Mutual Fund Monday - Dagen McDowell

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The Right -- and Wrong -- Steps to Reform the Fund Industry

Dagen McDowell

Regulators, politicians and at least one investing legend have recently turned their attention to problems they see in the mutual fund industry -- from excessive fees to ineffective boards.

They're a tad late.

These issues have been around for years. But the market's collapse and ensuing investor outrage have finally spurred this country's leaders to examine the fund business.

And now they're on the verge of taking this crusade too far. The fund industry has some obvious flaws that need fixing, but it does not need a major makeover. These well-intentioned reformers are turning some molehills into mountains.

Some of these initiatives do deserve your attention and should benefit you as a fund investor. The rest you can ignore.

Useful: Making Brokers Cough Up Rebates on Front-End Loads

Last week, regulators released a report that revealed brokerage firms have been routinely overcharging investors who buy funds that carry upfront sales charges. The more money you invest in a fund with a front-end load, the lower that sales charge is supposed to be. For example, an upfront sales charge of 5.75% could fall to 5.5% if you invest between $25,000 and $50,000 in a fund.

As it turns out, these discounts were not being passed on to many investors who were buying load funds. The report found that almost one in three transactions that were eligible for discounts didn't get one.

The regulators insist that those investors will get reimbursed. Plus, they are continuing to study the problem and promise to punish those brokers who were intentionally overcharging their customers.

Catching and policing this problem can only help investors. With the proliferation of load funds over the past few years, the fund industry has turned into a swamp of confusing share classes and purchase options. More than one third of investors now buy funds from a broker.

The brokerage firms, fund companies and regulators need to be more diligent in making sure that investors aren't getting fleeced when buying load funds.

But this recent revelation should also be a reminder to double-check the fees and commissions on any fund you're buying -- whether using a broker or not. Every fund prospectus has a fee table in it, which explains the costs of purchasing and owning a fund. Every prospectus has to include the costs of owning a fund over several time periods, based on a hypothetical $10,000 investment and a 5% annual return.

And if you're investing through a broker, you should ask the guy if you can or did qualify for a reduction in the sales charge. That's what he's there for: To answer your questions and give you decent advice.

Useful: Greater Attention to Fees in General

Expenses have always been an important consideration when buying a mutual fund. But after three years of losses in the market and years ahead that might only deliver single-digit gains, costs have become even more critical.

A fund's expenses are the one constant you can count on. You don't know if a manager will stick around or if a few stocks will blow up. But you can easily figure out how much money won't wind up in your pocket every year. The less you pay in expenses, the more money you get to keep.

And the more attention fees receive from people outside the fund business the better. Rep. Michael Oxley (R., Ohio), chairman of the House Financial Services Committee, wants to know why fund expenses are going up, while the funds themselves have been busy losing shareholder money.

Vanguard founder Jack Bogle is being as vocal as ever about the exorbitant fees that fund companies charge investors. The average U.S. stock fund charges investors close to 1.5% a year. But if you listen to Bogle, those fees are almost double that when you factor in additional costs such as trading. And in a market where you might be lucky if you make 5% a year, a fund's costs would be eating up more than half of your return.

If this uproar makes you more mindful of how much you pay for a fund, then it's accomplished something. If it shames the fund industry into cutting its fees, even better.

Useless: Disclosure of Proxy Votes and More Frequent Release of Fund Holdings

Over the last year, the Securities and Exchange Commission has been busy trying to clean up corporate America and its own reputation following all those nasty, embarrassing business scandals. And the agency hasn't left the mutual fund industry untouched.

The SEC is making mutual funds reveal how they vote on shareholder proxies, covering issues like executive pay. It also plans to require funds to release their portfolio holdings every quarter rather than every six months.

In theory, maybe more information is better. But will this increased disclosure help you as a mutual fund investor?

Nope.

How a fund company votes on proxies shouldn't have any bearing on whether you buy that fund or not. You examine a fund's expenses, risk, track record, management and strategy before you buy it. Those are the things that are important. Knowing how a management team voted on Coca-Cola's(KO Quote) most recent proxy is not going to help you make better fund choices.

The same thinking applies to more frequent disclosure of a fund's entire portfolio. Seeing all the holdings in a fund only twice a year is perfectly sufficient.

Some people will say: But I want to know what the manager owns. Well, you can get a good sense of what the fund holds by looking at the top 10 list, which you can get more frequently. Plus, you don't invest in a mutual fund to second-guess the manager. The professional is the stock-picker, not you. And if the manager has bought into one too many disasters, you'll quickly see it in the fund's performance. You don't need to comb through a list of holdings to figure out if a fund stinks or not.

If something should be added to regular fund reports, it's more information about the fees. And thankfully, the SEC is pushing for that.

Useful: Making Fund Boards More Accountable

Billionaire and investor extraordinaire Warren Buffett had some choice words for mutual fund directors in his annual missive out of Omaha. "These directors and the entire board have many perfunctory duties, but in actuality have only two important responsibilities: obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee," Buffett writes in his annual letter to Berkshire Hathaway(BRK.A Quote) shareholders. "Yet when it comes to independent directors pursuing either goal, their record has been absolutely pathetic."

He's right. But where's he been? Fund boards have always ruled with a rubber stamp. They rarely change a fund's advisor or close a fund. That's no different today than it was during the nineties.

People always say that shareholders could simply vote with their feet and dump a fund if they didn't like what they got. But today more investors are locked into fund choices through 401(k) plans and could use someone looking out for their best interests.

If Buffett can actually goad independent directors into being more responsible, then more power to him.

Here's another idea: The directors' names, addresses and occupations are already included in a fund's statement of additional information, which you have to request from the fund company. If fund firms would just print this information in every semiannual report -- along with each director's photo and home phone number -- then those boards might start behaving a little more responsibly.