

reforms are in place in the mutual 

fund industry, (3) the potential 

conflicts that arise when mutual 

fund advisers pay broker-dealers to 

sell fund shares, and (4) the 

benefits and concerns over fund 

advisers' use of soft dollars. 

GAO’s report recommends that 

SEC consider requiring additional 

disclosure by mutual funds of 

• the fees that investors pay in 

account statements, 

• revenue sharing payments that 

broker-dealers receive; and 

• fund adviser’s use of soft 

dollars. 

www.gao.gov/cgi-bin/getrpt?GAO-03-909T.

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-03-909T, a testimony to 

the Chairman, Subcommittee on Capital 

Markets, Insurance, and Government 

Sponsored Enterprises, Committee on 

Financial Services, House of 

Representatives 

June 18, 2003 

MUTUAL FUNDS 

Additional Disclosures Could Increase 

Transparency of Fees and Other 

Practices 
Page 1 GAO-03-909T 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 related mutual fund disclosures to 

investors. The fees and other costs that mutual fund investors pay as part 

of owning fund shares can significantly affect their investment returns. 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 recently issued report 

entitled Mutual Funds: Greater Transparency Needed in Disclosures to 

Investors, GAO-03-763 (Washington, D.C.: June 9, 2003) and describe how 

the results of this work relates to certain provisions of the proposed 

Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420). 

Specifically, I will discuss (1) mutual fund fee disclosures and 

opportunities for improving these disclosures, (2) the extent to which 

various corporate governance reforms are in place in the mutual fund 

industry, (3) the potential conflicts that arise when mutual fund advisers 

pay broker-dealers to sell fund shares, and (4) the benefits and concerns 

over fund advisers' use of soft dollars. 

In summary: 

The study that we have conducted at the request of this Committee 

directly supports several of the key provisions of H.R. 2420. In particular, it 

addresses the need to consider ways to increase the transparency of 

mutual fund fees and other disclosures. 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. Consistent with H.R. 2420, our 

report recommends that SEC consider requiring mutual funds to make 
Page 2 GAO-03-909T Mutual Fund Disclosures 

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 to produce such disclosures. However, we estimate 

that spreading these implementation costs across all investor accounts 

may result in minimal increases in fund expenses. 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. 

Each mutual fund in the United States is required to have a board of 

directors that is charged with overseeing the interests of fund 

shareholders. These boards also must include directors that are not 

employed or affiliated with the fund’s adviser, and these independent 

directors have specific duties to oversee the fees their fund’s charge. 

However, some industry critics have questioned whether fund directors 

are adequately performing their duties and various corporate governance 

reforms have been proposed to improve the effectiveness of mutual fund 

boards. We found that many of the corporate governance reforms are 

already being practiced by many funds as a result of either recent SEC 

actions or because they are recommended as best practices by the mutual 

fund industry body, the Investment Company Institute. By amending the 

Investment Company Act of 1940 to require these and other corporate 

governance practices, H.R. 2420 would further strengthen certain 

corporate governance practices and ensure that all mutual funds 

implement these practices. 

The work that we conducted for our report 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 to 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 brokerdealers 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. Consistent with H.R. 2420, our report also recommended that more 

disclosure be made to investors about any revenue sharing payments their 

broker-dealers are receiving. 
Page 3 GAO-03-909T Mutual Fund Disclosures 

Finally, we also reviewed a practice known as soft dollars, in which a 

mutual fund adviser uses fund assets to pay commissions to brokerdealers 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 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. Consistent with H.R. 2420, our report recommended 

that more disclosure be made to mutual fund directors and investors to 

allow them to better evaluate the benefits and potential disadvantages of 

their fund adviser’s use of soft dollars. 

Although mutual funds already disclose considerable information about 

the fees they charge, our report recommended 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 an investor could expect to pay if they invested 

$10,000 in a fund and held it for various periods. 

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. 

Additional Disclosure 

of Mutual Fund Costs 

Might Benefit 

Investors 
Page 4 GAO-03-909T Mutual Fund Disclosures 

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 

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. 
Page 5 GAO-03-909T Mutual Fund Disclosures 

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 it in funds’ 

annual and semiannual reports, SEC staff also indicate 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, ICI 

indicated that to shareholders, the account statement is probably the most 

important communication that they receive 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, ICI commissioned a 

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

 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-03-909T Mutual Fund Disclosures 

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 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 .000038 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 

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 

 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). 

3

To determine these amounts, we used the operating expense ratios that ICI has 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 0.000038 percent would therefore 

add $1.07 to this amount. 
Page 7 GAO-03-909T Mutual Fund Disclosures 

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. 

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

make mutual funds comparable to other products and provide information 

in the document that is most relevant to investors—the quarterly account 

statement—our report recommended that SEC consider requiring 

additional disclosures relating to fees be made to investors in these 

documents. In addition to specific dollar disclosures, we also noted that 

investors could be provided with other disclosures about the fees they pay 

on mutual funds that would have a range of implementation costs, 

including some that would have even less overall cost to the industry. H.R. 

2420 also mandates that SEC require additional information about fees be 

disclosed to investors. Seeing the specific dollar amount paid on their 

shares 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 both these documents 

and account statements, which would provide both prospective and 

existing investors in mutual funds access to valuable information about 

the costs of investing in funds. 

H.R. 2420 also mandates that SEC require mutual funds to disclose more 

information about portfolio transactions costs, including commissions 

paid with respect to the trading of portfolio securities. Although additional 

information about such costs could be beneficial to investors, we found 

that determining these costs in a way that allows them to be accurately 

and fairly compared across funds could prove difficult. 
Page 8 GAO-03-909T Mutual Fund Disclosures 

Mutual funds implemented many sound practices concerning their boards 

of directors, but these practices are not mandatory for all funds. The law 

governing U.S. mutual funds promotes investor protection by requiring 

funds to have a board of directors to protect fund shareholder interests. As 

a group, the directors of a mutual fund have various statutory 

responsibilities to oversee fund operations. In particular, the directors 

independent of the fund’s investment adviser have additional duties 

including approval of the contracts with the investment adviser. As a 

matter of practice, independent directors also review other arrangements 

such as transfer agency, custodial, or bookkeeping services. 

As a result of recent scandals such as Enron and Worldcom, new 

legislative and regulatory reforms have been adopted or proposed to 

increase the effectiveness and accountability of public companies’ boards 

of directors. In July 2002, the Sarbanes-Oxley Act (Sarbanes-Oxley) was 

enacted to address concerns related to corporate responsibility and 

governance.4

 In addition to enhancing the financial reporting regulatory 

structure, Sarbanes-Oxley sought to increase corporate accountability by 

reforming the structure of corporate boards audit committees. Section 301 

of Sarbanes-Oxley requires that directors who serve on a public company’s 

audit committee be “independent” and select and oversee outside auditors. 

The New York Stock Exchange (NYSE) and NASDAQ have also proposed 

changes to the corporate governance listing standards for public 

companies. However, many of the proposed reforms for public companies 

are either already required or have been recommended as best practices 

for mutual fund boards. Table 2 shows how the current or recommended 

corporate governance practices for mutual fund boards compare to 

current and proposed NYSE and NASDAQ listing standards applicable to 

public company boards. 

 4

Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29 

U.S.C.A.). 

Mutual Fund Boards 

Follow Many Sound 

Corporate 

Governance Practices 

but Such Practices are 

Not Mandatory for All 

Funds 
Page 9 GAO-03-909T Mutual Fund Disclosures 

Table 2: Current and Proposed NYSE and NASDAQ Listing Standards Compared to 

Current or Recommended Mutual Fund Corporate Governance Requirements 

NYSE/NASDAQ listing

standards Mutual Funds 

Governance 

requirement 

Currently 

required

Proposed 

requirement 

 Required by 

statute or 

SEC rulea

ICI 

recommended 

best practice 

Board must have a 

majority of independent 

directors 

X X X 

Independent directors 

must be responsible for 

nominating new 

independent directors 

X X X 

Audit committee must 

consist of only 

independent directorsb

X X X 

Standards that define 

who qualifies as an 

independent directorc

 

X X X X 

Independent directors 

required to meet 

separately in executive 

sessions 

X X 

Source: GAO analysis of ICI Best Practices, SEC rules, and NYSE and NASDAQ rule proposals. 

a

SEC requires the board of directors of any fund that takes advantage of various exemptive rules to 

meet these requirements and SEC staff indicated that, as a result, almost all funds must comply. 

b

Although fully independent audit committees is not a requirement for funds, SEC has adopted a rule 

to encourage fund boards to have audit committees consisting exclusively of independent directors by 

exempting such committees from having to seek shareholder approval of the fund’s auditor. 

c

Both the NYSE and NASDAQ definitions of director independence currently apply only to members 

of the audit committee, but their rule proposals would extend this definition to the full board. 

According to regulators and data from industry participants that we 

obtained, many mutual funds have implemented many of the practices that 

are being recommended for public companies. As shown in table 2 above, 

many of these practices are already required for many funds by SEC 

regulation or are recommended by ICI as a best practice. Officials of the 

fund companies and the independent directors that we interviewed told us 

that the majority of their boards consisted of independent directors, and, 

in many cases, had only one interested director. For public companies, 

some commenters have called for boards of directors to have 

supermajorities of independent directors as a means of ensuring that the 

voices of the independent directors are heard. ICI already advocates this 

practice in its best practice recommendations and one fund governance 

consulting official said that a 2002 survey conducted by his firm found 

that, in 75 percent of the mutual fund complexes they surveyed, over 70 
Page 10 GAO-03-909T Mutual Fund Disclosures 

percent of the directors were independent. An academic study we 

reviewed also found that funds’ independent directors already comprised 

funds’ nominating committees and most funds have self-nominating 

independent directors. 

However, not all of these sound corporate governance practices are 

currently mandatory for mutual funds. For example, if a fund does not 

take advantage of any of the exemptive rules that SEC cited in requiring 

certain corporate governance practices, such a fund may not already be 

following these practices. In addition, some of the reforms advocated by 

ICI’s best practices and by those advocating change for public companies 

are not currently required for mutual funds. H.R. 2420 would make these 

and other practices mandatory for all funds, which would ensure 

consistent implementation of the practices across the industry. 

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

become increasingly common involves mutual fund investment advisers 

making additional payments beyond those made under 12b-1 plans to 

broker-dealers that sell fund shares. Approximately 80 percent of mutual 

fund purchases are made through broker-dealers or other financial 

professionals, such as financial planners and pension plan administrators. 

To be compensated for providing advice and ongoing assistance to 

investors, many of these financial professionals receive payments from the 

mutual fund either through the sales charges paid up front by the investor 

(called loads) or from ongoing fees that are deducted from the fund’s 

assets. 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. 

However, 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 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 

Changes in Mutual 

Fund Distribution 

Practices Raise 

Potential Conflicts of 

Interest Between 

Broker-Dealers and 

Investors 
Page 11 GAO-03-909T Mutual Fund Disclosures 

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 

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 broker-
Page 12 GAO-03-909T Mutual Fund Disclosures 

dealers 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. This recommendation is consistent with 

the requirement in H.R. 2420 that mandates that SEC require mutual funds 

to further disclose revenue sharing payments and make annual or more 

frequent reports of such payments to fund boards of directors. 

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.5

 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 

 5

Instead of commissions, broker-dealers executing trades also could be compensated 

through markups or spreads. 

Soft Dollar 

Arrangements Provide 

Benefits, but Could 

Adversely Impact 

Investors 
Page 13 GAO-03-909T Mutual Fund Disclosures 

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 

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

those executed through other broker-dealers, including full-service brokerdealers.6

 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 

 6

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

of Finance, (February, 2001). 
Page 14 GAO-03-909T Mutual Fund Disclosures 

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 these proposed 

recommendations. 

As a result, our 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. If H.R. 2420 is enacted, investors and fund directors would get 

more information to allow them to make these evaluations. Also, the study 

that H.R. 2420 would require SEC to conduct of soft dollars would likely 

provide SEC with valuable information to allow it to best decide the form 

of these disclosures and whether any other changes to soft dollar practices 

are warranted. 

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

questions. 

(250152) 
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