Remembering the Past: Mutual Funds and the Lessons of the Wonder Years Barry P. Barbash, Director Division of Investment Management U.S. Securities and Exchange Commission 1997 ICI Securities Law Procedures Conference Washington, D.C. December 4, 1997 Thank you and good morning. In the face of the impending millennium, much of America these days seems to be looking backward. Teenagers are again wearing bell bottoms and flared collars. I fear leisure suits could be next to return. The new movies for this holiday season include remakes of fan favorites of the past -- "Flubber" and "Mr. Magoo." Oldies radio stations achieve high ratings, and everybody with cable TV can watch classics such as the "Dick Van Dyke Show," "That Girl," "Hawaii Five-O" and the "Odd Couple" on the Family Channel or Nick at Night. A recent addition to the Nick at Night lineup is a show of more recent vintage called the "Wonder Years," in which a narrator, who is about my age, looks back on his childhood and adolescence during the 1960s and 1970s. The 1960s were indeed the early Wonder Years for the fund industry. From 1960 to 1965, assets of stock mutual funds doubled. From 1965 to 1970 they doubled again, peaking at $56 billion in 1972. The Wonder Years of the 1960s for funds were followed by the Woeful Years of the 1970s. During 1973 and 1974, stock fund assets fell 44%. In the eight years between 1972 and 1979, fund redemptions exceeded sales in every year but one. During this period, assets did not leave mutual funds in a flood, but instead drained away slowly and relentlessly, year after year. The power of hindsight allows us today to point to critical oversights made by the fund industry during the Wonder Years of the 1960s that contributed to the Woeful Years of the 1970s. Some current trends that characterize the thriving fund business we have come to take for granted suggest that the industry could be making similar mistakes today. The industry would be well advised to heed the sage wisdom of the philosopher, George Santayana, who said that "those who do not remember the past are condemned to relive it." This morning, I am going to follow Santayana's advice and look to the 1960s and '70s for guidance on some of the issues facing today's industry. The Cult of Performance To many, the 1960s are best remembered as the "go-go years" of investing. In those years, glamour stocks, such as Xerox and Polaroid, were all the rage and mutual fund managers were first accorded the status of movie stars. Gerald Tsai, one of the first star managers, was compared in his retiring manner to Greta Garbo and was described in a Newsweek article of the time as "radiat[ing] total cool."[1] For a time, these fund "gunslingers," as they were called, chalked up annual gains like nothing seen before, and created what has been described as a cult following of investors. To these investors, prior performance of fund managers seemed to be the only important factor in making investment decisions. The performance cult lost many of its followers, though, when the stock market began to drop in 1969. As one press account described the effects of the downturn on the fund industry: "[t]he so-called 'go-go' funds, which led the performance cult, became agonizingly misnamed when the market turned. Values of many of them dropped 40% or 50%, leaving a wake of mauled and angry investors."[2] In 1972, Business Week predicted that "the fund industry has an image problem, and this will plague the funds in 1973."[3] The magazine was right about the image problem, but underestimated its duration -- the fund industry did not regain equity fund assets lost in the 1970s bear market until 1983. Today, the performance cult has regained its exalted status and has attracted a whole new group of followers. You can't go through the grocery check-out line these days without seeing one or another popular financial magazine publicizing its most recent list of "hot" funds and star managers, based on impressive performance gains, often achieved over a year or less. Fund groups tout their star managers and their performance records, and can't seem to start new funds quickly enough. Managers who don't meet performance goals are quickly replaced, and funds with less than stellar results are merged away. Too many investors seem to have adopted the view that performance is the be-all and end-all of investment. Investors today switch funds much more frequently than they did in the past; the average equity fund investor holding period today is less than one-third of what it was in the 1960s and 1970s.[4] A recent news account pointed out that, although participants in employee benefit plans generally are praised as buy and hold investors, they didn't live up to their reputation during the market volatility that occurred this past October. These investors reportedly moved over $80 million from diversified stock funds into more conservative investments one day, and then reversed that trend the very next day as the market rebounded.[5] The emphasis on performance that permeates both the industry and news accounts of the industry appears to have contributed in part to unrealistic investor expectations. A recent and oft- cited survey conducted by Montgomery Asset Management found that small investors expect a 34% yearly return on their investments over the next decade -- a return that is roughly three times the average annual return from stocks over the last 60 years.[6] While some commentators have criticized the Montgomery data as flawed, it seems fairly clear that investors today have become accustomed to high fund returns and chase performance much more than in the past. And while the race goes on, investors appear to disregard or pay only scant attention to the fees and costs of investment.[7] Chasing performance would be a fine activity if investors had a fighting chance of winning the race. History suggests that for many, the race will end only with disillusionment. It does not take the foresight of Nostradamus to predict that recent impressive fund gains and the bull market that fueled them inevitably will end, leaving in their wake, as in the early 1970s, many disappointed investors who may pull their assets from the stock market entirely. According to an Investment Company Institute survey of a couple of years ago, just about a third of fund investors have owned mutual fund shares for five years or less. These investors, who likely have never experienced a bear market, may have expectations built on short-term memories and may be particularly vulnerable to disillusionment in the face of a market decline of any significant length. By over-emphasizing performance, some in the mutual fund industry are helping to create short-sighted investors. The industry made this mistake some thirty years ago and paid a steep price. The challenge for the industry is to learn from the past and stop the growth of the new performance cult. Some industry commentators and participants argue that the key to dealing with the new performance cult would be for the Commission to prohibit the use of certain performance information. To my mind, this suggestion is far too simplistic and would only deny investors information that could be helpful in selecting among funds and fund managers. Of greater concern is the proposal's implicit assumption that the industry has little or no responsibility for the new performance cult. In my view, the key to dealing with the cult is for the industry to take greater responsibility when using performance information of all kinds. The industry must shift its focus away from a reliance on performance in both how it generates sales and how it manages assets if it wants to encourage fund shareholders to understand a basic truth about funds -- that they are long-term investments. Central to creating this new breed of long-term investor are investor education programs and sales practices designed to ensure that investors understand all of the significant factors in the investment equation -- risks, costs, and tax implications. Investor education programs and sales practices must also teach investors how to develop workable and achievable investment goals and how to select funds that will further those goals. By emphasizing these concepts, the industry will avoid the mistakes of the 1960s and instead will create knowledgeable investors with realistic expectations -- investors who are less likely to become disillusioned and flee the market in the event of any significant downturn. Back-Office Failures and the Year 2000 Problem The watchwords for many in the investment business during the go-go years were "produce, produce, produce -- and keep down the overhead."[8] A painful lesson of the time was that keeping down the overhead by neglecting essential back office functions can lead not to increased production, but to the destruction of existing business. The late 1960s was a period of tremendous growth in the securities industry. In 1965, the New York Stock Exchange predicted that trading volume over the next 10 years would increase to a level which was in fact exceeded only two years later. In 1967, trading volume on the Exchange exceeded the previous year's volume by over 33%.[9] The response of the securities industry to this tremendous increase in business was to pour even more resources into generating yet more sales. The industry's emphasis on the money- making front-office, however, was at the expense of the back- office administrative operations. The result was that many firms were poorly equipped to handle the huge surge in business and completely lost control over their paper flows and recordkeeping. The back rooms of many firms were stacked to the ceiling with papers that had not yet been processed or were being held for unreconciled errors. Payments were not made or were made to the wrong parties; securities were not delivered on time or were lost. By the early 1970s, these problems, complicated by the onset of a bear market, had almost ground the securities industry to a halt. The costs of remedying the back-office problems were tremendous, and between 1969 and 1970, approximately 160 New York Stock Exchange firms went out of business. Although the back offices of today's investment management firms bear no close resemblance to the back offices of the brokerage businesses of the 1960s, the investment management industry today must deal with a back-office issue that has as broad implications for the industry as the paperwork crunch of the '60s -- the Year 2000 Problem. Fixing this problem is especially critical for all participants in the industry because of their reliance on computer systems in communicating with counterparties and customers, processing transactions, and maintaining customer records. The gravity of the issue was emphasized in testimony presented last month before a subcommittee of the Senate Banking Committee by Edward Yardeni, a well-respected securities industry commentator. In his testimony, Mr. Yardeni warned that the Year 2000 Problem could disrupt the global economy which, in turn, could cause a global recession.[10] The Commission has recognized the seriousness of the Year 2000 Problem and has been active in communicating with the financial services industry and with the public generally about the need to address the problem. Chairman Levitt has sent letters to key industry participants, including every chief executive officer of every adviser registered with the Commission, expressing the Commission's concerns about Year 2000 compliance issues. Following the Chairman's lead, our Office of Compliance Inspections and Examinations is monitoring the industry's progress toward Year 2000 compliance through its examinations of self-regulatory organizations and other industry participants, including funds and investment advisers. While examining funds and advisers, we have tried to get a handle on the extent of the investment management industry's efforts to deal with the Year 2000 Problem. During our inspections, we have sought to determine whether advisers have taken the steps necessary to ensure that their businesses will not be impaired significantly by the glitch. In reviewing an adviser's Year 2000 remedial program, we have sought to assess whether the program takes into account both the adviser's own systems and electronic communication links to vendors and clients; has the full support and backing of the adviser's senior management; and involves continual monitoring of progress against the program's goals. To date, we generally are encouraged by the efforts of those advisers whose operations we have examined, but we remain concerned that other advisers have far more work to do. On the disclosure front, we have reminded all registrants, including funds and advisers, of their disclosure obligations under the federal securities laws with respect to the Year 2000 Problem. From now until the next millennium -- it's not as long as it sounds -- every fund whose registration statement we review will receive a comment pointing out that the fund may need to disclose, among other things, the effect that the Year 2000 glitch would have on the ability of the fund's adviser to provide the services described in the registration statement. Dealing effectively with a back-office matter such as the Year 2000 Problem can be costly and may subtract from an investment adviser's bottom line. As the 1960s back-office crisis in the securities business vividly demonstrates, however, it can be far more costly not to have effective administrative and compliance systems. By forgetting the lessons of the 1960s when assessing the Year 2000 Problem or any other compliance issue, an adviser risks not only financial loss, but also a Commission enforcement action, shareholder lawsuits, and -- most costly of all in the long run -- a loss of confidence among its clients. Clients who have little or no confidence in an adviser's ability to handle simple administrative matters -- processing orders correctly or sending account statements in a timely manner, for instance -- would seem far more likely to question the adviser's ability to manage money effectively. The lesson of the aftermath of the go-go years is that advisers would be wise to avoid this risk. Pricing Issues During the Wonder Years of the 1960s, the Commission took one of its most decisive actions ever in regulating mutual funds. In response to widespread abuses it believed existed at the time in the pricing of mutual fund shares, the Commission in 1968 adopted Rule 22c-1 under the Investment Company Act. The rule, which remains a core provision of mutual fund regulation, requires every fund to follow a forward pricing procedure under which each purchase and redemption order is executed by the fund at a current net asset value next computed after the order is received. In adopting Rule 22c-1, the Commission sought to address two significant problems that characterized the backward-looking pricing systems used by many funds in the early to mid-1960s. Under such a system, a fund used previously calculated net asset values to determine the prices at which it would sell or redeem its shares. The Commission's principal concern with backward pricing was that it could lead to significant dilution in the investments of existing fund shareholders. Dilution could result in either of two ways --when an investor purchased shares of the fund during a rising market at a price that was lower than the fund's current net asset value, or when an investor redeemed shares during a falling market at a price that was higher than the fund's current net asset value. In either case, existing shareholders would be harmed. The Commission's other concern with backward pricing was that it encouraged questionable sales and trading practices in fund shares. In the rising markets of the 1960s, backward pricing was often cited by aggressive brokers in seeking to convince potential investors that, by acting quickly, they could purchase fund shares at bargain basement prices that soon would disappear. Backward pricing also led some investors in the 1960s to become speculators in fund shares. A strategy used by some investors at the time was to arbitrage fund shares by purchasing a large block of shares during a rising market, and then quickly selling the shares after the fund's assets were revalued to reflect the market rise. This speculative practice, in addition to causing dilution of a fund's existing shareholders, often interfered with the ability of the fund's adviser to manage the fund effectively. An adviser might delay investing the money of speculators, for example, for fear that as soon as the "hot" money was invested, the speculators would redeem. The policies that the Commission sought to further in adopting Rule 22c-1 -- preventing significant dilution of the interests of existing fund shareholders and discouraging speculative selling and trading practices in fund shares -- led the Commission's staff in 1981 to take an important interpretive position that has been severely criticized recently by some investors and industry commentators. In calculating its current net asset value for purposes of the rule, a fund generally is required to price its portfolio securities using readily available market quotations. If market quotes are not available for particular securities, the fund is permitted to value the securities at their fair value determined in good faith by, or under the direction of, the fund's board of directors. Under the staff's 1981 position, a fund may (but is not required to) price portfolio securities traded on a foreign exchange using fair value, rather than the closing price of the securities on the exchange, when an event occurs after the close of the exchange that is likely to have changed the value of the securities. The staff's 1981 interpretation was front and center in news accounts when many of the world's markets dropped unexpectedly and quickly rebounded this past October. Investors in some funds principally holding securities of Asian companies said that they were taken by surprise when the funds priced the securities on the basis of fair value rather than the closing prices of the securities on the Asian markets. Seeking to rely on the staff's interpretation, the funds appear to have concluded that, by the time they priced their shares -- in some cases 12 to 14 hours after the close of the Asian markets -- subsequent market events had rendered the closing Asian market prices no longer valid. As a result, the funds determined that they could rely on fair value pricing procedures in calculating their net asset values. Some investors, expecting the funds to compute net asset values on the basis of the closing prices in the Asian markets, purchased large blocks of shares in anticipation of making a profit when the Asian markets rose the next day. These investors were dismayed when they did not receive the price they had expected. Many of them have expressed their disappointment to us, complaining that they were denied, with no advance warning, profits they thought they deserved. In light of the recent volatility in the world's markets and the complaints we received from fund investors about their experiences this past October, we undertook last month a series of special examinations designed to assess the operation of the fair value pricing procedure contemplated by our 1981 interpretive position. We also took a close look at fund disclosure relating to pricing procedures. Our review was completed last week and many of our findings are noteworthy. Our examinations revealed a lack of uniformity among fund groups in the methods they used to price the same or similar types of portfolio securities. Some fund groups used a fair value procedure in pricing Asian securities held by all funds in the complex, whereas other fund groups used fair value only in pricing the Asian securities held by certain of the funds in the complex. Still other groups determined their net asset values solely by reference to market quotations. All of these procedures can be undertaken in accordance with the Commission's fund pricing rules and the staff's interpretations of the rules. Funds that determined not to use fair value pricing at all or only in limited circumstances in October gave various reasons for their decisions. Some noted that fair value pricing can involve complicated judgment calls that are susceptible to second- guessing. Others pointed out that fair value pricing takes more time and is more costly to implement than pricing by reference to market quotations. Moreover, these funds asserted, the possibility of significant dilution in the value of their shares was not high enough to warrant the additional costs of fair value pricing. In general, our examinations showed that funds using fair values in pricing certain Asian securities experienced less dilution than funds that relied on market quotes in valuing the securities. A striking finding of our recent exams, particularly in view of the Commission's policy goals in adopting Rule 22c-1, was the extent to which fund investors in October appear to have speculated in the shares of funds investing in Asian securities. Our data suggests that fairly large numbers of investors attempted on October 28th and 29th to take advantage of the increase in funds' net asset values the investors anticipated would occur as soon as subsequent market events were reflected in the prices of the funds' portfolio securities. We found that redemption fees assessed by some funds of up to 1.5% of the amount invested did not deter this arbitrage activity, which promised investors potential gains in double digits on those days. The complaints of investors that they were left in the dark about the possibility of funds' using fair value pricing procedures were not borne out in our review of fund disclosure materials. Disclosure documents we reviewed did explain the circumstances under which the funds could use fair value pricing. Some of the explanations, though, were technical and legalistic and could stand a healthy dose of plain English. Taken as a whole, the results of our recent exams and disclosure reviews have convinced us that we need to undertake a broader and more comprehensive analysis of fund pricing issues. We have decided to make such an analysis a priority of the Division for 1998. As part of our review, we will look closely at the procedures funds follow in pricing their shares and will consider whether we should fine-tune some of our rules and current interpretations relating to pricing. In particular, we will consider whether we should require pricing procedures to be more uniform and, if so, whether uniformity can be accomplished in a cost-effective manner. I do not anticipate at this time that our review of fund pricing procedures will result in the staff's recommending changes to any of the fundamental concepts underlying our rules - - forward pricing, the use of market quotations in calculating prices, and the use in some cases of fair value pricing. Nor do I expect that we would recommend any action inconsistent with the public policy goals of the rules -- preventing significant dilution and speculative trading. I do believe it is likely that the staff will recommend updating and refining fund pricing requirements to reflect changes that have occurred in the fund industry since Rule 22c-1 was adopted during the Wonder Years of the 1960s. Conclusion Mutual funds have come a long way since the Wonder Years. Today, funds are experiencing a prosperity far greater than anyone could have imagined 30 years ago. Whether that prosperity will continue will depend in part on whether funds, in the words of Santayana, remember the past or relive it. Some of us would prefer not to remember the past. I certainly feel that way when I realize that my basement still contains a "Mod Squad"-era reversible vest that was part of a three-piece suit and some hideously wide ties with appalling color combinations. But perhaps the only thing worse than remembering the past would be to relive it. I know I wouldn't want to wear any of those ties today, and I'm sure that no one in this room would like to see a return of the Woeful Years of the 1970s. We must remember the past because it has so much to teach us. It teaches us that a single-minded focus on performance does not serve investors well; that well-functioning back-office systems are critical to the well-being of the fund industry; and that proper pricing procedures are necessary to prevent dilution and discourage speculative trading practices. The fund industry's most valuable asset -- the confidence of its investors -- is difficult to gain and easy to lose. The industry has a great stake in preventing problems that put that confidence in jeopardy. We have the opportunity to learn from history and, by doing so, to avoid the pitfalls of the past. I can only hope that we take full advantage of the opportunity. I promise to do my part by leaving my old ties and reversible vest in the basement. Thank you. _______________________________ [1] Joseph Nocera, A Piece of the Action 47 (1994). [2] Disenchanted Investors Bypass the Funds, Business Week, Nov. 13, 1971, at 116. [3] Anything is Better than '72 for Mutual Funds, Business Week, Dec. 23, 1972, at 82. [4] John C. Bogle, To What Avail? Computer Technology and Mutual Funds, Remarks Before Grant's Spring Investment Conference (Apr. 3, 1997). [5] Suzanne Woolley, So Much for the Buy-and-Hold Investor, Business Week, Nov. 24, 1997, at 156. [6] Edward Wyatt, The High Hopes of Investors in Stock Funds, New York Times, Oct. 10, 1997, at D1. [7] See Report on the OCC/SEC Survey of Mutual Fund Investors (1996). [8] Wall Street Drowns in Paper, Business Week, June 29, 1968, at 102, 104. [9] Study of Unsafe and Unsound Practices of Brokers and Dealers: Report and Recommendations of the Securities and Exchange Commission, H.R. Doc. No. 231, 92d Cong., 1st Sess. 13 (1971). [10] Hearing on Mandating Year 2000 Disclosure by Publicly Traded Companies Before the Subcomm. on Financial Services and Technology (Nov. 4, 1997) (statement of Dr. Edward E. Yardeni, Chief Economist & Managing Director, Deutsche Morgan Grenfell) (LEXIS, Genfed library, Fednew file).