Mutual Fund Scandals in the U.S. Market: Causes and ...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%)

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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 DirectorAsiaAsia--Pacific Financial Markets Research CenterPacific Financial Markets Research Center

University of University of HawaiHawai‘‘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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Global Mutual Funds

100.00%13,958World TotalWorld Total

88.72%12,383Top 10 TotalTop 10 Total

1.98%276GermanyGermany

2.42%338CanadaCanada

2.50%349JapanJapan

2.58%360IrelandIreland

2.84%397United KingdomsUnited Kingdoms

3.43%479ItalyItaly

3.71%518AustraliaAustralia

7.91%1,104LuxemburgLuxemburg

8.22%1,148FranceFrance

53.12%7,414United StatesUnited States

PercentagePercentageNet AssetsNet AssetsEconomiesEconomies

Unit: US$ billionUnit: US$ billion


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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 CategoriesTotal 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%)


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Net Assets by Fund Categories

288.37288.37

1,763.311,763.31

183.16183.16

150.94150.94

300.79300.79

224.71224.71

27.5627.56

153.7153.7

200.06200.06

436.68436.68

1,308.261,308.26

517.7517.7

1,858.841,858.84

US$ US$ bnbn PercentPercentTypeTypeCategoryCategory

Money Market FundsMoney Market Funds

Bond FundsBond Funds

Hybrid FundsHybrid Funds

Equity FundsEquity Funds

3.89%3.89%TaxTax--ExemptExempt

23.78%23.78%TaxableTaxable

2.47%2.47%National MunicipalNational Municipal

2.04%2.04%State MunicipalState Municipal

4.06%4.06%Strategic IncomeStrategic Income

3.03%3.03%GovernmentGovernment

0.37%0.37%WorldWorld

2.07%2.07%High YieldHigh Yield

2.70%2.70%CorporateCorporate

5.89%5.89%Hybrid FundsHybrid Funds

17.65%17.65%Total ReturnTotal Return

6.98%6.98%Capital AppreciationCapital Appreciation

25.07%25.07%WorldWorld


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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 Mutual Funds are holding 22% of total U.S. retirement assets of US$12.0 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 PracticesLate Trading Late Trading Market TimingMarket Timing

Questionable Industry Practices Questionable Industry Practices Soft Dollar ArrangementsSoft Dollar ArrangementsDirected BrokerageDirected BrokerageRevenue SharingRevenue SharingExcessive Charging of Fund FeesExcessive Charging of Fund Fees


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Abusive Trading Practices

1.1. Late tradingLate tradingAllowed 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 tradingAmong 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 tradingtrading

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 frequently Greater transaction costs due to more frequently buy or sell shares of the underlying securities buy or sell shares of the underlying securities

2.2. Declining Investment Returns Over TimeDeclining Investment Returns Over TimeGreater percentage of cash holding in the fundGreater percentage of cash holding in the fund’’s s assets to meet demand for redemptionsassets to meet demand for redemptionsOver the long term, cash holding lower Over the long term, cash holding lower investment returnsinvestment returns

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

than longthan long--term shareholdersterm shareholdersWith price decline:With price decline: ShortShort--term traders lose less term traders lose less

than longthan long--term investorsterm investors


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Net Asset Value with and without Market Timing

Source: U.S. GAO (July 2004)Source: U.S. GAO (July 2004)Asia-Pacific Financial Markets Research Center, University of Hawaii

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Arbitrage Profits and Dilution of Fund Value

A.A. Arbitrage ProfitsArbitrage ProfitsAnnualized Arbitrage ProfitsAnnualized Arbitrage Profits

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

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

19981998 19991999 20002000 20012001International Equity FundsInternational Equity Funds 66 66 4646 6363 114114SmallSmall-- and Midand Mid--Cap Equity FundsCap Equity Funds 5959 5151 8181 147147LargeLarge--Cap FundsCap Funds 44 22 22 --11

Source: Source: ZitzewitzZitzewitz (2003)(2003)


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Questionable Industry Practices

Revenue SharingRevenue SharingSoft Dollar ArrangementsSoft Dollar ArrangementsDirected BrokerageDirected BrokerageExcessive Charging of Fund FeesExcessive Charging of Fund Fees


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Revenue SharingMutual fund gives a brokerage firm a share of its revenues if the firm's brokers promote the fund's shares to their customersRevenue 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 paymentsAs large of $2 billion per year? SEC and NASD proposed rules that would require SEC and NASD proposed rules that would require brokerbroker--dealers to disclose revenue sharing dealers to disclose revenue sharing payments that fund advisers make to brokerpayments that fund advisers make to broker--dealers to compensate them for selling fund dealers to compensate them for selling fund sharesshares


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Soft Dollar ArrangementsMutual fund pays a brokerage firm for research or other services in the expectation that the firm's brokers will promote the fund's productsCurrent 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 mutual Directed brokerage occurs when a mutual fund agrees to use a brokerage firm to buy fund agrees to use a brokerage firm to buy stock for its holdings if that brokerage firm stock for its holdings if that brokerage firm promotes the fund's shares to its other promotes the fund's shares to its other customerscustomersIn August 2004 SEC voted to prohibit mutual In August 2004 SEC voted to prohibit mutual funds from directing securitiesfunds from directing securities--trading as a trading as a reward for selling fund shares to investorsreward for selling fund shares to investors


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

Directly Charged to a Fund ShareholderDirectly Charged to a Fund ShareholderSales Charge (or Load)Sales Charge (or Load)Redemption FeeRedemption FeeExchange FeeExchange FeeAnnual 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 FeeDistribution (12bDistribution (12b--1) Fee1) FeeOther ExpensesOther Expenses


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Shareholder FeesSales Charge (or Load):Sales Charge (or Load):

FrontFront--end load when purchasing sharesend load when purchasing sharesBackBack--end load when selling sharesend load when selling shares

Redemption Fee:Redemption Fee:Paid to a fund to cover the costs involved Paid to a fund to cover the costs involved with a redemption, other than sales costswith a redemption, other than sales costs

Exchange Fee:Exchange Fee:Charged when an investor transfers money Charged when an investor transfers money from one fund to another within the same from one fund to another within the same fund familyfund family

Annual Account Maintenance Fee:Annual Account Maintenance Fee:Charged by some funds to cover the costs of Charged by some funds to cover the costs of providing services to lowproviding services to low--balance accountsbalance accounts


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Annual Fund Operating ExpensesManagement FeeManagement Fee

Charged by a fundCharged by a fund’’s investment adviser for s investment adviser for managing the fundmanaging the fund’’s portfolio of securities and s portfolio of securities and providing related servicesproviding related services

Distribution (12bDistribution (12b--1) Fee1) FeeSEC Rule 12bSEC Rule 12b--1 permits funds to debit 1 permits funds to debit shareholders' accounts to pay marketing and shareholders' accounts to pay marketing and distribution expensesdistribution expenses

Other ExpensesOther ExpensesFees paid to a fundFees paid to a fund’’s transfer agent for providing s transfer agent for providing various fund shareholder services, such as tollvarious fund shareholder services, such as toll--free phone communications, computerized free phone communications, computerized account services, website services, account services, website services, recordkeeping, printing, and mailingrecordkeeping, printing, and mailing


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More on 12b-1 Expenses (I)SEC Rule 12bSEC Rule 12b--1 has been in place since 19801 has been in place since 1980Original intention:Original intention:

Facilitate growth of funds and sharing cost Facilitate growth of funds and sharing cost savings from economies of scale could be passed savings from economies of scale could be passed along to investors along to investors

Some 12bSome 12b--1 fees are as high as 1% per year1 fees are as high as 1% per year aided by aided by questionable practices; 12bquestionable practices; 12b--1 fees have largely 1 fees have largely degenerated into disguised loads degenerated into disguised loads Mutual Fund Reform Act under Review by US Senate Mutual Fund Reform Act under Review by US Senate would statutorily repeal Rule 12bwould statutorily repeal Rule 12b--11Eliot 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 annuallyannually””


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More on 12b-1 Expenses (II)SEC Study (2004) by Lori WalshSEC Study (2004) by Lori Walsh

Funds with 12bFunds with 12b--1 plans grow faster than 1 plans grow faster than funds without themfunds without themShareholders do not gain benefits in the form Shareholders do not gain benefits in the form of lower average expenses or lower flow of lower average expenses or lower flow volatilityvolatilityShareholders are paying the costs to grow Shareholders are paying the costs to grow the fund, but fund adviser is the beneficiary the fund, but fund adviser is the beneficiary from the growthfrom the growth


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Mutual Fund

Shareholders

Board of Directors

Fund Providers(Investment Adviser)

PrincipalUnderwriter

Administrator Transfer Agent

Custodian IndependentPublic Accountant

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


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Major Cause: Idiosyncratic Fund Governance SystemFund Providers: Caught between Two MastersFund Providers: Caught between Two MastersBODBOD’’ss Fiduciary Duty: Inadequate PerformanceFiduciary 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 companiesBOD is supposed to negotiate lower fees for their shareholdersBOD is supposed to oversee investment advisersThe Chairman of the BOD is usually a senior member of the owner of the fund providerDirectors 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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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 dayday’’s prices price

To Curb ShortTo Curb Short--Term Trading (including Market Term Trading (including Market Timing)Timing)

A mandatory 2A mandatory 2--% fee on the proceeds of fund shares % fee on the proceeds of fund shares redeemed within 5 business days of purchaseredeemed within 5 business days of purchaseSEC has shelved this proposal and considers SEC has shelved this proposal and considers recommending that funds adopt fees voluntarilyrecommending that funds adopt fees voluntarilyA greater disclosure of market timing, securities pricing, andportfolio 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)New regulations issued in April 2004 that require New regulations issued in April 2004 that require mutual funds to disclose the following information in mutual funds to disclose the following information in their prospectusestheir 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 policies and procedures regarding frequent purchases

and redemptions of sharesand redemptions of shares•• circumstances under which they will use fair value circumstances under which they will use fair value

pricing and the effects of using fair value pricingpricing and the effects of using fair value pricing•• policies and procedures with respect to the disclosure policies and procedures with respect to the disclosure

of their portfolio securities and any ongoingof their portfolio securities and any ongoingarrangements to make available information about their arrangements to make available information about their portfolio securitiesportfolio securities

Mutual funds must comply with these new Mutual funds must comply with these new regulations by December 5, 2004regulations by December 5, 2004


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Reform Measures by US SEC (III)

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

Appointment of Compliance Officer reporting to BODIndependent Directors meet at least quarterly in a separate sessionIndependent Directors authorized to hire employees and others to fulfill their fiduciary duties


Thank You!For Further References,

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


Mutual Fund Scandals in the U.S. Market: Causes and ...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%)

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