Smith Faculty Opinion Article

August 10, 2006

The following article is reprinted with the permission of the Journal of Indexes, which is the publication of record for the index industry. Any rebroadcast or distribution of this content requires the expressed permission of the Journal of Indexes. All Journal of Indexes content, including past columns by Professor Haslem can be accessed on www.indexuniverse.com/JOI

Indecent Disclosure
The need for normative transparency of mutual fund disclosure

by John Haslem

The past few years have been a nightmare for far too many investors. After suffering through the implosion of the stock market bubble, investors were sucker punched with revelations of fraud, greed and pervasive conflicts of interest at the very financial institutions they were supposed to trust. From greedy corporate executives to hear-no-evil mutual fund managers, corporate America failed its investors.

The world of mutual funds didn't escape the problems of abuse; in fact, it was in the center of it. As fund investors learned, they had been getting the short end of the performance stick over the past few years, as hedge funds and other short-term traders skimmed money off the top with
techniques like market timing, front running and late trading. Mutual fund managers aided and abetted their actions, either directly or softly, through techniques like selective disclosure. Lauricella (2003) quotes New York Attorney General Eliot Spitzer in the Wall Street Journal stating that the . . . breach of fiduciary duty is appalling. And indeed it was.

Following the major uproar surrounding the mutual funds scandals and the corresponding publicity of trials, Congressional hearings and regulatory actions, the consensus of public opinion would appear to be that fund shareholders need and deserve much more in the way of protection and disclosure. We have seen highly publicized legal actions to punish the perpetrators of these misdeeds, along with a raft of initiatives aimed at improving the laws and
regulations protecting investors. Still, objective students of the mutual fund industry agree that real problems remain.

The trouble is, much of the furor over the scandals has waned. And before it disappears entirely, its time to ask: What are shareholders still owed in the way of fiduciary protections and disclosures? Here are some answers:

First, mutual funds owe shareholders fiduciary protection of the huge amount of money invested in their funds. The Investment Company Institute (ICI) in 2005 reported that 92 million individuals in 54 million households held fund assets of $8.6 trillion, and that number is growing. Mutual funds play a key intermediation role between Main Street and Wall Street.

Second, as Morningstar's Don Phillips observed in Congressional testimony in 2004, mutual funds have foolishly jeopardized the publics trust, their largest asset. As a result:

. . . it would behoove the industry to redouble its commitment to the effective stewardship of the publics assets. [T]he recent scandals make it abundantly clear that too many people in this industry were willing to forsake their responsibility in exchange for short-term personal profit. Sadly, these...were violations of trust that took place at the highest levels, including [among] company founders, CEOs, portfolio managers and several current or former members of the Investment Company Institutes Board of Governors.

Fund investors deserve better.

Third, much yet remains to be done in actually providing mutual fund shareholders with the broad protections they already have in theory under the Investment Company Act of 1940 (the 1940 Act). The 1940 Act states that the national public interest and the interest of investors is adversely affected . . . when investment companies are organized, operated, or managed in the interest of investment advisors.

And yet, that is exactly what has happened investment companies have been organized with the investment advisors in mind. There is still time for Congress and the Securities and Exchange Commission (SEC) to reassert the intent of the 1940 Act to guide the greatly needed improvements in mutual fund regulation and disclosure. The 1940 Act holds independent fund directors responsible for selecting investment advisers who will maintain effective legal separation between themselves and shareholders, but this degree of separation has not been achieved. Independent fund directors have not been effective fiduciaries in their legal roles as shareholder watchdogs.

Transparency In Governance
For investors to have the protection they deserve, they must first have the transparency in disclosure to allow them to make reasoned decisions.

In the broader scheme of things, transparency has become accepted in its own right as an inherent component of good public and private governance. The key issue is no longer whether or not transparency is desirable, but rather, how domestic and foreign publicly traded firms, nonprofit organizations and governments can better achieve transparency.

In the mutual fund world, there is still much work to be done. To move toward normative transparency, all of the players lawmakers, regulators, fund independent directors, managers and advisers must give shareholders their legal due as fund owners.

The transparency issue assumes particular importance in the mutual fund world because of the principal-agent problem, which arises when work is delegated to others. When a principal hires an agent to perform tasks on his behalf, he cannot be sure that the agent will perform the tasks precisely as he would like. The agents decisions and performance are expensive to monitor. The principal-agent problem is a major problem in the mutual fund world, where the
incentives to shareholders and the short-term incentives to fund managers are quite different. That puts an absolute premium on transparency. What, exactly, is transparency? Vishwanath and Kaufmann (1999) of the World Bank define transparency (broadly) as the increased flow of timely and reliable economic, social and political information, which is accessible to all relevant stakeholders.

Bellver and Kaufmann (2005) state that for information to be transparent it must also be accessible, relevant, reliable and of good quality. In other words, transparency means institutional openness, which, for mutual funds, requires that shareholders be able to monitor and evaluate the actions of fund advisers and managers. Current fund disclosure falls well short of meeting this test.

The Need For Normative Transparency
One of the major objectives of the 1940 Act is to ensure that investors receive adequate and accurate information. However, mutual fund shareholders have yet to receive either in a normative fashion. It is this need for normative transparency of disclosure that drives this study. That is, this study focuses on the should be of fund disclosure, especially as regards the true and full fees that fund investors pay, above an beyond the expense ratio listed in their prospectus.

As the recent mutual fund timing scandal reminded us (and as we should have known all along), stated expenses are not the only things detracting from returns. Beyond the relatively transparent sales loads and expense ratios, investment advisory fees, other expenses and especially transaction costs are much less transparent if at all in the latter case. Investment advisory fees and other expenses are deducted from fund assets, while transaction costs add to the costs of purchased portfolio securities and reduce net sales prices. Fund disclosures under current industry practice and regulatory requirements are too often incorrect, incomplete, missing, misleading or perfunctory. These fees should be laid out to shareholders in clear and simple language.

Positive Versus Normative Transparency
The first approach to defining mutual fund transparency of disclosure is positive (a.k.a. what is) transparency. In this case, a funds degree of transparency is identified relative to current laws and regulations, and compared to the industry composite. This approach requires an initial transparency analysis of each fund. The adequacy of positive transparency has long been debated, but the fund timing scandal provided strong evidence that much more than positive
disclosure under current laws and regulation is required.

The second approach to defining mutual fund transparency of disclosure is normative (a.k.a. should be) transparency. As defined here, normative transparency refers to the degree of proactive voluntary disclosure and revised legal and regulatory disclosure required for mutual fund shareholders to have all the information they need to make efficient fund investment decisions.

This definition provides a test consistent with the classic finance proposition that corporations should maximize the value of their shares. As applied here, the test of whether particular information should be disclosed is a function of whether such disclosure enhances the ability of shareholders to make normative fund investment decisions. It should be noted that any restrictions on the actions of a fund that negatively affect the shareholders ability to make normative investment decisions are subsumed by normative transparency.

If Congress and the SEC enact laws and regulations requiring normative transparency of disclosure, nothing further should be required. But while additional laws and regulatory disclosure are likely to be forthcoming, it is most unlikely that the political process will achieve normative transparency. Instead, the political obstacles are much more likely to be overcome if individual funds and the fund industry work vigorously, voluntarily and proactively in cooperation
with Congress and the SEC to reach this goal.

Even with this cooperation, however, it will be difficult for the industry to reach true normative transparency. Further, what is normative transparency of disclosure today will evolve over time, as fund, industry, legal, regulatory and shareholder conditions change. Thus, there is a need
for a study to lay out the benchmark for what makes for true normative transparency, as a stimulus to achieving real normative transparency of fund disclosure over the long haul. That is the goal of this study.

Cost To Achieve
The achievement of normative transparency for individual mutual funds should not be as difficult or expensive as most fund managers are likely to claim. After all, funds are now required to have regulatory compliance staff on board, and, to a large degree, much of the information required for normative transparency is, or should be, available in written or oral form already. For example, the record of the topics, deliberations and decisions of fund directors and committees should include much of what is needed for normative transparency of disclosure. There may be a need for more analysis and explanation of the decisions made, but that is
a marginal difference.

Normative transparency of mutual fund disclosure will not prevent shareholders from making investment mistakes, but it will at least enhance their potential for making informed buy/sell decisions. It also will help attract patient, long-term investors. As noted in Haslem (2003), such shareholders should know whether portfolio managers are investing with them in the fund portfolios. In turn, these patient shareholders are more likely to favor funds with a long-term focus and transparency in disclosure. The result is that these funds are more likely to have fewer share redemptions during times of poor returns and the inevitable surprises along the way.

Normative Transparency Of Costs And Expenses
The achievement of normative transparency of disclosure with respect to mutual fund costs and expenses requires revised law and regulations. But pending these actions (or lack thereof), fund advisers, managers and independent directors must voluntarily, proactively and collectively
pursue the goal.

Mutual fund disclosure should, of course, include the expense ratio. The expense ratio has three categories: (1) management fees, (2) Rule 12b-1 fees, and (3) other expenses. Management fees constitute the largest part of the expense ratio, and include investment advisory fees for portfolio management and administrative or other fees paid to the investment adviser or its affiliates. Rule 12b-1 fees include marketing, distribution and other fees spent according to this rule. Meanwhile, other expenses are a residual component that may include transfer fees, securities custodian fees, shareholder accounting fees, legal fees, auditor fees and independent director fees.

Normative transparency also requires revised percentage disclosure of the expense ratio and its categories and subcategories, but with some definitional changes to standardize fund reporting. Management fees should include subcategories of investment advisory fees, and other service provider fees paid to the investment adviser/affiliates. Of these, investment advisory fees are of prime concern. No changes are needed in the 12b-1 fees category. "Other"
expenses should include subcategories of service provider fees paid to parties other than the investment adviser/affiliates, and residual fund expenses. The expense ratio, as well as its categories and subcategories, also should be stated as a cost per account on each shareholder statement. (For a look at the empirical and policy treatment of excessive fund
expenses, see Haslem (2003, 2004a, 2004b, 2006), Haslem, Baker and Smith (2005, 2006a, 2006b), and Haslem, Smith and Baker (2007). Haslem (2005) provides guidance on identifying
fund advisors and funds that are both superior performers and likely to remain shareholder stewards.)

A fourth, and as yet undisclosed, expense category is transaction costs. Contrary to misinformed opinion, transaction costs have been and can be closely estimated (Haslem 2006). These costs also have been found to be exceedingly large relative to the size of expense ratios. The costs of portfolio turnover and its magnifying effect on transaction costs are often overlooked. Transaction costs are not currently included in the expense ratio, but they do reduce portfolio returns.

Normative transparency would require the percentage, asset-based disclosure of transaction costs, as well as its two subcategories: brokerage commissions and implicit trading costs (bid-ask spread, plus market impact). Transaction costs and its subcategories should be disclosed alongside the expense ratio, and computed comparably. These also should be stated as to the cost per account on each shareholder statement.

Normative Transparency Of Fund Practices And Prohibitions
Real normative transparency requires the disclosure of the issues, analysis and decisions of mutual funds and their independent directors. Normative transparency requires complete disclosure of fund policies and practices for multiple share classes, including potential and actual charges. Conflicts of interest have been found in the sale of Class B shares, where 12b-1 fees can make these shares much more expensive than Class A shares for longer-term investors. Without waiting for potential regulatory actions, and until the SEC acts, fund independent directors should prohibit Class B shares, as well as other actions that hurt shareholder returns, including the existence of hedge fund accounts without prior approval, the selling of shares through no transaction fee fund supermarkets that actually add to fund expense ratios, market timing and, of course, illegal late trading. A number of steps must be taken.

First, Rule 12b-1 fees should be prohibited. These fees have no economic justification to fund shareholders, and they create inherent and costly conflicts of interest between fund advisers and shareholders. Rule 12b-1 fees are charged against fund assets to pay distribution expenses, including sales and brokerage fees, customer servicing fees, administrative expenses, advertising and promotion. Mutual fund advisers should pay the costs of acquiring new assets, as beneficiaries of the larger amounts of advisory fees. Fund advisers have not substantially shared with shareholders the much-promised savings from the economies of scale that come with greater assets. As a result, for shareholders, 12b-1 fees are deadweight costs they pay on a continuing basis.

Rule 12b-1 fees have also provided the basis for offering multiple classes of fund shares with various confusing labels and cost packages. Fund advisers often promote Class B shares to reduce or remove front-end loads, but instead charge 12b-1 fees annually to shareholders. As mentioned, these fees reduce fund returns. Independent directors should prohibit Class B shares because they are more costly than Class A shares for longer-term investors.

Second, soft-dollar arrangements should be prohibited. Soft dollars also have no economic justification for mutual fund shareholders, and they create inherent and costly conflicts
of interest between fund advisers and fund shareholders. They also reduce fund returns. These arrangements require funds to pay broker/dealers larger brokerage fees than competitively required for the trades they execute. Brokers use these bonus brokerage fees the soft dollars to provide fund advisers with some proportion of the bonus in the form of in-kind research products and services (and not always legally so).

Soft dollars represent undisclosed trading costs and result in misleadingly stated lower expense ratios, because transaction costs are not currently broken out. Fund advisers should pay cash for the research products and services they actually (rather than might) need. If independent research is truly worthwhile, then these firms will not require soft-dollar payments to survive.

How much do soft-dollars cost investors? As expected, Conrad, Johnson and Wahal (2001) find brokerage commissions are higher for soft-dollar than full-service transactions. Further, they estimate the total execution cost differences between soft-dollar and full-service brokers to be 30 basis points for buys and 25 basis points for sells. Other studies confirm this, or push the numbers higher still (see Steil and Perfumo, 2003).

Third, revenue sharing agreements should be prohibited. Revenue sharing has no economic justification for mutual fund shareholders, and it creates inherent and costly conflicts of interest between fund advisers and shareholders, and between broker/dealers and their clients. Revenue sharing simply represents wholesale marketing costs to fund advisers, whereby they pay for shelf space at brokerage houses to gain preferred (or not) access to brokers and their customers. Blake (2001) provides an excellent inside review of revenue sharing and the lack of real disclosure about it to fund shareholders.

These selling-group contracts require mutual fund advisers to make specified dollar payments to broker/dealers in return for the promotion and sale of their fund shares. The payments are normally based on a percentage of annual broker sales of fund shares, a percentage of dollars of fund shares held in broker customer accounts, payments for special events, and straight dollar payouts. These payments may exceed $50 million annually for the average fund company.

Revenue sharing payments are paid directly from mutual fund adviser assets, but their increasing size, given the increasing size of fund assets, makes it likely or possible that some portion of these dollar costs gets shifted over time to fund expense ratios. If so, the result is larger than-operationally-required expense ratios paid by current shareholders on a continuing basis. Some revenue sharing payments may also be included in 12b-1 fees.

Fourth, market timing should be prohibited for its obvious conflict of interest problem, which results in several billion dollars in annual costs to long-term mutual fund shareholders. While market-timing arbitrage has been well known in the industry for decades, nothing substantive has been done to prevent it in spite of the recent scandals. Some mutual funds have actually facilitated market-timing transactions by favored investors, even in cases where it is prohibited in the prospectus. In these cases the transactions are illegal, as are those cases of market timing by fund insiders. These market-timing transactions often are illegally transacted after the close of the trading day.

There are two types of regular mutual fund market timing. In the first type, the market timer buys fund shares in expectation of selling them at a profit within a few weeks to several months; the market timer anticipates a short-term upward movement in fund share prices. In the second type, the market timer buys fund shares in expectation of selling them at a profit within a day or so. This market timer anticipates a very short-term gain using arbitrage. This type of market timing should be restricted by significant redemption fees on very-short-term, round-trip transactions.

Both types of market timing cost investors, as funds are forced to hold more cash than otherwise needed in order to be able to execute fast timer trades promptly. This additional cash has the effect of lowering fund performance in bull markets.

The latter type of mutual fund market timer would normally use stale-price arbitrage, which takes advantage of the real-time difference between when foreign and domestic exchanges close. Funds price foreign securities at the close of the domestic trade day using the prices at
the end of the earlier foreign exchange trade day. Foreign security prices are therefore stale by the time the funds price their portfolios. If market events after the close of the foreign exchange foretell a sharp and immediate increase in foreign stock prices the next trading day, arbitrageurs then buy mutual fund shares priced at the close of the domestic trading day, and prepare to flip them the next day.

To further defuse the motivation for market timing, fair value pricing should be required for mutual funds. This pricing can help insure against the discounted Net Asset Value (NAV) share prices and reduced fund returns that arise from market timing. Fair-value pricing is shorthand for the use of sophisticated pricing tools to estimate, for instance, what the prices of foreign stocks would be if the foreign exchange closed at the same real time as the domestic exchange. Fair value pricing would thus be required for funds that hold foreign securities. Currently, the SEC requires its use where markets do not provide continuous prices or prices are not deemed reliable.

The requirement for fair-value pricing, if vigorously enforced and applied, would help limit the potential profits of mutual fund market timers who are successful in buying shares. However, for fair-value pricing to be effective as a regulatory tool, its application must be consistent across all mutual funds. For this to occur, the SEC must require a particular fair-value pricing methodology with specific and precise guidelines for use. Without this, fair-value pricing will continue to provide inconsistent results among funds.

Finally, the SEC should impose several other requirements to reduce the potential profitability of market timing. One requirement would impose significant redemption fees on very-short-term, round-trip transactions to reduce arbitrage profits. A second requirement would enforce a hard 4 p.m. close for trades of all kinds. This hard close would require all investor transactions to be received by the fund and time-dated before 4:00 p.m. Eastern time in order to be transacted at the closing price.

Phillips Approach To Disclosure
To complete the circle, let us return to the 2004 Congressional testimony of Morningstar's Don Phillips. Phillips states that mutual funds should prohibit or improve disclosure of numerous activities. He recommends ten actions to ensure that funds will not further betray the trust of fund investors, which I paraphrase here:

1) Eliminate abusive market timing and late trading.
2) Eliminate directed brokerage (now prohibited) and
improve disclosure of pay-to-play arrangements.
3) Eliminate soft-dollar arrangements.
4) Eliminate or reconsider 12b-1 fees.
5) Provide vigilant and properly funded regulatory
oversight.
6) Enforce director visibility and accountability to
shareholders.
7) Disclose portfolio manager trades in their portfolios.
8) Disclose portfolio manager compensation.
9) Improve disclosure of portfolio holdings.
10) Disclose the dollar amount of actual fund costs on
shareholder statements.

Conclusions
The Investment Company Act of 1940 states that the interests of shareholders are compromised when mutual funds are operated in the interest of fund advisers. In this regard, one of the Acts major objectives is to ensure that investors receive adequate and accurate information.

This study focuses on the achievement of normative transparency of disclosure. Normative transparency refers to the degree of proactive voluntary disclosure and revised legal and regulatory disclosure required for mutual fund shareholders to have all the information they need to make efficient fund investment decisions.

Normative transparency requires changes in the current practices of individual funds across the fund industry, as well as changes in current laws and regulation. To attain normative transparency in mutual fund disclosure, Congress and the SEC, as well as fund advisers, managers and independent directors, must voluntarily and collectively become more proactive in serving and protecting shareholders. Basically, the achievement of fund normative transparency rests with independent directors who are proactively motivated and further
empowered to vigorously pursue their fiduciary mandate as shareholder watchdogs.

References
Bellver, Ann and Daniel Kaufmann, Transparenting Transparency: Initial Empirics and Policy Applications, working paper, The World Bank, Washington, D.C., 2005.
Bicksler, James L., Mutual Funds Debacle: Economic Foundations, Fundamental Problems and First Step Governance Reforms, working paper, Rutgers University, 2004.
Blake, Rich, How High Can Costs Go? Institutional Investor, May 2001, pp. 56ff.
Bogle, John C., Common Sense in Mutual Funds: New Imperatives for the Intelligent Investor, New York: John Wiley & Sons, 1999.
Bogle, John C., The Mutual Fund Industry 60 Years Later: For Better or Worse? Financial Analysts Journal 61, January/February 2005, pp. 15-24.
Conrad, Jennifer S., Johnson, Kevin M. and Sunil Wahal, Institutional Trading and Soft Dollars, Journal of Finance 56, February 2001, pp. 397-416.
Haslem, John A., Mutual Funds: Risk and Performance for Decision Making, Oxford: Blackwell Publishing, 2003.
Haslem, John A, Are Mutual Fund Expenses Too High? A Commentary, Journal of Investing 13, Summer 2004a, pp. 8-12.
Haslem, John A., A Tool for Improved Mutual Funds Transparency, Journal of Investing 13, Fall 2004b, pp. 54-64.
Haslem, John A., Investing in Fiduciary Mutual Funds: How to Improve the Odds, Journal of Investing 14, Winter 2005, pp. 63-68.
Haslem, John A., Assessing Mutual Fund Expenses and Trading Costs, Journal of Investing 15, Winter 2006, forthcoming.
Haslem, John A., and David M. Smith, Excessive Mutual Fund Expenses also Mean Higher Risk and Worse Performance, Journal of Indexes 7, July/August 2005, pp. 40-41, 50.
Haslem, John A., Baker, H. Kent and David M. Smith, Are Retail S&P 500 Index Funds a Financial Commodity? Insights for Investors, Financial Services Review 15, Summer
2006a, forthcoming.
Haslem, John A., Baker, H. Kent and David M. Smith, S&P 500 Index Funds: Diverse Expenses and Performance Characteristics, under review, Journal of Indexes 8, 2006b.
Haslem, John A., Baker, H. Kent and David M. Smith, Identification and Performance of Equity Mutual Funds with Excessive Management Fees and Expense Ratios, Journal of Investing 16, Spring 2007, forthcoming.
Investment Company Institute, Enhancing a Culture of Independence and Effectiveness, Report of the Advisory Group on Best Practices for Fund Directors, Washington, D.C., June 24,1999.
Investment Company Institute, Investment Company Fact Book, Washington, D.C., 2005.
Phillips, Don, Phillips Senate Testimony: Morningstar Proposes 10 Steps to Reform the Mutual Fund Industry, Morningstar.com, February 25, 2004.
Steil, Benn and Diego Perfumo, The Economics of Soft Dollar Trading, New York: Efficient Frontiers, LLC, November 2003.
United States General Accounting Office, Mutual Funds: Additional Disclosure Could Increase Transparency of Fees and Other Practices, statement by Richard J. Hillman. Washington,
DC, June 18, 2003.
Vishwanath, T. and D. Kaufmann, Towards Transparency in Finance and Governance, working paper, The World Bank, Washington, D.C., 1999.

This article is reprinted with the permission of the Journal of Indexes, which is the publication of record for the index industry. Any rebroadcast or distribution of this content requires the expressed permission of the Journal of Indexes. All Journal of Indexes content, including past columns by Professor Haslem can be accessed on www.indexuniverse.com/JOI

John A. Haslem, Professor Emeritus of Finance, served as the founding academic affairs dean and founding chair of the finance department. His mutual funds analysis course was the first in the finance curriculum of a collegiate school of business. He also taught at the University of North Carolina and on the faculty of the University of Wisconsin.