oversight

Mutual Funds: Additional Disclosures Could Increase Transparency of Fees and Other Practices

Published by the Government Accountability Office on 2003-06-18.

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, June 18, 2003     MUTUAL FUNDS
                             Additional Disclosures
                             Could Increase
                             Transparency of Fees and
                             Other Practices
                             Statement of Richard J. Hillman, Director,
                             Financial Markets and Community Investment




GAO-03-909T
                                                June 18, 2003


                                                MUTUAL FUNDS

                                                Additional Disclosures Could Increase
Highlights of GAO-03-909T, a testimony to       Transparency of Fees and Other
the Chairman, Subcommittee on Capital
Markets, Insurance, and Government              Practices
Sponsored Enterprises, Committee on
Financial Services, House of
Representatives




Concerns have been raised over                  The work that GAO has conducted at the request of this Committee
whether the disclosures of mutual               addresses several of the areas that are included in the recently introduced
fund fees and other fund practices              Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420).
are sufficiently transparent and fair           Mutual funds disclose considerable information about their costs to
to investors. GAO’s testimony                   investors, but unlike many other financial products and services, they do not
discusses (1) mutual fund fee
disclosures, (2) the extent to which
                                                disclose to each investor the specific dollar amount of fees that are paid on
various corporate governance                    their fund shares. Consistent with H.R. 2420, our report recommends that
reforms are in place in the mutual              SEC consider requiring mutual funds to make additional disclosures to
fund industry, (3) the potential                investors, including considering requiring funds to specifically disclose fees
conflicts that arise when mutual                in dollars to each investor in quarterly account statements, which we
fund advisers pay broker-dealers to             estimate may result in minimal increases in fund expenses. Our report also
sell fund shares, and (4) the                   discusses other alternatives that could also prove beneficial to investors and
benefits and concerns over fund                 spur increased competition among mutual funds on the basis of fees but be
advisers' use of soft dollars.                  even less costly to the industry overall.

                                                U.S. mutual funds have boards of directors who are charged with overseeing
GAO’s report recommends that                    the interests of fund shareholders. Various corporate governance reforms
SEC consider requiring additional               have been proposed to improve the effectiveness of mutual fund boards. As
disclosure by mutual funds of                   a result of SEC requirements or industry best practice recommendations,
•    the fees that investors pay in             many of these practices were already in place at many funds, but not all such
     account statements,                        practices were mandatory. H.R. 2420 would ensure that all mutual funds
•    revenue sharing payments that              implement these practices.
     broker-dealers receive; and
•    fund adviser’s use of soft                 Mutual fund advisers have been increasingly making additional payments out
     dollars.
                                                of their own profits to the broker-dealers that sell their fund shares.
                                                Although allowed under current rules, these revenue sharing payments can
                                                create conflicts between the interests of broker-dealers and their customers
                                                that could limit the choices of funds that investors are offered. Under
                                                current disclosure requirements, however, investors may not always be
                                                explicitly informed that their broker-dealer, who is obligated to recommend
                                                only suitable investments based on the investor’s financial condition, is also
                                                receiving payments to sell particular funds. Consistent with H.R. 2420, our
                                                report also recommended that more disclosure be made to investors about
                                                any revenue sharing payments their broker-dealers are receiving.

                                                Under a practice known as soft dollars, a mutual fund adviser uses fund
                                                assets to pay commissions to broker-dealers for executing trades in
                                                securities for the mutual fund’s portfolio but also receives research or other
                                                brokerage services as part of the transaction. Although this research and
                                                other services can benefit fund investors, these arrangements could result in
                                                increased expenses for fund shareholders if fund advisers trade excessively
                                                to obtain additional soft dollar research. SEC has addressed soft dollar
www.gao.gov/cgi-bin/getrpt?GAO-03-909T.
                                                practices in the past and recommended actions could provide additional
To view the full report, including the scope    information to fund directors and investors, but has not yet acted on all of its
and methodology, click on the link above.       own recommendations. Consistent with H.R. 2420, our report recommended
For more information, contact Richard Hillman
at (202) 512-8678 or hillmanr@gao.gov.
                                                that more disclosure be made to mutual fund directors and investors.
Mr. Chairman and Members of the Subcommittee:

I am pleased to be here to discuss GAO’s work on the disclosure of mutual
fund fees and the need for other related mutual fund disclosures to
investors. The fees and other costs that mutual fund investors pay as part
of owning fund shares can significantly affect their investment returns. As
a result, it is appropriate to debate whether the disclosures of mutual fund
fees and fund marketing practices are sufficiently transparent and fair to
investors.

Today, I will summarize the results from our recently issued report
entitled Mutual Funds: Greater Transparency Needed in Disclosures to
Investors, GAO-03-763 (Washington, D.C.: June 9, 2003) and describe how
the results of this work relates to certain provisions of the proposed
Mutual Funds Integrity and Fee Transparency Act of 2003 (H.R. 2420).
Specifically, I will discuss (1) mutual fund fee disclosures and
opportunities for improving these disclosures, (2) the extent to which
various corporate governance reforms are in place in the mutual fund
industry, (3) the potential conflicts that arise when mutual fund advisers
pay broker-dealers to sell fund shares, and (4) the benefits and concerns
over fund advisers' use of soft dollars.

In summary:

The study that we have conducted at the request of this Committee
directly supports several of the key provisions of H.R. 2420. In particular, it
addresses the need to consider ways to increase the transparency of
mutual fund fees and other disclosures. Mutual funds disclose
considerable information about their costs to investors, including
presenting the operating expense fees that they charge investors as a
percentage of fund assets and providing hypothetical examples of the
amount of fees that an investor can expect to pay over various time
periods. However, unlike many other financial products and services,
mutual funds do not disclose to individual investors the specific dollar
amount of fees that are paid on their fund shares. The Securities and
Exchange Commission (SEC) has proposed that mutual funds make
additional disclosures to investors that would provide more information
that investors could use to compare fees across funds. However, SEC is
not proposing that funds disclose the specific dollar amount of fees paid
by each investor nor is it proposing to require that any fee disclosures be
made in the account statements that inform investors of the number and
value of the mutual fund shares they own. Consistent with H.R. 2420, our
report recommends that SEC consider requiring mutual funds to make

Page 1                                      GAO-03-909T Mutual Fund Disclosures
additional disclosures to investors, including considering requiring funds
to specifically disclose fees in dollars to each investor in quarterly account
statements. SEC has agreed to consider requiring such disclosures but was
unsure that the benefits of implementing specific dollar disclosures
outweighed the costs to produce such disclosures. However, we estimate
that spreading these implementation costs across all investor accounts
may result in minimal increases in fund expenses. Our report also
discusses less costly alternatives that could also prove beneficial to
investors and spur increased competition among mutual funds on the
basis of fees.

Each mutual fund in the United States is required to have a board of
directors that is charged with overseeing the interests of fund
shareholders. These boards also must include directors that are not
employed or affiliated with the fund’s adviser, and these independent
directors have specific duties to oversee the fees their fund’s charge.
However, some industry critics have questioned whether fund directors
are adequately performing their duties and various corporate governance
reforms have been proposed to improve the effectiveness of mutual fund
boards. We found that many of the corporate governance reforms are
already being practiced by many funds as a result of either recent SEC
actions or because they are recommended as best practices by the mutual
fund industry body, the Investment Company Institute. By amending the
Investment Company Act of 1940 to require these and other corporate
governance practices, H.R. 2420 would further strengthen certain
corporate governance practices and ensure that all mutual funds
implement these practices.

The work that we conducted for our report also found that mutual fund
advisers have been increasingly engaged in a practice known as revenue
sharing under which they make additional payments to the broker-dealers
that sell their fund shares. Although we found that the impact of these
payments on the expenses to fund investors was uncertain, these
payments can create conflicts between the interests of broker-dealers and
their customers that could limit the choices of funds that these 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. Consistent with H.R. 2420, our report also recommended that more
disclosure be made to investors about any revenue sharing payments their
broker-dealers are receiving.



Page 2                                     GAO-03-909T Mutual Fund Disclosures
                        Finally, we also reviewed a practice known as soft dollars, in which a
                        mutual fund adviser uses fund assets to pay commissions to 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 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. Consistent with H.R. 2420, our report recommended
                        that more disclosure be made to mutual fund directors and investors to
                        allow them to better evaluate the benefits and potential disadvantages of
                        their fund adviser’s use of soft dollars.


                        Although mutual funds already disclose considerable information about
Additional Disclosure   the fees they charge, our report recommended that SEC consider requiring
of Mutual Fund Costs    that mutual funds make additional disclosures to investors about fees in
                        the account statements that investors receive. Mutual funds currently
Might Benefit           provide information about the fees they charge investors as an operating
Investors               expense ratio that shows as a percentage of fund assets all the fees and
                        other expenses that the fund adviser deducts from the assets of the fund.
                        Mutual funds also are required to present a hypothetical example that
                        shows in dollar terms what an investor could expect to pay if they invested
                        $10,000 in a fund and held it for various periods.

                        Unlike many other financial products, mutual funds do not provide
                        investors with information about the specific dollar amounts of the fees
                        that have been deducted from the value of their shares. Table 1 shows that
                        many other financial products do present their costs in specific dollar
                        amounts.




                        Page 3                                      GAO-03-909T Mutual Fund Disclosures
Table 1: Fee Disclosure Practices for Selected Financial Services or Products

    Type of product or
    service                                    Disclosure requirement
    Mutual funds                              Mutual funds show the operating expenses as
                                              percentages of fund assets and dollar amounts for
                                              hypothetical investment amounts based on estimated
                                              future expenses in the prospectus.
    Deposit accounts                          Depository institutions are required to disclose itemized
                                              fees, in dollar amounts, on periodic statements.
    Bank trust services                       Although covered by varying state laws, regulatory and
                                              association officials for banks indicated that trust service
                                              charges are generally shown as specific dollar amounts.
    Investment services                       When the provider has the right to deduct fees and other
    provided to individual                    charges directly from the investor’s account, the dollar
    investment accounts (such                 amounts of such charges are required to be disclosed to
    as those managed by a                     the investor.
    financial planner)
    Wrap accountsa                            Provider is required to disclose dollar amount of fees on
                                              investors’ statements.
    Stock purchases                           Broker-dealers are required to report specific dollar
                                              amounts charged as commissions to investors.
    Mortgage financing                        Mortgage lenders are required to provide at time of
                                              settlement a statement containing information on the
                                              annual percentage rate paid on the outstanding balance,
                                              and the total dollar amount of any finance charges, the
                                              amount financed, and the total of all payments required.
    Credit cards                              Lenders are required to disclose the annual percentage
                                              rate paid for purchases and cash advances, and the dollar
                                              amounts of these charges appear on cardholder
                                              statements.
Source: GAO analysis of applicable disclosure regulations, rules, and industry practices.
a
 In a wrap account, a customer receives investment advisory and brokerage execution services from
a broker-dealer or other financial intermediary for a “wrapped” fee that is not based on transactions in
the customer’s account.


Although mutual funds do not disclose their costs to each individual
investor in specific dollars, the disclosures that they make do exceed those
of many products. For example, purchasers of fixed annuities are not told
of the expenses associated with investing in such products. Some industry
participants and others including SEC also cite the example of bank
savings accounts, which pay stated interest rates to their holders but do
not explain how much profit or expenses the bank incurs to offer such
products. While this is true, we do not believe this is an analogous
comparison to mutual fund fees because the operating expenses of the
bank are not paid using the funds of the savings account holder and are
therefore not explicit costs to the investor like the fees on a mutual fund.




Page 4                                                                      GAO-03-909T Mutual Fund Disclosures
A number of alternatives have been proposed for improving the disclosure
of mutual fund fees, that could provide additional information to fund
investors. In December 2002, SEC released proposed rule amendments,
which include a requirement that mutual funds make additional
disclosures about their expenses.1 This information would be presented to
investors in the annual and semiannual reports prepared by mutual funds.
Specifically, mutual funds would be required to disclose the cost in dollars
associated with an investment of $10,000 that earned the fund’s actual
return and incurred the fund’s actual expenses paid during the period. In
addition, SEC also proposed that mutual funds be required to disclose the
cost in dollars, based on the fund’s actual expenses, of a $10,000
investment that earned a standardized return of 5 percent. If these
disclosures become mandatory, investors will have additional information
that could be directly compared across funds. By placing it in funds’
annual and semiannual reports, SEC staff also indicate that it will facilitate
prospective investors comparing funds’ expenses before making a
purchase decision.

However, SEC’s proposal would not require mutual funds to disclose to
each investor the specific amount of fees in dollars that are paid on the
shares they own. As result, investors will not receive information on the
costs of mutual fund investing in the same way they see the costs of many
other financial products and services that they may use. In addition, SEC
did not propose that mutual funds provide information relating to fees in
the quarterly or even more frequent account statements that provide
investors with the number and value of their mutual fund shares. In a 1997
survey of how investors obtain information about their funds, ICI
indicated that to shareholders, the account statement is probably the most
important communication that they receive from a mutual fund company
and that nearly all shareholders use such statements to monitor their
mutual funds.

SEC and industry participants have indicated that the total cost of
providing specific dollar fee disclosures might be significant; however, we
found that the cost might not represent a large outlay on a per investor
basis. As we reported in our March 2003 statement, ICI commissioned a
large accounting firm to survey mutual fund companies about the costs of



1
 “Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management
Investment Companies, Securities and Exchange Commission,” Release Nos. 33-8164; 34-
47023; IC-2587068 (Dec. 18, 2002).



Page 5                                          GAO-03-909T Mutual Fund Disclosures
producing such disclosures. 2 Receiving responses from broker-dealers,
mutual fund service providers, and fund companies representing
approximately 77 percent of total industry assets as of June 30, 2000, this
study estimated that the aggregated estimated costs for the survey
respondents to implement specific dollar disclosures in shareholder
account statements would exceed $200 million, and the annual costs of
compliance would be about $66 million. Although the ICI study included
information from some broker-dealers and fund service providers, it did
not include the reportedly significant costs that all broker-dealers and
other third-party financial institutions that maintain accounts on behalf of
individual mutual fund shareholders could incur. However, using available
information on mutual fund assets and accounts from ICI and spreading
such costs across all investor accounts indicates that the additional
expenses to any one investor are minimal. Specifically, at end of 2001, ICI
reported that mutual fund assets totaled $6.975 trillion. If mutual fund
companies charged, for example, the entire $266 million cost of
implementing the disclosures to investors in the first year, then dividing
this additional cost by the total assets outstanding at the end of 2001
would increase the average fee by .000038 percent or about one-third of a
basis point. In addition, ICI reported that the $6.975 trillion in total assets
was held in over 248 million mutual fund accounts, equating to an average
account of just over $28,000. Therefore, implementing these disclosures
would add $1.07 to the average $184 that these accounts would pay in total
operating expense fees each year—an increase of six-tenths of a percent.3

In addition, other less costly alternatives are also available that could
increase investor awareness of the fees they are paying on their mutual
funds by providing them with information on the fees they pay in the
quarterly statements that provide information on an investor’s share
balance and account value. For example, one alternative that would not
likely be overly expensive would be to require these quarterly statements



2
U.S. General Accounting Office, Mutual Funds: Information on Trends in Fees and Their
Related Disclosure, GAO-03-551T (Washington, D.C.: Mar. 12, 2003).
3
 To determine these amounts, we used the operating expense ratios that ICI has estimated
in its September 2002 fee study—which reported average expense ratios of 0.88 percent for
equity funds, 0.57 percent for bond funds, and 0.32 percent for money market funds. By
weighting each of these by the total assets invested in each fund type, we calculated that
the weighted average expense ratio for all funds was 0.66 percent. Using this average
expense ratio, the average account size of $28,000 would pay $184 in fees. The additional
expense of implementing specific dollar disclosures of 0.000038 percent would therefore
add $1.07 to this amount.



Page 6                                            GAO-03-909T Mutual Fund Disclosures
to present the information—the dollar amount of a fund’s fees based on a
set investment amount—that SEC has proposed be added to mutual fund
semiannual reports. Doing so would place this additional fee disclosure in
the document generally considered to be of the most interest to investors.
An even less costly alternative could be to require quarterly statements to
also include a notice that reminds investors that they pay fees and to
check their prospectus and with their financial adviser for more
information.

Because SEC’s current proposal, while offering some advantages, does not
make mutual funds comparable to other products and provide information
in the document that is most relevant to investors—the quarterly account
statement—our report recommended that SEC consider requiring
additional disclosures relating to fees be made to investors in these
documents. In addition to specific dollar disclosures, we also noted that
investors could be provided with other disclosures about the fees they pay
on mutual funds that would have a range of implementation costs,
including some that would have even less overall cost to the industry. H.R.
2420 also mandates that SEC require additional information about fees be
disclosed to investors. Seeing the specific dollar amount paid on their
shares could be the incentive that some investors need to take action to
compare their fund’s expenses to those of other funds and make more
informed investment decisions on this basis. Such disclosures may also
increasingly motivate fund companies to respond competitively by
lowering fees. Because the disclosures that SEC is currently proposing be
included in mutual fund annual and semiannual reports could also prove
beneficial, it could choose to require disclosures in both these documents
and account statements, which would provide both prospective and
existing investors in mutual funds access to valuable information about
the costs of investing in funds.

H.R. 2420 also mandates that SEC require mutual funds to disclose more
information about portfolio transactions costs, including commissions
paid with respect to the trading of portfolio securities. Although additional
information about such costs could be beneficial to investors, we found
that determining these costs in a way that allows them to be accurately
and fairly compared across funds could prove difficult.




Page 7                                     GAO-03-909T Mutual Fund Disclosures
                         Mutual funds implemented many sound practices concerning their boards
Mutual Fund Boards       of directors, but these practices are not mandatory for all funds. The law
Follow Many Sound        governing U.S. mutual funds promotes investor protection by requiring
                         funds to have a board of directors to protect fund shareholder interests. As
Corporate                a group, the directors of a mutual fund have various statutory
Governance Practices     responsibilities to oversee fund operations. In particular, the directors
                         independent of the fund’s investment adviser have additional duties
but Such Practices are   including approval of the contracts with the investment adviser. As a
Not Mandatory for All    matter of practice, independent directors also review other arrangements
Funds                    such as transfer agency, custodial, or bookkeeping services.

                         As a result of recent scandals such as Enron and Worldcom, new
                         legislative and regulatory reforms have been adopted or proposed to
                         increase the effectiveness and accountability of public companies’ boards
                         of directors. In July 2002, the Sarbanes-Oxley Act (Sarbanes-Oxley) was
                         enacted to address concerns related to corporate responsibility and
                         governance.4 In addition to enhancing the financial reporting regulatory
                         structure, Sarbanes-Oxley sought to increase corporate accountability by
                         reforming the structure of corporate boards audit committees. Section 301
                         of Sarbanes-Oxley requires that directors who serve on a public company’s
                         audit committee be “independent” and select and oversee outside auditors.
                         The New York Stock Exchange (NYSE) and NASDAQ have also proposed
                         changes to the corporate governance listing standards for public
                         companies. However, many of the proposed reforms for public companies
                         are either already required or have been recommended as best practices
                         for mutual fund boards. Table 2 shows how the current or recommended
                         corporate governance practices for mutual fund boards compare to
                         current and proposed NYSE and NASDAQ listing standards applicable to
                         public company boards.




                         4
                         Pub. L. No. 107-204, 116 Stat. 745 (codified in scattered sections of 11, 15, 18, 28, and 29
                         U.S.C.A.).



                         Page 8                                               GAO-03-909T Mutual Fund Disclosures
Table 2: Current and Proposed NYSE and NASDAQ Listing Standards Compared to
Current or Recommended Mutual Fund Corporate Governance Requirements

                                       NYSE/NASDAQ listing
                                            standards                                   Mutual Funds
                                                                                 Required by              ICI
    Governance                        Currently           Proposed                 statute or recommended
    requirement                        required         requirement                SEC rulea    best practice
    Board must have a                                            X                          X               X
    majority of independent
    directors
    Independent directors                                               X                    X             X
    must be responsible for
    nominating new
    independent directors
    Audit committee must                          X                     X                                  X
    consist of only
                           b
    independent directors
    Standards that define                         X                     X                    X             X
    who qualifies as an
                         c
    independent director
    Independent directors                                               X                                  X
    required to meet
    separately in executive
    sessions
Source: GAO analysis of ICI Best Practices, SEC rules, and NYSE and NASDAQ rule proposals.
a
SEC requires the board of directors of any fund that takes advantage of various exemptive rules to
meet these requirements and SEC staff indicated that, as a result, almost all funds must comply.
b
 Although fully independent audit committees is not a requirement for funds, SEC has adopted a rule
to encourage fund boards to have audit committees consisting exclusively of independent directors by
exempting such committees from having to seek shareholder approval of the fund’s auditor.
c
Both the NYSE and NASDAQ definitions of director independence currently apply only to members
of the audit committee, but their rule proposals would extend this definition to the full board.


According to regulators and data from industry participants that we
obtained, many mutual funds have implemented many of the practices that
are being recommended for public companies. As shown in table 2 above,
many of these practices are already required for many funds by SEC
regulation or are recommended by ICI as a best practice. Officials of the
fund companies and the independent directors that we interviewed told us
that the majority of their boards consisted of independent directors, and,
in many cases, had only one interested director. For public companies,
some commenters have called for boards of directors to have
supermajorities of independent directors as a means of ensuring that the
voices of the independent directors are heard. ICI already advocates this
practice in its best practice recommendations and one fund governance
consulting official said that a 2002 survey conducted by his firm found
that, in 75 percent of the mutual fund complexes they surveyed, over 70


Page 9                                                                GAO-03-909T Mutual Fund Disclosures
                         percent of the directors were independent. An academic study we
                         reviewed also found that funds’ independent directors already comprised
                         funds’ nominating committees and most funds have self-nominating
                         independent directors.

                         However, not all of these sound corporate governance practices are
                         currently mandatory for mutual funds. For example, if a fund does not
                         take advantage of any of the exemptive rules that SEC cited in requiring
                         certain corporate governance practices, such a fund may not already be
                         following these practices. In addition, some of the reforms advocated by
                         ICI’s best practices and by those advocating change for public companies
                         are not currently required for mutual funds. H.R. 2420 would make these
                         and other practices mandatory for all funds, which would ensure
                         consistent implementation of the practices across the industry.


                         One mutual fund distribution practice—called revenue sharing—that has
Changes in Mutual        become increasingly common involves mutual fund investment advisers
Fund Distribution        making additional payments beyond those made under 12b-1 plans to
                         broker-dealers that sell fund shares. Approximately 80 percent of mutual
Practices Raise          fund purchases are made through broker-dealers or other financial
Potential Conflicts of   professionals, such as financial planners and pension plan administrators.
                         To be compensated for providing advice and ongoing assistance to
Interest Between         investors, many of these financial professionals receive payments from the
Broker-Dealers and       mutual fund either through the sales charges paid up front by the investor
Investors                (called loads) or from ongoing fees that are deducted from the fund’s
                         assets. These fees are called 12b-1 fees after the rule that allows fund
                         assets to be used to pay for fund marketing and distribution expenses.
                         NASD, whose rules govern the distribution of fund shares by broker
                         dealers, limits the annual rate at which 12b-1 fees may be paid to 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.

                         However, broker-dealers, whose extensive distribution networks and large
                         staffs of financial professionals who work directly with and make
                         investment recommendations to investors, have increasingly required
                         mutual funds to make additional payments to their firms beyond the sales
                         loads and 12b-1 fees. These payments, called revenue sharing payments,
                         come from the adviser’s profits and may supplement distribution-related

                         Page 10                                   GAO-03-909T Mutual Fund Disclosures
payments from fund assets. According to an article in one trade journal,
revenue sharing payments made by major fund companies to 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-

Page 11                                    GAO-03-909T Mutual Fund Disclosures
                       dealers disclose to their clients that their firms receive such payments
                       from fund advisers is not clear. Rule 10b-10 under the Securities Exchange
                       Act of 1934 requires, among other things, that broker-dealers provide
                       customers with information about third-party compensation that 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. This recommendation is consistent with
                       the requirement in H.R. 2420 that mandates that SEC require mutual funds
                       to further disclose revenue sharing payments and make annual or more
                       frequent reports of such payments to fund boards of directors.


                       Soft dollar arrangements allow fund investment advisers to obtain
Soft Dollar            research and brokerage services that could potentially benefit fund
Arrangements Provide   investors but could also increase investors’ costs. When investment
                       advisers buy or sell securities for a fund, they may have to pay the broker-
Benefits, but Could    dealers that execute these trades a commission using fund assets.5 In
Adversely Impact       return for these brokerage commissions, many broker-dealers provide
                       advisers with a bundle of services, including trade execution, access to
Investors              analysts and traders, and research products.

                       Some industry participants argue that the use of soft dollars benefits
                       investors in various ways. The research that the fund adviser obtains can



                       5
                        Instead of commissions, broker-dealers executing trades also could be compensated
                       through markups or spreads.



                       Page 12                                          GAO-03-909T Mutual Fund Disclosures
directly benefit a fund’s investors if the adviser uses it to select securities
for purchase or sale by the fund. The prevalence of soft dollar
arrangements also allows specialized, independent research to flourish,
thereby providing money managers a wider choice of investment ideas. As
a result, this research could contribute to better fund performance. The
proliferation of research available as a result of soft dollars might also
have other benefits. For example, an investment adviser official told us
that the research on smaller companies helps create a more efficient
market for such companies’ securities, resulting in greater market liquidity
and lower spreads, which would benefit all investors including those in
mutual funds.

Although the research and brokerage services that fund advisers obtain
through the use of soft dollars could benefit a mutual fund investor, this
practice also could increase investors’ costs and create potential conflicts
of interest that could harm fund investors. For example, soft dollars could
cause investors to pay higher brokerage commissions than they otherwise
would, because advisers might choose broker-dealers on the basis of soft
dollar products and services, not trade execution quality. One academic
study shows that trades executed by broker-dealers that specialize in
providing soft dollar products and services tend to be more expensive than
those executed through other broker-dealers, including full-service broker-
dealers.6 Soft dollar arrangements could also encourage advisers to trade
more in order to pay for more soft dollar products and services.
Overtrading would cause investors to pay more in brokerage commissions
than they otherwise would. These arrangements might also tempt advisers
to “over-consume” research because they are not paying for it directly. In
turn, advisers might have less incentive to negotiate lower commissions,
resulting in investors paying more for trades.

Under the Investment Advisers Act of 1940, advisers must disclose details
of their soft dollar arrangements in Part II of Form ADV, which investment
advisers use to register with SEC and must send to their advisory clients.
However, this form is not provided to the shareholders of a mutual fund,
although the information about the soft dollar practices that the adviser
uses for particular funds are required to be included in the Statement of
Additional Information that funds prepare, which is available to investors
upon request. Specifically, Form ADV requires advisers to describe the



6
 J.S. Conrad, K.M Johnson, and S. Wahal, “Institutional Trading and Soft Dollars” Journal
of Finance, (February, 2001).



Page 13                                            GAO-03-909T Mutual Fund Disclosures
           factors considered in selecting brokers and determining the
           reasonableness of their commissions. If the value of the products,
           research, and services given to the adviser affects the choice of brokers or
           the brokerage commission paid, the adviser must also describe the
           products, research and services and whether clients might pay
           commissions higher than those obtainable from other brokers in return for
           those products.

           In a series of regulatory examinations performed in 1998, SEC staff found
           examples of problems relating to investment advisers’ use of soft dollars,
           although far fewer problems were attributable to mutual fund advisers. In
           response, SEC staff issued a report that included proposals to address the
           potential conflicts created by these arrangements, including
           recommending that investment advisers keep better records and disclose
           more information about their use of soft dollars. Although the
           recommendations could increase the transparency of these arrangements
           and help fund directors and investors better evaluate advisers’ use of soft
           dollars, SEC has yet to take action on some of these proposed
           recommendations.

           As a result, our report recommends that SEC evaluate ways to provide
           additional information to fund directors and investors on their fund
           advisers’ use of soft dollars. SEC relies on disclosure of information as a
           primary means of addressing potential conflicts between investors and
           financial professionals. However, because SEC has not acted to more fully
           address soft dollar-related concerns, investors and mutual fund directors
           have less complete and transparent information with which to evaluate the
           benefits and potential disadvantages of their fund adviser’s use of soft
           dollars. If H.R. 2420 is enacted, investors and fund directors would get
           more information to allow them to make these evaluations. Also, the study
           that H.R. 2420 would require SEC to conduct of soft dollars would likely
           provide SEC with valuable information to allow it to best decide the form
           of these disclosures and whether any other changes to soft dollar practices
           are warranted.

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




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           Page 14                                   GAO-03-909T Mutual Fund Disclosures
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