Statement of Senator Carl Levin before U.S. Senate Subcommittee on Financial Management, the Budget, and International Security on Oversight Hearing on Mutual Funds

Hidden Fees, Misgovernance and Other Practices that Harm Investors

With 95 million Americans invested in mutual funds, hoping and planning to use their investment dollars for college expenses, mortgages, retirement, and to help their children, the recently-exposed mutual fund scandals have brought home the need to look at potential reforms -- to stop late trading and market timing abuses as previously examined, but as we’ll examine this morning, to prevent hidden fees and end ongoing conflicts of interest and other harmful practices that hurt mutual fund investors.

Investors pay $75 billion each year in fees that support the mutual fund industry. The immense size of this dollar amount reflects the importance of the subjects of this hearing: clear fee disclosure and the elimination of conflicts of interest. Investors deserve complete and accurate information about mutual fund costs so they can make informed investment decisions and comparison shop to find well-run, low-cost mutual fund products. They also need to have confidence that the fees they incur are legitimate. They deserve to know that the persons in charge of their investments are exercising independent and careful judgments on their behalf, and that their investment advisors are providing them with objective investment advice. As we consider appropriate mutual fund reforms, it is critical to recognize and address conflicts of interest and lax oversight practices. We can start at the top. Like a typical corporation, every mutual fund is governed by a board of directors that has a duty to act in the best interests of the fund’s shareholders. But as we see from recent scandals, many of these boards as currently constituted have failed to provide needed oversight of their funds.

One way to address director conflict of interest concerns is to make sure the requirement for so-called “independent” directors is met with directors who are truly independent of the funds they oversee. For instance, right now a current officer or director of a service provider to the fund can be counted as an “independent” director. We must change that.

Other troubling conflicts of interest arise when mutual funds make undisclosed arrangements with brokerage houses, which now sell about half of all mutual fund shares. For instance, recent press reports indicate that some brokers receive undisclosed incentives from mutual funds, without telling their customers about the compensation they get to push that fund’s products. These types of secret commissions and arrangements mean investors aren’t getting objective investment advice.

For example, we need to throw a spotlight on hidden, difficult-to-understand arrangements between mutual funds and brokerage houses involving so-called revenue sharing, directed brokerage, and soft dollar arrangements. In revenue sharing, the mutual fund gives the brokerage firm a share of its revenues if the firm’s brokers sell the mutual fund’s shares to their customers. Directed brokerage occurs when a mutual fund buys stock from a brokerage firm for its holdings if that brokerage firm promotes the fund’s shares to its other customers. With soft dollar arrangements, a mutual fund pays a brokerage firm for research and other services, in the expectation that the firm’s brokers will promote the fund’s products.

These hidden practices raise troubling conflicts of interest that need to be ended. As SEC Chairman William Donaldson has said, “Investors have the right to know everything that’s inducing a broker to recommend a particular fund.”

Another key reform would be to standardize the method for calculating and disclosing mutual funds’ “expense ratios” and ensure they include all material costs. That ratio is designed to show the total annual operating expenses of a fund as a percentage of its total assets. The figure is already compiled by every fund, and theoretically should be one of the most helpful numbers to investors comparing fees. If designed well, it should function in a way similar to the per unit price listed on grocery shelf price tags giving a “price per ounce” so comparison shoppers can assess the price savings between different brands and sizes.

But right now, many funds leave out key expenses when calculating this ratio. For example, while the ratio now includes the management fee charged by the fund manager, distribution fees, and other administrative expenses, it excludes what can be one of the fund’s largest expenses: portfolio transaction costs such as broker commissions. Studies have shown that these portfolio transaction costs sometimes exceed all the costs combined that currently are included in the expense ratio. These transaction costs ought to be disclosed in a standard and easily understood format.

Other fee reforms are also needed. Many investors find the various fee options for mutual funds bewildering and rely on their broker’s advice on which to choose. However, a broker’s interests are often at odds with the investor’s—the fee option with the greatest payoff for the broker may result in the highest charge to the investor. This conflict of interest could be addressed by requiring a clear fee disclosure, prior to the purchase, that presents a clear comparison of the dollar cost of investing in each class of shares over a certain period of time.

Mutual funds are the investment of choice for a large percentage of Americans. It is their money that provides much of the fuel for economic growth. All of us have a duty to protect the average investor and, in turn, the American economy. It’s sad but true that the mutual fund industry has shown it can’t be relied upon to protect its customers, and strong reforms must be put in place, both in law and in regulation. I salute Senator Fitzgerald, Senator Akaka, Senator Collins and others’ leadership in advocating needed reforms of the mutual fund industry on behalf of the average investor.