Rocked by late-trading and market-timing scandals in 2003, the embattled mutual fund industry faces a regulatory overhaul this year.
"It's not easy to guess what's going to come out the other end after all is said and done, but clearly it's going to be a more open, more shareholder-oriented industry," said Russ Kinnel, director of funds research at Morningstar Inc., an independent fund research and analysis company in Chicago.
Though influential industry officials have resisted past attempts to reform the $7.2 trillion mutual fund business, 2004 will be different, analysts said. The call for change - to make it harder for fund managers and their large clients to game the system to their advantage - is coming from all angles. With mounting evidence of industry abuses that have cost investors millions of dollars, both the Securities and Exchange Commission and members of Congress are weighing new rules and legislation that will shed more light on industry fees while making directors more accountable to shareholders.
At the same time, regulators in New York, Massachusetts, Colorado and other states are going after fund companies within their jurisdictions, forcing several to institute new shareholder-friendly policies and, in at least one case, lower fees as punishment for trading scandals.
New York Attorney General Eliot Spitzer is leading the movement. He called attention to the industry's sins in September, when he exposed market-timing and illegal late-trading practices at hedge fund Canary Capital Partners. Since then, even the Investment Company Institute, a mutual fund industry trade group that has lobbied against past reform proposals, has called on the industry to get behind rules that the SEC has proposed in an effort to curb abuses.
"The scandals are horrifying and I'm outraged by them, but I think people are dealing with them and I think it will probably be a better industry a year from now," said Matthew P. Fink, president of the trade group.
The SEC is well on its way to changing the way mutual funds do business. The agency is taking public comment on new rules that will require investors to place trades in mutual funds before the 4 p.m. close of trading. Any trades that come in after that time will be posted at the next day's share price, which is usually set daily at 4 p.m.
The rule is designed to prevent middlemen from posting buy and sell orders after markets have closed, a practice that allows them to take advantage of potentially market-moving news that occurs after the closing bell.
"This was a huge loophole in the system, yet I think very few people knew about it except for some clever hedge funds," Kinnel said.
Federal regulators also are going after market timers, who trade in and out of funds rapidly in order to take advantage of small moves in the share price. While not necessarily illegal, the practice hurts long-term investors by forcing fund managers to keep more of their assets in cash in order to satisfy frequent redemptions.
Most mutual funds have rules against market timers, but regulators have discovered numerous cases in which the rules were bent to favor large investors. Congress and the SEC are demanding that mutual fund companies adopt clear policies and enforce them equally for all investors.
In addition, legislation coming out of the House and Senate will require mutual funds to disclose their fees in dollar terms, rather than listing them as a percentage of fund assets. Funds also will be forced to place more independent directors on their boards - a move that proponents say will remove conflicts of interest and spur boards to negotiate with management companies for lower fees. "They have a cultural norm within these boards of sort of having an audit function ... but rarely, if ever, making waves and rarely, if ever, entering into true arms-length negotiations with either management companies over their fees or with brokers over their ... sales charges," said Gary Gensler, a Treasury Department undersecretary in the Clinton administration and co-author of The Great Mutual Fund Trap.
Gensler is skeptical that Congress and the SEC will do enough to protect investors. But analysts say the regulations under consideration might prove to be a first step in a longer process. Said Jeff Tjornehoj, a research analyst for Lipper Inc., "There's a whole lot of momentum now for reform, and I can't see what sort of occurrences would force regulators and legislators to change their minds on this."
TIMELINE
1940
Investment Company Act of 1940 establishes rules to protect investors in mutual funds and other instruments.
2003
New York Attorney General Eliot Spitzer exposes late-trading and market-timing abuses.
2004
Securities and Exchange Commission and Congress expected to impose new regulations to protect mutual fund investors.