It’s in Our Mutual Interest

Evidence of illegal and improper trading practices and conflicts of interest in the mutual fund industry has shocked the 95 million Americans who own mutual fund shares. The investigations into wrongdoing are continuing, but what we have already uncovered compels us to ask what went wrong and how we can prevent it from happening again.

My office’s examination of the industry suggests that the problems stem from a governance structure that favors mutual fund managers at the expense of mutual fund investors. Although many mutual funds are worth billions of dollars, they tend to operate without any employees. Instead, a fund will have a board of directors that hires outside managers to handle its investing, marketing and day-to-day management needs. These managers get paid a percentage of the funds under management. If the amount invested in the mutual fund rises, so does the managers’ compensation. That’s why the managers insisted that traders engaging in illegal late trading and improper market timing had to increase the amount of money they had invested with the fund. This was good for the fund managers but bad for investors, who lost money as a result of these activities.

In most other industries, a board of directors would generally be expected to guard against such behavior. Unfortunately for investors, mutual fund directors are as conflicted as the managers they hire. In most if not all cases, the chairman of the fund’s board of directors is affiliated with the management company. And even the funds’ so-called independent directors are often people who have joined the board after retiring from a job at the management company.

The directors’ lack of independence is most evident in their abdication of any meaningful effort to negotiate lower advisory and management fees. In 2002, it is estimated that mutual fund investors paid advisory fees of more than $50 billion and other management fees of nearly $20 billion. How do we know that these fees could and should have been lower? Consider what these same management companies charge pension funds for investment advice. On average, mutual funds pay about a quarter of a percent more than pension funds for the same advice. Mutual fund investors would have saved $10 billion in 2002 if they had been charged the lower rates given to pension funds.

The reason mutual fund investors pay a higher rate is simple: Their directors don’t put the contract out for bid. Instead, the contract is invariably given to the management company that the fund directors are affiliated with.

Going forward, funds must be required to maintain independent boards of directors -- with an independent board chairman -- that act as the fiduciaries of the money that investors have entrusted them. The boards can begin to demonstrate that they have earned that trust by negotiating lower fees from the advisory and management firms.

In fact, mutual funds should be required to establish the fairness of the fees that they agree to pay or, more precisely, that their investors pay. This can be done by obtaining multiple bids or an independent evaluation or by some other means. Mutual funds should also insist on contracts that entitle them to the lowest fees charged. This provision, known as a “most-favored nations� clause, will ensure that mutual fund investors do not pay significantly higher advisory fees than pension funds. Directors need to have their own staff to ensure the fund managers’ compliance. That limited oversight is necessary to curb abuses by managers to whom so much authority has been delegated.

Finally, mutual funds should not be allowed to continue deducting what amounts to billions of dollars in fees from their customers’ accounts without providing them with a disclosure statement. Fee reporting should be uniform and should include the specific costs of advisory, management and marketing. This would encourage investors to compare the cost of competing funds.

In fact, there is a bill pending before Congress that would require funds to provide shareholders with a statement of the fees charged on a hypothetical $1,000 investment in the fund. Why not require the funds to disclose the actual fees charged to each investor?

The mutual funds that allowed late trading and timing should also be required to repay to investors the advisory fees that they collected during the time that they were permitting improper trading. Simply put, those who breached their fiduciary duty should not be permitted to profit from the experience.

Taken together, these steps would begin the process of restoring the rights of investors and realign the interests of the funds with those of their investors.

Thursday’s announcement of Putnam Investment Management’s preliminary settlement with the Securities and Exchange Commission on charges of management improprieties includes a few of these proposed reforms, but unfortunately does not address the issues most important to investors: Will the funds that acted improperly repay the hefty advisory fees they took, and what is being put into place to ensure the fairness of fees charged in the future?

As the assets in mutual funds grew 90-fold in the last two decades, the chasm between the interests of investors and those of managers and directors also widened. Bridging that divide must be the priority of lawmakers, regulators and industry officials alike.