Chapter 2
Mutual Fund
Regulation
and Issues
HISTORICAL PERSPECTIVE
• Since its beginnings around 70 years ago, the
open-end fund industry has largely avoided major
legal troubles until the past few years. To start the
discussion, it is useful for the reader to
understand what might explain such a long
period of relative legal and regulatory calm. Some
explanatory power would seem to be related to
the open-end product’s unique characteristics,
namely its self-liquidating feature and its simple
(all equity) capital structure.
• Open-end portfolio managers generally
cannot use leverage (borrowed money) to
magnify fund returns, and if investors are not
happy with a fund’s performance, they can
redeem funds at net asset value (NAV) on a
daily basis. Many of the largest problems in
finance, whether personal investments or
corporate matters, typically trace to one or
two basic issues: high leverage and/or (low)
liquidity. The reader can take note of the 2008
implosion of the real estate market to find
both aspects.
• Highly leveraged investors (e.g., those making a zero
down payment on a house) bought highly illiquid
assets (real estate). When the value of these assets
began to fall, buyers were quickly in a negative equity
scenario. Eventually, there were no buyers, and an
economic catastrophe ensued. This panic soon spread
to the stock market. In the last few months of 2008,
investors had a taste of stock market panic not unlike
what happened in the Crash of 1929. Most major
indexes lost about 40 percent over just a few months’
time in late 2008, and daily stock price volatility was
extremely high.
• A number of the titans of modern finance,
including Lehman Brothers, Bear Stearns, and
Merrill Lynch, have either failed or been forced to
merge in order to avoid failure. The major
automakers stand on the brink of collapse. Think
about how much more frightening this would be
if, in a period of rapidly falling stock prices,
investors could not find any other investors with
whom to trade. Closed-end funds (those offering
a fixed number of shares) were more popular
than open-end funds until the Crash of 1929.
Often closed-end funds would lever themselves.
• Many continue that practice to this day.
During the Crash, investors suffered from a
lack of disclosure about fund leverage
combined with an inability to sell since the
(closed-end) fund itself did not stand ready to
purchase and redeem shares each day (as an
open-end fund would have). A panic ensued.
In contrast, open-end funds must offer daily
liquidity, so the funds themselves tend to hold
more liquid securities than closed-end funds.
• Despite the panic, investors in open-end funds
could redeem their shares from the open-end
company. This brought investors comfort and
arguably formed the foundation for the
popularity of the open-end product that
continues to this day. The stock market
implosion of late 2008 has brought back some
of the same types of investor behaviors as the
Crash of 1929, so a historical perspective on
regulation may take on a heightened level of
interest for contemporary readers.
• Following the Crash of 1929, the federal
government began to put a structure into
place to address the underlying problems in
securities markets, including mutual funds. In
the paragraphs that follow, this chapter lays
out that fundamental structure as it applies to
open-end funds. The goal is to give the reader
a sense of the overall regulatory framework.
The sections that follow focus in more detail
on a few issues that have been of increased
interest in the past few years.
REGULATION OF OPEN-END FUNDS
• The Securities Act of 1933 pertains to open-end
funds as it requires registration if the fund
intends to offer shares to the public. The broad
goal of this act was to protect investors from
fraudulent sales and misrepresentations by those
selling shares. The act requires funds to provide a
prospectus that discloses the key aspects of the
fund. Open-end funds also typically provide
additional disclosure in a Statement of Additional
Information.
• While some of the elements of required
disclosure have been well settled for decades,
several disclosure topics remain a lively topic
of debate. As this chapter’s introductory story
illustrates, required fund performance
disclosure is one area that is still controversial.
Disclosures about fund management
(advisory), marketing and distribution (12b-1)
fees, and other costs (such as brokerage fees)
also remain hot topics.
• While there is lively policy debate about
disclosure requirements in several areas, it is
clear that funds’ failure to follow their
prospectus can be very costly. For example,
some funds’ selective failure to enforce
trading restrictions spelled out in their
prospectus was the major legal “hammer” in
the mutual fund market timing scandal, which
is discussed in more detail later in this chapter.
• The Securities Exchange Act of 1934 also impacts
open-end mutual funds. This act focuses on
regulating the trading of securities, requiring
various types of record keeping, qualifications,
and business practices for broker-dealers. In
open-end funds, these rules pertain mainly to
funds’ distributors and transfer agents. The latter
are involved with a number of the interactions
that a shareholder has with the fund, including
account maintenance, processing of trades,
dividend and capital gains payments, and
document transfer (Gremillion, 2005, p. 233).
• While the 1933 and 1934 Securities Acts apply
to open-end funds as well as to other financial
products, the Investment Advisory Act of 1940
targets the investment management industry
more directly. The Investment Advisory Act
requires those advising mutual funds to
register with the Securities and Exchange
Commission (SEC). The act also regulates the
contract between the investment adviser and
funds.
• Some of the key contractual provisions are
those that specify a maximum contract length
between adviser and fund (two years), those
that give the fund the ability to terminate the
agreement (with at least 60 days’ notice), and
those that require the approval of a majority
of the outside directors for adviser–fund
contract renewal. For those readers desiring
more details, Gremillion (2005) is an excellent
resource.
• The Investment Company Act of 1940 is the
major piece of legislation pertaining to open-end
mutual funds. The SEC describes the scope and
intent of the act quite nicely on itsWeb page
(www.sec.gov/about/laws.shtml):
This Act regulates the organization of companies,
including mutual funds, that engage primarily in
investing, reinvesting, and trading in securities, and
whose own securities are offered to the investing
public.
• The regulation is designed to minimize conflicts of
interest that arise in these complex operations.
The Act requires these companies to disclose their
financial condition and investment policies to
investors when stock is initially sold and,
subsequently, on a regular basis. The focus of the
Act is on disclosure to the investing public of
information about the fund and its investment
objectives, as well as on investment company
structure and operations. It is important to
remember that the Act does not permit the SEC to
directly supervise the investment decisions or
activities of these companies or judge the merits
of their investments.
• This quotation captures the overall philosophy
of the Investment Company Act, which is
based on disclosure. The emphasis is on those
areas of operation where there could be a
conflict of interest between the adviser and
the investor. The next paragraphs highlight a
few of those areas in the law. Some tie to the
more in-depth discussion of contemporary
issues in subsequent sections.
• At the outset, the reader should recognize
that the Investment Company Act carves out a
special category for the open-end mutual fund.
The open-end fund is deemed an open-end
management company because of the
investor’s ability to redeem shares of the fund
for cash upon request. This distinction matters
as it goes to a fundamental characteristic of
the open-end fund and one that distinguishes
it from other investment structures: its selfliquidating nature.
• The open-end management company
characterization also is important because the
rules for open-and closed-end management
companies (as well as for other types of
investment companies) also differ in other
dimensions.
• The Investment Company Act of 1940 covers five
primary areas of open-end operations: fund
management, sales practices, investment
advisory fees, fund capital structures, and
financial statements and accounting (Sjostrom,
2006).
• Within each of these areas, particular sections
are devoted to issues where there are potential
conflicts of interest between fund management
and investors. For example, section 10 requires
the fund to provide detailed statements of its
policies and structure. This section also outlines
the requirement that at least 40 percent of the
fund’s directors not be “interested persons” in
the fund. These are the “independent” directors.
If the fund is to have various sorts of exemptions
from other requirements under the act, then a
majority (greater than 50 percent) of the
directors must be independent.
• Section 13 of the act gives shareholders the right
to vote on certain matters, including a change in
investment policy. Section 15 of the act requires a
written investment contract, which is negotiated
by the adviser and the independent directors.
Section 17 prohibits affiliated transactions, so the
advisers or other service providers cannot
conduct financial transactions with the fund. This
section also requires that securities be held in
custody and that those who have access to
securities or cash be adequately bonded.
• In addition, governance is accomplished by the
section 12 requirement that the fund’s annual
reports be audited by an independent party.
Usually this is an accounting firm (e.g., Ernst &
Young). As was discussed in Chapter 1, open-end
funds cannot issue senior securities (e.g., debt in
an equity fund). That prohibition is contained in
sections 12 and 18 of the act.
• This sampling of provisions illustrates some of the
ways that the 1940 Investment Company Act
addresses conflicts of interest between investors
and fund managers.
• For example, suppose that open-end funds could
freely borrow money. If the fund manager were
paid as a percentage of assets under
management, perhaps the manager would be
inclined to overleverage the fund and increase
risk. Assessing the potential for a conflict of
interest is a useful approach to consider any
regulatory issue under the scope of the act.
• Having built a foundation for open-end fund
regulation, this chapter now turns to discussing a
few regulatory issues that have been in the
headlines in the recent past.
RECENT REGULATORY ISSUES
IN OPEN-END FUNDS
• The open-end mutual fund’s self-liquidating
feature, the ability for investors to buy and sell
shares each day at NAV, has brought about
several regulatory challenges. This feature sets up
two kinds of investors in a fund: those who buy
and sell (trade) a lot (even daily) and those who
buy and hold funds for long periods (i.e., they
might go years without trading). The fund
management and regulatory challenges in openend funds often involve striking a reasonable
balance in the interests of these two groups.
• Consider for a moment that those who want
to hold funds for long periods are “sheep” and
those that want to trade funds daily are
“wolves.” Suppose further that those who
want to trade in and out of the fund in short
intervals harm fund performance and/or
impose a burden on fund management. Ideally,
the sheep need to be protected from the risks
associated with wolves’ behavior, or at least
be adequately warned about them.
• Howcould the sheep be protected fromthe
wolves?
• One way is to limit trading, either via
individual fund rules (such as those in a fund
prospectus that limit number of round-trip
[buy-and-sell] trades per year by an investor,
e.g.) and/or by regulatory fiat, such as a
mandatory fee imposed for sales of fund
shares held for only short periods of time.
• These sound appealing until one recognizes that
trading limits or costs reduce liquidity for all
investors, even some of the “innocent” sheep
who might want to trade based on a change in
their investment circumstances. Plus limits on
liquidity raise the cost for all investors to get out
of the fund and, if high enough, could trap the
investors with a poorly performing manager.
Trading restrictions are one regulatory area
where conflicts of interests between investors
and fund managers, as well as those between
investors themselves, remain an ongoing
challenge.
NAV Pricing and Trading Policies
• Every investment product structure has strengths
and weaknesses, and the open-end fund is no
exception. So where would the open-end fund be
vulnerable?
• Consider the daily self-liquidation feature. The
fund itself stands ready to buy and sell to
individual shareholders at NAV each day.
Consider that a fund can hold billions of dollars in
assets, made up of thousands of individual
accounts. Given its size alone, such a large fund
presents an interesting target for fraud.
• What if an individual can take a small amount
of money from a very large number of other
individuals? In this case, the amount taken
from each individual is so small as to make it
unnoticeable or not worth pursuing a remedy
even if noticed. If the target number of victims
is large enough, then the scam artist can make
a lot of money, even if the per-victim rate is
very small.
• The words fund and target were used in the
same sentence on purpose. As Ciccotello,
Edelen, Greene, and Hodges (2002) state:
“Suppose that the calculated NAV were to
deviate systematically and predictably from
the value of the fund’s underlying assets.”
Assume further that mutual fund trading
technology allows rapid order submission for
large numbers of shares each day. Together,
these are a mix for trouble.
• If a trader could take systematic advantage of
predictability in movements of a fund’s NAV
and trade large amounts of shares daily, that
trader could trade at favorable prices. In the
context of an open-end fund, that would
translate into wealth taken by the trading
shareholders and extracted from buy-andhold shareholders. Hence, the one takes from
the many, and typically in small amounts each
day.
• How could the NAV be biased? As it turns out, pricing
of open-end fund shares is not a new problem, having
vexed regulators from the birth of open-end funds in
the 1920s. Many of the early problems were due to
rules that priced the fund shares before the orders to
buy or sell at that price were made (backward pricing).
Responding to what it perceived to be widespread
abuses that resulted from this practice, the SEC
adopted Rule 22c-1 in 1968. Reversing what had been
the norm (backward pricing), Rule 22c-1 requires funds
to adopt a forward-pricing rule in which they sell or
redeem shares at the NAV that is first computed after
the order is received.
• Backward pricing is an example of a broader issue
of traders being able to buy or sell at a “stale”
NAV. That is, the price at which the investor could
buy or sell the fund (the NAV) did not reflect all
market information when the trader executed the
trade. So a stale price trader had an advantage
somewhat like placing a bet on a horse race after
watching the race. Problems with stale prices are
worse in open-end funds that are domiciled in
one location but hold assets that are traded on
markets in other countries (Bhargava, Bose, and
Dubofsky, 1998).
• Consider the situation with a U.S.-domiciled
fund that holds international (say, stocks
traded on Asian exchanges) assets. When the
fund computes its price as of 4:00 P.M.
Eastern Standard Time (EST), most Asian
markets are closed. The prices of those Asian
stocks have not changed to reflect market
movements in the United States during that
day. As such, they are “stale” prices (Chalmers,
Edelen, and Kadlec, 2001).
• Academic research has shown that prices in
international markets tend to follow U.S.
moves the following day, thus opening up a
pattern for trading in U.S. mutual funds that
can “dilute” buy-and-hold shareholders while
rewarding the stale price traders (Greene and
Ciccotello, 2006; Greene and Hodges, 2002).
The problem became extreme in the case
when markets are highly volatile, as in the late
1990s in Asian markets.
• On Tuesday, October 28, 1997, the Hong Kong
market index declined about 14 percent,
following the previous day’s decline on the New
York Stock Exchange. Later on Tuesday, October
28, the New York market rallied. U.S. funds
holding Hong Kong securities were now faced
with a dilemma: Should they compute NAV from
the Tuesday closing prices in Hong Kong? That
would seem to be a stale price. In that scenario,
some funds concluded that the closing prices in
Hong Kong did not represent “fair value” and
calculated their funds’ NAV based on another
method.
• For the purposes of calculating value, the Investment
Company Act of 1940 divides securities into two
classes. Where securities have “readily available”
market quotations, “current market value” should be
used. Current market value is generally accepted to be
a security’s last quoted sales price on a national
exchange. Where securities do not have a “readily
available” market quotation, “fair value” should be
used. The fund’s board of directors has the power to
determine “fair value” in good faith. As detailed in
Ciccotello et al. (2002), the SEC has made a number of
recent attempts to clarify the use of fair value in terms
of both application and disclosure.
Fund Pricing and the (Late) Trading
Scandal
• OnLabor Day weekend in September 2003,
thenNewYork Attorney General Elliott Spitzer
broke the Canary trading scandal (Masters, 2003;
State of New York, 2003). The Canary hedge fund
attacked the open-end structure’s self-liquidating
feature in an innovative manner. While
international funds were known to have
vulnerability to market timing trades due to links
between markets as just described, domestic
funds (holding domestic securities) were thought
to be (relatively) safe frommarket timing trades
because their prices were not stale.
• At 4:00 P.M., for example, when the stock
fund computed its NAV using closing prices,
these were the 4:00 P.M. prices of the stocks
in the fund. Among Canary’s innovations were
the alleged submissions of orders as late as
9:00 P.M. EST to buy or sell at the 4:00 P.M.
price. Often the submissions of orders would
relate to moves in the after-market (post−
4:00 P.M.) futures market. In effect, Canary
had transformed a domestic fund into an
international fund in terms of staleness.
• Being able to trade at 9:00 P.M. for a 4:00 P.M.
price is valuable. The price move from 4:00
P.M. to 9:00 P.M. today can shed light on the
market move tomorrow just as the
movements in the U.S. stock market today can
shed light on international stock market
moves tomorrow. In a domestic fund, the
odds of predicting the next day’s market
return (as either positive or negative) are
roughly 50 percent, the flip of a fair coin, if
one trades at 4:00 P.M. today
• With the five-hour after-market advantage
today, the odds of correctly predicting a
positive or negative market return tomorrow
become closer to 66 percent. If one conducts
100 round trips in a fund a year using $100M
per buy order, and one is right 66 percent of
the time (next day), this lucrative (although
illegal) operation for the trader can be quite
damaging to the buy-and-hold shareholder
(Damato, 2003; Hulbert, 2003).
• Canary allegedly submitted late orders under several
(false) pretenses, including masquerading as a
qualified pension investor (which at that time could
submit late orders due to the time lag for bundling all
of the individual orders together). This abuse and the
concern for the anonymity of bundled orders have led
the SEC to adopt more stringent order submission
guidelines. In December 2003 the SEC proposed:
amendments dictating that an order to purchase or
redeem fund shares would receive the current day’s
price only if the fund, its designated transfer agent, or
a registered securities clearing agency receives the
order by the time that the fund establishes for
calculating its net asset value. The amendments are
designed to prevent unlawful late trading in fund
shares (See SEC, Amendments to Rules Governing
Pricing of Mutual Fund Shares, 2003).
• In sum, the rules surrounding enforcement of
prospectus trading limits, fair valuation of
fund shares, and timely order submission have
become much more important in an era
where large (and sometimes bundled) trades
can be submitted electronically through
various channels to the open-end fund
(Ciccotello et al., 2002).
CURRENT REGULATORY ISSUES IN
FUNDS
• The mutual fund market timing scandal went
beyond the escapades of the Canary hedge fund.
Over the period from 2003 to 2006, regulators
implicated a number of other late traders and
mutual fund families in the scandal. In some of
these cases, the mutual fund had made explicit
special arrangements for certain investors to
trade in excess of stated prospectus limits. Often
this was done in exchange for that investor’s
agreement to put buy-and-hold (sticky assets)
cash into other funds in the family.
• In other cases, the market timers had no explicit
agreement with the fund but nevertheless traded
in and out of funds by switching accounts or by
taking on other “cloaking” devices. Regulators
often alleged that these timers were “tolerated”
by the family, although there were circumstances
where timers were kicked out of funds (by the
fund’s “timing police”) for their trading behavior.
As a result of this timing phenomenon, fund
families did (in general) step up their awareness
of investor trading practices.
• The market timing scandal was a big deal. Over
$2 billion to date has been placed in settlement
funds for disbursement to open-end fund
shareholders who were harmed by market timing
trades. Market timing was the largest scandal
ever to hit the open-end fund industry, and it has
had several regulatory spillovers. Recall that the
major goal of the 1940 Act is to address areas of
conflict of interest between investors and fund
managers. Allowing preferential trading rights (in
violation of prospectus limits) to some investors
in return for sticky assets looks like such a conflict
of interest.
• The “timing” of the market timing scandal is also
informative as to the nature of the conflict-ofinterest issues at hand. Some of the leading
“creative” investors with strategies to market
time (or late trade in) funds made their pitch to
funds in years 2001 and 2002. Recall that by late
2002, the market had dropped about 25 percent
(based on the Dow Jones index) and over 50
percent (based on the Nasdaq index) since early
2000. Mutual funds advisory fees are normally
assessed a flat percentage of assets under
management.
• With declining asset values and flat percentage
fees, the amount of money that the fund
manager gets to manage the fund goes down—
even if no investors pull their money out of the
fund. If asset values fall 50 percent, then
revenues to the fund manager are down
significantly—indeed, exactly 50 percent if that
management (advisory) fee is a flat percentage of
assets. So a market timer’s promises to add sticky
assets to one fund in exchange for the ability to
trade in excess of prospectus limits in another
made for an interesting business proposition for
some fund managers in this period, when
management fees were down.
• These market timing offers set off quite a struggle
in some fund families between compliance
personnel and marketing (sales) managers. The
former argued that the deal would violate
prospectus (harming buy-and-hold shareholders);
the latter looked at more of the revenue upside—
and perhaps thought that market timing in a
domestic fund would not hurt shareholders
anyway since the NAV was not stale. It is
apparent in some cases that the sales side won
the battle, although the war ended up being a
different story.
• For the reader, the important point is to see the
clear conflict of interest between shareholders in
the fund (especially those who buy and hold
shares) and fund management in this matter.
How could this happen? Why weren’t
shareholders’ interests protected by the board of
directors? One pressure point in the 1940
Investment Company Act to deal with conflicts of
interest like this is the structure of the mutual
fund board of directors. Recall from earlier in the
chapter that most mutual fund boards have a
simple majority of independent (disinterested)
directors.
• Where were the independent directors in
preventing these deals with late traders? In the
aftermath of the scandal, the SEC promulgated
changes requiring that three-quarters of the
board be independent directors and that funds
have an independent board chairman. The
mutual fund industry did not agree with these
changes, and litigation over them has taken place
over the past few years. As of late 2008, the
changes had not been implemented due mainly
to legal procedural issues. Despite the legal
holdups, some funds have voluntarily changed
board structure to comply with the enhanced
independence standards.
• Would the enhanced independence standards
be a net benefit for mutual fund investors?
Added board independence certainly would
seem to favor investor interests over those of
fund management, although the costs of
adding independent board members to get to
a three-quarters independent position might
be nontrivial—especially in small mutual fund
families or funds. Director fees are paid by the
funds themselves.
• Making the chairman independent would
probably also require additional
compensation and administrative support.
Recent research does not provide a clear
answer to whether the benefits would
outweigh the costs; mixed evidence has been
found regarding the relationship of fund board
independence, fees, and fund performance
(Kong and Tang, 2008; Meschke, 2007).
• Board governance in a mutual fund has some
unusual features relative to an operating
company scenario. With an operating company,
such as IBM or Microsoft, for example, the board
of directors can hire and fire the chief executive
officer (CEO) while keeping (in many cases) at
least some of the rest of the company’s officers
to operate the firm in the interim. In a mutual
fund, the board essentially hires or fires the
entire operating company through renewal or
nonrenewal of the manager’s investment
contract.
• While CEOs are often fired in operating
companies, investment managers are very
seldom replaced in mutual funds, perhaps due in
part to the logistical issues associated with
replacing all the functions that the manager
controls. Consider also that mutual funds have a
substitute governance mechanism: daily liquidity.
If a shareholder does not like the policies or
performance of the fund, she can sell out at NAV.
But that investor does need to have adequate
disclosure of what the performance and policies
are in order to make an informed decision.
• The real problem in the market timing case as it
relates to governance may be that the timing
arrangements were not disclosed to investors. As
Ciccotello et al. (2002) argue, fund policies ought
to make it clear to investors what type of trading
environment is tolerated in the fund—for all
investors. If the fund indeed wants to cater to
wolves (market timers), then buy-and-hold
shareholders (sheep) ought to know that. Some
fund groups (e.g., Rydex) cater to investors who
like to trade.
• As to the board structure issue, whether the
fund’s board knew about these arrangements
and failed to act (to either stop them or
compel their disclosure) or whether they were
hidden from the board remain interesting
questions. In either case, it seems likely that a
more independent board would at least have
been more likely to act (or discover the
market timing side deals), although it is hard
to argue that this more independent board
structure would have provided a guarantee.
Fees
• The market timing scandal also highlighted
another area where there are potential
conflicts of interest between fund investors
and fund managers. The major cost in
operating a mutual fund is the advisory fee,
normally a percentage of assets under
management
• This is the charge levied by the adviser to
manage the fund. The market timing scandal
revealed that some funds were willing to
sacrifice their investors’ interests for higher
fees. In some of the regulatory proceedings
involving market timing, an advisory fee
reduction schedule was included as part of the
overall settlement. Fee reductions were often
part of the deal when the New York Attorney
General’s office was involved with the case.
• Aside from the settlements related to market
timing, the issue of mutual fund fees has been
debated by both academics and practitioners
for a long while. In a provocative article,
Freeman and Brown (2001) argue that openend mutual fund investors are charged more
for investment advisory services than are
pension fund investors.
• Since the difference between the two groups of
investors is primarily the governance mechanism,
the authors assert that the costs differences are
evidence of a failure of mutual fund boards to
protect shareholders’ interests when negotiating
the advisory fee since pension funds have lower
fees. Is the comparison a valid one? A number of
class actions have been brought against mutual
fund companies in recent years for excessive fees,
seeking relief under Section 36(d) of the
Investment Company Act of 1940.
• To this point, these cases generally have failed to
bring any remuneration to investors. Section 36(d)
is a high legal hurdle; in order to win, plaintiffs
must show that fees must bear not reasonable
relationship to performance. Also, courts typically
have rejected comparisons between mutual
funds and pension funds. Moreover, and
unfortunately for plaintiffs, their counsel often
has chosen to sue mutual fund families for
excessive fees based on the fund’s involvement in
the market timing scandal.
• Some of these market timing funds and fund
families have rather low fees (at least by
comparison to other mutual fund families), a fact
that makes a case for excessive fees tough to
build.
• The average advisory fee for an actively managed
fund is about 0.68 percent (Gremillion, 2005).
Mutual fund management can be highly
profitable; indeed, the regulatory settlements in
the market timing cases reduced fees by as much
as a third in some cases.
• These settlements reinforced the belief that
effective fund management could go on at
lower cost to shareholders. Some of the
controversy about the high cost of funds has
sprung from fund managers’ failing to pass
along the benefits of scale economy to
investors as funds have grown larger. Stated
succinctly, mutual fund companies are not
passing the economies of scale on to their
customers as funds grow bigger in size.
• One way to accomplish this might be to have
“break points” in fees, where the manager gets a
lower percentage of the assets as a fee when the
fund reaches a certain size. For example, a breakpoint fee schedule might be: 0.75 percent of
assets for the first $1B under management and
0.65 percent of assets thereafter.
• Fee defenders, however, point to the vast number
of choices investors have, among both active and
passive funds, and the liquidity of funds that
permits relatively easy switching.
• The logic is that if fees are too high, investors
will move their money. Moreover, unlike the
undisclosed arrangements with market timers,
advisory fees are disclosed, allowing for
informed choice. Ongoing discussions about
fee disclosure remain, however, and raise
several issues and questions. First, there are a
large number of funds from which to choose,
making investors’ basic search for a fund a
non-trivial task.
• Even upon choosing a specific fund, can
investors be expected to sort through the
large volume of documentation to find the
actual fees? Are fees disclosures reasonably
transparent? For more in-depth discussion of
these topics, the reader should consult
Haslem (2003, 2004, 2006); Haslem, Baker,
and Smith (2005, 2006); and Haslem, Smith,
and Baker (2007).
• Beyond the advisory fee issue, another concern
regarding conflicts of interest involves charging
investors for marketing and distribution (12b-1
fees) and other payments to the fund manager
for preferential steering of fund business, such as
brokerage services. Whether investors should be
paying for fund marketing and distribution (Dukes,
English, and Davis, 2006), or whether fund
service provider “soft-dollar” payments to the
fund manager made in exchange for business
considerations remain issues hotly debated in the
academic and professional literatures (Steil and
Perfumo, 2003).
• The market price declines in late 2008 do put an
interesting perspective on fees, at least with
regard to stock mutual funds. Over the past 25
years ending in 2008, stock prices have
appreciated tremendously, adding greatly to the
revenues of fund managers. Moreover, lots of
new money flowed into stock funds as asset
values appreciated, adding to the total assets
under management. Much of this inflow over the
past two decades is in retirement funds (in the
form of 401[k] contributions).
• But in late 2008, stock markets worldwide lost
about half their value, basically cutting
revenues for many fund managers in half. So it
appears that the markets have done what the
lawsuits have generally failed to do: cut fund
manager compensation. Moreover, investors
followed their typical pattern and withdrew
money from stock funds during late 2008,
further decreasing fund manager revenue.
Going forward, if depressed stock prices
continue, it will be interesting to follow two
issues regarding fees:
1. Will break points become more popular?
Break points offer higher fees at lower asset
values under management and reflect the
notion of scale economy better than flat
percentage fees.
2. Will lower fees drive consolidation in the
mutual fund industry, as smaller and highercost families are unable to survive in the lower
revenue environment?
Performance Reporting
• The last section in this survey of current
regulatory issues and mutual funds concerns the
issue of performance reporting. As this chapter’s
opening story suggests, this issue presents some
significant regulatory challenges. It is an
interesting issue to use to summarize a chapter
about regulation, however, as it also highlights
the tension between the economy of presenting
the performance of the mutual fund as a whole
and the performance of the literally thousands of
individual investors within that fund.
• This tension reflects the overall challenge with
the disclosurebased rationale of the 1940 Act.
If the demands for more complete and
transparent disclosure also lead to an increase
in the volume and complexity of disclosure,
the net result of more disclosure could be
negative. The SEC continues to wrestle with
both the required elements of disclosure and
the various methods of communication to
shareholders (SEC, 2007).
• Funds are required to report time-weighted
performance for 1-, 5-, and 10-year periods, if
they have been in existence that long (Jain and
Wu, 2000). Funds must report at least 1-year’s
return ending with the latest calendar quarter.
Jain and Wu (2000) observe that funds tend to
advertise after periods of good performance and
that performance does not persist
postadvertisement. Performance reporting issues
in open-end funds are especially interesting
because of fund liquidity. Jain and Wu find that
advertising funds attract large amounts of new
money, which tends to arrive just in time to
receive poor returns.
• Friesen and Sapp (2007) and Ciccotello et al.
(2008), have documented that time-weighted
performance of funds is greater than dollarweighted performance of funds. Recall that timeweighted performance is the return of the fund
taken as a whole, measured over some period,
such as a year. So if the NAV of the fund were $10
on January 1 and $15 on December 31, and the
fund paid no dividends, its time-weighted return
is 50 percent. An investor owning the fund at the
beginning of the year and holding it throughout
the year, without buying or selling any shares,
earns the time-weighted return.
• In contrast, dollar weighting considers the
beginning and ending sizes of the fund as well
as inflows and outflows during the period.
Computing a fund’s dollar-weighted returns is
more complicated than computing timeweighted returns, and various methods have
been applied (Ciccotello et al., 2008; Friesen
and Sapp, 2007). Moreover, every investor
buying or selling during the time period would
have his or her own dollar-weighted return.
• The differences in time–dollar-weighted fund
returns are quite noticeable. In stock mutual
funds, dollar-weighted returns are 15 percent
lower than time-weighted returns (8.45 percent
versus 10.29 percent on an average annual basis)
over the sample period from 1929 through 2005.
This means new money tends to flow into funds
just before stock market returns decline and flow
out of funds just before stock market returns
increase. That causes a dollar-weighted return to
be less than a time-weighted return.
• This pattern of returns is consistent with Jain and
Wu’s (2000) observation that funds with good
recent performance tend to advertise and attract
new money. In sum, open-end fund investors
tend to chase recent performance, and flows into
funds tend to be poorly timed (Edelen, 1999).
These time–dollar differences in performance are
huge, and would seem to demand adequate
disclosure to investors. Consider the fact that
huge legal battles about mutual fund fees are
occurring over 10 to 20 basis points in an annual
fee, while the annual time–dollar performance
difference stated above is 180 basis points.
• Given this large difference between what the
required disclosure states as the return and what
investors actually are earning, what should a fund
be required to disclose and report in a prospectus?
Clearly there is no simple answer to this question,
and the problem gets more complicated if one
considers multiyear periods and returns. Some
fund data firms, such as Morningstar, are
considering the addition of dollar-weighted
measures; the challenge is to establish a standard
that will be simple enough to convey meaning
but rigorous enough to have meaning.`
• In closing this chapter on fund regulation,
performance reporting provides a useful example
of a number of the regulatory issues impacting
open-end funds. These issues generally tend to
rest fundamentally on the open-end product’s
unique attribute: its self-liquidating feature.
Because of the daily liquidity funds offer to
investors, large amounts of inflows and outflows
can happen each day. Investors tend to chase
good performance, spurred on by fund
advertisements and favorable financial media
rankings. Modern technology has made trading in
and out of funds very fast and simple.
• Forget the old days when one had to (snail)
mail in a check to buy shares, with the
transaction taking days if not weeks to clear.
Now trading can be done electronically. The
number of distribution channels in open-end
funds has also grown dramatically (Reid and
Rea, 2003), and some of these (such as mutual
fund supermarkets) submit bundled orders
such that the open-end fund may not even
know the identity of the individual investors.
• Rapid trading has presented several
challenges to fund management, the most
fundamental of which is to ensure that the
daily NAV is not calculated with any systematic
bias that would allow a trader to take
advantage. In addition, given the multiple
distribution channels, enforcing trading limits,
when they exist, is not a simple task.
• In sum, the goal of the 1940 Act is to protect
investors against conflicts of interest. Some of
those interest misalignments are with fund
management. What the contemporary issues
suggest is that conflicts of interest can also
exist between subgroups of investors, such as
those who want to trade a lot and those who
do not. Moving forward, regulation must
consider the range of investors (and
distribution channels) in open-end funds to
harmonize a more complicated set of
demands.