Mutual Funds, Fee Transparency, and Competition

Article excerpt

The mutual fund industry has attracted widespread media attention in recent months. A day rarely passes without a story about alleged fund misdeeds or proposed remedies. The breadth of the scandal raises a serious question about the need for actions that might strengthen and protect the public's trust in the integrity of mutual funds. In light of these concerns, the Securities and Exchange Commission and Congress are considering remedies aimed at reducing the likelihood of future abuses.

The scandal has also brought scrutiny to fund fees and costs, raising questions about the adequacy of competition as a disciplinary force. Federal Reserve Board Chairman Alan Greenspan and Treasury Secretary John Snow pointed to this concern when they urged legisla- tors, as they consider possible reforms, to "make sure that the fees associated with mutual funds are subject to competitive tests of the market place." The issue centers on whether the rules governing fee disclosure ensure that mutual fund fees are exposed to these tests.

One reason the mutual fund market may not be adequately competitive is that not all investors have what would be considered "sufficient" information, and such a deficiency can result in undesirable outcomes, like some investors paying more for identical products. Changes imposed on the mutual fund marketplace need to address this information deficiency, and new rules for improved disclosure are a step in the pright direction.

* Mutual Fund Basics

Mutual funds are investment companies that collect savings from many individual investors and invest those savings in a wide range of financial assets or securities. The funds' pooling of individual savings makes it possible for small investors to obtain fractional shares of many different securities and thereby enables them to gain the benefits of diversification and lower transaction costs. For households with limited wealth, mutual funds provide one of the only practical means to own a diversified portfolio of stocks and bonds. It is well established that owning such a portfolio provides significant advantages for building a retirement nest egg.

Mutual funds come in many varieties. For, example, there are mutual funds for stocks, bonds, money market instruments, and combinations of themcommonly called hybrids. Many varieties exist within these general classes. Some stock funds, for example, invest broadly in an effort to produce yields close to market indexes, such as the S&P 500 or the Wilshire 5000. Others differentiate according to prespecified investment criteria such as size (large, medium, or small firms), and style (value, growth, or blend). Moreover, some funds specialize in sectors of the economy, such as information technology or biomedicine, while others may invest in international portfolios.

When held over long periods of time, broad portfolios of stocks and bonds have produced returns that substantially exceed the interest rate paid on less risky assets such as short-term U.S. Treasury bills or hank deposits. So, to the extent that mutual funds have made it possible for the small investor to participate in the stock and bond markets, they have enabled small investors-in principle at least-to earn higher returns on their savings.

The virtues of mutual funds have become widely recognized, with household participation increasing dramatically over the last 25 years. Fund assets have increased from less than $1 trillion in 1980 to more than $7 trillion today. Stock funds currently account for about $3.5 trillion-or half the value of all funds. The sheer magnitude of these numbers suggests that the ongoing reassessment of the adequacy of market discipline is no small matter.

* Elements of Competition

Highly competitive markets are generally characterized by four basic elements: First, they often have many buyers and sellers. Having many participants reduces the power of anyone (buyer or seller) to dictate his own price. …