Mutual Funds: Additional Disclosures Could Increase Transparency of Fees and Other Practices
Published: 2004-01-27T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Concerns have been raised over whether the disclosures of mutual fund fees and other fund practices are sufficiently fair and transparent to investors. Our June 2003 report, Mutual Funds: Greater Transparency Needed in Disclosures to Investors, GAO-03- 763, reviewed (1) how mutual funds disclose their fees and related trading costs and options for improving these disclosures, (2) changes in how mutual funds pay for the sale of fund shares and how the changes in these practices are affecting investors, and (3) the benefits of and the concerns over mutual funds' use of soft dollars. This testimony summarizes the results of our report and discusses certain events that have occurred since it was issued.
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, SEC is not proposing that funds disclose the specific dollar amount of fees paid by each investor nor is it proposing to require that any fee disclosures be made in the account statements that investors receive. Although some of these additional disclosures could be costly and data on their benefits to investors was not generally available, less costly alternatives exist that could increase the transparency and investor awareness of mutual funds fees, making consideration of additional fee disclosures worthwhile. Changes in how mutual funds pay intermediaries to sell fund shares have benefited investors but have also raised concerns. Since 1980, mutual funds, under SEC Rule 12b-1, have been allowed to use fund assets to pay for certain marketing expenses. Over time the use of these fees has evolved to provide investors greater flexibility in choosing how to pay for the services of individual financial professionals that advise them on fund purchases. Another increasingly common marketing practice called revenue sharing involves fund investment advisers making additional payments to the broker-dealers that distribute their funds' shares. However, these payments may cause the broker-dealers receiving them to limit the fund choices they offer to investors and conflict with their obligation to recommend the most suitable funds. Regulators acknowledged that the current disclosure regulations might not always result in complete information about these payments being disclosed to investors. Under soft dollar arrangements, mutual fund investment advisers use part of the brokerage commissions they pay to broker-dealers for executing trades to obtain research and other services. Although industry participants said that soft dollars allow fund advisers access to a wider range of research than may otherwise be available and provide other benefits, these arrangements also can create incentives for investment advisers to trade excessively to obtain more soft dollar services, thereby increasing fund shareholders' costs. SEC staff has recommended various changes that would increase transparency by expanding advisers' disclosure of their use of soft dollars. By acting on the staff's recommendations SEC would provide fund investors and directors with needed information about how their funds' advisers are using soft dollars.

section_title: Letter
paragraphs: I am pleased to be here to discuss GAO’s work on the disclosure of mutual  fund fees and the need for other disclosures of mutual fund practices. The  fees and other costs that mutual fund investors pay as part of owning fund  shares can significantly affect their investment returns. In addition,  changes over time in how mutual funds pay intermediaries to sell fund  shares have also raised concerns. As a result, it is appropriate to debate  whether the disclosures of mutual fund fees and fund marketing practices  are sufficiently transparent and fair to investors.
Today, I will summarize the results from our report entitled Mutual Funds:  Greater Transparency Needed in Disclosures to Investors, GAO-03-763  (Washington, D.C.: June 9, 2003). Specifically, I will discuss (1) mutual  fund fee disclosures and opportunities for improving these disclosures,   (2) the potential conflicts that arise when mutual fund advisers pay  broker-dealers to sell fund shares, and (3) the benefits and concerns over  fund advisers’ use of soft dollars. I will also provide information relating to  certain events that have occurred since our June 2003 report was issued.
The results of our work suggest a need to consider ways to increase the  transparency of mutual fund fees and other fund practices. Mutual funds  disclose considerable information about their costs to investors, including  presenting the operating expense fees that they charge investors as a  percentage of fund assets and providing hypothetical examples of the  amount of fees that an investor can expect to pay over various time  periods. However, unlike many other financial products and services,  mutual funds do not disclose to individual investors the specific dollar  amount of fees that are paid on their fund shares. The Securities and  Exchange Commission (SEC) has proposed that mutual funds make  additional disclosures to investors that would provide more information  that investors could use to compare fees across funds. However, SEC is  not proposing that funds disclose the specific dollar amount of fees paid  by each investor nor is it proposing to require that any fee disclosures be  made in the account statements that inform investors of the number and  value of the mutual fund shares they own. Our report recommends that  SEC consider requiring mutual funds to make additional disclosures to  investors, including considering requiring funds to specifically disclose  fees in dollars to each investor in quarterly account statements. SEC has  agreed to consider requiring such disclosures but was unsure that the  benefits of implementing specific dollar disclosures outweighed the costs  to produce such disclosures. However, we estimate that spreading these  implementation costs across all investor accounts might not represent a  large outlay on a per investor basis. Our report also discusses less costly  alternatives that could also prove beneficial to investors and spur  increased competition among mutual funds on the basis of fees.
The work that we conducted for our report also found that 12b-1 fees,  which allow fund companies to deduct certain distribution expenses such  as sales commissions from fund assets, can raise costs to investors but  also provide additional ways for investors to pay for investment advice.  Our work also found that mutual fund advisers have been increasingly  engaged in a practice known as revenue sharing under which they make  additional payments to the broker-dealers that sell their fund shares.  Although we found that the impact of these payments on the expenses of  fund investors was uncertain, these payments can create conflicts between  the interests of broker-dealers and their customers that could limit the  choices of funds that these broker-dealers offer investors. However, under  current disclosure requirements investors may not always be explicitly  informed that their broker-dealer, who is obligated to recommend only  suitable investments based on the investor’s financial condition, is also  receiving payments to sell particular funds. Our report recommends that  more disclosure be made to investors about any revenue sharing payments  their broker-dealers are receiving. On January 14, 2004, SEC proposed new  rules and rule amendments designed to enhance the information that  broker-dealers provide to their customers concerning conflicts of interest  that arise from the sale of mutual funds.
We also reviewed a practice known as soft dollars, in which a mutual fund  adviser uses fund assets to pay commissions to broker-dealers for  executing trades in securities for the mutual fund’s portfolio but also  receives research or other brokerage services as part of the transaction.  These soft dollar arrangements can result in mutual fund advisers  obtaining research or other services, including research from third party  independent research firms, that can benefit the investors in their funds.  However, these arrangements also create a conflict of interest that could  result in increased expenses to fund shareholders if a fund adviser trades  excessively to obtain additional soft dollar research or chooses broker- dealers more on the basis of their soft dollar offerings than their ability to  execute trades efficiently. SEC has addressed soft dollar practices in the  past and recommended actions could provide additional information to  fund directors and investors, but has not yet acted on some of its own  recommendations. Our report recommends that more disclosure be made  to mutual fund directors and investors to allow them to better evaluate the  benefits and potential disadvantages of their fund adviser’s use of soft  dollars.
Finally, since September 2003, federal and state authorities’ widening  investigation of illegal late trading and improper timing of fund trades has  involved a growing number of prominent mutual fund companies and  brokerage firms. To address these abusive practices, regulators are  considering the merits of various proposals that have been put forth. In  addition, in November 2003, the House of Representatives acted on  legislation that addresses abusive trading and various other mutual fund  issues and legislation was introduced in the Senate. The House of  Representatives passed H.R. 2420, the Mutual Funds Integrity and Fee  Transparency Act of 2003. H.R. 2420’s purpose is to (1) improve  transparency of mutual fund fees and costs and (2) improve corporate  governance and management integrity of mutual funds. Also in November  2003, three bills addressing mutual fund concerns were introduced in the  Senate. The Mutual Fund Transparency Act of 2003, S. 1822, would require  disclosure of financial relationships between brokers and mutual fund  companies and of certain brokerage commissions paid by mutual fund  companies. S. 1958, the Mutual Fund Investor Protection Act of 2003, was  introduced to prevent the practice of late trading by mutual funds, and for  other purposes. S. 1971, the Mutual Fund Investor Confidence Restoration  Act of 2003 seeks to improve transparency relating to the fees and costs  that mutual fund investors incur and to improve corporate governance of  mutual funds.
subsections: section_title: Additional Disclosure of Mutual Fund Costs Might Benefit Investors
paragraphs: Although mutual funds already disclose considerable information about  the fees they charge, our report recommends that SEC consider requiring  that mutual funds make additional disclosures to investors about fees in  the account statements that investors receive. Mutual funds currently  provide information about the fees they charge investors as an operating  expense ratio that shows as a percentage of fund assets all the fees and  other expenses that the fund adviser deducts from the assets of the fund.  Mutual funds also are required to present a hypothetical example that  shows in dollar terms what investors could expect to pay in fees if they  invested $10,000 in a fund and held it for various periods. It is important to  understand the fees charged by a mutual fund because fees can  significantly affect investment returns of the fund over the long term. For  example, over a 20-year period a $10,000 investment in a fund earning 8  percent annually, with a 1-percent expense ratio, would be worth $38,122;  but with a 2-percent expense ratio it would be worth $31,117—over $7,000  less.
Unlike many other financial products, mutual funds do not provide  investors with information about the specific dollar amounts of the fees  that have been deducted from the value of their shares. Table 1 shows that  many other financial products do present their costs in specific dollar  amounts.
Although mutual funds do not disclose their costs to each individual  investor in specific dollars, the disclosures that they make do exceed those  of many products. For example, purchasers of fixed annuities are not told  of the expenses associated with investing in such products. Some industry  participants and others including SEC also cite the example of bank  savings accounts, which pay stated interest rates to their holders but do  not explain how much profit or expenses the bank incurs to offer such  products. While this is true, we do not believe this is an analogous  comparison to mutual fund fees because the operating expenses of the  bank are not paid using the funds of the savings account holder and are  therefore not explicit costs to the investor like the fees on a mutual fund.
A number of alternatives have been proposed for improving the disclosure  of mutual fund fees, that could provide additional information to fund  investors. In December 2002, SEC released proposed rule amendments,  which include a requirement that mutual funds make additional  disclosures about their expenses. This information would be presented to  investors in the annual and semiannual reports prepared by mutual funds.  Specifically, mutual funds would be required to disclose the cost in dollars  associated with an investment of $10,000 that earned the fund’s actual  return and incurred the fund’s actual expenses paid during the period. In  addition, SEC also proposed that mutual funds be required to disclose the  cost in dollars, based on the fund’s actual expenses, of a $10,000  investment that earned a standardized return of 5 percent. If these  disclosures become mandatory, investors will have additional information  that could be directly compared across funds. By placing the disclosures  in funds’ annual and semiannual reports, SEC staff also indicated that it  will facilitate prospective investors comparing funds’ expenses before  making a purchase decision.
However, SEC’s proposal would not require mutual funds to disclose to  each investor the specific amount of fees in dollars that are paid on the  shares they own. As result, investors will not receive information on the  costs of mutual fund investing in the same way they see the costs of many  other financial products and services that they may use. In addition, SEC  did not propose that mutual funds provide information relating to fees in  the quarterly or even more frequent account statements that provide  investors with the number and value of their mutual fund shares. In a 1997  survey of how investors obtain information about their funds, the Investment  Company Institute (ICI) indicated that, to shareholders, the account  statement is probably the most important communication that they receive  from a mutual fund company and that nearly all shareholders use such  statements to monitor their mutual funds.
SEC and industry participants have indicated that the total cost of  providing specific dollar fee disclosures might be significant; however, we  found that the cost might not represent a large outlay on a per investor  basis. As we reported in our March 2003 statement for the record to the  Subcommittee on Capital Markets, Insurance, and Government Sponsored  Enterprises, House Committee on Financial Services, ICI commissioned a  large accounting firm to survey mutual fund companies about the costs of  producing such disclosures.  Receiving responses from broker-dealers,  mutual fund service providers, and fund companies representing  approximately 77 percent of total industry assets as of June 30, 2000, this  study estimated that the aggregated estimated costs for the survey  respondents to implement specific dollar disclosures in shareholder  account statements would exceed $200 million, and the annual costs of  compliance would be about $66 million. Although the ICI study included  information from some broker-dealers and fund service providers, it did  not include the reportedly significant costs that all broker-dealers and  other third-party financial institutions that maintain accounts on behalf of  individual mutual fund shareholders could incur. However, using available  information on mutual fund assets and accounts from ICI and spreading  such costs across all investor accounts indicates that the additional  expenses to any one investor are minimal. Specifically, at the end of 2001,  ICI reported that mutual fund assets totaled $6.975 trillion. If mutual fund  companies charged, for example, the entire $266 million cost of  implementing the disclosures to investors in the first year, then dividing  this additional cost by the total assets outstanding at the end of 2001  would increase the average fee by 0.0038 percent or about one-third of a  basis point. In addition, ICI reported that the $6.975 trillion in total assets  was held in over 248 million mutual fund accounts, equating to an average  account of just over $28,000. Therefore, implementing these disclosures  would add $1.07 to the average $184 that these accounts would pay in total  operating expense fees each year—an increase of six-tenths of a percent.
In addition, other less costly alternatives are also available that could  increase investor awareness of the fees they are paying on their mutual  funds by providing them with information on the fees they pay in the  quarterly statements that provide information on an investor’s share  balance and account value. For example, one alternative that would not  likely be overly expensive would be to require these quarterly statements  to present the information—the dollar amount of a fund’s fees based on a  set investment amount—that SEC has proposed be added to mutual fund  semiannual reports. Doing so would place this additional fee disclosure in  the document generally considered to be of the most interest to investors.  An even less costly alternative could be to require quarterly statements to  also include a notice that reminds investors that they pay fees and to  check their prospectus and with their financial adviser for more  information. In September 2003, SEC amended fund advertising rules,  which require funds to state in advertisements that investors should  consider a fund’s fees before investing and directs investors to consult  their funds’ prospectus. However, also including this information in the  quarterly statement could increase investor awareness of the impact that  fees have on their mutual fund’s returns. H.R. 2420 would require that  funds disclose in the quarterly statement or other appropriate shareholder  report an estimated amount of the fees an investor would have to pay on  each investment of $1,000. S. 1958, like H.R. 2420, would require disclosure  of fees paid on each $1,000 invested. S. 1971, among other disclosures,  would require that funds disclose the actual cost borne by each  shareholder for the operating expenses of the fund.
SEC’s current proposal, while offering some advantages, does not make  mutual funds comparable to other products and provide information in the  document that is most relevant to investors—the quarterly account  statement. Our report recommends that SEC consider requiring additional  disclosures relating to fees be made to investors in the account statement.  In addition to providing specific dollar disclosures, we also noted that  investors could be provided with a variety of other disclosures about the  fees they pay on mutual funds that would have a range of implementation  costs, including some that would be less costly than providing specific  dollar disclosures. However, seeing the specific dollar amount paid on  shares owned could be the incentive that some investors need to take  action to compare their fund’s expenses to those of other funds and make  more informed investment decisions on this basis. Such disclosures may  also increasingly motivate fund companies to respond competitively by  lowering fees. Because the disclosures that SEC is currently proposing be  included in mutual fund annual and semiannual reports could also prove  beneficial, it could choose to require disclosures in these documents and  the account statements, which would provide both prospective and  existing investors in mutual funds access to valuable information about  the costs of investing in funds.
subsections: section_title: Disclosures of Trading Costs Could Benefit Investors
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’ Statement of Additional Information.
Mutual fund officials raised various concerns about expanding the  disclosure of brokerage commissions and trading costs in general. Some  officials said that requiring funds to present additional information about  brokerage commissions by including such costs in the fund’s operating  expense ratios would not present information to investors that could be  easily compared across funds. For example, funds that invest in securities  on the New York Stock Exchange (NYSE), for which commissions are  usually paid, would pay more in total commissions than would funds that  invest primarily in securities listed on NASDAQ because the 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. Officials at one  fund company told us that it would be difficult for fund companies to  produce a percentage figure for other trading costs outside of  commissions because no agreed upon methodology for quantifying market  impact costs, spreads, and markup costs exists within the industry. Other  industry participants told us that due to the complexity of calculating such  figures, trading cost disclosure is likely to confuse investors. For example  funds that attempt to mimic the performance of certain stock indexes,  such as the Standard & Poors 500 stock index, and thus limit their  investments to just these securities have lower brokerage commissions  because they trade less. In contrast, other funds may employ a strategy  that requires them to trade frequently and thus would have higher  brokerage commissions. However, choosing among these funds on the  basis of their relative trading costs may not be the best approach for an  investor because of the differences in these two types of strategies.
To improve the disclosure of trading costs to investors, the House-passed  H.R. 2420 would require mutual fund companies to make more prominent  their portfolio turnover disclosure which, by measuring the extent to  which the assets in a fund are bought and sold, provides an indirect  measure of transaction costs for a fund. The bill directs funds to include  this disclosure in a document that is more widely read than the prospectus  or Statement of Additional Information, and would require fund  companies to provide a description of the effect of high portfolio turnover  rates on fund expenses and performance. H.R 2420 also requires SEC to  issue a concept release examining the issue of portfolio transaction costs.  S. 1822 would require mutual funds to disclose brokerage commissions as  part of fund expenses. S. 1958 would require SEC to issue a concept  release on disclosure of portfolio transaction costs. S. 1971 would require  funds to disclose the estimated expenses paid for costs associated with  management of the fund that reduces the funds overall value, including  brokerage commissions, revenue sharing and directed brokerage  arrangements, transactions costs and other fees. In December 2003, SEC  issued a concept release to solicit views on how SEC could improve the  information that mutual funds disclose about their portfolio transaction  costs.
section_title: Changes in Some Fund Distribution Practices Likely Beneficial But Others Raise Potential Conflicts of Interest
paragraphs: The way that investors pay for the advice of financial professionals about  their mutual funds has evolved over time. Approximately 80 percent of  mutual fund purchases are made through broker-dealers or other financial  professionals, such as financial planners and pension plan administrators.  Previously, the compensation that these financial professionals received  for assisting investors with mutual fund purchases were paid by either  charging investors a sales charge or load or by paying for such expenses  out of the investment adviser’s own profits.
However, in 1980, SEC adopted rule 12b-1 under the Investment Company  Act to help funds counter a period of net redemptions by allowing them to  use fund assets to pay the expenses associated with the distribution of  fund shares. Rule 12b-1 plans were envisioned as temporary measures to  be used during periods of declining assets. Any activity that is primarily  intended to result in the sale of mutual fund shares must be included as a  12b-1 expense and can include advertising; compensation of underwriters,  dealers, and sales personnel; printing and mailing prospectuses to persons  other than current shareholders; and printing and mailing sales literature.  These fees are called 12b-1 fees after the rule that allows fund assets to be  used to pay for fund marketing and distribution expenses.
NASD, whose rules govern the distribution of fund shares by broker  dealers, limits the annual rate at which 12b-1 fees may be paid to 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. Rule 12b-1 provides investors  an alternative way of paying for investment advice and purchases of fund  shares. Apart from 12b-1 fees, brokers can be paid with sales charges  called “loads”; “front-end” loads are applied when shares in a fund are  purchased and “back-end” loads when shares are redeemed. With a 12b-1  plan, the fund can finance the broker’s compensation with installments  deducted from fund assets over a period of several years. Thus, 12b-1  plans allow investors to consider the time-related objectives of their  investment and possibly earn returns on the full amount of the money they  have to invest, rather than have a portion of their investment immediately  deducted to pay their broker.
Rule 12b-1 has also made it possible for fund companies to market fund  shares through a variety of share classes designed to help meet the  different objectives of investors. For example, Class A shares might charge  front-end loads to compensate brokers and may offer discounts called  breakpoints for larger purchases of fund shares. Class B shares,  alternatively, might not have front-end loads, but would impose 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.
Although providing alternative means for investors to pay for the advice of  financial professionals, some concerns exist over the impact of 12b-1 fees  on investors’ costs. For example, our June 2003 report discussed academic  studies that found that funds with 12b-1 plans had higher management fees  and expenses. Questions involving funds with 12b-1 fees have also been  raised over whether some investors are paying too much for their funds  depending on which share class they purchase. For example, SEC recently  brought a case against a major broker dealer that it accused of  inappropriately selling mutual fund B shares, which have higher 12b-1  fees, to investors who would have been better off purchasing A shares that  had much lower 12b-1 fees. Also, in March 2003, NASD, NYSE, and SEC  staff reported on the results of jointly administered examinations of 43  registered broker-dealers that sell mutual funds with a front-end load. The  examinations found that most of the brokerage firms examined, in some  instances, did not provide customers with breakpoint discounts for which  they appeared to have been eligible.
subsections: section_title: Revenue Sharing Raises Conflict of Interest Concerns
paragraphs: One mutual fund distribution practice—called revenue sharing—that has  become increasingly common raises potential conflicts of interest between  broker-dealers and their mutual fund investor customers. Broker-dealers,  whose extensive distribution networks and large staffs of financial  professionals who work directly with and make investment  recommendations to investors, have increasingly required mutual funds to  make additional payments to compensate their firms beyond the sales  loads and 12b-1 fees. These payments, called revenue sharing payments,  come from the adviser’s profits and may supplement distribution-related  payments from fund assets. According to an article in one trade journal,  revenue sharing payments made by major fund companies to broker- dealers may total as much as $2 billion per year. According to the officials  of a mutual fund research organization, about 80 percent of fund  companies that partner with major broker-dealers make cash revenue  sharing payments. For example, some broker-dealers have narrowed their  offerings of funds or created preferred lists that include the funds of just  six or seven fund companies that then become the funds that receive the  most marketing by these broker-dealers. In order to be selected as one of  the preferred fund families on these lists, the mutual fund adviser often is  required to compensate the broker-dealer firms with revenue sharing  payments.
One of the concerns raised about revenue sharing payments is the effect  on overall fund expenses. A 2001 research organization report on fund  distribution practices noted that the extent to which revenue sharing  might affect other fees that funds charge, such as 12b-1 fees or  management fees, was uncertain. For example, the report noted that it was  not clear whether the increase in revenue sharing payments increased any  fund’s fees, but also noted that by reducing fund adviser profits, revenue  sharing would likely prevent advisers from lowering their fees. In addition,  fund directors normally would not question revenue sharing arrangements  paid from the adviser’s profits. In the course of reviewing advisory  contracts, fund directors consider the adviser’s profits not taking into  account marketing and distribution expenses, which also could prevent  advisers from shifting these costs to the fund.
Revenue sharing payments may also create conflicts of interest between  broker-dealers and their customers. By receiving compensation to  emphasize the marketing of particular funds, broker-dealers and their  sales representatives may have incentives to offer funds for reasons other  than the needs of the investor. For example, revenue sharing arrangements  might unduly focus the attention of broker-dealers on particular mutual  funds, reducing the number of funds considered as part of an investment  decision−potentially leading to inferior investment choices and potentially  reducing fee competition among funds. Finally, concerns have been raised  that revenue sharing arrangements might conflict with securities 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.
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 10b-10 requirements 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 would not receive a confirmation and  might not view a prospectus until after purchasing mutual fund shares.
As a result of these concerns, our report recommends that SEC evaluate  ways to provide more information to investors about the revenue sharing  payments that funds make to broker-dealers. Having additional disclosures  made at the time that fund shares are recommended about the  compensation that a broker-dealer receives from fund companies could  provide investors with more complete information to consider when  making their investment decision. To address revenue sharing issues, we  were pleased to see that a recent NASD rule proposal would require  broker-dealers to disclose in writing when the customer first opens an  account or purchases mutual fund shares compensation that they receive  from fund companies for providing their funds “shelf space” or preference  over other funds. On January 14, 2004, SEC proposed new rules and rule  amendments designed to enhance the information that broker-dealers  provide to their customers. H.R. 2420 would require fund directors to  review revenue sharing arrangements consistent with their fiduciary duty  to the fund. H.R. 2420 also would require funds to disclose revenue sharing  arrangements and require brokers to disclose whether they have received  any financial incentives to sell a particular fund or class of shares. S. 1822  would require brokers to disclose in writing any compensation received in  connection with a customer’s purchase of mutual fund shares. S. 1971  would require fund companies and investment advisers to fully disclose  certain sales practices, including revenue sharing and directed brokerage  arrangements, shareholder eligibility for breakpoint discounts, and the  value of research and other services paid for as part of brokerage  commissions.
section_title: Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact Investors
paragraphs: Soft dollar arrangements allow fund investment advisers to obtain  research and brokerage services that could potentially benefit fund  investors but could also increase investors’ costs. When investment  advisers buy or sell securities for a fund, they may have to pay the broker- dealers that execute these trades a commission using fund assets. In  return for these brokerage commissions, many broker-dealers provide  advisers with a bundle of services, including trade execution, access to  analysts and traders, and research products.
Some industry participants argue that the use of soft dollars benefits  investors in various ways. The research that the fund adviser obtains can  directly benefit a fund’s investors if the adviser uses it to select securities  for purchase or sale by the fund. The prevalence of soft dollar  arrangements also allows specialized, independent research to flourish,  thereby providing money managers a wider choice of investment ideas. As  a result, this research could contribute to better fund performance. The  proliferation of research available as a result of soft dollars might also  have other benefits. For example, an investment adviser official told us  that the research on smaller companies helps create a more efficient  market for such companies’ securities, resulting in greater market liquidity  and lower spreads, which would benefit all investors including those in  mutual funds.
Although the research and brokerage services that fund advisers obtain  through the use of soft dollars could benefit a mutual fund investor, this  practice also could increase investors’ costs and create potential conflicts  of interest that could harm fund investors. For example, soft dollars could  cause investors to pay higher brokerage commissions than they otherwise  would, because advisers might choose broker-dealers on the basis of soft  dollar products and services, not trade execution quality. One academic  study shows that trades executed by broker-dealers that specialize in  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 are not paying for it directly. In  turn, advisers might have less incentive to negotiate lower commissions,  resulting in investors paying more for trades.
Under the Investment Advisers Act of 1940, advisers must disclose details  of their soft dollar arrangements in Part II of Form ADV, which investment  advisers use to register with SEC and must send to their advisory clients.  However, this form is not provided to the shareholders of a mutual fund,  although the information about the soft dollar practices that the adviser  uses for particular funds are required to be included in the Statement of  Additional Information that funds prepare, which is available to investors  upon request. Specifically, Form ADV requires advisers to describe the  factors considered in selecting brokers and determining the  reasonableness of their commissions. If the value of the products,  research, and services given to the adviser affects the choice of brokers or  the brokerage commission paid, the adviser must also describe the  products, research and services and whether clients might pay  commissions higher than those obtainable from other brokers in return for  those products.
In a series of regulatory examinations performed in 1998, SEC staff found  examples of problems relating to investment advisers’ use of soft dollars,  although far fewer problems were attributable to mutual fund advisers. In  response, SEC staff issued a report that included proposals to address the  potential conflicts created by these arrangements, including  recommending that investment advisers keep better records and disclose  more information about their use of soft dollars. Although the  recommendations could increase the transparency of these arrangements  and help fund directors and investors better evaluate advisers’ use of soft  dollars, SEC has yet to take action on some of its proposed  recommendations.
As a result, our June 2003 report recommends that SEC evaluate ways to  provide additional information to fund directors and investors on their  fund advisers’ use of soft dollars. SEC relies on disclosure of information  as a primary means of addressing potential conflicts between investors  and financial professionals. However, because SEC has not acted to more  fully address soft dollar-related concerns, investors and mutual fund  directors have less complete and transparent information with which to  evaluate the benefits and potential disadvantages of their fund adviser’s  use of soft dollars.
To address the inherent conflicts of interest with respect to soft dollar  arrangements, H.R. 2420 would  require SEC to issue rules mandating disclosure of information about  soft dollar arrangements; require fund advisers to submit to the fund’s board of directors an  annual report on these arrangements, and require the fund to provide  shareholders with a summary of that report in its annual report to  shareholders; impose a fiduciary duty on the fund’s board of directors to review soft  dollar arrangements;   direct SEC to issue rules to require enhanced recordkeeping of soft  require SEC to conduct a study of soft-dollar arrangements, including  the trends in the average amounts of soft dollar commissions, the types  of services provided through these arrangements, the benefits and  disadvantages of the use of soft dollar arrangements, the impact of soft  dollar arrangements on investors’ ability to compare the expenses of  mutual funds, the conflicts of interest created by these arrangements  and the effectiveness of the board of directors in managing such  conflicts, and the transparency of soft dollar arrangements.
S. 1822 would discourage use of soft dollars by requiring that funds  calculate their value and disclose it along with other fund expenses. S.  1971 also would require disclosure of soft dollar arrangements and the  value of the services provided. Also, it would require that SEC conduct a  study of the use of soft dollar arrangements by investment advisers.
section_title: Various Scandals Involving Mutual Funds Surfaced in 2003
paragraphs: Since we issued our report in June 2003, various allegations of misconduct  and abusive practices involving mutual funds have come to light. In early  September 2003, the Attorney General of the State of New York filed  charges against a hedge fund manager for arranging with several mutual  fund companies to improperly trade in fund shares and profiting at the  expense of other fund shareholders. Since then federal and state  authorities’ widening investigation of illegal late trading and improper  timing of fund trades has involved a growing number of prominent mutual  fund companies and brokerage firms.
The problems involving late trading arise when some investors are able to  purchase or sell mutual fund shares after the 4:00 pm Eastern Time close  of U.S. securities markets, the time at which funds price their shares.  Under current mutual fund regulations, orders for mutual fund shares  received after 4:00 pm are required by regulation to be priced at the next  day’s price. An investor permitted to engage in late trading could be  buying or selling shares at the 4:00 pm price knowing of developments in  the financial markets that occurred after 4:00 pm, thus unfairly taking  advantage of opportunities not available to other fund shareholders.  Clearly, to ensure compliance with the law, funds should have effective  internal controls in place to prevent abusive late trading. Regulators are  considering a rule change requiring that an order to purchase or redeem  fund shares be received by the fund, its designated transfer agent, or a  registered securities clearing agency, by the time that the fund establishes  for calculating its net asset value in order to receive that day’s price.
The problems involving market timing occur when certain fund investors  are able to take advantage of temporary disparities between the share  value of a fund and the values of the underlying assets in the fund’s  portfolio. For example, such disparities can arise when U.S. mutual funds  use old prices for their foreign assets even though events have occurred  overseas that will likely cause significant movements in the prices of those  assets when their home markets open. Market timing, although not illegal,  can be unfair to funds’ long-term investors because it provides the  opportunity for selected fund investors to profit from fund assets at the  expense of fund long-term investors. To address these issues, regulators  are considering the merits of various proposals that have been put forth to  discourage market timing, such as mandatory redemption fees or fair  value pricing of fund shares.
To protect fund investors from such unfair trading practices H.R. 2420  would, with limited exceptions, require that all trades be placed with funds  by 4:00 pm and includes provisions to eliminate conflicts of interest in  portfolio management, ban short-term trading by insiders, allow higher  redemption fees to discourage short-term trading, and encourage wider  use of fair value pricing to eliminate stale prices that makes market timing  profitable. S. 1958 would require that fund companies receive orders prior  to the time they price their shares. S. 1958 would also increase penalties  for late trading and require funds to explicitly disclose their market timing  policies and procedures. S.1971 also would restrict the placing of trades  after hours, require funds to have internal controls in place and  compliance programs to prevent abusive trading, and require wider use of  fair value pricing.
In conclusion, GAO believes that various changes to current disclosures  and other practices would benefit fund investors. Additional disclosures of  mutual fund fees could help increase the awareness of investors of the  fees they pay and encourage greater competition among funds on the basis  of these fees. Likewise, better disclosure of the costs funds incur to  distribute their shares and of the costs and benefits of funds’ use of soft  dollar research activities could provide investors with more complete  information to consider when making their investment decision. In light of  recent scandals involving late trading and market timing, various reforms  to mutual fund rules will also likely be necessary to better protect the  interests of all mutual fund investors.
This concludes my prepared statement and I would be happy to respond to  questions.
section_title: Contacts and Acknowledgements
paragraphs: For further information regarding this testimony, please contact Cody J.  Goebel at (202) 512-8678. Individuals making key contributions to this  testimony include Toayoa Aldridge and David Tarosky.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.