TCS Daily

SEC Shame

By James K. Glassman - June 22, 2004 12:00 AM

The Wall Street Journal reported Tuesday morning that the SEC is expected Wednesday to pass a rule requiring mutual funds to have independent chairmen. The action will be, write Deborah Solomon and John Hechinger of the Journal, "a stinging defeat" for mutual fund companies. Well, yes, but, far worse, this act of regulator lunacy will be a disaster for small investors, who will likely end up with fewer choices, higher fees and worse performance. Not to mention utter confusion.

Do you own a mutual fund? O.K., let me ask you a few simple questions: Say you own shares of Fidelity Growth & Income fund. What do you think you own? A product with the Fidelity brand name behind it, right? An investment vehicle issued by a large and stable institution that you trust. And what do you do if Fidelity Growth & Income fund doesn't perform to your expectations? You sell it, of course, and buy another fund, issued by another investment company, such as Dreyfus Growth and Income.

In fact, because of a strange law passed in 1940, you don't really own a product when you buy a mutual fund. Instead, you become a shareholder in a company, which uses its assets to buy stocks or bonds. That company -- Fidelity G & I, in this case -- has a separate board of directors, and the board engages an "advisor," in this case Fidelity, to do the real work of managing the fund. In fact, it was Fidelity that set up this board in the first place!

But, I would venture, not one investor in a thousand thinks of his or her fund ownership this way. Most investors think a fund is a product, like a certificate of deposit issued by a bank. If you don't like it, you sell it and buy another one. That is the practical definition of a mutual fund, and it has worked brilliantly. The original law that established this strange system purposely allowed firms like Fidelity to keep control of mutual fund company boards. Of course. Otherwise, why would the firms set up the mutual funds in the first place?

Imagine the alternative. Fidelity G & I has a board made up of outsiders, with nothing to do with Fidelity. One day, these outsiders decide, because of poor performance or just because they don't like the manager's haircut, to fire Fidelity and hire Dreyfus to run their fund. Would investors be well served? Of course not. They would be angry as hell. They bought Fidelity; now here

comes Dreyfus!

But this is precisely what the Securities and Exchange Commission is about to do Wednesday. It will require that control of mutual fund boards move from the firms that set them up in the first place to a bunch of "independent" people who may or may not have the best interests of the shareholders at heart. I would much rather know for certain that when I buy Fidelity I am getting Fidelity. (Any investor who feels otherwise, of course, could buy one of the funds -- and there are about 1,000 of them -- that have an independent board.)

Investors are not morons, as the SEC seems to think. They buy Fidelity or Dreyfus or Vanguard or Janus because that's what they want. They don't want to put their trust in Joe Blow, the tax lawyer or ex-CEO of a paper-box company or former congressman, who is now the chairman of their mutual fund.

The mutual fund has been the most popular investment vehicle of all time. Nearly half of all U.S. families own funds, and they have 8,124 funds from which to choose. The fund business is viciously competitive, as well. The five largest firms control only about one-third of the total market. So if investors are disappointed with their funds, they can vote with their feet. What numbskull believes that an investor, faced with poor performance, will say, "Oh, gee. I don't like Fidelity G & I, so I will put pressure on the board of directors of the fund to switch advisors and hire Dreyfus to manage it"? If an investor doesn't like the way Fidelity G & I is run, a far simpler solution is the one that prevails today: sell Fidelity and buy Dreyfus.

Indeed, this is precisely what investors did after it was revealed last year that some mutual funds had allowed favored customers to practice "late trading" and "market timing." Investors walked out the door. One fund lost $29 billion in assets in a few months.

One result of the change the SEC is about to make is that firms like Fidelity will have far less incentive to set up mutual funds in the first place. What kind of firm would go to the time and expense of establishing a mutual fund company, whose board, at any moment, could turn around and engage another firm to run it?

Instead of setting up mutual funds, I expect that firms like Fidelity will look seriously at alternatives such as unit investment trusts, which are bundles of stocks and bonds that are not actively managed. UITs have been around a long time, but investors have widely rejected them, mainly because of high fees.

Speaking of fees: the only serious research that has been conducted on two sets of mutual funds -- independently chaired and non-independently chaired -- has found that the non-independently chaired funds charge lower fees and achieve sensationally better performance. You can bet that fees will rise as a result of the SEC's action -- both because the number of mutual funds will shrink (or not expand as fast as it would otherwise) and because independent chairmen have less incentive to run a competitive fund. But the SEC doesn't seem to care about fees or performance. In fact, the majority of the SEC, I have come to conclude, sadly, does not really care about investors. It does not care about the facts or the data. It cares instead about its own vague notions of propriety and about its embarrassment at being upstaged in enforcement by the New York Attorney General.

Worst of all, the SEC -- and this is the BUSH Administration, remember -- has no faith at all in markets or in the ability of legal authorities to punish wrongdoing. The robust market for mutual funds has brutally punished funds like Putnam and Janus that were nailed by Eliot Spitzer. Investors fled these funds in droves and moved their money to fund families like Fidelity and American, which are spotless. And then there is criminal and civil law to send people to jail and exact penalties.

Finally, the SEC, at a time when it is trying to improve investor education, is actually doing investors a terrible disservice by duping them. The law on the structure of mutual funds is a complicated one. "Independence" is an absurd concept in the context of this structure, and the SEC's commissioners know it.

So, I would assume, does the press -- which has portrayed this story in its usual puerile way: the good regulators vs. the bad lobbyists for corporate interests. But we can't expect too much from the media. The real responsibility lies with the SEC. Rather than explaining the truth to investors -- and vigorously encouraging investors to dump funds that disappoint them -- the SEC is exploiting investor ignorance by enshrining a dangerous idea that's called independence but that is (as the commissioner know very well) something else entirely. That's a shame.


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