oversight

Mutual Funds: Information on Trends in Fees and Their Related Disclosure

Published by the Government Accountability Office on 2003-03-12.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                             United States General Accounting Office

GAO                          Testimony
                             Before the Subcommittee on Capital Markets,
                             Insurance and Government Sponsored
                             Enterprises, Committee on Financial Services,
                             House of Representatives
For Release on Delivery
Expected at 10:00 a.m. EST
Wednesday,
March 12, 2003
                             MUTUAL FUNDS
                             Information on Trends in
                             Fees and Their Related
                             Disclosure
                             Statement for the Record by
                             Richard J. Hillman
                             Director, Financial Markets and
                              Community Investment




GAO-03-551T
                                                March 2003



                                               MUTUAL FUNDS

                                               Information on Trends in Fees and Their
Highlights of GAO-03-551T, a statement         Related Disclosure
for the record to the Chairman,
Subcommittee on Capital Markets,
Insurance and Government Sponsored
Enterprises, Committee on Financial
Services, House of Representatives




Millions of U.S. households have               Recent data indicate that mutual fund fees may have increased. Studies by
invested in mutual funds whose                 the staff of the Securities and Exchange Commission (SEC) and the
value exceeds $6 trillion. The fees            Investment Company Institute found that expense ratios for mutual funds
and other costs that these investors           overall have increased since 1980. GAO’s prior analysis of large mutual
pay as part of owning mutual funds             funds showed that these funds’ average expense ratios generally decreased
can significantly affect their
investment returns. Recent press
                                               between 1990 and 1998, but between 1999 and 2001, the average ratio for the
reports suggest that mutual fund               large stock funds analyzed has increased somewhat while the average ratio
fees have increased during the                 for the large bond funds has continued to decline. The average expense
market downturn in the last few                ratio for these large funds overall remains lower than their average in 1990.
years. In addition, questions have
been raised as to whether the                  SEC is proposing that investors receive additional information about
disclosures of these fees and other            mutual fund fees in the semiannual reports sent to fund shareholders. If
costs, such as brokerage                       adopted, these new disclosures would appear to provide additional
commissions, are sufficiently                  useful information to investors and would allow for fees to be compared
transparent. GAO updated its
analysis from its June 2000 report,            across funds. However, various alternatives to the disclosures that SEC
which showed the trends in mutual              is proposing could provide information specific to each investor and in a
fund fees from 1990 and 1998 for               more frequently distributed and relevant document to mutual fund
large funds by collecting data on              shareholders—the quarterly account statement, which presents
how these 76 funds’ fees changed               information on the actual number and value of each investor’s
between 1998 to 2001. GAO also                 shareholdings. Industry participants have raised concerns that requiring
reviewed the Securities and                    additional disclosures in quarterly statements would be costly and that
Exchange Commission’s recent
rule proposal on fee disclosure as
                                               the additional benefits to investors have not been quantified.
well as studies by industry.
                                               Asset-Weighted Average Expense Ratios for 76 Stock and Bond Funds 1990 -
                                               2001




www.gao.gov/cgi-bin/getrpt?GAO-03-551T.
To view the full statement, including the
scope and methodology, click on the link
above. For more information, contact Richard
J. Hillman at (202) 512-8678 or
hillmanr@gao.gov.
Mr. Chairman and Members of the Subcommittee:

I appreciate the opportunity to provide information on GAO’s recent work
on mutual fund fees. Millions of U.S. households have invested in mutual
funds whose value exceeds $6 trillion. The fees and other costs that these
investors pay as part of owning mutual funds can significantly affect their
investment returns. Recent press reports suggest that mutual fund fees
have increased during the market downturn in the last few years. In
addition, questions have been raised as to whether the disclosures of these
fees and others costs, such as brokerage commissions, are sufficiently
transparent. In a report issued in June 2000, we found that fees for the
largest stock and bond mutual funds had declined from 1990 to 1998 but
that not all funds had reduced their fees.1 We also found that mutual funds
do not usually compete directly on the basis of their fees, and we
recommended that Securities and Exchange Commission (SEC) consider
additional disclosures regarding fees to increase investor awareness and
to encourage additional price competition among funds.

The operating costs that mutual funds incur are expressed as a percentage
of fund assets and called the fund’s operating expense ratio. This expense
ratio includes the management fee (the amount the fund’s investment
adviser charges for managing the fund), the fund’s other operating
expenses (such as fund accounting or mailing expenses), and 12b-1 fees
(distribution expenses paid out of fund assets).2 Moreover, funds incur
other costs not included in the expense ratio that also can affect investor
returns. For example, funds pay commissions to broker-dealers to execute
trades for their fund. This statement responds to your request that we (1)
provide updated information on how mutual fund fees have changed since
our June 2000 report, (2) discuss how fund fees are currently disclosed
and various alternatives for expanding these disclosures, and (3) provide
information on how mutual funds’ trading costs are disclosed.

To evaluate trends in mutual fund fees, we obtained and analyzed data on
the fees and other expenses of 76 mature stock and bond mutual funds
from financial research organizations to update analysis presented in our
June 2000 report. At the time we conducted the work for our June 2000



1
 U.S. General Accounting Office, Mutual Fund Fees: Additional Disclosure Could
Encourage Price Competition, GAO/GGD-00-126 (Washington, D.C.: June 7, 2000).
2
 12b-1 refers to the specific rules under the Securities Exchange Act that authorized
mutual funds to pay for marketing and distribution expenses directly from fund assets.



Page 1                                                                      GAO-03-551T
report, these were the largest funds in existence during the period 1990-
1998.3 Because these funds had grown more than other funds, we expected
them to have been subject to the greatest economies of scale, which could
have allowed their advisers to reduce the fees they charge investors. For
this statement, we obtained information on these funds’ assets, expenses,
and other information from 1999 to 2001, which was the latest year
complete data were available for all these funds. We also reviewed recent
studies by regulators and industry associations on trends in mutual fund
fees. To describe how fund fees are disclosed and various alternatives for
expanding these disclosures, we relied on our prior work on this subject;
also we reviewed current SEC rule proposals and comment letters by
industry participants and investors.4 To assess the brokerage commissions
mutual funds pay and how these are disclosed, we reviewed SEC rules and
studies by academics and others. For each of the topics we addressed in
this statement, we also gathered views and relevant documentation from
staff at SEC, three mutual fund companies, the Investment Company
Institute (ICI), which represents mutual fund companies, and an investor
advocate.

In summary, recent studies show that mutual fund fees may be on the rise.
Our prior analysis of large mutual funds showed that these funds average
expense ratios generally decreased between 1990 and 1998, but between
1999 and 2001, the average ratio for the large stock funds we analyzed has
increased somewhat while the average ratio for the large bond funds has
continued to decline. The average expense ratio for these 76 funds overall
fees remains lower than their average in 1990. However, since 1998, the
majority of stock and bond funds we analyzed had higher expense ratios in
2001 than they did in 1998. The decline in assets for many stock funds
since 2000 may have contributed to the recent increase in expense ratios
because many funds have fee schedules that decrease fees at various
increments as fund assets increase.5 However, when assets decline, less of


3
 For our June 2000 report, we analyzed data for 77 large funds—46 stock funds and 31
bond funds—between 1990 and 1998. However, since we issued that report, one of these
funds no longer exists, so our data for 1999 to 2001 presented in this statement included
data for 76 funds.
4
 U.S. General Accounting Office, SEC’s Report Provides Useful Information on Mutual
Fund Fees and Recommends Improved Fee Disclosure. GAO-01-655R (Washington, D.C.:
May 3, 2001).
5
 For example, a fund’s management fee could be 0.35 percent on assets up to $5 billion,
0.30 percent on assets between $5 billion and 10 billion, and 0.27 percent on assets above
$10 billion.



Page 2                                                                        GAO-03-551T
                       these funds’ assets are charged the lower fee increments, which increases
                       the expense ratio they report as a percentage of their total assets.
                       Although most of the expense ratios for the large bond funds we analyzed
                       had also increased, the overall average of these funds’ ratios had declined
                       because assets for lower-fee funds were growing faster than those of
                       higher-fee funds.

                       In response to the recommendation in our 2000 report that SEC consider
                       additional disclosures regarding fees, SEC issued proposed rule
                       amendments in December 2002 that would require that mutual funds make
                       additional disclosures of fees to their shareholders. These new disclosures
                       would appear to provide additional useful information to investors and
                       will allow for fees to be compared across funds. However, SEC is
                       proposing that this information be included only in the semiannual
                       shareholder reports, which provides information to all of a mutual fund’s
                       investors that is not investor specific. Various alternatives to the
                       disclosures that SEC is proposing were discussed in our prior reports and
                       those of others that could provide information specific to each investor in
                       a more frequently distributed and relevant document to mutual fund
                       shareholders—the quarterly account statement, which presents
                       information on the actual number and value of each investor’s
                       shareholdings. However, industry participants have raised concerns that
                       requiring additional disclosures in quarterly statements would be costly
                       and their additional benefits to investors have not been quantified.

                       Industry participants and others are also debating whether to increase the
                       disclosures that mutual funds are required to make about their trading
                       costs, such as the commissions funds pay to broker-dealers when they
                       trade securities. Currently, funds are required to disclose the amount of
                       brokerage commissions they paid only in reports sent to SEC, which are
                       available to investors only if specifically requested. Although SEC has not
                       proposed any changes to how funds disclose these costs, academics and
                       investor advocates believe that additional disclosures of these expenses
                       would be useful to investors. However, industry participants raised
                       concerns over whether such disclosures would provide information that
                       could be meaningfully compared across funds.


                       Data from others and our own analysis indicates that mutual fund fees
Mutual Fund Fees       may have increased recently. Studies by SEC and ICI found that expense
Appear to Have Risen   ratios for mutual funds overall have increased since 1980. Our own
                       analysis finds that average expense ratios for large stock funds have
Recently

                       Page 3                                                          GAO-03-551T
                           increased since 1998, but those for large bond funds have declined since
                           then.

Recent Studies Indicate    Since we issued our report in 2000, the staff at SEC have published a study
that Mutual Fund Expense   of mutual fund fees that showed that fund expense ratios have increased.6
Ratios Have Increased      The SEC staff study measured the mutual fund expense ratio of all stock
                           and bond mutual funds between 1979 and 1999. The study used a weighted
                           average of mutual funds in order to give more weight to funds with more
                           assets. Their study found that the average expense ratio for these funds
                           rose from 0.73 percent in 1979 to 0.94 percent in 1999. However, they
                           noted that the increase in mutual fund expense ratios since the 1970s can
                           be attributed primarily to changes in the manner that mutual funds and
                           their shareholders pay for distribution and marketing expenses. Over this
                           period, many funds have decreased or replaced front-end loads, which are
                           not included in a fund’s expense ratio with ongoing rule 12b-1 fees, which
                           are included in a fund’s expense ratio. Front-end loads are charged to
                           investors as a percentage of the initial investment when they buy shares
                           and are used to compensate financial professionals, such as the investor’s
                           broker or financial planner.

                           Using a different methodology, ICI also published a series of studies that
                           show that, although expense ratios may be rising, the overall cost of
                           investing in mutual funds has decreased. ICI’s studies attempt to measure
                           what it calls the “total shareholder cost” of investing in mutual funds by
                           considering both a fund’s operating expense ratio and any sales charges,
                           such as loads, investors paid when investing in that fund. To determine the
                           average total cost of investing in funds as a percentage of fund assets, ICI
                           also weights each individual fund’s total cost by the fund’s sales each year.
                           By using sales to weight each fund’s contribution to the overall average,
                           ICI indicates that it is attempting to present the cost and the actual
                           investment choices made by investors purchasing mutual fund shares in
                           particular years. In its latest study using this methodology, ICI reports that
                           the total shareholder costs for equity funds fell from 2.26 percent of fund
                           assets in 1980 to 1.28 percent in 2001, and that the total cost of investing in
                           bond funds declined from 1.53 percent to 0.90 percent during the same
                           period.7



                           6
                            U.S. Securities and Exchange Commission Division of Investment Management, Report on
                           Mutual Fund Fees and Expenses (Washington, D.C.: December 2000).
                           7
                            Investment Company Institute, Total Shareholder Cost of Mutual Funds: An Update
                           (Washington D.C.: September 2002).


                           Page 4                                                                  GAO-03-551T
According to ICI’s study, the primary reason that the total cost of mutual
fund investing has declined results from the reduction in sales and other
distribution costs paid by mutual fund investors over this period. For
example, ICI finds that the average load has fallen from 7.0 percent of the
dollar value of investors’ purchases to 5.2 percent and sales of shares not
subject to such loads have also increased. For example, some funds waive
the load for certain investors, such as purchases by retirement plans.

Some industry participants have criticized the ICI’s methodology. As we
discussed in our June 2000 report, analysts at one industry research
organization acknowledged that the ICI data may indicate that the total
cost of investing in mutual funds has declined.8 However, they said that
because ICI weighted the fund fees and other charges by sale volumes, the
decline ICI reports results mostly from actions taken by investors rather
than advisers of mutual funds. These research organization officials noted
that ICI acknowledged in its study that about half of the decline in fund
costs resulted from investors increasingly purchasing shares in no-load
funds.

Although ICI’s study shows that the total cost of investing in funds may be
declining, it also shows that stock funds’ expense ratios have risen.
According to ICI’s September 2002 study, the average stock fund operating
expense ratio has risen from 0.77 percent in 1980 to 0.88 percent in 2001.
ICI’s study also shows that the average expense ratio of the stock funds it
reviewed has continued to rise in recent years from 0.83 in 1998 to 0.88
percent in 2001. ICI attributes this increase to two factors. First, funds
with higher expense ratios, such as aggressive growth funds or
international stock funds, have been popular lately and increased sales of
these funds would increase the overall average. Second, the decline in
assets experienced by many stock funds as a result of the market decline
since 2000 also means that such funds have fewer assets over which to
spread their fixed operating costs and thus their expense ratio would rise
as a percentage of their assets.

Recent press reports have also indicated that fees for mutual funds may be
increasing. For example, a March 2003 press report presented data from
Lipper, Inc., a mutual fund research service, that shows that the median




8
 Morningstar, Inc., Morningstar.Net Commentary: Revisiting Fund Costs: Up or Down?,
Scott Cooley, (Feb. 19, 1999).



Page 5                                                                GAO-03-551T
                            expense ratio for stock funds increased from 1.30 percent in 1998 to 1.46
                            percent in 2002.


Our Analysis Shows that     Although our June 2000 report found that fees for large stock and bond
Average Fees for Large      funds had generally declined between 1990 and 1998, analysis of recent
Stock Funds Have            years shows that the average expense ratios for large stock funds have
                            risen since 1998 while fees for bond funds have continued to decline. For
Increased Recently, but     our June 2000 report, we analyzed the change in expense ratios from 1990
Fees for Large Bond Funds   to 1998 for 77 large stock and bond mutual funds, which because of their
Have Declined               growth during this period—which collectively averaged over 600
                            percent—were likely to have experienced economies of scale in their
                            operations that would allow them to reduce their expense ratios. To
                            calculate the average expense ratios on the large mutual funds identified
                            in our previous report, we weighted each fund’s expense ratio by its total
                            assets. The resulting asset-weighted average expense ratios represent the
                            fees an average investor would expect to pay on every $100 dollars
                            invested in these funds during this period. Since our 2000 report one of the
                            bond funds was liquidated, so our analysis for this statement presents
                            comparable results for 76 funds.

                            As shown in figure 1, since 1990, the average expense ratio charged by the
                            large stock funds we analyzed, after generally rising during the mid-1990s,
                            declined the second half of the 1990s and then began rising again. The
                            asset-weighted average expense ratio for these stock funds declined from
                            0.74 percent in 1990 to 0.70 percent in 2001. However, the average expense
                            ratio of these funds has increased recently by about 8 percent, from 0.65
                            percent in 1998 to 0.70 percent in 2001. The average expense ratios for the
                            large bond funds also generally declined between 1990 and 2001, from 0.62
                            percent to 0.54 percent. However, unlike the stock funds, the bond funds
                            have continued to decline since 1998.9




                            9
                              For our June 2000 report, the asset-weighted average expense ratios were calculated
                            using each fund’s year-end net assets. Consistent with industry practice, we calculated the
                            average expense ratios for our updated analysis using each fund’s average net assets for
                            each year. Based on a comparison of 1998 information calculated both ways, the
                            difference does not appear to materially affect the overall trends we identified.



                            Page 6                                                                       GAO-03-551T
Figure 1: Asset-Weighted Average Expense Ratios for 76 Large Stock and Bond Funds, 1990–2001




                                       Various factors may explain the recent rise in stock fund expense ratios.
                                       ICI and industry participants attribute recent increases in average expense
                                       ratios industrywide to asset declines among stock funds. For example, ICI
                                       reported that total assets held by stock funds have declined from over
                                       $4 trillion in 1999 to about $3.4 trillion at the end of 2001. The decline in
                                       assets for many stock funds may have contributed to the recent increase in
                                       expense ratios because many funds have fee schedules that charge lower
                                       management fees at various increments as the fund’s assets increase. As
                                       the assets of a fund with such a declining rate fee schedule increase, these
                                       additional assets are assessed a lower-percentage rate fee, which results in
                                       the fund reporting a lower total expense ratio overall. However, when
                                       assets decline, more of the fund’s assets are charged the higher


                                       Page 7                                                          GAO-03-551T
                                                         management fee increments, resulting in an increase in the overall
                                                         expense ratio of the fund.

                                                         However, asset declines and resulting increases in some expense ratios do
                                                         not explain all of the increases in the average expense ratio for the large
                                                         stock funds we analyzed because the assets of most of these funds
                                                         continued to grow. Overall, the total assets in the 46 stock funds we
                                                         reviewed increased from $835 billion in 1998 to over $1,052 billion in 2001.
                                                         Individually, 28 of the 46 stock funds experienced asset growth between
                                                         1998 and 2001, although most of these funds’ assets declined from 2000 to
                                                         2001.

                                                         The decline in the average expense ratio for bond funds shown in figure 1
                                                         appeared to arise from stronger asset growth in lower-fee funds. We
                                                         divided the 30 bond funds in our analysis into two groups: (1) those funds
                                                         with expense ratios in 1998 that were higher than the 0.60 percent
                                                         weighted average ratio for all 30 funds and (2) those funds with expense
                                                         ratios in 1998 that were lower than the 0.60 percent weighted average ratio
                                                         for all 30 funds. As shown in table 1, the 16 low-fee funds experienced
                                                         overall asset growth of about 32 percent, whereas the assets of the 14 high-
                                                         fee funds declined 16 percent from 1998 to 2001. In addition, the low-fee
                                                         funds’ average expense ratio declined by 7 percent whereas the high-fee
                                                         funds’ ratio decreased only 2 percent.

Table 1: Change in Assets and Expense Ratios for 30 Bond Funds, by High- and Low-Fee Funds, 1998—2001

                                               Total assets                 Percentage        Expense ratios             Percentage
                                              (in millions)                    change          (in percent)                 change
                                               1998              2001                           1998         2001
 14 high-fee funds                          $74,295           $62,045        -16 percent          0.84        0.82         -2 percent
 16 low-fee funds                            87,571           115,380         32 percent          0.41        0.38         -7 percent
Source: GAO analysis of data from Lipper.

                                                         Looking specifically at the extent to which individual funds expense ratios
                                                         changed, we found that the expense ratios for the majority of the large
                                                         stock and bond funds we analyzed had also increased since 1998. As
                                                         shown in table 2, the expense ratios for 28 or 61 percent of the 46 large
                                                         stock funds we analyzed increased from 1998 to 2001. The table also
                                                         shows that half of these 28 funds had increased their total assets but their
                                                         expense ratios continued to increase. However the majority of these
                                                         expense ratios increases were less than 10 percent. Table 2 shows four
                                                         funds whose assets increased by more than 30 percent and whose expense
                                                         ratios increased by more than 10 percent. However, these four funds
                                                         management fees included provisions that would allow the fund adviser to


                                                         Page 8                                                          GAO-03-551T
charge a higher rate if the fund’s performance exceeded certain
benchmarks. For example, the expense ratio of one of these funds
increased from under 0.60 percent in 1998 to 0.88 percent in 2001. This
increase is due in large part to the fund’s fee schedule, which calls for part
of the fund’s management fee to go up or down between 0.02 percent and
0.20 percent of assets annually, depending on whether the fund’s 3-year
performance was better or worse than the return of the S&P 500 index,
which this fund’s performance did exceed. Of the remaining 18 funds we
analyzed, most of whose assets increased, their expense ratios either did
not change or decreased between 1998 and 2001.

Table 2: Changes in Assets and Expense Ratios in 46 Large Stock Funds, 1998–
2001

                                                    Percentage change in assets
 Change in expense                                   +100 to +30 to      0 to   -30 or
 ratios                                +100 or more     +30        0     –30     more    Total
 Increase over 30
 percent                                          1        1       1       1         -      4
 Increase between 10
 percent and 30 percent                           -        2       1       2         -      5
 Increase under 10
 percent                                         -         3       5       9        2      19
 Subtotal                                        1         6       7      12        2      28
 No change                                       -         -       1       -        -       1
 Decrease under 10
 percent                                          5        4       2       3         -     14
 Decrease between 10
 percent and 30 percent                           1        1        -      -        1       3
 Decrease over 30
 percent                                         -         -       -       -        -       -
 Subtotal                                        6         5       3       3        1      18
 Total                                           7        11      10      15        3      46
Source: GAO analysis of data from Lipper.



The expense ratios for the majority of bond funds that we analyzed also
increased. As shown in table 3, the expense ratios for 18, or 60 percent, of
the 30 large bond funds we analyzed also increased from 1998 to 2001.
Over this period, 14 of the funds’ assets decreased—which could increase
their expense ratios because less of their assets would be subject to lower
fee rates under a declining rate fee schedule. Four funds assets and
expense ratios increased between 1998 and 2001. However, of the 18 funds
with increased expense ratios, the majority of the increases were less than
10 percent.




Page 9                                                                          GAO-03-551T
                            Table 3: Changes in Assets and Expense Ratios in 30 Large Bond Funds, 1998–
                            2001

                                                                                Percentage change in assets
                             Change in                        +100 or                                             -30 or
                             expense ratios                     more        +100 to +30   +30 to 0   0 to –30      more Total
                             Increase over 30
                             percent                                    -             -          -            -        -        -
                             Increase
                             between 10
                             percent and 30
                             percent                                    -             -          -            2       1     3
                             Increase under
                             10 percent                                 1            2          1          9          2    15
                             Subtotal                                   1            2          1         11          3    18
                             No change                                  -            -          -          -          -     -
                             Decrease under
                             10 percent                                 -            1          5             2        -    8
                             Decrease
                             between 10
                             percent and 30
                             percent                                    -            3           -            1        -    4
                             Decrease over
                             30 percent                                 -            -          -          -          -     -
                             Subtotal                                   -            4          5          3          -    12
                             Total                                      1            6          6         14          3    30
                            Source: GAO analysis of data from Lipper.



                            SEC is proposing that investors receive additional information about
SEC Is Proposing            mutual fund fees, but other alternatives for disclosing fees exist that could
Additional Fee              better inform investors of the actual fees they are charged. The SEC
                            proposal would allow fees to be compared across funds, but would
Disclosures, but Other      present information to investors in dollar amounts using only illustrative
Alternatives Could          investment amounts. In contrast, various alternative means of providing
                            additional fee disclosures would provide dollar amounts calculated using
Provide More Specific       each investors’ own account balances or number of shares owned and
Information                 present this information in the quarterly statements they receive that show
                            the value of their mutual fund holdings. Although mutual funds generally
                            do not emphasize the level of their fees in their advertisements, SEC is
                            also proposing that additional disclosures be made in such materials.


SEC Proposal Provides       Since 1988, SEC has required that mutual fund prospectuses include a
Additional Information on   table that shows all fees and charges associated with a mutual fund
Fees                        investment as a percentage of net assets. The fee table reflects (1) charges
                            paid directly by shareholders out of their investment such as front- and


                            Page 10                                                                               GAO-03-551T
back-end sales loads and (2) recurring charges deducted from fund assets
such as management and 12b-1 fees. The fee table is accompanied by a
numerical example that illustrates the aggregate expenses that investors
could expect to pay over time on a $10,000 investment if they received a 5-
percent annual return and remained in the fund for 1, 3, 5, or 10 years.10 In
addition, SEC adopted requirements in January 2001 that require mutual
funds to disclose their after-tax returns. SEC staff told us that taxes can
have an even more significant impact on investors’ returns than fund
expenses.

In response to the recommendation in our 2000 report that SEC consider
additional disclosures regarding fees, SEC released proposed rule
amendments in December 2002 whose primary purpose is to require
mutual funds to disclose additional information about their portfolio
holdings, but also proposes that they make additional disclosures about
their expenses.11 Under this proposal, SEC would require that mutual fund
investors be provided with information on the dollar amount of fees paid
using preset investment amounts. This information would be presented to
investors in the annual and semiannual reports prepared by mutual funds.
Specifically, mutual funds would be required to present a table showing
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. This disclosure is intended to permit investors to
estimate the actual costs in dollars that they bore over the reporting period
using the actual return for the period. In addition, SEC is also proposing
that mutual funds present in the table the cost in dollars, based on the
fund’s actual expenses, of a $10,000 investment that earned a standardized
return of 5 percent. This second disclosure, would allow investors to more
easily compare the differences in the actual expenses of two funds
irrespective of any performance differences between the two.

SEC is also proposing that a narrative accompany these two new expense
disclosures. The narrative would explain that mutual funds have
transaction-based charges, such as loads or fees for exchanging shares of


10
  In 1998, SEC increased the hypothetical investment amount illustrated in the fee table
example from $1,000 to $10,000 to reflect the size of the more typical fund investment.
11
  Securities and Exchange Commission, Shareholder Reports and Quarterly Portfolio
Disclosure of Registered Management Investment Companies, 68 Fed. Reg. 160-01
(Washington, D.C.: Dec. 18, 2002).




Page 11                                                                      GAO-03-551T
one fund for another, and ongoing costs, as represented by the expense
ratio, and that the numerical examples are intended to help shareholders
understand these ongoing costs and to compare these costs with the
ongoing costs of investing in other mutual funds. The narrative would also
explain the assumptions used in the examples, note that the examples do
not reflect any of the transaction-based costs, and advise investors that
examples are useful in comparing ongoing but not total costs of investing
in different funds.

The method of disclosure that SEC is proposing is consistent with one of
the alternatives discussed in our June 2000 report. As SEC’s rule proposal
states, the two new expense figures being proposed are designed to
increase investor understanding of the fees that they pay on an ongoing
basis for investing in a fund. The proposed disclosure in shareholder
reports would supplement the fee disclosure required in the mutual fund
prospectus. According to SEC staff, the new disclosures they are
recommending would be placed in the annual and semiannual reports
because these documents contain more information than quarterly
statements and thus would allow investors to better understand fee
information in an appropriate context. SEC staff also believe that
providing this information in these reports will allow investors to compare
the fees of one fund to another. If adopted, we agree that the proposed
disclosures would provide investors with additional useful information.

SEC has received a wide range of comments on their proposal specific to
disclosure of fund expenses. Most comments were in support of SEC’s
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. Some commenters also noted that
requiring specific dollar disclosures was not necessary, given the potential
costs and burdens to mutual fund companies. One large labor union
supported SEC’s proposal, but encouraged SEC to explore cost-effective
methodologies to provide investors with their actual share of fees. An
industry association representing attorneys stated in its letter that it
generally supported the additional disclosures SEC was proposing, but
given existing disclosures requirements, the benefits of these additional
disclosures appeared marginal at best.




Page 12                                                         GAO-03-551T
Alternative Disclosures     Alternatives to the SEC proposal could offer more investor-specific
Could Provide Investors     information. While SEC’s proposed disclosures would provide additional
More Specific Information   information that investors could use to compare fees across funds, the
                            disclosures in SEC’s 2002 proposed rule amendments would not be
                            investor specific because they would not use an investor’s individual
                            account balances or number of shares owned. In addition, SEC’s proposed
                            placement of these new disclosures in the semiannual shareholder reports,
                            instead of in quarterly statements, may be less likely to increase investor
                            awareness and improve price competition among mutual funds. Quarterly
                            statements, which show investors the number of shares owned and value
                            of their fund holdings, are generally considered to be of most interest to
                            investors.

                            In our June 2000 report, we offered another alternative for disclosing fee
                            information that would provide shareholders with the specific-dollar
                            amounts of fees paid on their shares in their quarterly account statements.
                            We noted that such disclosure would make mutual funds comparable to
                            other financial products and services such as bank checking accounts or
                            stock or bond 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, we stated that additional competition
                            on the basis of price would likely result among funds.

                            SEC and industry officials raised concerns about requiring specific-dollar
                            disclosures in quarterly statements. They believed that the potential costs
                            associated with accounting for, and reporting, costs on an individual basis
                            could be significant. After our June 2000 report was issued, ICI
                            commissioned a study by a large accounting firm to survey mutual fund
                            companies about the costs of producing such disclosures.12 This study
                            obtained information from 39 mutual fund companies and entities that
                            provide services to mutual funds.13 To produce specific-dollar disclosures,
                            the respondents indicated the most costly activities that would be
                            necessary to produce this information included



                            12
                              PriceWaterhouseCoopers, ICI Survey on GAO Report on Mutual Fund Fees, (Jan. 31,
                            2001).
                            13
                              The survey obtained information from 39 mutual fund companies and their designated
                            affiliates, as well as from independent transfer agents and shareholder servicing agents,
                            national and regional broker-dealers, securities clearing firms, and financial planning firms.
                            The assets of 39 mutual fund companies that provided data represent approximately 77
                            percent of total industry net assets as of June 30, 2000.



                            Page 13                                                                        GAO-03-551T
•   enhancing current data processing systems
•   modifying investor communication systems and media
•   developing new policies and procedures and
•   implementing employee training and customer support programs.

    Officials highlighted, in many cases, that mutual fund companies do not
    have access to the name and account information for individual
    shareholders to whom the fee disclosures would be made. Instead, broker-
    dealers or financial planners maintain account information on the many
    shareholders who purchase their mutual fund shares through these third
    parties. The third parties in turn maintain what are called omnibus
    accounts at the mutual fund. As a result, the mutual fund will know only
    the total number of shares owned by clients of a particular party, but not
    know how many actual shareholders there are and how many shares each
    shareholder owns. To disclose the specific-dollar amount of fees for each
    of these shareholders would require funds and third parties to
    communicate daily to receive the specific cost information that would
    then have to be attributed to each shareholder’s individual account.

    The ICI study concluded that the aggregated estimated costs of 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. However, this estimate did not
    include the reportedly significant costs that would be borne by third-party
    financial institutions, which maintain accounts on behalf of individual
    mutual fund shareholders.

    Although ICI’s estimates are significant in the aggregate, 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 39 fund companies, which represent
    77 percent of industry assets, also maintain about the same percentage of
    customer accounts, then the 39 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 costs to these accounts would
    amount to $0.35 per account.

    Another option to improve mutual fund fee disclosures would involve
    calculating estimates of fund expenses attributable to individual investors.
    One former fund adviser suggested that mutual funds could provide
    investors with fairly precise estimates of what they are paying in fees in
    their quarterly account statement by multiplying the funds’ expense ratio


    Page 14                                                         GAO-03-551T
                            for the prior year by the assets that the shareholder held as of the last day
                            of the year or period. According to the former fund adviser, this
                            calculation, which would help investors better understand the fees their
                            investments are incurring, could be made at minimum cost to mutual
                            funds.

                            According to some mutual fund officials, the expense calculation
                            disclosure presents similar cost concerns and raises other issues.
                            According to ICI staff, mutual funds and third-party financial institutions
                            may have to develop improved communication links to pass the
                            information needed to make this calculation, and thus would incur some
                            of the same costs as specific-dollar disclosures would entail. In addition,
                            mutual fund officials expressed concerns that providing investors
                            estimates could also create problems. For example, an estimate calculated
                            on the basis of the investor’s holding on the closing day of the statement
                            could be highly inaccurate if the number of shares owned by the investor
                            has changed dramatically during the period. ICI staff also noted that fund
                            complexes would likely want to include considerable explanatory material
                            or disclaimers about the nature of the estimated information that this type
                            of disclosure would provide. Before requiring mutual fund companies and
                            others to incur such costs to produce these additional disclosures, ICI
                            officials said that the benefits to investors would have to be better
                            quantified.

                            As a result, although additional disclosures could provide investor-specific
                            information and in documents that investors receive more frequently, fund
                            companies and other financial institutions would incur costs to produce
                            such additions to the existing reporting made to fund shareholders. The
                            benefit to investors from receiving this additional information has not
                            been quantified.


Mutual Fund                 Although mutual fund officials say that funds compete vigorously against
Advertisements Usually Do   each other, they generally do not emphasize fees in their advertisements
Not Focus on Fees, but      and SEC is proposing additional disclosures be made. In our 2000 report,
                            we reported that fund advisers generally do not emphasize the level of
SEC Is Proposing            their fees when attempting to differentiate their funds from those of their
Additional Disclosures      competitors. We recently analyzed 29 different mutual fund
                            advertisements that ran in the 2002 and 2003 mutual fund editions of three
                            major business magazines. Of these, only three advertisements
                            emphasized low management fees, 12b-1 fees, or expense ratios. In
                            addition, while one mutual fund family, which accounted for 9 of the 29
                            advertisements, frequently advertised that its funds had no loads, the

                            Page 15                                                           GAO-03-551T
                        primary emphasis in the majority of advertisements was on other themes
                        such as, in order of their frequency, the importance of long-term
                        investments, risk management, good performance as evidenced by high
                        rating by mutual fund advisory services, and tax savings.

                        In 2002, SEC proposed amendments to investment company advertising
                        rules.14 These changes would allow mutual funds to advertise more timely
                        information than that appearing in fund prospectuses and would require
                        more balanced disclosure of information, particularly in the area of past
                        performance. The proposal also includes a provision that would require
                        funds to indicate that information about charges and fees can be found in
                        a fund’s prospectus. Under current requirements, mutual funds are not
                        required to discuss fees in advertisements. Nevertheless, in practice, most
                        of the mutual fund advertisements that we analyzed already included
                        language that referred investors to the fund prospectus for information on
                        fees and charges.


                        In addition to the expenses reflected in the expense ratio, mutual funds
Mutual Fund Trading     also incur trading costs that also affect investors’ returns. Among these
Costs Are Additional    costs are brokerage commissions that funds pay to broker-dealers when
                        they trade securities on a fund’s behalf. Currently brokerage commissions
Expense to Investors    are not routinely or explicitly disclosed to investors and there have been
but Are Not             increasing calls for disclosure as well as debate on the benefits and costs
                        of added transparency.
Prominently
Disclosed
Brokerage Commissions   When mutual funds buy or sell securities for the fund, they may have to
Add to Investor Costs   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 or spreads. For example, the broker-dealers offering the
                        stocks traded on NASDAQ are often compensated by the spread between
                        the buying and selling prices of the securities they offer.15 Other trading-
                        related costs that mutual funds can incur include potential market impact
                        or other costs that can arise when funds seek to trade large amounts of


                        14
                         U.S. Securities and Exchange Commission, Proposed Amendments to Investment
                        Company Advertising Rules, 67 Fed. Reg. 36712-01 (May 24, 2002).
                        15
                         These different prices are called the (1) bid, the price at which the broker-dealer is
                        willing to pay and (2) ask, the price at which the broker-dealer is willing to sell.



                        Page 16                                                                        GAO-03-551T
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.

Data from mutual funds indicates that brokerage commissions and other
trading costs can be significant. Estimates of the size of brokerage
commissions mutual funds pay ranged from 0.15 percent of funds’ assets
to as much as 0.50 percent. Various academic studies conducted in the
mid-1990s found that brokerage commissions were around 0.30 percent of
a mutual fund’s total assets.16 For example, a study that looked at more
than 1,100 stock and bond funds found that brokerage commissions for
these funds averaged 0.31 percent of fund assets.17 These studies also
found that brokerage commissions increase as turnover—the extent to
which the fund buys and sells securities—increases.

In some cases, a portion of the brokerage commissions that funds pay may
represent payment for research services from the executing broker-dealer.
When a portion of the commission entitles the fund to such research, this
amount is called “soft dollars.” One academic study estimated that mutual
funds pay brokerage commissions of about $0.06 per share traded.18
Because individual investors trading through discount broker-dealers can
trade for as little as $0.02 per share, the study’s author attributes the
higher amount of commissions—about 66 percent of the total amount per
share—paid by mutual funds to charges for soft dollar research. Fund
managers are allowed to engage in this practice under a provision created
by the Congress in Section 28 (e) of the Securities Exchange Act of 1934.
In adopting this section, the Congress acknowledged the important service
broker-dealers provide by producing and distributing investment research
to fund managers and permitted fund managers to use commission dollars
paid by managed accounts to acquire research. SEC staff told the authors
of this study that funds that obtain research using soft dollars would have
the opportunity to reduce their expense ratios because the fund’s manager



16
  These studies include: R. Fortin and S. Michelson, “Mutual Fund Trading Costs,” Journal
of Investing, (Spring 1998); J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, “Mutual Fund
Trading Costs,” Rodney L. White Center for Financial Research, The Wharton School,
University of Pennsylvania, (Nov. 2, 1999); and M. Livingston and E.S. O’Neal, “Mutual Fund
Brokerage Commissions,” Journal of Financial Research, (Summer 1996).
17
     R. Fortin and S. Michelson.
18
     M. Livingston and E.S. O’Neal.



Page 17                                                                     GAO-03-551T
                           is not incurring as many direct costs for research activities. However, this
                           study, which looked at 240 stock funds, also found that the funds with
                           higher expense ratios also had higher brokerage commission costs. The
                           authors said that this could either mean that these funds are investing in
                           stocks that are more costly to research and to trade or that the managers
                           of these funds were less resolute about reducing their expense ratios even
                           though they did not have to pay directly for some of the research services
                           obtained for their funds.


Calls Made for Increased   Brokerage commissions are not disclosed in documents routinely sent to
Disclosure of Brokerage    investors, and some parties have called for additional disclosures.19
Commissions                Currently, 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 fund policies, officers and directors,
                           and tax matters. Specifically, SEC requires funds to disclose in their SAI
                           how transactions in portfolio securities are conducted; how brokers are
                           selected; and how they determine the overall reasonableness of brokerage
                           commissions. 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. 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. SEC
                           staff told us that, although investors are not sent the disclosures on
                           brokerage commissions unless they request it, funds are required to
                           disclose their portfolio turnover in their prospectuses, which new and
                           existing investors are routinely sent.

                           Academics and other officials have called for increased disclosures
                           relating to mutual fund brokerage commissions and other trading costs. In
                           the academic studies we reviewed that looked at brokerage commission
                           costs, the authors often urged that investors pay increased attention to
                           such costs. For example, one study noted that investors seeking to choose
                           their funds on the basis of expenses should also consider reviewing




                           19
                             The cost of brokerage commissions to a fund is reflected in the fund’s daily net asset
                           value. Nevertheless, SEC requires a fund to disclose the aggregate amount of brokerage
                           commissions paid during its 3 most recent fiscal years in the statement of additional
                           information. If there is any material difference from the most recent fiscal year’s brokerage
                           commissions paid as compared with the prior 2 fiscal years, the material difference must
                           also be explained.



                           Page 18                                                                       GAO-03-551T
trading costs as relevant information.20 The authors of another study note
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.21

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 documents in
which they disclose their expense ratios. 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 also indicated that when funds are
required to disclose information, competition among funds usually results
in them attempting to improve their performance in the area subject to the
disclosures. 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 lower-turnover
funds.

However, mutual fund officials raised various concerns about expanding
the disclosure of brokerage commissions. For example, some officials said
that requiring funds to include brokerage commissions in their expense
ratios would not present comparable information to investors because of
the differences between funds that invest in securities upon which
commissions are usually paid, such as shares listed on the New York Stock
Exchange and funds that invest more in securities listed on the NASDAQ,
for which usually the broker-dealers offering such securities are
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. ICI staff and others also 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 (or
basis) of the security purchased. As a result, this amount is used to


20
     J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec.
21
     M. Livingston and E.S. O’Neal.



Page 19                                                           GAO-03-551T
           compute the gain or loss when the security is eventually sold and thus the
           amount of any commissions or other trading costs are already explicitly
           included in funds’ performance returns. If these costs were to be included
           in the expense ratio, then funds could seek to be allowed to present their
           returns without such costs included so that the additional disclosure
           would not appear to be a new expense amount.

           In addition, SEC staff told us that fund directors are expected to oversee
           their fund’s brokerage arrangements and review the fund’s transactions to
           ensure that they are getting good trade executions. As a result, these
           directors have a fiduciary obligation to ensure that the level of brokerage
           commissions and other trading costs are being managed in the fund
           investors’ best interests.




(250128)
           Page 20                                                         GAO-03-551T