Mutual Funds Scandals in the U.S. Market: Causes and Reform ...

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Mutual Fund Scandals in the U.S. Market: Causes and Reform Measures

S. Ghon RheeS. Ghon RheeK. J. Luke Distinguished Professor of Finance K. J. Luke Distinguished Professor of Finance

Executive DirectorExecutive DirectorAsia-Pacific Financial Markets Research CenterAsia-Pacific Financial Markets Research Center

University of HawaiUniversity of Hawai‘‘ii

6th Tokyo Roundtable on Capital Market Reform in AsiaSeptember 28-29, 2004

Tokyo, Japan

Asia-Pacific Financial Markets Research Center, University of Hawaii

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Structure of My Presentation

I.I. Overview of Global and U.S. Overview of Global and U.S. Markets for Mutual FundsMarkets for Mutual Funds

II.II. Nature of Mutual Fund ScandalsNature of Mutual Fund Scandals

III.III. Major Cause Major Cause

IV.IV. On-Going Reform Measures On-Going Reform Measures Undertaken by the U.S. AuthoritiesUndertaken by the U.S. Authorities


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Global Mutual Funds

EconomiesEconomies Net AssetsNet Assets PercentagePercentage

United StatesUnited States 7,414 53.12%

FranceFrance 1,148 8.22%

LuxemburgLuxemburg 1,104 7.91%

AustraliaAustralia 518 3.71%

ItalyItaly 479 3.43%

United KingdomsUnited Kingdoms 397 2.84%

IrelandIreland 360 2.58%

JapanJapan 349 2.50%

CanadaCanada 338 2.42%

GermanyGermany 276 1.98%

Top 10 TotalTop 10 Total 12,383 88.72%

World TotalWorld Total 13,958 100.00%

Unit: US$ billionUnit: US$ billion

Asia-Pacific Financial Markets Research Center, University of HawaiiSource : Investment Company InstituteSource : Investment Company Institute

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Geographical Distribution of Global Mutual Funds

AfricaUS$35

(0.25%)

AsiaUS$1,361

(10%)

Europe US$4,593

(33%)

South America US$217

(2%)

North America US$7,752

(55%)

Unit: US$ billionUnit: US$ billion


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Total Net Assets (US$ bn)

0

1000

2000

3000

4000

5000

6000

7000

8000

1965 1970 1975 1980 1985 1990 1995 2000 2005 Year

Growth of US Mutual FundsGrowth of US Mutual Funds


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Number of Funds

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

1960 1970 1980 1990 2000 2010

Number of US Mutual FundsNumber of US Mutual Funds

YearYear


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Net Assets by Fund Categoriesas of 2003

Total Net Assets: US$7,414.08 billion

Hybrid Funds

US$436.68 (6%)

Bond Funds US$1,240.92

(17%)

Equity Funds

US$3,684.80 ( 49%)

Money Market Funds

US2,051.68 (28%)


Source : Investment Company InstituteSource : Investment Company Institute

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US Retirement Market Assets (As of 2003)

1.1. Mutual Funds are holding 22% of total U.S. retirement assets of US$12.0 Mutual Funds are holding 22% of total U.S. retirement assets of US$12.0 trilliontrillion

2.2. 36% of all mutual fund assets are held in retirement accounts36% of all mutual fund assets are held in retirement accounts


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Nature of Industry Scandals

Abusive Trading PracticesAbusive Trading Practices Late Trading Late Trading Market TimingMarket Timing

Questionable Industry Practices Questionable Industry Practices Revenue Sharing Revenue Sharing Soft Dollar ArrangementsSoft Dollar Arrangements Directed BrokerageDirected Brokerage Excessive Charging of Fund FeesExcessive Charging of Fund Fees


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Abusive Trading Practices

1.1. Late tradingLate trading Allowed some investors to Allowed some investors to illegallyillegally place orders place orders

for funds after the 4 P.M., EST close of tradingfor funds after the 4 P.M., EST close of trading Among 34 brokerage firms surveyed by SEC, Among 34 brokerage firms surveyed by SEC,

more than 25 percent reported instances of late more than 25 percent reported instances of late trading: trading: But This number may be higherBut This number may be higher

2.2. Market timing Market timing Allowed some investors to take advantage of Allowed some investors to take advantage of

temporary disparities between the temporary disparities between the stale net asset stale net asset valuevalue of a fund and the of a fund and the value of its underlying value of its underlying assetsassets


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Adverse Impact of Market Timing1.1. Increasing Costs Increasing Costs

Greater transaction costs due to more frequent Greater transaction costs due to more frequent buying or selling shares of the underlying buying or selling shares of the underlying securities securities

2.2. Declining Investment Returns Over TimeDeclining Investment Returns Over Time Greater percentage of cash holding in the fund’s Greater percentage of cash holding in the fund’s

assets to meet demand for redemptionsassets to meet demand for redemptions Over the long term, cash holding lower investment Over the long term, cash holding lower investment

returnsreturns

3.3. Dilution of GainsDilution of GainsWith price increase: With price increase: Short-term traders gain more Short-term traders gain more

than long-term shareholders than long-term shareholdersWith price decline:With price decline: Short-term traders lose less Short-term traders lose less

than long-term investors than long-term investors


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Arbitrage Profits and Dilution of Fund Value

A.A. Arbitrage ProfitsArbitrage Profits Annualized Arbitrage ProfitsAnnualized Arbitrage Profits

International Equity FundsInternational Equity Funds 35% - 70% 35% - 70% Small-Cap Equity FundsSmall-Cap Equity Funds 20% - 25%20% - 25%High Yield Bond Funds and Convertibles FundsHigh Yield Bond Funds and Convertibles Funds 10% -25%10% -25%

B.B. Dilution of Fund Value (Basis Point)Dilution of Fund Value (Basis Point)

19981998 19991999 2000200020012001

International Equity FundsInternational Equity Funds 66 66 4646 6363 114114Small- and Mid-Cap Equity FundsSmall- and Mid-Cap Equity Funds 5959 5151 8181 147147Large-Cap FundsLarge-Cap Funds 44 22 22 -1-1

Source: Zitzewitz (2003)Source: Zitzewitz (2003)


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Questionable Industry Practices (Shadow Transactions)

Revenue SharingRevenue Sharing Soft Dollar ArrangementsSoft Dollar Arrangements Directed BrokerageDirected Brokerage Excessive Charging of Fund FeesExcessive Charging of Fund Fees


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Revenue Sharing Mutual fund gives a brokerage firm a

share of its revenues if the firm's brokers promote the fund's shares to their customers

Revenue sharing in addition to the sales loads and 12b-1 fees

Approximately 80% of mutual funds that partner with major broker-dealers make cash revenue sharing payments

As large of $2 billion per year?


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Soft Dollar Arrangements Mutual fund pays a brokerage firm for

research or other services in the expectation that the firm's brokers will promote the fund's products

Current expense ratios of mutual funds are understated because the cost of research purchased with "soft dollars" is ignored.

With the fixed commission rate abolished in 1975, broker-dealers differentiated themselves by offering research-related products and services to investment advisers


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Directed Brokerage

Directed brokerage occurs when a Directed brokerage occurs when a mutual fund agrees to use a brokerage mutual fund agrees to use a brokerage firm to buy stock for its holdings if that firm to buy stock for its holdings if that brokerage firm promotes the fund's brokerage firm promotes the fund's shares to its other customersshares to its other customers

Similar to Preferenced Trading Similar to Preferenced Trading Arrangements on NASDAQ prior to the Arrangements on NASDAQ prior to the 1997 Market Reforms 1997 Market Reforms


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Mutual Fund Fees I.I. Shareholder Fees: Shareholder Fees:

Directly Charged to a Fund ShareholderDirectly Charged to a Fund Shareholder• Sales Charge (or Load)Sales Charge (or Load)• Redemption FeeRedemption Fee• Exchange FeeExchange Fee• Annual Account Maintenance FeeAnnual Account Maintenance Fee

II.II. Annual Fund Operating Expenses: Annual Fund Operating Expenses: Deducted from Fund Assets Prior to Deducted from Fund Assets Prior to Distribution of Earnings Distribution of Earnings

• Management FeeManagement Fee• Distribution (12b-1) FeeDistribution (12b-1) Fee• Other ExpensesOther Expenses


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Annual Fund Operating Expenses Management FeeManagement Fee

Charged by a fund’s investment adviser for managing Charged by a fund’s investment adviser for managing the fund’s portfolio of securities and providing related the fund’s portfolio of securities and providing related servicesservices

Distribution (12b-1) FeeDistribution (12b-1) FeeSEC Rule 12b-1 permits funds to debit shareholders' SEC Rule 12b-1 permits funds to debit shareholders' accounts to pay marketing and distribution expensesaccounts to pay marketing and distribution expenses

Other ExpensesOther ExpensesFees paid to a fund’s transfer agent for providing Fees paid to a fund’s transfer agent for providing

various fund shareholder services, such as toll-various fund shareholder services, such as toll- free free phone communications, computerized phone communications, computerized account account services, website services, services, website services, recordkeeping, printing, recordkeeping, printing, and mailingand mailing


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More on 12b-1 Expenses (I) SEC Rule 12b-1 has been in place since 1980SEC Rule 12b-1 has been in place since 1980 Original intention:Original intention:

Facilitate growth of funds so that cost savings Facilitate growth of funds so that cost savings from economies of scale could be passed on to from economies of scale could be passed on to investors investors

Some 12b-1 fees:Some 12b-1 fees: As high as 1% per yearAs high as 1% per year Degenerated into disguised loadsDegenerated into disguised loads

Eliot Spitzer (2003): Eliot Spitzer (2003): ““A 25 basis point reduction in the fees would A 25 basis point reduction in the fees would result in a $10 billion savings for shareholders result in a $10 billion savings for shareholders annually”annually”


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More on 12b-1 Expenses (II)

SEC Study (2004) by Lori WalshSEC Study (2004) by Lori Walsh Funds with 12b-1 plans grow faster than Funds with 12b-1 plans grow faster than

funds without themfunds without them Shareholders do not gain benefits in the Shareholders do not gain benefits in the

form of lower average expensesform of lower average expenses Shareholders are paying the costs to Shareholders are paying the costs to

grow the fund, but fund adviser is the grow the fund, but fund adviser is the beneficiary from the growthbeneficiary from the growth


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Mutual Fund

Shareholders

Board of Directors

Fund Providers(Investment Adviser)

PrincipalUnderwriter

Administrator Transfer

Agent

Custodian Independent

Public

Accountant

Structure of a Mutual FundStructure of a Mutual FundOwners of Fund Providers


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Major Cause: Idiosyncratic Fund Governance System

Fund Providers: Caught between Two MastersFund Providers: Caught between Two Masters BOD’s Fiduciary Duty: Inadequate PerformanceBOD’s Fiduciary Duty: Inadequate Performance

Are directors serving as Are directors serving as the stewards of shareholders’ investments?

They rather act at the behest of the advisory and management companies

BOD is supposed to negotiate lower fees for their shareholders

BOD is supposed to oversee investment advisers The Chairman of the BOD is usually a senior member of

the owner of the fund provider Directors sometimes serve on dozens or more fund

boards and often join the fund board after retiring from a job at the management company


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Congressional Efforts

The Mutual Fund Reform Act of 2004The Mutual Fund Reform Act of 2004 Promoting Fiduciary Fund Governance Promoting Fiduciary Fund Governance Promoting Transparency & DisclosurePromoting Transparency & Disclosure Eliminating 12b-1 FeesEliminating 12b-1 Fees Prohibiting Shadow Transactions Prohibiting Shadow Transactions Requiring Enforceable Market Timing Policies Requiring Enforceable Market Timing Policies

and Mandatory Redemption Fees and Mandatory Redemption Fees


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Reform Measures by US SEC (I) To Stop Late Trading: A Hard 4 ProposalTo Stop Late Trading: A Hard 4 Proposal

All fund transactions be received before 4:00 p.m., All fund transactions be received before 4:00 p.m., EST in order for investors to receive the same EST in order for investors to receive the same

day’s priceday’s price To Curb Short-Term Trading (including Market To Curb Short-Term Trading (including Market

Timing)Timing) A mandatory 2%-fee on the proceeds of fund shares A mandatory 2%-fee on the proceeds of fund shares

redeemed within 5 business days of purchaseredeemed within 5 business days of purchase SEC has shelved this proposal. It considers recommending SEC has shelved this proposal. It considers recommending

that funds adopt fees voluntarilythat funds adopt fees voluntarily A greater disclosure of market timing, securities pricing, and

portfolio disclosure policies New guidance issued: mutual funds may delay exchanges of New guidance issued: mutual funds may delay exchanges of

shares from one fund to another in order to combat market shares from one fund to another in order to combat market timingtiming


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Reform Measures by US SEC (II)

For Improved Governance and Oversight Independent Chairman75% of BOD: Independent (currently 40%)

Appointment of Compliance Officer reporting to BOD

Independent Directors meet at least quarterly in a separate session

Independent Directors authorized to hire employees and others to fulfill their fiduciary duties


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Reform Measures by US SEC (III) Disclosure in Prospectuses Disclosure in Prospectuses

risks to shareholders of frequent purchases and risks to shareholders of frequent purchases and redemptions of sharesredemptions of shares

policies and procedures regarding frequent purchases and policies and procedures regarding frequent purchases and redemptions of sharesredemptions of shares

circumstances under which they will use fair value pricing circumstances under which they will use fair value pricing and the effects of using fair value pricingand the effects of using fair value pricing

policies and procedures with respect to the disclosure of policies and procedures with respect to the disclosure of their portfolio securities and any ongoing arrangements to their portfolio securities and any ongoing arrangements to make available information about their portfolio securitiesmake available information about their portfolio securities

Broker-dealers disclose revenue Broker-dealers disclose revenue sharing payments from Mutual Fundssharing payments from Mutual Funds

Prohibit Directed Brokerage ActivitiesProhibit Directed Brokerage Activities


Thank You!For Further References,

Please visit http://www2.hawaii.edu/~rheesg


Mutual Funds Scandals in the U.S. Market: Causes and Reform ...

Economy & Finance

Transcript of Mutual Funds Scandals in the U.S. Market: Causes and Reform ...