TCS Daily

Spitzer vs. the SEC

By James K. Glassman - December 19, 2003 12:00 AM

Two U.S. regulators are at odds over how to punish a large investment firm caught in the recent mutual fund scandal. The choice is crucial. The final settlement will set a powerful precedent for handling other Wall Street miscreants.

The Securities and Exchange Commission, the top federal regulator, has decided to impose a $250 million fine on Alliance Capital Management Holding, LP. That's the largest financial penalty ever imposed on a mutual fund. New York Attorney General Eliot Spitzer, who started the investigation this summer, has something very different in mind. He wants Alliance to cut the fees it charges mutual fund customers immediately by 20 percent and guarantee those rates for the next five years. According to published reports, Alliance has agreed to the deal, and an announcement will come soon.

While Spitzer deserves praise for pursuing firms like Alliance, which allowed a few large clients to engage in trading practices that harmed other fund shareholders, his punitive approach is dead wrong. Consider its perverse logic.

First, in order to benefit from the mandatory discount, current Alliance clients -- the ones who were hurt by the improper trading -- would have to keep their accounts at the firm. No wonder Alliance has acquiesced to the approach; it helps lock in customers who might otherwise flee. The greatest fear of mutual funds that have been exposed by Spitzer and the SEC is that their customers will leave in droves. Second, the lower fees will be a boon to new Alliance clients, who weren't victims of the scam. Third, the fees have nothing to do with the charges against Alliance. "This enforcement case doesn't involve improper fee charging," says SEC Commissioner Roel Campos. And, fourth, the deal will put downward pressure on fees charged by Alliance's competitors, most of whom did not engage in improper practices.

But there's something even worse about the Spitzer penalty. It accepts the faulty economic analysis of politicians and consumer groups, who have long complained that the mutual fund industry overcharges its customers and have sought government action to limit or reduce fees. "We have a major problem with excessive fees in the fund industry," says Barbara Roper of the Consumer Federation of America, reflecting the views of her peers.

The politically ambitious Mr. Spitzer has a history of trying to use prosecution, not merely to punish, but to restructure businesses and industries. He pressured investment firms into changing the way they compensate stock analysts, and, in a less visible case, he agreed to exempt owners of New York produce stores from future litigation if they would promise to pay workers extra wages for overtime.

Certainly, the fund industry could use some changes. Higher ethical standards -- plus a dose of humility -- are called for, and, it would seem, brutal fines and prison sentences will do the trick. But Spitzer and his supporters seem to think that the real problem is gouging customers. Are fees "excessive"? Such a judgment seems absurd and misinformed when you consider the fragmented and fiercely competitive nature of the fund industry. The five largest fund houses owned just 33 percent of mutual-fund assets in 2002, down from 37 percent in 1990. The 10 largest houses owned 46 percent of assets last year, down from 56 percent in 1990.

Investors have vast choices. At the end of 2002, there were 8,256 mutual funds (up from just 564 in 1980). Some funds charge commissions (or "loads") at the time of purchase; others at the time of sale. Others impose no loads at all, instead collecting annual fees, which, expressed as a percentage of a shareholder's investment, are published not only in the fund's prospectus but by popular research services like Morningstar Mutual Funds. Do investors respond to low fees? Absolutely. The largest equity mutual fund, with $89 billion in assets at last count, is Vanguard Index 500, which mimics the benchmark Standard & Poor's 500-Stock Index. The fund carries no load and charges just 18 basis points in annual expenses. The second-largest equity fund, Fidelity Magellan, also imposes no load and charges only 76 basis points -- or about half the average for all stock funds.

Investors, however, don't opt for low costs alone. Nor should they. They consider financial returns and service as well. PIMCO Total Return, for example, has accumulated $73 billion in assets despite a 4.5 percent front load and annual expenses of about 1 percent annually. The reason is simply that the bond fund's manager, Bill Gross, has compiled a spectacular record in recent years. As a financial columnist, I am often infuriated when investors rush to funds with great short-term performance, paying little heed to fees. But that's no reason for government policy to be directed at imposing someone's concept of "fair" costs, any more than government should cap the price of hot movie tickets or automobiles. After all, the responsiveness of investors to good performance is an incentive to better performance. What's troubling is that policymakers who take a free-market approach to other economic questions are singing Spitzer's song.

On Wednesday, two top Republicans, Rep. Mike Oxley of Ohio, who heads the House Financial Services Committee, and Rep. Richard Baker of Louisiana, who chairs its capital markets subcommittee, issued a press release that seemed to side with the New York Attorney General in the dispute. "All mutual fund shareholders deserve lower fees," they said. "Not just shareholders who invested in funds that engaged in questionable trading practices; not just shareholders invested in one fund family; but all mutual fund shareholders deserve relief from fees that continue to rise." In fact, not all fees are rising. For example, Fidelity, the largest fund house, recently did away with its 3 percent loads on sector funds.

And even if fees do rise, so what? In a competitive market, with few supply constraints, higher fees are a reflection of greater demand. In other words, mutual funds are providing investors with a desirable service. The best proof is the industry's success. In 1980, there were 12 million fund accounts with $135 billion in assets; today, there are more than 250 million accounts with $7.2 trillion in assets. Mutual funds, along with defined-contribution pension plans, have democratized American finance. Spitzer should stick to investigating and prosecuting firms that break the law. That's a big enough job.

James K. Glassman is a resident fellow at the American Enterprise Institute and host of the website He writes a weekly syndicated financial column for the Washington Post.


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