Mutual Funds: Greater Transparency Needed in Disclosures to Investors
Published: 2003-06-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The fees and other costs that investors pay as part of owning mutual fund shares can significantly affect their investment returns. As a result, questions have been raised as to whether the disclosures of mutual fund fees and other practices are sufficiently transparent. GAO 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.
section_title: What GAO Found
paragraphs: 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, other disclosures could also increase the transparency of these fees, such as by providing existing investors with the specific dollar amounts of the expenses paid or by placing fee-related disclosures in the quarterly 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 that make 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. Since then, funds have developed ways to apply Rule 12b-1 fees 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, receiving these payments can limit fund choices offered to investors and conflict with the broker-dealer's 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.

section_title: Letter
paragraphs: Millions of U.S. households have invested in mutual funds with assets  exceeding $6 trillion by year-end 2002.  The fees and other costs that these  investors pay as part of owning mutual fund shares can significantly affect  their investment returns.  As a result, questions have been raised as to  whether the disclosures of mutual fund fees and others costs, including the  trading costs that mutual funds incur when they buy or sell securities, are  sufficiently transparent.  Some have also questioned the effectiveness of  mutual fund boards of directors in protecting shareholder interests and  overseeing the fees funds pay to investment advisers.  Many mutual funds  market their shares to investors through broker-dealers or other financial  professionals, such as financial planners.  However, concerns have been  raised over how the payments that fund advisers make to the entities that  sell fund shares affect investors.  When mutual fund investment advisers  use broker-dealers to buy or sell securities for the fund, they generally pay  these broker-dealers a commission for executing the trade.  Under  arrangements known as soft dollars, part of these brokerage commissions  may pay for research and brokerage services that the executing broker- dealer or third parties provide to the fund’s investment adviser.  Because  the amount of brokerage commissions a fund adviser pays directly reduces  the ultimate return earned by investors in its funds, questions exist over the  extent to which investors benefit from or are harmed by these soft dollar  arrangements.
To address these concerns, this report responds to your January 14, 2003,  request that we review issues relating to the transparency and  appropriateness of certain fees and practices among mutual funds.   Specifically, our objectives were to review (1) how mutual funds and their  advisers disclose their fees and related trading costs and options for  improving these disclosures, (2) mutual fund directors' role in overseeing  fees and various proposals for improving their effectiveness, (3) changes in  how mutual funds and their advisers pay for the sale of fund shares and  how the changes in these practices are affecting investors, and (4) the  benefits of and the concerns over mutual funds' use of soft dollars and  options for addressing these concerns.
To determine how mutual funds currently disclose their fees and other  costs, we reviewed regulatory requirements and disclosures made by a  selection of mutual funds.  We discussed various proposals to increase  disclosure with staff from regulators that oversee mutual funds, including  the Securities and Exchange Commission (SEC) and NASD, and staff from  mutual fund companies, industry groups and researchers.  We also  interviewed officials of 10 mutual fund companies that sell their funds  through broker-dealers and a judgmental sample of 15 certified financial  planners.  To identify the activities that mutual fund directors perform, we  reviewed federal laws and regulations, interviewed staff from an  association representing independent directors and used a structured  questionnaire to interview a judgmental sample of six independent director  members of this association.  To determine how mutual funds and their  advisers pay for distribution, we interviewed various regulatory staff,  industry associations and researchers, fund companies, and two broker- dealers that sell fund shares.  We also reviewed and analyzed various  documents and studies of mutual fund distribution practices.  To describe  the benefits and potential conflicts of interest raised by mutual funds’ use  of soft dollars, we spoke with SEC, NASD, and regulators in the United  Kingdom and reviewed studies by regulators and industry experts on soft  dollar arrangements. We conducted our work in accordance with generally  accepted government auditing standards in Boston, MA; Kansas City, MO;  Los Angeles and San Francisco, CA; New York, NY; and Washington, DC  from February to June 2003. Our scope and methodology is described in  detail in appendix I.
subsections: section_title: Background
paragraphs: Mutual funds are distinct legal entities owned by the shareholders of the  fund. Each fund contracts separately with an investment adviser, who  provides portfolio selection and administrative services to the fund.  The  costs of operating a mutual fund are accrued daily and periodically  deducted from the fund’s assets.  These costs include the fee paid to the  fund’s investment adviser for managing the fund and the expenses  associated with operating the fund, such as the costs for accounting and  preparing fund documents.  Each mutual fund has a board of directors,  which is responsible for reviewing fund operations and overseeing the  interests of the fund’s shareholders, including monitoring for conflicts of  interest between the fund and its adviser.
The incredible growth of mutual fund assets and in the number of investors  that hold funds has raised concerns within Congress and elsewhere over  the fees funds charge investors.  In a report issued in June 2000, we found  that the average fees charged by 77 of the largest stock and bond mutual  funds had declined between 1990 and 1998.  In our report, we also  concluded that although many mutual funds exist that compete for investor  dollars, they conduct this competition primarily on the basis of their  performance rather than on the basis of the price of their service, that is,  the fees they charge.  In updating the results of the analysis from our June  2000 report for a hearing on mutual funds in March 2003, we found that the  average fees for this group of funds had increased slightly, due in part to  some funds paying higher management fees to their investment advisers  because of the effect of performance fees.
Mutual funds are sold through a variety of distribution channels. For  instance, investors can buy them directly by telephone or mail or they can  be sold by a sales staff employed by the adviser or by third parties, such as  broker-dealer account representatives.  To compensate financial  professionals not affiliated with the adviser for distributing or selling a  fund’s shares, funds may levy a sales charge which is based on a percentage  of the amount being invested—called a load—that the investor can either  pay at the time the investment is made (a front-end load) or later when  selling or redeeming the fund shares (a back-end load).  Many funds that  use broker-dealers or other financial professionals to sell their fund shares  may also charge investors ongoing fees, called 12b-1 fees that are used by  funds to pay these distributors for recommending the fund or for servicing  the investor’s account after purchases have been made.  Mutual fund shares  are also available for investors to purchase through mutual fund  supermarkets.  These are offered by broker-dealers, including those  affiliated with a fund adviser, that allow their customers to purchase and  redeem the shares of mutual funds from a wide range of fund companies  through their accounts at the broker-dealer operating the supermarket.
SEC is the federal regulatory agency with responsibility for overseeing the  U.S. securities markets and protecting investors. Various self-regulatory  organizations (SRO) also oversee the activities of securities industry  participants. NASD is the SRO with primary responsibility for overseeing  broker-dealers. SEC is responsible for oversight of the SROs and it also  oversees and regulates the investment management industry.
section_title: Additional Disclosure of Mutual Fund Costs May Benefit Investors
paragraphs: Various alternatives with different advantages and disadvantages exist that  could increase the amount of information that investors are provided about  mutual fund fees and other costs.  Currently, mutual funds disclose  information about their fees as percentages of their assets whereas most  other financial services disclose their costs in dollar terms.  SEC and others  have proposed various alternatives to disclose more information about  mutual fund fees, but industry participants noted these alternatives could  also involve costs to implement and data on the benefits associated with  additional disclosures is not generally available.  Mutual funds also incur  brokerage commissions and other costs when they buy or sell securities  and currently these costs are not routinely or explicitly disclosed to  investors and there have been increasing calls for disclosure as well as  debate on the benefits and costs of added transparency.
subsections: section_title: Unlike Other Financial Products, Mutual Funds Do Not Disclose the Actual Dollar Amount of Fees Paid by Individual Investors
paragraphs: Mutual funds provide various disclosures to their shareholders about fees.   Presently, all funds must provide investors with disclosures about the fund  in a written prospectus that must be provided to investors when they first  purchase shares.  SEC rules require that the prospectus include a fee table  containing information about the sales charges, operating expenses, and  other fees that investors pay as part of investing in the fund.  Specifically,  the table that mutual funds must provide presents (1) charges paid directly  by shareholders out of their investment such as front or back-end sales  loads and (2) recurring charges deducted from fund assets such as  management fees, distribution fees, and other expenses charged to  shareholder accounts.  The fees deducted from the fund’s assets on an  ongoing basis are reported to investors as a percentage of fund assets and  are called the fund’s operating expense ratio.  The fee table also contains a  hypothetical example that shows the estimated dollar amount of expenses  that an investor could expect to pay on a $10,000 investment if the investor  received a 5-percent annual return and remained in the fund for 1, 3, 5, and  10 years.  The examples do not reflect costs incurred as a result of the  fund’s trading activity, including brokerage commissions that funds pay to  broker-dealers when they trade securities on a fund’s behalf.
Unlike many other financial products, mutual funds do not provide the  exact dollar amounts of fees that individual investors pay while they hold  the investment.  Although mutual funds provide information about their  fees in percentage terms and in dollar terms using hypothetical examples,  they do not provide investors with information about the specific dollar  amounts of the fees that have been deducted from the value of their shares.   In contrast, most other financial products and services do provide specific  dollar disclosures.  For example, when a borrower obtains a mortgage loan  the lender is required to provide a uniform mortgage costs disclosure  statement.  This disclosure must show both the interest rate in percentage  terms that the borrow will be charged for the loan and also the costs of the  loan in dollar terms.  Under the law, the lender must provide a truth in  lending statement, which shows the dollar amount of any finance charges,  the dollar amount being financed, and the total dollar amount of all  principal and interest payments that the borrower will make under the  terms of the loan.  As shown in table 1, investors in other financial  products or users of other financial services also generally receive  information that discloses the specific dollar amounts for fees or other  charges they pay.
Although mutual funds are not required to disclose specific dollar amounts  of fees paid by individual investors, the amount of information that they do  provide does exceed that provided by some investment products. For  example, fixed-rate annuities or deposit accounts that provide investors a  guaranteed return on their principal at a fixed rate do not specifically  disclose to the purchasers of these products the provider’s operating  expenses.  The financial institutions offering these products generate their  profits on these products by attempting to invest their customers’ funds in  other investment vehicles earning higher rates of return than they are  obligated to pay to the purchasers of the annuities. However, the returns  they earn on customer funds and the costs they incur to generate those  returns are not required to be disclosed as operating expenses to their  customers.
section_title: Various Alternatives Could Improve Fee Disclosure, but the Benefits Have Not Been Quantified
paragraphs: In recent years, a number of alternatives have been proposed for improving  the disclosure of mutual fund fees, which could provide additional  information to fund investors.  In response to a recommendation in our  June 2000 report that SEC consider additional disclosures regarding fees,  SEC has introduced a proposal to improve mutual fund fee disclosure.  In  December 2002, SEC released proposed rule amendments, which include a  requirement that mutual funds make additional disclosures about their  expenses.  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, the staff 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.
The SEC’s proposed disclosures have various advantages and  disadvantages.  If adopted, this proposal would provide additional  information to investors about the fees they pay when investing in mutual  funds.  In addition, these disclosures would be presented in a format that  would allow investors to compare fees directly across funds.  However, the  disclosures would not be investor specific because they would not use an  investor’s individual account balance or number of shares owned.  In  addition, SEC is proposing to place these new disclosures in the  semiannual shareholder reports, instead of in quarterly statements.   Quarterly statements, which show investors the number of shares owned  and value of their fund holdings, are generally considered to be of most  interest and utility to investors.  As a result, SEC’s proposal may be less  likely to increase investor awareness and improve price competition  among mutual funds.  According to SEC staff, they are open to consider  additional disclosures if the benefits to investors appear clear, but have  decided to continue pursuing approval of the proposed disclosure format  from their December 2002 rule proposal.  This proposal has received a wide  range of comments.  Most comments were in support of SEC’s proposed  requirement to include the dollar cost associated with a $10,000  investment.  For example, one investment advisory firm commented in its  letter that the new disclosures SEC is proposing would benefit investors by  allowing them to estimate actual expenses and compare costs between  different funds in a meaningful way.
Another alternative for disclosing mutual funds fees would involve funds  specifically disclosing the actual dollar amount of fees paid by each  investor.  In our June 2000 report, we noted that such disclosure would  make mutual funds comparable to other financial products and services  such as bank checking accounts or stock transactions through broker- dealers. As our report noted, such services actively compete on the basis of  price. If mutual funds made similar specific dollar disclosures, investors  would be clearly reminded that they pay fees for investing in mutual funds  and we stated that additional competition among funds on the basis of  price could likely result among funds.  An attorney specializing in mutual  fund law told us that requiring funds to disclose the dollar amount of fees in  investor account statements would likely encourage investment advisers to  compete on the basis of fees. He believed that this could spur new entrants  to the mutual fund industry and that the new entrants would promote their  funds on the basis of their low costs, in much the same way that low-cost  discount broker-dealers entered the securities industry.
Although some financial planners, who directly assist investors in choosing  among mutual funds, thought that requiring mutual funds to provide  investors with the specific dollar amounts of fees paid would be useful,  most indicated that other information was more important.  We spoke to a  judgmental sample of 15 certified financial planners whose names were  provided by the Certified Financial Planner Board of Standards, a non- profit professional regulatory organization that administers the certified  financial planner examination.  Of the 15 financial planners with whom we  spoke, 6 believed specific dollar disclosure of mutual fund fees would  provide additional benefit to investors.  For example, one said that  providing exact dollar amounts for expenses would be useful because  investors don’t take the next step to calculate the actual costs they bear by  multiplying their account value by the fund’s expense ratio.  In contrast, the  other 9 financial planners we interviewed said that the factor most  investors consider more than others is the overall net performance of the  fund and thus did not think that specific dollar disclosures of fees would  provide much additional benefit.
Industry officials raised concerns about requiring specific dollar fee  disclosures.  For example, one investment company official stated that the  costs of making specific dollar disclosures would not justify any benefit  that might arise from providing such information, particularly because a  majority of investors make their investment decisions through  intermediaries, such as financial planners, and not on their own.  Some  industry officials stated that additional disclosure could confuse investors  and create unintended consequences.  For example, one official noted that  specific dollar disclosure might lead investors to think that they could  deduct those expenses from their taxes.  Others noted that this type of  disclosure would tell current mutual fund investors what they were paying  in fees, but would not provide the proper context for evaluating how much  other funds would charge, and thus would be unlikely to increase  competition. Another official stated that disclosing fees paid in dollars in  account statements would not be beneficial to prospective investors.
Although the total cost of providing specific dollar fee disclosures might be  significant, the cost might not represent a large outlay on a per investor  basis.  As we reported in our March 2003 statement, the Investment  Company Institute (ICI), the industry association representing mutual  funds, commissioned a study by a large accounting firm to survey mutual  fund companies about the costs of producing such disclosures.  The study  concluded 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 these are significant costs, when spread over  the accounts of many investors, the amounts are less sizeable.  For  example, ICI reported that at the end of 2001, a total of about 248 million  shareholder accounts existed.  If the fund companies represented in ICI’s  study, which represent 77 percent of industry assets, also maintain about  the same percentage of customer accounts, then the companies would hold  about 191 million accounts. As a result, apportioning the estimated $200  million in initial costs to these accounts would amount to about $1 per  account.  Apportioning the estimated $66 million in annual costs to these  accounts would amount to about $0.35 per account.
We also spoke with a full-service transfer agent that provides services for  about one third of the total 240 million accounts industrywide.  Staff from  this organization prepared estimates of the costs to their organization of  producing specific dollar fee disclosures for fund investors.  They  estimated that to produce this information, they would incur one-time  development costs between $1.5 and $3 million to revise their systems to  accept and maintain individual investor account expense data, and ongoing  data processing expenses of about $0.15 to $0.30 per fund/account per year.   These ongoing expenses would reflect about 1 percent of the estimated $18  to $23 per year of administrative costs per account already incurred.  The  officials also estimated that shareholder servicing costs would increase as  investors would call in to try to understand the new disclosures or offer to  send payments under the mistaken impression that this was a new charge  that they had to explicitly pay.  Funds would also incur costs to update and  modify their Web sites so that investors could find this specific expense  information there as well.
Another concern raised regarding requiring mutual funds to disclose the  specific dollar amount of fees was that information on the extent to which  such disclosures would benefit investors is not generally available.  For our  work on this report, we attempted to identify studies or analyses on the  impact of disclosing prices in dollars versus percentage terms, but no  available information was found to exist.  We also reviewed surveys done  of investor preferences relative to mutual funds but none of the surveys we  identified discussed disclosure of mutual fund fees in dollar terms.  In our  June 2000 report, we presented information from a survey of over 500  investors that was administered by a broker-dealer to its clients.  As we  reported, this survey found that almost 90 percent of these investors  indicated that specific dollar disclosures would be useful or very useful.   However, only 14 percent of these investors were very or somewhat likely  to be willing to pay for this information.  SEC and industry participants  noted that having more definitive data on the extent to which investors  want and would benefit from receiving information on the specific dollar  amount of fees they paid would be necessary before requiring mutual  funds, broker-dealers, and other intermediaries to undertake the costly  revisions to their systems necessary to capture such information.
Another option for disclosure was proposed by an industry official that  may not impose significant costs on the industry.  The official said that fund  companies could include a notice in account statements to remind  investors that they pay fees as part of investing in mutual funds.  The  notice, the official said could remind investors that, “Mutual funds, like all  investments, do have fees and ongoing expenses and such fees and  expenses can vary considerably and can affect your overall return.  Check  your prospectus and with your financial adviser for more information.”  By  providing this notice in the quarterly account statements that mutual fund  investors receive, mutual fund investors would be reminded about fees in a  document that, because it contains information about their particular  account and its holdings, is more likely to be read.
section_title: Trading and Other Costs Impact Mutual Fund Investor Returns, but Are Not Prominently Disclosed
paragraphs: In addition to the expenses reflected in a mutual fund’s expense ratio—the  fund’s total annual operating expenses as a percentage of fund assets— mutual funds incur trading costs that also affect investors’ returns. Among  these costs are brokerage commissions that funds pay to broker-dealers  when they trade securities on a fund’s behalf.  When mutual funds buy or  sell securities for the fund, they may have to pay the broker-dealers that  execute these trades a commission. In other cases, trades are not subject to  explicit brokerage commissions but rather to “markups,” which is an  amount a broker-dealer may add to the price of security before selling it to  another party.  Trades involving bonds are often subject to markups.   Commissions have also not traditionally been charged on trades involving  the stocks traded on NASDAQ because the broker-dealers offering these  stocks are compensated by the spread between the buying and selling  prices of the securities they offer.
Other trading-related costs that can also affect investor returns include  potential market impact costs that can arise when funds seek to trade large  amounts of particular securities. For example, a fund seeking to buy a large  block of a particular company’s stock may end up paying higher prices to  acquire all the shares it seeks because its transaction volume causes the  stock price to rise while its trades are being executed.  Various  methodologies exist for estimating these types of trading costs, however,  no generally agreed upon approach exists for accurately calculating these  costs.
Although trading costs affect investor returns, these costs are not currently  required to be disclosed in documents routinely provided to investors.  ICI  staff and others told us that the costs of trading, including brokerage  commissions, are required under current accounting practices and tax  regulations to be included as part of the initial value of the security  purchased. As a result, this amount is used to compute the gain or loss  when the security is eventually sold and thus the amount of any  commissions or other trading costs are already implicitly included in fund  performance returns.  Investors do receive some information relating to a  fund’s trading activities because funds are required to disclose their  portfolio turnover, (the frequency with which funds conduct portfolio  trading) in their prospectuses, which are routinely sent to new and existing  investors.  However, the frequency with which individual mutual funds  conduct portfolio trading and incur brokerage commissions can vary  greatly and the amount of brokerage commissions a fund pays are not  disclosed in documents routinely sent to investors.  Instead, SEC requires  mutual funds to disclose the amount of brokerage commissions paid in the  statement of additional information (SAI), which also includes disclosures  relating to a fund’s policies, its officers and directors, and various tax  matters.  Regarding their trading activities, funds are required to disclose in  their SAI how transactions in portfolio securities are conducted, how  brokers are selected, and how the fund determines the overall  reasonableness of brokerage commissions paid.  The amount disclosed in  the SAI does not include other trading costs borne by mutual funds such as  spreads or the market impact cost of the fund’s trading.  Unlike fund  prospectuses or annual reports, SAIs do not have to be sent periodically to  a fund’s shareholders, but instead are filed with SEC annually and are sent  to investors upon request.
section_title: Academics and Others Have Also Called for Increased Disclosure of Mutual Fund Trading Costs, but Others Noted that Producing Such Disclosures Would be Difficult
paragraphs: 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. 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’ SAIs.
Others who advocated additional disclosure of brokerage commissions  cited other benefits.  Some officials have called for mutual funds to be  required to include their trading costs, including brokerage commissions,  in their expense ratios or as separate disclosures in the same place their  expense ratios are disclosed.  For example, one investor advocate noted  that if funds were required to disclose brokerage commissions in these  ways, funds would likely seek to reduce such expenses and investors  would be better off because the costs of such funds would be similarly  reduced.  He explained that this could result in funds experiencing less  turnover, which could also benefit investors as some studies have found  that high-turnover funds tend to have lower returns than low-turnover  funds.
The majority of certified financial planners we interviewed also indicated  that disclosing transaction costs would benefit investors.  Of the 15 with  whom we spoke, 9 stated that investors would benefit from having more  cost information such as portfolio transaction costs.  For example, one said  that investors should know the costs of transactions paid by the fund and  that this information should be disclosed in a document more prominent  than the SAI.  Another stated that brokerage commissions should be  reported as a percentage of average net assets.  Overall they felt that more  information would help investors compare costs across funds, which could  likely result in more competition based on costs, but they also varied in  opinion on the most appropriate format and place to present these  disclosures.  The planners who did not think transaction costs should be  disclosed generally believed that investors would not benefit from this type  of additional information because they would not understand it.
Some industry observers and financial planners we interviewed indicated  that investors should be provided all the information that affects a fund’s  returns in one place.  This information could include the current disclosed  costs such as the total expense ratio, the impact of taxes, and undisclosed  trading costs.  Some financial planners and an industry consultant  suggested disclosing all such expenses in percentages.  They also  expressed the importance of including after-tax performance returns.  SEC  adopted a rule in January 2001 requiring all funds to disclose their after-tax  returns in their prospectus.  A mutual fund industry analyst noted that  when an item is disclosed, investment advisers will likely attempt to  compete with one another to maximize their performance in the activity  subject to disclosure.  Therefore, presenting investors with information on  the factors that affect their return and that are within the investment  adviser’s control could spur additional competition and produce benefits  for investors.  A financial planner we interviewed also agreed that having  mutual funds disclose information about expenses, tax impacts, and  trading costs, particularly brokerage commissions all in one place would  increase investor awareness of the costs incurred for owning mutual fund  shares and could increase competition among funds based on costs and  lead to lower expenses for investors.
Although additional disclosures in this format could possibly benefit  investors, developing the information needed to provide a disclosure of this  type could pose difficulties.  SEC officials said that, if funds were required  to separately disclose brokerage commission costs as a percentage of fund  assets, fund advisers would also likely want to present their fund’s gross  return before trading costs were included so that the information does not  appear to be counted twice.  However, the SEC staff noted that determining  a fund’s gross return before trading costs could be challenging because it  could involve having to estimate markups and spread costs.  ICI officials  also stated that disclosing gross returns could create the idea of cost free  investing, which is not a realistic expectation for investors.  They also  worried that mutual funds could try and market their gross return figures,  which would be misleading.
Mutual fund officials also 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 broker-dealers  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.  As discussed earlier, ICI  staff and others said that separate disclosure of these costs is not needed  because the costs of trading are already included in the performance return  percentages that mutual funds report.  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.
Finally, some financial planners and an industry expert stated that  additional disclosure of mutual fund costs would be monitored not by  investors but more so by financial professionals, such as financial planners,  and the financial media.  These groups serve as intermediaries between  fund companies and investors, and are the primary channel through which  information on the performance and costs across mutual funds is  distributed. The financial planners and the industry expert believed that  increased disclosures of trading costs could prove beneficial to the  financial professionals that help select mutual funds for their investor  clients.
section_title: Independent Directors Play a Critical Role in Protecting Mutual Fund Investors
paragraphs: Mutual fund boards of directors have a responsibility to protect  shareholder interests. Independent directors, who are not affiliated with  the investment adviser, play a critical role in protecting mutual fund  investors.  Specifically, independent directors have certain statutory  responsibilities to approve investment advisory contracts and monitor  mutual fund fees.  However, some industry observers believe that  independent directors could do more to assert their influence to reduce  fees charged by fund advisers.  Alternatives are being considered to  improve public company governance such as changing board composition  and structure, however many practices are already in place within the  mutual fund industry.
subsections: section_title: Mutual Fund Boards of Directors Are Responsible for Protecting Shareholder Interests
paragraphs: Because the organizational structure of a mutual fund can create conflicts  of interest between the fund’s investment adviser and its shareholders, the  law governing U.S. mutual funds requires funds to have a board of directors  to protect the interest of the fund’s shareholders.  A fund is usually  organized by an investment management company or adviser, which is  responsible for providing portfolio management, administrative,  distribution, and other operational services.  In addition, the fund’s officers  are usually provided, employed, and compensated by the investment  adviser.  The adviser charges a management fee, which is paid with fund  assets, to cover the costs of these services.  With the level of the  management fee representing its revenue from the fund, the adviser’s  desire to maximize its revenues could conflict with shareholders’ goal of  reducing fees.  As one safeguard against this potential conflict, the  Investment Company Act of 1940 (the Investment Company Act) requires  mutual funds to have boards of directors to oversee shareholder’s interests.   These boards must also include independent directors who are not  employed by or affiliated with the investment adviser.
As a group, the directors of a mutual fund have various responsibilities and  in some cases, the independent directors have additional duties.  In  addition to approval by the full board, the Investment Company Act  requires that a majority of the independent directors separately approve  the contracts with the investment adviser that will manage the fund’s  portfolio and the entity that will act as distributor of the fund’s shares.  A  mutual fund’s board, including a majority of the independent directors, are  also required to review other service arrangements such as transfer agency,  custodial, or bookkeeping services.
If the services to the fund are provided by an affiliate of the adviser, the  independent directors also generally consider several items before  approving the arrangement.  Specifically they determine that the service  contract is in the best interest of the fund and its shareholders, the services  are required for the operation of the fund, the services are of a nature and  quality at least equal to the same or similar services provided by  independent third parties, and the fees for such services are fair and  reasonable in comparison to the usual and customary fees charged for  services of the same nature and quality.
The independent directors also have specific duties to approve the  investment advisory contract between the fund and the investment adviser  and the fees that will be charged.  Specifically, section 15 of the Investment  Company Act requires the annual approval of an advisory contract by a  fund’s full board of directors as well as by a majority of its independent  directors, acting separately and in person, at a meeting called for that  purpose.  Under section 36(b) of the Investment Company Act, investment  advisers have a fiduciary duty to the fund with respect to the fees they  receive, which under state common law typically means that the adviser  must act with the same degree of care and skill that a reasonably prudent  person would use in connection with his or her own affairs.  Section 36(b)  also authorizes actions by shareholders and the SEC against an adviser for  breach of this duty.  Courts have developed a framework for determining  whether an adviser has breached its duty under section 36(b), and directors  typically use this framework in evaluating advisory fees.  This framework  finds its origin in a Second Circuit Court of Appeals decision, in which the  court set forth the factors relevant to determining whether an adviser’s fee  is excessive.   In addition to potentially considering how a fund’s fee  compared to those of other funds, this court indicated that directors may  find other factors more important, including  the nature and quality of the adviser’s services,  the adviser’s costs to provide those services,  the extent to which the adviser realizes and shares with the fund  economies of  scale as the fund grows,  the volume of orders that the manager must process,  indirect benefits to the adviser as the result of operating the fund, and  the independence and conscientiousness of the directors.
Fund company officials and independent directors with whom we spoke  said their boards review extensive amounts of information during the  annual contract renewal process to help them evaluate the fees and  expenses paid by the fund.  For example, they stated that they hire a third- party research organization, such as Lipper, Inc., to provide data on their  funds investment performance, management fee rates, and expense ratios  as they compare to funds of similar size, objective, and style.  They also  compare performance to established benchmarks, such as the Standard &  Poors 500 Stock Index.  For example, officials at one fund company told us  that, for each of their funds, their board reviews information on the  performance and fees charged by 20 funds with a similar investment  objective, including the 10 funds closest in size with more assets than their  fund and the 10 funds closest in size with fewer assets.  In addition to  comparing themselves to peers, they explained that their board reviews the  profitability of the adviser, stability of fund personnel or staff turnover, and  quality of adviser services.  Fund officials stated that their boards receive a  large package of information that includes all of the necessary information  to be reviewed for the contract renewal process in advance of board  meetings.
SEC oversight of mutual funds indicates that fund directors generally  conduct their activities in accordance with the law.  Staff from SEC’s Office  of Compliance Inspections and Examinations, which conducts  examinations of mutual funds and their investment advisers, told us that as  part of their examinations they review the minutes of past board meetings  to ensure that the directors were told and discussed the relevant  information as part of the board’s decision-making process.  The SEC staff  also told us they review the information provided to the board by the  investment adviser to ensure its completeness and accuracy.  Based on  their review, SEC staff said that they have not generally found problems  with mutual fund board proceedings.  SEC has brought cases against  mutual fund directors but these involved other activities.  For example,  SEC settled a case involving a mutual fund’s board of directors that had  knowingly filed misleading information in the fund's prospectus and other  fund disclosures regarding the liquidity and value of the shares of their  money market fund.
section_title: Critics Suggest Independent Directors Could Do More to Assert Their Influence and Reduce Fees
paragraphs: Some industry experts have criticized independent directors for not  exercising their authority to reduce fees.  For example, in a speech to  shareholders, one industry expert stated that mutual fund directors have  failed in negotiating management fees.  Part of the criticism arises from the  fact that during the annual contract renewal process, when boards  compare fees of similar funds, the process maintains the status quo by  comparing fees with the industry averages thus keeping fees at their  current level.  However, another industry expert complained that fund  directors are not required to ensure that fund fees are reasonable, much  less as low as possible, but instead are only expected to ensure that fees  fall within a certain range of reasonableness.  An academic study we  reviewed criticized the court cases that have shaped director’s roles in  overseeing mutual fund fees because these cases generally found that  comparing a fund’s fees to other similar investment management services,  such as pension funds was inappropriate as fund advisers do not compete  with each other to manage a particular fund.  Without being able to  compare fund fees to these other products, the study’s authors say that  investors bringing these cases have lacked sufficient data to show that a  fund’s fees are excessive.
One method offered by some industry critics for improving the  effectiveness of boards in lowering fees for investors was to have fund  directors seek competitive bids for their fund’s investment advisory  contracts.  Advocates of having boards take this action said that pension  funds more routinely seek competitive bids from investment advisers for  pension fund assets.  A former Treasury Department official said that  pension funds commonly seek new investment advisers every 2 to 3 years,  and, as a result, pension fund investors pay two to three times less in fees  than the average mutual fund investors. One academic study we reviewed  that compared advisory fees for similarly-sized pension funds and mutual  funds found that the average mutual fund advisory fee is twice as large as a  pension fund advisory fee.  The study showed that the average pension  fund pays 28 basis points for its advisory fee compared to 56 basis points  for mutual funds.  The study concluded that the main reason for differences  between pension funds and mutual funds was that advisory fees for  pension funds are set in a marketplace in which arm’s-length bargaining  occurs because of the separation of the fund and the investment advisers.
Regulators and industry participants indicated that differences in the costs  and services provided by mutual funds can explain why mutual funds  charge more than pension funds.  According to staff of SEC and ICI with  whom we spoke, investment advisers usually perform many other services  for their mutual funds than does the adviser of a pension fund and that their  advisory fee compensates them for these additional services.  Among the  services that advisers of mutual funds would provide that a pension fund  adviser would not include around the clock telephone customer service,  preparing periodic account statements and shareholder communications,  and compiling annual tax information for fund investors.  Some industry  officials also noted the difference in cost structure between pension and  mutual funds.  One official stated that pension funds have one institutional  account, whereas mutual funds have thousands of smaller accounts, which  requires substantial record keeping and customer service expenses.   Mutual fund advisers would also have increased costs because they have to  manage their fund’s daily inflows and outflows, whereas pool of assets that  a pension fund adviser manages are not subject to such frequent  fluctuations.
Based on information we collected, very few mutual funds change their  investment advisers.  According to research organizations that monitor  developments in the mutual fund industry, less than 10 funds have changed  their primary investment adviser within the last 15 years.  The process of  changing investment adviser is not solely dependent upon the board of  directors.  If the fund board of directors made a decision to change an  investment adviser, the board would need to file a proxy statement and  have the shareholders of the fund vote to approve the change.
Industry participants also said that having mutual fund boards put out their  advisory service contracts for bid may not produce expected savings and  could increase fund shareholders’ costs.  According to staff at one fund  company, they would not likely bid on contracts to manage mutual fund  assets at the same rate that they bid for pension fund assets because their  costs to manage and administer mutual fund assets are higher.  They said  that pension fund assets are offered to investment advisers in a large pre- existing pool.  In contrast, mutual fund assets must be accumulated over  time from many investors.  Each time a fund’s board hired a new  investment adviser, the fund’s shareholders costs would also likely go up  because all the accounts would have to be transferred to the new adviser  and the fund would likely incur additional document preparation, legal, and  customer service costs.  For example, we identified a case in which a small  fund had removed its investment adviser, which resulted in a significant  increase of fund expenses.  In this case, the fund’s investment adviser  resigned and a majority of the fund’s board of directors voted to take over  the fund’s management.  The decision was submitted to the shareholders  for a proxy vote and passed.  As a result the fund’s expense ratio went from  1.8 percent in 2001 to 3.4 percent in 2002.  The fund attributed this  significant increase to a number of one-time items, which consisted  primarily of legal expenses associated with the removal of the investment  adviser and the management of the fund’s portfolio.
Finally, industry participants indicated that mutual fund shareholders likely  do not expect their fund’s board to change the fund’s investment adviser.   They said that mutual fund shareholders often choose their funds because  of the reputation or services offered by a particular investment adviser and  having their fund’s board seek to move their fund to another company  would not likely be supported by the shareholders.  Furthermore, having  fund boards seek new investment advisers is unnecessary because mutual  fund shareholders can choose to redeem their shares of a particular  adviser’s fund and invest them in the funds of other advisers if they are  unhappy with their existing fund or its adviser. In contrast, pension fund  participants cannot move their pension fund investments if they are  unhappy with their fund’s investment adviser or its performance.  Instead,  the decisions about which advisers are hired to manage pension fund’s  assets are made by their fund administrators.  ICI officials also questioned  whether pension funds actually change investment advisers that frequently.   They said that pension funds often seek long-term relationships with  investment advisers.
Although they do not frequently change advisers, mutual fund directors  engage in other activities to lower fees.  Industry officials said that advisers  typically institute management fee “breakpoints” based on the level of fund  assets or performance.  These breakpoints reduce the level of management  fees when funds exceed certain asset levels, thus as a fund’s assets grow,  the investment adviser’s fee is reduced for those additional assets above  the levels set in the breakpoint.  Directors could also approve performance  fees as a part of an investment adviser’s compensation that would reduce  the fee the adviser was able to charge if the fund’s performance fails to  meet or exceed a specified performance benchmark, such as the Standard  & Poors 500 Stock Index.  Industry officials also stated that advisers will at  times offer to waive management fees, and may also waive or cap certain  expenses such as certain transfer agency fees.  Noting that the fees for  mutual funds in the United States are lower compared to those of other  countries, SEC and ICI officials attributed this to the role and influence of  U.S. funds’ board of directors because such independent oversight is not  always required in other countries.
section_title: Mutual Funds Already Employ Many Practices Being Suggested to Improve Public Company Governance
paragraphs: Changes in the structure of mutual fund boards of directors have been  proposed and adopted in recent years and recent corporate scandals have  prompted consideration of additional reforms but industry participants  note that most funds have already adopted such practices.  In February  1999, SEC held a forum on the role of independent mutual fund directors to  consider ways to improve mutual fund governance.  At the forum, the SEC  Chairman at that time requested proposals for improving fund governance.   At the same time, ICI created the Advisory Group on Best Practices for  Fund Directors.  This advisory group identified 15 best practices used by  fund boards to enhance the independence and effectiveness of mutual fund  directors and recommended that all fund boards adopt them.  The ICI  recommendations included having   independent directors constitute at least two thirds of the fund’s board,  independent directors select and nominate other independent directors,   independent counsel for the independent directors.
After evaluating the ideas and suggestions of the forum participants, SEC  proposed various rule and form amendments designed to reaffirm the  important role that independent directors play in protecting fund investors.   These amendments were adopted in January 2001.  They included requiring  funds relying on certain exemptive rules—which includes almost all funds  according to SEC staff—to have a majority of independent directors on  their boards and to have their independent directors select and nominate  other independent directors.  SEC also required that any legal counsel for  the independent directors also be independent.
As a result of recent scandals such as Enron and Worldcom, various new  reforms have been 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.  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 also be “independent”  and be responsible for selecting and overseeing outside auditors.  In  response to the scandals at public companies, officials at the two primary  venues where public companies are traded—the NYSE and NASDAQ— have also proposed changes to the corporate governance standards that  public companies seeking to be listed on their markets must meet.
However, many of the corporate governance reforms being proposed for  public companies are already either required or have been recommended  as best practices for mutual fund boards.  Table 2 presents how the  corporate governance practices that are currently required by mutual fund  law or rules or recommended by ICI’s best practices for mutual fund boards  compare to the current and proposed NYSE and NASDAQ listing standards  applicable to public company boards.  As the table shows, the mutual funds  boards are already recommended to have in place all of the proposed  corporate listing standards.
According to industry participants, most mutual fund boards already have  the corporate governance practices recommended by these various  standards in place.  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.   As noted above, this practice has already been advocated by ICI’s 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 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.
Another change related to board composition that has been proposed for  mutual funds would be to have an independent director serving as the  board’s chair, but industry participants did not see this as a beneficial  change.  Some industry critics have stated that the lack of an independent  chair allows the board’s activities during the meeting to be controlled by  fund management, as the fund’s board chair is typically the chairman or  other senior official of the investment adviser.  A number of fund  companies and independent directors we spoke with indicated that their  board did have an independent chair.  For the fund companies that did not  have an independent chair, they had instead a lead independent director.   An official from the Mutual Fund Directors Forum, an independent  directors association which provides continuing education and outreach on  mutual fund governance, said that the most important factor is the  initiative demonstrated by the independent director, whether the individual  is the lead or chair.  He stated that if the lead independent director is  motivated, it doesn’t matter who the chair is, because the lead director will  be proactive and effective on behalf of fund shareholders.  Other fund  company officials indicated that an independent chair could be harmful to  the board.  One stated that investors are better served by having a fund  company executive chair the fund’s board because such an official is better  positioned to ensure that all of the information that the adviser needs to  share with the independent directors is provided efficiently.
section_title: Changes in Mutual Fund Distribution Practices Have Increased Choices for Investors, but Have Raised Potential Concerns
paragraphs: Concerns have been raised over changes in how mutual funds pay for the  distribution of their shares to investors.  SEC Rule 12b-1 allows mutual  fund companies to use fund assets to pay expenses for distributing their  funds through broker-dealers, and has evolved into a means for fund  companies to offer investors a variety of ways to pay for the services of  financial professionals, such as broker-dealer staff or financial planners.  However, 12b-1 fees remain controversial among mutual fund researchers  because, in addition to increasing a fund’s overall expense ratio, funds with  12b-1 fees may be more costly to own in other ways.  In a recent study, SEC  staff recommended rule 12b-1 modifications to reflect changes in how  funds are being marketed, but as of May 2003, SEC had not proposed any  amendments.  Concerns also have been raised as to whether the disclosure  of 12b-1 fees is sufficient and whether, another distribution practice— referred to as revenue sharing, in which investment advisers make  payments to broker-dealers for selling and marketing their funds—could  limit the number of mutual fund choices offered to investors. Revenue  sharing also may result in a broker-dealer’s failure to recommend funds  from which the brokerage firm is not being compensated by the funds’  advisers, which some suggest could conflict with broker-dealers’  responsibilities to recommend suitable investments.
subsections: section_title: 12b-1 Plans Provide Alternative Means for Compensating Financial Professionals but Also Raise Concerns Over Costs
paragraphs: Previously, mutual funds distribution expenses were paid for either by  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.
To be allowed to use fund assets for marketing purposes, funds are  required to adopt 12b-1 plans that outline how they intend to use these  payments. A fund’s written 12b-1 plan must describe all material aspects of  the proposed financing of distribution and related agreements with  distributors about how the plan is to be implemented.  Before  implementing a plan that will allow a fund to begin charging 12b-1 fees, rule  12b-1 requires fund shareholders and directors to approve 12b-1 plans and  places other requirements on plan adoption.  The plans must also be  approved by a vote of a majority of outstanding shareholders and by a  majority of funds’ directors, including a majority of the fund’s independent  directors.  Because such plans were envisioned to be of a limited duration,  a majority of funds’ directors, including a majority of the fund’s  independent directors, must also make various approvals on an ongoing  basis, including approving the 12b-1 plans annually.  They must also  approve any amendment to the plan and approve on at least a quarterly  basis the reports of plan expenditures and the purposes of the  expenditures.  12b-1 plans must also provide for plan termination upon the  vote of a majority of independent directors or a majority of shareholders.
In the adopting release for the rule, SEC presented various factors that  directors should consider when approving a fund’s 12b-1 plan.  These  factors were offered to provide guidance to directors in determining  whether to use fund assets to bear expenses for fund distribution. The nine  factors are shown in figure 1.
The 12b-1 fees that are used to pay marketing and distribution expenses are  deducted directly from fund assets and are reported as a separate line item  in the fund’s fee table and included in funds’ expense ratios. 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 broker-dealers 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.  The actual dollar amount of distribution and service  expenses paid under a fund’s 12b-1 plan must be disclosed in an SAI, which  supplements the prospectus, and in the fund’s annual report.
As part of its oversight, SEC staff periodically examines mutual funds and  their advisers for compliance with securities laws and rules and generally  find that mutual fund boards adequately oversee their fund’s 12b-1 plan. An  SEC official told us that SEC examiners check to see that the directors and  shareholders have approved 12b-1 plans and whether the funds have  controls in place to ensure that relationships with distributors are  reasonable, such as having the directors review 12b-1 fees. The official said  that some examinations have found that funds lack adequate control  procedures, but the SEC staff rarely have found serious material  deficiencies.
subsections: section_title: 12b-1 Plans Provide Additional Ways for Investors to Pay for Investment Advice and Fund Companies to Market Fund Shares
paragraphs: Rule 12b-1 provides investors an alternative way of paying for investment  advice and purchases of fund shares. Funds can be sold directly to  investors by a fund company or through financial intermediaries such as  broker-dealers or financial advisers. According to ICI, approximately 80  percent of investors’ mutual fund purchases are made through brokers,  financial advisers, and other intermediaries, including employer-sponsored  pension plans. 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 asset-based  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.
Industry officials and analysts generally viewed the alternative marketing  arrangements fostered by rule 12b-1 favorably.  ICI and fund company  officials generally agreed that rule 12b-1 plans gave fund distributors more  options for offering investors multiple ways to pay for fund investments.  For example, one company official said that 12b-1 plans have allowed  investors to choose the type of fund in which they want to invest and have  helped stabilize fund assets. Another official said that rule 12b-1 has  provided investors choices on how to pay their broker, which investors  have grown to like. He said that in his fund complex, 50 percent of shares  are now held in Class B shares that charge 12b-1 fees as opposed to other  share classes. A broker-dealer official that distributes funds said that 12b-1  plans are beneficial because the fees provide a revenue stream that  encourages financial advisers to plan for the long-term. A mutual fund  shareholders advocate said that this incentive is good because it would  cause the financial advisers to recommend funds that will work out well for  investors over time, rather than focus on earning front-end loads.
section_title: 12b-1 Fees Raise Some Concerns Over Cost of Funds
paragraphs: 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, an academic study of 3,861 multiple share  class funds available at the end of 1997 found that funds with multiple  share classes and 12b-1 fees also had higher management fees than those  charged by funds with only a single share class, and, therefore, were more  costly to investors before considering the additional expenses used to  compensate their financial professional.  However, another study found  that funds with 12b-1 fees might provide investors with greater  performance. This study, which reviewed the risk-adjusted performance of  a sample of 568 mutual funds for the period 1987-1992, found that 12b-1  plans increased fund expenses but on average generated higher risk- adjusted performance than funds with front-end loads. For this reason, the  study concluded that investors should not avoid funds with 12b-1 plans.
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.  Earlier in 2003, in federal court in  Nashville, Tennessee, investors filed lawsuits against a brokerage firm  alleging that the firms’ brokers placed the investors’ funds into share  classes with higher 12b-1 fees when other share classes with different fee  structures would have been more appropriate for the investors. A 1999  academic study also found that differing distribution arrangements cause  broker-dealer sales representatives to be compensated differently  depending on the class of shares they sell. These individuals, the study  found, have monetary incentives to steer long-term investors to low load,  high 12b-1 fee share classes and to steer short-term investors to high load,  12b-1 fee share classes.  However, depending on the time that they are  likely to hold the investment, some investors would be better off investing  in funds that charge a front-end load and have smaller 12b-1 fees than by  purchasing shares in funds without loads but higher 12b-1 fees.  The study  noted that this conflict of interest between investors and brokers is most  serious when broker-dealer representatives advise relatively uninformed  investors, who are more likely to seek advice on mutual fund investing.
In addition to concerns over 12b-1 fees, regulators have recently begun  investigations of whether investors are receiving the appropriate discounts  in mutual fund sales loads.  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  purpose of the examinations was to determine whether investors were  receiving the benefit of available breakpoint discounts on front-end loads  in mutual fund transactions. The examinations found that most of the  brokerage firms examined, in some instances, did not provide customers  with breakpoint discounts for which they appeared to have been eligible. In  instances where investors were not afforded the benefit of a breakpoint  discount, the average discount not provided was $364 per transaction. The  most frequent causes for the broker-dealers not providing a breakpoint  discount were not linking a customer’s ownership of different funds within  the same mutual fund family, not linking shares owned in a fund or fund  family in all of a customer’s accounts at the firm, and not linking shares  owned in the same fund or fund family by persons related to the customer  in accounts at the firm. The regulators concluded that many of the  problems did not appear to have been intentional failures to charge correct  loads.  Among other things, the report noted that, although most of the  firms had written supervisory procedures addressing breakpoints, the  procedures often were not comprehensive.
section_title: SEC Report Recommended That Rule 12b-1 Be Updated to Reflect Changes in Fund Marketing
paragraphs: In a December 2000 report on mutual fund fees and expenses, staff in SEC’s  Division of Investment Management recommended that SEC consider  reviewing the requirements of rule 12b-1 that govern how funds adopt and  renew their 12b-1 plans.  The division’s staff noted that modifications  might be needed to reflect changes in the manner in which funds are  marketed and distributed and the experience gained from observing how  rule 12b-1 has operated since its adoption in 1980.  The report noted that  the development of multiple fund share classes permit investors to choose  how distribution expenses are to be paid—for example, up front, in  installments over time, or at redemption. Many funds that offer shares  through broker-dealer fund supermarkets also adopt 12b-1 plans to pay for  the fees that the sponsoring broker-dealer charges the funds sold through  their supermarket.  The division’s report noted that because these 12b-1  plans are essential to the funds’ participation in these supermarkets, such  plans could be viewed as indefinite commitments.  Also since 1980, some  fund distributors have been using 12b-1 receivable revenues as collateral to  obtain loans to finance their distribution efforts.  The SEC staff noted that  such changes illustrate that 12b-1 fees have come to be used in different  ways than were originally envisioned under the rule and that changes may  be needed to reflect current practices.  Because of these changes, the  report noted that SEC should consider whether it needed to give additional  or different guidance to fund directors with respect to their review of rule  12b-1 plans, including whether the nine factors published in the 1980  release of rule 12b-1 were still valid (shown in fig. 1 of this report).
Although SEC has not yet provided additional guidance on or updated rule  12b-1 to reflect market changes, SEC staff told us that any amendment of  rule 12b-1 could also involve changes to how distribution fees and  expenses are disclosed. One fund independent director with whom we  spoke said that rule 12b-1 should be amended to allow payment only to  broker-dealers with net sales of fund shares and broker-dealers with net  redemptions would not be paid. He said that this change would make sense  for rule 12b-1 to fulfill its original purpose of increasing fund assets.
section_title: Concerns Raised over Adequacy of 12b-1 Fee Disclosure
paragraphs: Some concerns have been raised over the adequacy of 12b-1 fee  disclosures. A mutual fund shareholder advocacy organization has called  for reform in the disclosure of fund distribution expenses to better inform  investors of possible conflicts of interest that could compromise the  adviser’s responsibility to control fund costs and provide investors a  satisfactory return. For example, this group notes that 12b-1 fee disclosure  is misleading to investors because a fund’s money can be paying for  distribution expenses either through a 12b-1 fee or the adviser’s  management fee. However, the group asserts, the fee table in the  prospectus could give the investor the impression all distribution expenses  are covered by 12b-1 fees, while the fund adviser benefits from all of the  expenses paid from fund assets, the group noted. The group also noted that  12b-1 disclosures do not inform investors of potential conflicts of interest  affecting brokers because, based on the fee disclosures in the prospectus,  an investor cannot determine whether his broker received compensation  from the 12b-1 fees.
section_title: Revenue Sharing Arrangements Provide Additional Distribution Options and Are Increasingly Used to Compensate Fund Distributors
paragraphs: Revenue sharing payments are compensation that investment advisers pay  from their profits to the broker-dealers that distribute their funds.  Some  broker-dealers whose sales representatives market mutual funds have  narrowed their offerings of funds or created preferred lists of funds, which  then become the funds that receive the most marketing by these broker- dealer sales representatives. 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.  According to one research  organization official, there are significantly fewer distributing broker- dealers than there are mutual fund investment advisers. As a result, the  mutual fund distributors have the clout to require advisers to pay more to  have their funds sold by the distributing broker-dealers staff. For example,  distributors sometimes require investment advisers to share their profits  and pay for expenses incurred by the distributing broker-dealers, such as  advertising or marketing materials that are used by the distributing broker- dealers.
The revenue sharing payments that come from the adviser’s profits may  supplement distribution-related payments out of fund assets.  As noted,  funds may annually pay up to one percent of fund assets to distributors  pursuant to 12b-1 plans. However, SEC officials state that revenue sharing  arrangements, paid out of the adviser’s management fee, can permit broker- dealer distributors to receive payments outside of the 12b-1 limits. Further,  broker-dealers have discretion as to how to use these payments, including  using them to defray expenses incurred in marketing funds or to invest  them in other areas of the broker-dealer’s business.
Mutual funds and their investment advisers also may make distribution  payments or incur revenue sharing costs when they offer funds through  mutual fund supermarkets. Various broker-dealers, including those  affiliated with a mutual fund adviser, allow their customers to purchase  through their brokerage accounts the shares of funds operated by a wide  range of investment advisers. Although these fund supermarkets provide  the advisers of participating funds with an additional means of acquiring  investor dollars, the firms that provide such supermarkets generally require  investment advisers or funds themselves to pay a certain percentage on the  dollars attracted from purchases by customers of the firm’s supermarket.  For example, funds or advisers for the funds participating in the Charles  Schwab One Source supermarket pay that broker-dealer firm up to 0.40  percent of the amount invested by that firm’s customers. While some  portion of those payments may be paid out of fund assets pursuant to 12b-1  plans, those payments also may represent sharing of advisory fees.  Some  or all of these payments may be for transfer agency and shareholder  services.
According to SEC officials, revenue sharing is legitimate and consistent  with provisions of rule 12b-1. SEC’s adopting release of Rule 12b-1 states  that the rule should apply to both direct and indirect distribution expenses.  However, because there can be no precise definition of what expenses are  indirect, SEC decided that fund directors, particularly independent  directors, would bear the responsibility for determining on a case-by-case  basis whether the use of fund assets for distribution is in compliance with  the rule. SEC further noted that fund advisers can use the revenues they  receive from their management fee to pay for distribution expenses as long  as the adviser’s profits are legitimate and not excessive.
subsections: section_title: Actual Amount of Revenue Sharing Occurring Is Unknown
paragraphs: Mutual funds are not required to disclose the revenue sharing payments  made by their advisers as they are other distribution expenses paid by the  funds. As noted above, any sales loads or 12b-1 fees that funds charge are  disclosed in funds’ prospectuses and annual reports. However, the amount  of revenue sharing payments, which are paid out of the fund adviser’s  profits earned from the management fee or income from other sources, are  not typically disclosed to investors, except for possible general disclosure  in a fund’s prospectus or SAI. Funds do disclose 12b-1 payments and may  disclose that they may make other distribution-related payments but do not  have to disclose the total amount paid or identify the recipients of those  payments. As a result, complete data are not available on the extent to  which mutual fund advisers are making revenue sharing payments.  An  industry researcher said that the cost of revenue sharing does not show up  in advisers’ financial reports because there is no line item for it and costs  that fund advisers may incur to pay for sales meetings attended by broker- dealer staff or other promotion efforts are not specifically shown in fund  adviser income statements. According to an article in one trade journal,  revenue sharing payments made by major fund companies to broker- dealers may total as much as $2 billion per year.  These amounts have been  growing.  According to the officials of a mutual fund research organization,  revenue sharing costs are hard to quantify but are rising. For example, the  organization reports that about 80 percent of fund companies that partner  with major broker-dealers make cash revenue sharing payments.
section_title: Some Industry Participants Are Concerned that Revenue Sharing Could Negatively Impact Investors
paragraphs: The increased use of revenue sharing payments is raising concerns among  some industry participants.  Although revenue sharing payments are  becoming a major expense for fund advisers, industry research  organization officials told us that most fund advisers are not willing to  publicly discuss the extent to which they are making such payments.  A  2001 report on fund distribution practices states that “the details and levels  of revenue sharing vary widely across the industry and are seldom codified  in written contracts.”  In one industry magazine article, a mutual fund  industry researcher referred to revenue sharing as “the dirty little secret of  the mutual fund industry.”
One of the concerns raised about revenue sharing payments is the effect on  overall fund expenses.  The 2001 research organization report on fund  distribution practices noted that the extent to which revenue sharing may  affect other fees that funds charge, such as 12b-1 fees or management fees,  is uncertain.  For example, the report noted that it was not clear whether  the increase in revenue sharing payments had increased any fund’s fees but  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 because they  are paid from the adviser’s profits, unless the payments are financed  directly from fund assets as part of the adviser’s management fee or a 12b-1  plan. Fund directors, however, in the course of their review of the advisory  contract, consider the adviser’s profits before marketing and distribution  expenses, which also may limit the ability of advisers to shift 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, these revenue sharing  arrangements may have the effect of unduly focusing the attention of  investors and their broker-dealers on particular mutual fund choices, which  can reduce the number of funds they consider as part of the investment  decision.  That not only may lead to inferior investment choices, but may  also reduce fee competition among funds.  Finally, concerns have been  raised that revenue sharing arrangements may conflict with securities self- regulatory 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.
Mutual fund officials’ opinions about revenue sharing were mixed.  Some of  the fund officials with whom we spoke viewed revenue sharing as a cost of  doing business, which enabled them to obtain “shelf space” for their funds  with major broker-dealers and did not regard these arrangements as  potentially conflicting with investors’ interests. They explained that the  payments are made directly to the brokerage firm and not to individual  staff financial advisers. One fund official said that there would be no  incentive for broker-dealers’ sales staff to push certain funds, unless  managers exerted pressure on sales staff to sell those funds. Officials of  one large broker-dealer with whom we spoke said that their fund sales  platform has an “open architecture” through which all participating funds’  agreements and payments are the same, which creates a level playing field  on which no funds are given priority.  One fund official commented that  NASD rules require that broker-dealers sales staff recommend funds that  are most suitable to the individual investor’s financial situation.  However,  in letters commenting on certain compensation arrangements among  broker-dealers, ICI has stated that cash compensation creates potential  conflicts of interest between the broker-dealer receiving the compensation  and the customer because the sale of a recommended security could  increase the compensation paid to the broker-dealer’s sales representative.
Although the extent to which revenue sharing payments are affecting the  appropriateness of the fund recommendations that broker-dealers make is  not known, investor’s complaints regarding mutual fund shares they  purchased have recently increased dramatically.  According to NASD  statistics, the number of NASD-administered arbitration cases involving  mutual funds have increased by over 900 percent from 121 cases in 1999 to  1,249 cases in 2002.  According to NASD staff, about 34 percent of the 2002  cases involved complaints of unsuitable mutual fund purchases.  The  extent to which revenue sharing payments are involved with these cases is  unknown and NASD staff said the likely reason behind the increase in  arbitrations involving mutual funds is the decline in the stock market and  the associated declines in mutual fund performance.
section_title: Extent to Which Investors Are Told About the Potential Conflict That Revenue Sharing Creates Is Unclear
paragraphs: Although revenue sharing payments can create conflicts of interest  between broker-dealers and their clients, the extent to which broker- 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 broker- dealers receive in connection with securities transactions. While broker- dealers generally satisfy the requirements of rule 10b-10 by providing  customers with written “confirmations,” the rule does not specifically  require broker-dealers 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 will not receive a confirmation, and may  not view a prospectus, until after purchasing mutual fund shares.   According to SEC staff, the compensation-disclosure requirements of rule  10b-10 in large part are geared toward providing investors with information  that is useful over a course of dealing with a broker-dealer, rather than just  one transaction.  Information disclosed following the first transaction in a  security can help the investor determine whether to continue to use that  broker-dealer for future transactions.  That is particularly applicable in the  context of mutual funds, given that investors often purchase fund shares  over time in a series of transactions.
Regulators and others acknowledged that additional disclosures may be  necessary to better help investors assess the potential conflicts of interest  associated with mutual fund transactions when distributing broker-dealers  receive revenue sharing payments.  According to SEC staff, additional  disclosure is consistent with the principle that investors should be  informed about the financial interest that their broker-dealers have with  respect to mutual fund transactions.  Additional disclosure about revenue  sharing also may help investors be more sensitive to the question of  whether they are being presented with an adequate range of investment  choices within a fund class. SEC officials also told us that additional  disclosure of revenue sharing payments may be justified so that investors  can better assess whether the fund’s advisory fees are excessive. SEC  officials, in addition, noted that additional disclosure also might help  promote fee competition among funds.
NASD officials said that mutual funds’ revenue sharing arrangements with  broker-dealers could present a conflict of interest for the broker-dealer.   However, NASD looked at this issue in the past and found no hard evidence  of sales representatives recommending unsuitable funds, but they  acknowledged that making such a determination would be difficult.  The  NASD officials told us that it may be time to reexamine this issue. They said  that NASD Rule 2830 prohibits member brokers from accepting  compensation from fund advisers unless the funds disclose these payments  in fund prospectuses. ICI has also endorsed regulatory rule changes that  would require broker-dealers to disclose if they are receiving compensation  from fund advisers, in addition to requiring disclosure of these payments in  fund prospectuses. However, an official at one mutual fund adviser with  whom we spoke said that disclosure of funds’ revenue sharing agreements  would not be helpful because it would include only their largest  distributors and might mislead investors about the extent of revenue  sharing.
section_title: Soft Dollar Arrangements Provide Benefits, but Could Also Have an Adverse Impact on Investors
paragraphs: Soft dollar arrangements allow investment advisers of mutual funds and  other clients to use part of the brokerage commissions paid to broker- dealers that execute trades on the fund's behalf to obtain research and  brokerage services that can potentially benefit fund investors but could  increase the costs borne by their funds. The research and brokerage  services that fund advisers obtain through the use of soft dollars can  benefit a mutual fund investor by increasing the availability of research.  This practice also creates potential conflicts of interest that could harm  fund investors. Some industry participants argued that when mutual fund  investment advisers use fund assets to pay brokerage commissions and  receive research or brokerage services as part of soft dollar arrangements,  such services improve the investment advisers’ management of the fund.  However, others expressed concerns that such arrangements create  conflicts of interest that could result in fund advisers paying higher  brokerage commissions than necessary, which increases costs to fund  investors.  Investors’ expenses also could be higher if investment advisers  use brokerage commissions to pay for research and brokerage services that  they do not need or would otherwise pay for out of their own profits.   Expenses to investors would also be higher if investment advisers traded  more to generate and receive more soft dollar services.  According to SEC,  soft dollar arrangements could also compromise advisers’ fiduciary  responsibility to seek brokers capable of providing the best execution on  fund trades by choosing broker-dealers on the basis of their soft dollar  offerings. With these potential conflicts of interest in mind, several  interested parties in the United States and abroad have made suggestions  for how potential soft dollar abuses could be mitigated, although some of  these actions could have other negative consequences.
subsections: section_title: Soft Dollars Pay for Research and Brokerage Services
paragraphs: When investment advisers buy or sell securities for a fund, they may have  to pay the broker-dealers that execute these trades a commission using  fund assets.  In return for brokerage commissions, many broker-dealers  provide advisers with a bundle of services, including trade execution,  access to analysts and traders, and research products.  Soft dollar  arrangements refer to the exchange of research and brokerage services  from broker-dealers to fund advisers in return for brokerage commissions.  For example, many full-service broker-dealers offer trade execution  services, and in exchange for paying their stated institutional commission  rate, advisers conducting trades through them could be entitled to research  produced by the broker-dealers’ analysts or receive priority notification of  market or company-specific news.  In addition to providing this proprietary  research, these broker-dealers may also allow the fund adviser to generate  soft dollar credits with a portion of the brokerage commissions paid that  the fund adviser can then use to purchase other research from third parties.   These third parties can be other broker-dealers, independent research or  analytical firms, or service providers such as market data or trading  systems software and hardware vendors.   In a 1998 inspection report that  documented reviews of soft dollar practices at 75 broker-dealers and 280  investment advisers and investment companies, SEC reported for every  $1.70 in commissions paid to a broker-dealer, the adviser would receive  $1.00 worth of soft dollar products and services.
Soft dollar arrangements are not unique to the mutual fund industry. They  are widely used by investment advisers who manage portfolios for other  clients besides mutual funds, including pension funds, hedge funds, and  individual retail clients.
section_title: Soft Dollar Arrangements Have Evolved Over Time
paragraphs: Many of the features of soft dollar arrangements that exist today are the  result of regulatory changes in the 1970s. Until the mid-1970s, the  commissions charged by all brokers were fixed at one equal price. To  compete for commissions, broker-dealers differentiated themselves by  offering research-related products and services to advisers. In 1975, to  increase competition, SEC abolished fixed brokerage commission rates.  However, investment advisers were concerned that they could be held in  breach of their fiduciary duty to their clients to obtain best execution on  trades if they paid anything but the lowest commission rate available to  obtain research and brokerage services. In response, Congress created a  “safe harbor” under section 28(e) of the Securities Exchange Act of 1934  that allowed advisers to pay more than the lowest available commission  rate for security transactions in return for research and brokerage services  and not be in breach of their fiduciary duty.  In order to be protected  against a claim of breach of fiduciary duty under this safe harbor, the  adviser must make a good faith determination that the amount of  commission paid is reasonable in relation to the value of the brokerage and  research services provided by the broker-dealer.
The definition of what research and brokerage services can be obtained  through soft dollar arrangements has evolved over time.  In a 1976 release,  SEC issued guidelines for determining when a product or service is within  the meaning of brokerage and research services and available for the safe  harbor under section 28(e).  The 1976 guidelines provided the product or  service must not be “readily and customarily available and offered to the  general public on a commercial basis.”  In 1986, noting that this standard  was difficult to apply and unduly restrictive in certain instances, SEC  reinterpreted the safe harbor as permitting soft dollar arrangements to  purchase products and services that “provide lawful and appropriate  assistance to the money manager in the performance of his investment  decision-making responsibilities,” which could then include those  commercially available to the public. Under the revised interpretation, the  cost of products and services that provide lawful and appropriate  assistance, such as computer hardware and seminars, may be paid for with  soft dollars.
section_title: Although the Complete Extent of Soft Dollar Use Is Unknown, Soft Dollars Could Represent a Significant Portion of Trading Commissions
paragraphs: Because soft dollar research is often bundled, only aggregate value  estimates of soft dollar arrangements are available.  According to one  industry research organization, the total amount paid in brokerage  commissions for U.S. stocks totaled $8.6 billion in 2001, up from $7.7 billion  in 2000. Of this amount, industry participants estimate that 15 percent of  total annual brokerage commissions, or roughly $1 billion, is used to obtain  third-party research. However, this figure does not include the value of  proprietary research, which cannot be unbundled as easily as third-party  research. Moreover, in light of recent declines in fund assets, concern has  been raised that advisers are under increased pressure to use soft dollars to  pay for research rather than incur additional fund expenses.
Soft dollar products and services appear to represent a substantial portion  of the cost of brokerage commissions on individual trades.  Industry  participants estimate that on average broker-dealers charge commissions  of between $.05 and $.06 per share traded. In contrast, one industry expert  has noted that it costs less than $.01 per share to execute a trade through  an electronic communications network (ECN).  ECNs are registered  broker-dealers that operate as electronic exchanges.  Because ECNs do not  offer as many of the services offered by full service broker-dealers and  execute trades electronically, the cost of executing trades through these  brokers is lower.  However, the estimated costs of trading on an ECN may  not be representative of trading in all securities because most activity on  ECNs involves widely traded, liquid stocks.  Other estimates of the portion  of individual brokerage commissions represented by soft dollars and  execution services varied.  One academic study, for example, attributes 67  percent of the cost of brokerage commissions on individual trades to soft  dollars that pay for proprietary or third-party research. However,  recognizing that a portion of brokerage commissions goes towards broker- dealer profits, a consulting firm that specializes in mutual funds estimates  more conservatively that soft dollars constitute 33 percent of brokerage  commission costs.
Advisers who offer mutual funds use soft dollar arrangements to varying  degrees. According to one SEC official, many fund companies do their own  research and thus have less use for broker-dealer or third-party research.  Fixed-income funds, because their trades largely do not involve paying  commissions, may not generate many soft dollar credits that could be used  to obtain third-party research. However, one adviser of fixed-income funds  with whom we spoke said that his firm does receive proprietary research  from the full-service broker-dealers with whom they trade. Nine of the ten  fund companies with whom we spoke also used soft dollars to varying  degrees.  One of the fund companies indicated that they did not engage in  any soft dollar arrangements. However, this company specializes in  indexed funds, which do not require research, and therefore seeks  execution-only trades when it engages in portfolio transactions. Officials  from other firms indicated that they limited the items that they obtained  with soft dollars to research reports and analysis. On the other hand, some  fund companies with whom we spoke indicated that their funds engaged in  greater use of soft dollar arrangements for a variety of research and  brokerage services permissible under section 28(e), including computer  monitors and analytical software.
section_title: Disclosure of Soft Dollar Use to Mutual Fund Investors Is Limited
paragraphs: Fund advisers and investment companies must make some disclosure of  their soft dollar arrangements, but these disclosures are not specific and  not required to be routinely provided to mutual fund investors. Under the  Investment Advisers Act of 1940, advisers must disclose details of their soft  dollar arrangements in Part II of Form ADV, which is the form that  investment advisers use to register with SEC and are required to send to  their advisory clients. Specifically, Form ADV requires advisers to describe  the factors considered in selecting brokers and determining the  reasonableness of their commissions when the adviser has discretion in  choosing brokers.  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 may pay commissions higher than those obtainable  from other brokers in return for those products.  The adviser is also to  disclose whether research is used to service all of the adviser’s accounts or  just those accounts paying for it and any procedures the adviser used  during the last fiscal year to direct client transactions to a particular broker  in return for products and research services received. However, SEC staff  told us that the Form ADV disclosures tend to use standardized language  that is difficult for advisory clients to evaluate.
The information that investment advisers disclose about their choice of  broker-dealers and their use of soft dollars in their Form ADV is not  required to be routinely provided to mutual fund investors.  As noted  above, investment advisers are required to provide their Form ADV to their  advisory clients.  However, in the case of mutual funds, the client is  considered to be the legal entity that is registered as the investment  company with SEC and not the individual shareholders of the mutual fund.  SEC rules also require advisers to disclose the aggregate brokerage  commissions paid by the investment adviser with fund assets, the criteria  for broker selection, and the products and services obtained through soft  dollar arrangements in their SAI.  However, SAIs are only sent to  investors upon request, and industry officials noted that investors rarely  request SAIs.  As a result, mutual fund shareholders do not routinely  receive information about the extent to which their funds’ advisers receives  and uses soft dollar credits when making purchases or sales of the  securities in the mutual funds that they own.
In addition to oversight of fees and fund distribution expenses, mutual fund  directors also have a responsibility to monitor advisers’ soft dollar  arrangements to ensure best execution on portfolio trades. According to  SEC, fund directors typically have access to more detailed information  about an adviser’s soft dollar practices than described in the Form ADV,  including a list of brokers used and the total commissions dollars paid to  each broker, the average commission rate per share by broker, the list of  brokers with which the fund adviser has soft dollar arrangements and a  description of research and brokerages services received by the fund.  Additionally, directors often receive the advice of independent counsel  about an adviser’s soft dollar practices. Both SEC examiners and fund  directors evaluate soft dollar arrangements in the context of whether  advisers are getting best execution on portfolio transactions. Directors and  industry participants with whom we spoke indicated that boards evaluate  how advisers use soft dollars, whether these charges are reasonable, and  whether these arrangements affect best execution of portfolio  transactions.
section_title: Soft Dollars Benefit Investors in Various Ways, but Could Also Increase Investor Costs or Raise Conflicts of Interest
paragraphs: Some industry participants argue that the use of soft dollar benefits  investors in various ways. They note that the prevalence of soft dollar  arrangements allow 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 may also have  other benefits. For example, an investment adviser official told us that the  research on smaller companies for which soft dollars pay helps create a  more efficient market for such companies’ securities, resulting in greater  market liquidity and lower spreads.
However, concerns have been raised about soft dollar arrangements  because they could increase the costs that investors incur when investing  in a mutual fund. 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. As a result, soft dollar trades  might have both higher brokerage commissions and worse trade execution.  One academic study, for example, 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 broker-dealers. 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 were  not paying for it directly. In turn, advisers might have less incentive to  negotiate lower commissions, resulting in investors paying more for trades.  Some believe soft dollars are used to purchase research and brokerage  services for which advisers should pay out of their own profits and not out  of fund assets. As a result, the investor assumes the direct financial burden  for the advisers’ costs.
Concerns have also been expressed that the range of products and services  that advisers are obtaining with client commissions might be too broad.  Critics of soft dollar arrangements have argued that the 1986 principle has  legitimized the use of investor dollars to pay for products and services with  only marginal research applications, such as computer terminals,  telephone bills, and magazine subscriptions. Using soft dollars for such  services could harm investors because advisers have an incentive to freely  obtain such services that they would otherwise have to pay for out of their  profits.
SEC noted that mutual fund advisers tend to abide by the spirit of section  28(e) more diligently than other investment advisers. In 1996 and 1997, SEC  examiners conducted an examination sweep into the soft dollar practices  of broker-dealers, investment advisers and mutual funds. In their 1998  inspection report, SEC staff documented instances of soft dollars being  used for products and services outside the safe harbor, as well as  inadequate disclosure and bookkeeping of soft dollar arrangements.  However, SEC staff indicated that their review found that mutual fund  advisers engaged in far fewer soft dollar abuses than other types of  advisers.  They attributed mutual fund adviser compliance to the role that  independent directors play in overseeing and approving advisers’ soft  dollar arrangements. The SEC staff also indicated that active involvement  by legal counsel in the affairs of mutual funds may contribute to the relative  lack of soft dollar abuses among mutual fund advisers as well.
Investment advisers also receive services in exchange for part of the  brokerage commissions they pay with fund assets that directly reduce the  costs borne by mutual fund investors.  In these cases, instead of the adviser  receiving research or brokerage services, the adviser, at the request of the  fund board, could direct the broker-dealer executing a trade to use a  portion of the commission paid to pay an expense of the mutual fund.  For  example, the executing broker-dealer could mail a payment to the fund’s  custodian for the services rendered to the mutual fund that could reduce  the amount the fund itself would have to directly pay the custodian out of  fund assets.  Alternatively, the executing broker-dealer could rebate part of  the brokerage commission to the fund in cash. Such directed brokerage  arrangements do not fall under the section 28(e) safe harbor and do not  present the same conflicts of interest as traditional soft dollar  arrangements, because the investor, not the adviser, is directly benefiting  from them. An industry participant has indicated that such arrangements  are not very common in the mutual fund industry.
section_title: Regulators and Industry Participants Have Proposed Alternatives for Mitigating Potential Conflicts Involving Soft Dollar Use
paragraphs: As a result of its 1998 inspection report on its soft dollar examination  sweep, SEC staff made several proposals that could help investors better  evaluate advisers’ use of soft dollars. In the examination sweep, SEC  examiners found inconsistencies in how advisers and broker-dealers  interpreted the section 28(e) safe harbor.  Staff also found poor record  keeping and internal controls for soft dollar arrangements and that advisers  were not adequately disclosing their soft dollar usage.  As a result, SEC  staff recommended that Form ADV be modified to require more meaningful  disclosure. To facilitate this disclosure, SEC staff also recommended that  SEC publish the inspection report and issue additional guidance to clarify  the scope of the safe harbor. SEC published the inspection report to  reiterate guidance with respect to the scope of the safe harbor and to  emphasize the obligations of broker-dealers, investment advisers, and  investment companies that participate in soft dollar arrangements. This  recommendation may help industry participants apply the standards  articulated in the 1986 interpretive release more consistently and ensure  that investor dollars only pay for research and brokerage services within  the scope of section 28(e). Additionally, SEC staff recommended that SEC  consider adopting a bookkeeping requirement. A bookkeeping requirement  would enable advisers to disclose more easily to investors the products and  services for which soft dollars are paying. It would also ensure that  directors are able to receive information that fairly reflects the adviser’s  soft dollar arrangements.  SEC staff told us that if the expanded disclosure  and other changes envisioned in their sweep report were implemented,  clients of investment advisers also would have more specific information  that could allow them to evaluate the appropriateness of their own  adviser’s use of soft dollars.  The Department of Labor, which oversees  pension funds, and the Association for Investment Management and  Research, which administers professional certification examinations for  financial analysts, have also called for improved disclosure of soft dollar  usage by investment advisers.
However, SEC has yet to implement some of these recommendations due  to staff turnover and other high priority business. Except for publishing the  inspection report and issuing interpretative guidance that classifies certain  riskless principal transactions as falling under the section 28(e) safe  harbor, SEC has not issued further guidance regarding soft dollars.   A soft  dollar bookkeeping requirement has been discussed as part of a larger SEC  initiative on bookkeeping, but no formal proposal has been presented.  Finally, the SEC issued a proposed rule on Form ADV modifications in  April 2000, which solicited comments on several changes that could force  advisers to make more meaningful disclosures of soft dollar arrangements.  However, this rule has not been adopted.  SEC staff told us that they have  not taken further actions on these proposals due to staff turnover and the  press of business in other areas.
Some industry participants are not convinced that greater disclosure would  benefit investors. Form ADV is sent to advisory clients, not fund investors.  Thus, the proposed disclosure requirements do not address the needs of  fund investors. Investors do have access to information on a fund’s soft  dollar arrangements through the SAI, which is available upon request.  However, representatives of one fund company with whom we spoke  indicated that investors very rarely request SAIs. Industry participants also  noted that it might be difficult for investors to evaluate an adviser’s best  execution policies, which are not uniform across funds. Moreover, more  disclosure might lead investors to infer that soft dollar arrangements are  necessarily harmful and therefore adverse to their best interests.
Some proposals would seek to restrict or ban the use of soft dollars in  order to encourage brokerage commissions to fall. As a result of  recommendations from a government-commissioned review of  institutional investment in the United Kingdom, the Financial Services  Authority (FSA), which regulates the financial services industry in that  country, issued a consultation paper that argued that soft dollar  arrangements create incentives for advisers to route trades to broker- dealers on the basis of soft dollar arrangements and, further, that these  practices do not result in a good value for investors.  As a result of these  findings, the paper proposed banning soft dollars for market pricing and  information services, as well as various other products. This  recommendation would provide a more direct incentive for advisers to  consider what services are necessary for efficient fund management, which  could lower investors costs by reducing the extent to which advisers use  client funds for services that the adviser does not need.  The paper also  recommended that advisers quantify, or unbundle, the cost of all other soft  dollar products and services and rebate those costs to investors’ accounts  with hard dollars, which would result in investors having lower trading  costs in their funds.
Whether implementing the actions envisioned by the FSA’s proposals is  feasible is not certain.  For example, FSA staff acknowledged that  restricting soft dollar arrangements in the United Kingdom could hurt the  international competitiveness of their fund industry because fund advisers  outside their country would not have to comply with these restrictions.   Such restrictions could also encourage UK advisers to move their  operations elsewhere.  In addition, SEC staff told us that implementing the  FSA proposal would be more difficult here without legislative change  because the United States has the statutory safe harbor under Section  28(e), whereas the United Kingdom does not.
We learned of another proposal related to soft dollars and brokerage  commissions from an industry participant who was concerned that the  general practice of full-service broker-dealers charging about $0.05 to $0.06  per share in commissions and then offering discounts in the form of soft  dollars was serving to keep commissions artificially high.  His first  suggestion would be to ban soft dollar arrangements to obtain products  and services with marginal research applications, forcing advisers to pay  for these products with their own profits rather than with fund assets and  therefore reducing the trading costs borne by fund investors. Another  suggestion he had would have broker-dealers quantify the execution-only  portion of their brokerage commissions.  If this information were collected  by SEC and reported as industry averages, mutual fund directors would  have more information to use to evaluate their fund’s trading activities.
However, many industry participants are skeptical about whether soft  dollar arrangements contribute to investors paying higher brokerage  commissions. For example, according to SEC officials and an industry  participant, many broker-dealers claim that they would not negotiate lower  commission rates with investment advisers regardless of whether an  adviser was willing to forfeit soft dollar products and services in return.  One group with whom we spoke suggested that soft dollars might be more  of a volume rebate for brokerage than a factor influencing commission  rates. Moreover, surveys of investment advisers and broker-dealers  conducted in the United Kingdom found that third-party soft dollar  arrangements were a very minor factor on which broker-dealers competed  for business and advisers selected broker-dealers. These results suggest  that advisers’ incentive to compromise their fiduciary responsibility to seek  best execution in return for generous soft dollar arrangements might be  overstated.
Concern has also been raised about how the value of some soft dollar  products and services could be fairly determined. Because proprietary soft  dollar products and services are bundled, their values as individually  purchased items are difficult to estimate. For example, SEC officials noted  that it is hard to put a meaningful value on the cost of information  exchanged in a phone call between a fund adviser and a broker-dealer.  Nevertheless, brokerage commissions pay for this type of informal access.  Some industry experts, including SEC, have noted that attempts to require  the industry to quantify the value of soft dollar services could have a  disproportionate impact on third-party research. Third-party research is  free from the potential conflicts of interest that have recently tainted some  proprietary research from brokerage houses. Additionally, several fund  companies have indicated that they find research provided by specialized  research firms does provide valuable insights into investment decisions.  Because broker-dealers use soft dollar credits to purchase third-party  research, its value is more easily determined than proprietary research. As  a result, some have expressed concern that this distinction could make  third-party research more vulnerable if regulatory changes were enacted.
Some have suggested that limiting the products and services that could be  obtained with soft dollars might have some unintended consequences.  According to some fund officials, this option could shift a greater financial  burden onto advisers, who might be tempted to raise management fees as a  result. While having investment advisers pay directly for research and  brokerage services rather than receive them through soft dollars could  increase the transparency of these arrangements, the increased costs to the  adviser could cause advisers to seek fee increases or at least prevent  further reductions in the fees advisers do charge.
section_title: Conclusions
paragraphs: Although mutual funds disclose considerable information about their costs  to investors, some industry participants urge that additional disclosures are  needed to further increase the awareness of investors of the fees they pay  as part of investing in mutual funds and to encourage greater competition  among mutual funds on the basis of these fees.  The SEC staff’s proposal to  require funds to disclose the actual expenses in dollars based on an  investment amount of $10,000 would provide investors with more  information on fund fees and in a form that would allow for direct  comparison across funds.  If adopted, this will provide investors selecting  among different funds with useful information prior to investing.  However,  additional disclosures could also improve investor awareness and the  transparency of these fees.  Providing existing investors with the specific  dollar amounts of the fees paid on their shares and placing fee related  disclosures in the quarterly account statements that investors receive  would put mutual fund disclosures on comparable footing to many other  financial services that already disclose specifically in dollars the cost of  their services.  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.
Given the cost of producing such disclosures and the lack of data on the  additional benefits to investors, the SEC staff have indicated that they were  not certain that specific dollar disclosures are warranted.  However, we  believe that actively weighing the costs and benefits of providing additional  disclosure is worthwhile.  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 that SEC has proposed be added to  mutual fund’s semiannual reports that would disclose the dollar amounts of  a fund’s fees based on a set investment amount.  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.  If additional fee disclosures such as these  were used to supplement the existing information already provided in  prospectuses and semiannual reports, both prospective and existing  investors in mutual funds would have access to valuable information about  the relative costs of investing in different funds.
Mutual fund directors play a critical role in overseeing fund advisers  activities and have been credited with ensuring that U.S. mutual funds have  lower fees than those charged in other countries.  However, the popularity  of mutual fund investing and the increasing importance of such  investments to investors’ financial well being and ability to retire securely  also increases the need for regulators and industry participants to  continually seek to ensure that mutual fund corporate governance  practices remain strong.  The recent corporate scandals have resulted in  various corporate governance reforms being proposed to improve the  oversight of public companies by their boards of directors.  We have  supported regulatory and industry efforts to strengthen the corporate  governance of public companies.  Although many of the reforms being  sought for public companies are already either embodied in regulatory  requirements or recommended as best practices by the mutual fund  industry group, additional improvements to mutual fund governance, such  as mandating supermajorities of independent directors, are likely to  continue to be considered by regulators and industry participants, which  should further benefit mutual fund investors.
Although the ways that funds use 12b-1 fees has changed over time, these  fees appear to have provided investors with increased flexibility in  choosing how to pay for the services of the individual financial  professionals providing them with advice on fund purchases.  As a result,  they appear to provide benefits to the large number of investors that  require assistance with their financial decisions.  The revenue sharing  payments that funds make to broker-dealers illustrate that mutual funds  must compete to obtain access to the distribution networks that these  firms provide.  How and the extent to which these payments affect the  overall level of fees that fund investors pay is not clear.  However, by  compensating broker-dealers to market the funds of a particular company,  they can introduce a conflict with the broker-dealer obligation to  recommend the funds most suitable to the investor’s needs.  Further, even  if the payments do not conflict with this obligation, the payments can result  in financial professionals providing investors with fewer investment  choices.  Regulators acknowledged that the currently required disclosures  might not provide needed transparency to investors at the time that mutual  fund shares are being recommended for purchase.   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.
Fund investors can benefit when their fund’s investment adviser uses soft  dollars to obtain research and brokerage services that benefit the fund or to  pay other fund expenses.  However, investment advisers may also use soft  dollars for services that may just reduce the adviser’s own expenses.  The  SEC staff has recommended various changes that would increase the  transparency of soft dollar practices by clarifying the acceptable uses of  soft dollars and providing fund investors and directors with more  information about how their fund’s adviser is using soft dollars.  However,  the rule proposal to expand advisers’ disclosure of their use of soft dollars  was issued about 3 years ago and has not yet been acted upon.  In addition,  the SEC staff have not developed and issued a formal rule proposal to  implement its recommendation to require increased soft dollar  recordkeeping by broker dealers and advisers that would increase the  transparency of these arrangements.  SEC relies on disclosure of  information as a primary means of addressing potential conflicts between  investors and financial professionals.  However, by not acting on these soft  dollar-related measures, 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.
section_title: Recommendations
paragraphs: To promote greater investor awareness and competition among mutual  funds on the basis of their fees, we recommend that the Chairman, SEC  increase the transparency of the fees and practices that relate to mutual  funds by  considering the benefits of additional disclosure relating to mutual fund  fees, including requiring more information in mutual fund account  statements about the fees investors pay;   evaluating ways to provide more information that investors could use to  evaluate possible conflicts of interest resulting from any revenue  sharing payments their broker-dealers receive; and   evaluating ways to provide more information that fund investors and  directors could use to better evaluate the benefits and potential  disadvantages of their fund adviser’s use of soft dollars, including  considering and implementing the recommendations from its 1998 soft  dollar examinations report.
section_title: Agency Comments and Our Evaluation
paragraphs: SEC and ICI generally agreed with the contents of this report.  Regarding  our recommendation that SEC consider additional ways to provide fee  information to investors in account statements, the letter from the director  of the Division of Investment Management notes that the SEC staff agreed  that mutual fund shareholders need to understand the amount of fees that  mutual funds charge and indicated that they would consider whether some  form of fee disclosure could be included in account statements as they  continue to evaluate the comments they have received on their proposed  disclosure changes.  Regarding our recommendations on increasing the  amount of information disclosed about revenue sharing and soft dollar  arrangements, the SEC staff also indicated that they intend to consider  ways in which additional information about these practices could be  disclosed.
The letter from the president of ICI notes that our report’s discussion of  mutual fund regulatory requirements is generally balanced and well  informed.  However, his letter indicates concern over how we compare the  disclosures made by mutual fund fees to those made by other financial  products.   According to the letter, ICI staff are convinced that current  mutual fund fee disclosures allow individuals to make much more informed  and accurate decisions about the costs of their funds than do the  disclosures made by other financial service firms.  In particular, they  indicated that they are not aware of any other financial product that is  legally required to provide standardized information that reveals the exact  level of all of its fees and expenses and projects their impact in dollar terms  over various time periods.
We agree with ICI that mutual funds are already required to make  considerable disclosures that are useful to investors for comparing the  level of fees across funds.  Although our report notes that, unlike mutual  funds, other financial products generally do disclose their costs in specific  dollar terms, we do not make a judgment as to whether the overall  disclosures provided by these products are superior to that provided for  mutual funds.  Instead, we believe that supplementing the existing mutual  fund disclosures with additional information, particularly in the account  statements that provide investors with the exact number and value of their  mutual fund shares, could also prove beneficial for increasing awareness of  fees and prompting additional fee-based competition among funds.
The ICI’s staff’s letter also indicates that our report presents a thorough and  useful discussion of the role played by independent directors in overseeing  mutual fund fees.  However, they expressed concern that mutual fund  independent directors are not usually given sufficient credit for protecting  fund shareholder interests.  ICI noted that independent directors have  helped keep the industry free of major scandal and that mutual fund  governance standards, as set by the Investment Company Act of 1940,  places strict requirements on funds that exceed the voluntary standards  with which public companies are expected to adhere.   We agree with ICI  that independent directors have played important roles in overseeing funds  and, in each of the issues addressed by our report, we discuss the actions  taken by mutual fund directors to oversee the issues and that SEC reviews  generally find that directors have fulfilled their duties in accordance with  the law.  However, given recent scandals and concerns related to corporate  responsibility in the financial sector and the growing importance of fund  investments to the financial health and retirement security of investors,  continued debate by the Congress and among regulators and industry  participants about the effectiveness of existing mutual fund corporate  governance standards is appropriate. SEC’s and ICI’s written responses are  shown in appendixes II and III.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution of this report until 30  days from the report date. At that time, we will provide copies of this report  to the Chairman and the Ranking Minority Member, Senate Committee on  Banking, Housing, and Urban Affairs, and the Ranking Minority Members,  House Committee on Financial Services and its Subcommittee on Capital  Markets, Insurance, and Government Sponsored Enterprises.  Copies also  will be provided to the Chairman, SEC; the President, ICI; and other  interested parties. The report will also be available at no charge on GAO’s  home page at http://www.gao.gov.
If you or your staff have any questions regarding this report, please contact  Mr. Cody Goebel or me at (202) 512-8678. GAO staff that made major  contributions to this report are shown in appendix IV.
section_title: Scope and Methodology
paragraphs: To describe mutual fund fee and trading cost disclosures and other  financial product disclosures and the related costs we reviewed SEC rules  and studies by academics and others, and various mutual fund company  fund literature including prospectuses and SAIs, as well as prior GAO work.   To evaluate the benefits of additional mutual fund cost disclosure we  collected opinions from a judgmental sample of 15 certified financial  planners with the use of a structured questionnaire.
To describe the role of mutual fund independent directors we reviewed  federal laws and regulations, academic studies, and prior GAO work.  We  collected opinions from officials representing an independent directors  association and from a judgmental sample of independent directors with  the use of a structured questionnaire.
To obtain information on mutual fund distribution practices we  interviewed officials of ten mutual fund companies, two broker-dealers,  ICI, NASD, SEC, mutual fund research organizations, and investor  advocacy organizations and individuals. We also reviewed and analyzed  various documents and studies of mutual fund distribution practices.
To address the benefits and potential conflicts of interest raised by mutual  funds’ use of soft dollars, we spoke with the FSA and other industry  experts on soft dollars. We also reviewed studies by regulators and industry  experts on soft dollar arrangements. Some groups we spoke to had made  specific recommendations for regulatory changes to soft dollar  arrangements. To the extent possible, we discussed the potential  advantages and disadvantages of these recommendations with officials of  the ten mutual fund companies, two broker-dealers, ICI, NASD, SEC,  mutual fund research organizations, and investor advocacy organizations  and individuals.
For each of the topics we reviewed in this report we gathered views from  staff at SEC, mutual fund company officials, broker-dealers, ICI, mutual  fund research organizations, and investor advocacy organizations and  individuals.  We conducted our work in Washington, D.C.; Boston, MA;  Kansas City, MO; Los Angeles, CA; New York, N.Y.; and San Francisco, CA,  from February to June 2003, in accordance with generally accepted  government auditing standards.
section_title: Comments from the Securities and Exchange Commission
section_title: Comments from the Investment Company Institute
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to the individuals named above, Toayoa Aldridge, Jonathan  Altshul, Marc Molino, Robert Pollard, Barbara Roesmann, David Tarosky,  and Sindy Udell made key contributions to this report.
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section_title: Public Affairs