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CHAPTER SEVENTEEN
NORMATIVE TRANSPARENCY OF
MUTUAL FUND DISCLOSURE
John A. Haslem, Ph.D.
PROFESSOR EMERITUS OF FINANCE, ROBERT H. SMITH
SCHOOL OF BUSINESS, UNIVERSITY OF MARYLAND
Mutual fund disclosure is dismal.
—Barbara Black, University of Cincinnati School of
Law
The recent years have been a nightmare for far too many investors.
After the imploding stock market bubble, investors were hit with abundant
findings of conflicts of interest, greed, and fraud that pervaded too many
corporate executive suites and directors’ boardrooms, along with their
willing participants on Wall Street. This fall from grace on Wall Street and
in corporate America has fueled many legal actions to punish the
perpetrators but also limited actions to improve laws and regulations
protecting investors.
Correspondingly, in 2003, mutual fund investors had to deal with
widespread findings of major fund adviser misconduct and illegality that
still calls for much improved regulation and disclosure. The scandal
findings require a new look at the Investment Company Act of 1940
(40Act), and the role of independent directors in providing adviser
oversight.
The Wall Street Journal’s Lauricella (2003) quoted then New York
Attorney General Spitzer as stating that the “breach of fiduciary duty is
appalling.” And, indeed, it was and still is. Spitzer examined the moat
around the mutual fund industry’s self-proclaimed “wall of trusteeship” and
found it all too shallow. This was seen in the all-too-frequent findings of
selective disclosure of portfolio holdings, insider market timing and front
running, allowance of illegal late trading to selected traders, and more.
Following revelations of the mutual funds scandal, the fund industry
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 1
was anything but early in facing up to the situation and offering real
remedies. Who better knows what goes on in fund management? But then
the Investment Company Institute (ICI) offered some remedies for the
failings of fund governance. Moreover, the Securities and Exchange
Commission (SEC) followed Spitzer in investigating problems in the fund
industry it is responsible for regulating. However, initially the SEC
appeared less than aware, even surprised, by the scandals.
Congressional hearings and limited legal actions followed the major
uproar of the scandals and the publicity of trials and settlements. The
consensus of public opinion and serious researchers appears to agree that
fund shareholders continue to need and deserve much more in the way of
protection and disclosure. Vanguard’s John C. Bogle (2005) reports the
scandal was not an isolated event but rather involved mutual fund advisers
holding $1.6 trillion in shareholder assets and included some of the oldest,
largest, and formerly most respected, fund advisers.
Now that much of the corresponding furor over the lack of fiduciary
behavior in the mutual fund scandals has peaked, what is it that fund
shareholders are still owed in the way of fiduciary protections and
disclosures? First, funds owe shareholders fiduciary protection of the huge
amounts they have invested in funds, including retirement plans. The ICI
(2007) reports that 96 million individuals in 55 million households hold
fund assets of $10.4 trillion, and increasing. Mutual funds thus play a key
intermediation role between Main Street and Wall Street.
Second, Morningstar’s Phillips (2004) observes mutual funds have
foolishly jeopardized the public’s trust, their major asset. As a result:
. . .[I]t would behoove the industry to redouble its
commitment to the effective stewardship of the public’s
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 company founders, CEOs,
portfolio managers, and several current or former members
of the Investment Company Institute’s Board of Governors.
Third, industry leader Bogle (2005) finds that the growth and
management of mutual funds and their practices call for major reform. He
notes that the asset size of the 25 largest fund advisers increased 3,600-fold
between 1945 and 2004, while their direct fund expenses increased 6,600-
fold. This huge growth in shareholder expenses occurred while advisers
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 2
benefited from “staggering” economies of scale.
Bogle (2005) also summarizes the steps the mutual fund industry
must take to improve the lot of those who actually own the funds, the
shareholders.
To enhance the share of fund returns earned by fund
shareholders, the industry needs to reorder its product
strategies to focus once again on broadly diversified funds
with sound objectives, prudent policies, and long-term
strategies. The industry needs to take its foot off the
marketing pedal and press down firmly on the stewardship
pedal. At the same time, the industry must give investors
better information about asset allocation, fund selection,
risks, potential returns and costs—all with complete
candor. To do otherwise will doom the industry to a dismal
future. For whatever the profession, finally, the client must
be served. For whatever business, finally, the customer must
be served. [Latter italics added.]
But in spite of the broad-based agreement that something more needs
to be done, far too much remains to be done in actually providing mutual
fund shareholders with their broad protections under the Investment
Company Act of 1940.
The 1940 Act states that “[t]he national public interest and the
interest of investors is adversely affected…when investment companies are
organized, operated, or managed…in the interest of investment advisers.”
Independent mutual fund directors are responsible for selecting (and
compensating) fund advisers who will maintain effective legal separation
between themselves and shareholders. However, effective separation has
not been achieved. Independent fund directors have failed as fiduciaries in
their legal roles as shareholder watchdogs.
Palmiter (2006) explains that the act’s “outsourcing” of regulatory
oversight of mutual fund advisers to independent directors, rather than to
the SEC, has not provided essential fiduciary protections to fund
shareholders. Further, the outlook remains bleak for Congress and the SEC
to achieve all, or even most, of what should be done for fund shareholders.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 3
Disclosure as an Effective
Regulatory Tool
Before continuing, it is important to consider whether disclosure is
an effective tool of mutual fund regulation. Professor Zingales (2004)
reviews and assesses regulatory theories, and analyzes the costs and
benefits of financial market and fund regulation. The two most important
costs are those of compliance and the burden on firms that should not be
regulated. He distinguishes between disclosure requirements and other
types of regulation. Disclosure is found to be almost without question the
desired form of regulation.
Other types of regulation can be justified in particular situations,
such as when it is very costly to enforce contracts, when limited liability
restricts punishment, and, as in financial markets, when shareholders are
too dispersed for coordinating their individual rights.
However, regulation is not designed from the ground up but is the
result of political pressure by lobbies with varying degrees of political
power. The incumbent lobbies are usually the stronger and better organized,
and the weaker lobbies are the customers, investors, and new market
entrants. The result is regulation biased against new entrants and
competition. Not all regulation is bad, but in the “real world” welfare
enhancing regulation can have unintended consequences, none of them
normative.
Zingales (2004) finds a conflict of interest between mutual fund
advisers and shareholders. This conflict is evident in four practices: (1)
“stale” price arbitrage and illegal “late trading;” (2) lack of disclosure of
brokerage commissions, bid-ask spreads, custodial fees, including soft-
dollar brokerage commissions; (3) large and increasing expense ratios; and
(4) excessive risk taking. (The author summarizes these issues widely
discussed in the literature.)
Another major source of mutual fund adviser–shareholder conflicts
lies in the structure of fund adviser compensation. Shareholders are
rewarded by fund performance, but advisers are rewarded primarily by the
size of assets under management. The major reason for this difference lies
in the adviser rewards system. The law prohibits incentive-based
compensation that rewards superior performance but does not also penalize
inferior performance.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 4
Mutual fund shareholders can “fire” fund advisers by redeeming
their shares at net asset value. But in contrast to traded corporations, there
is no corresponding market signal in the form of downward pressure on
fund prices. Often it is the sophisticated investors who redeem their shares
when fund advisers are found to misbehave, leaving the less informed
shareholders to continue to receive the adviser’s tender mercies. This
pattern has encouraged some advisers to take perverse advantage of these
typically smaller shareholders by increasing fund expenses and not
improving portfolio management, all with the expectation that no further
major redemptions will occur.
The threat of shareholder lawsuits is less of a deterrent to mutual
fund advisers. Federal courts have refused to hear cases of excessive
advisory fees. The tremendous growth in mutual fund assets, including
those in retirement plans, has major implications. The growth of fund assets
and economies of scale and scope have greatly benefited fund advisers in
cases where large trade size has not subsumed economies of scale. The
diffuse ownership of fund shares has increased the likelihood and risk of
abuses, especially for unsophisticated shareholders. All of this has enabled
opportunities for adviser abuse.
Zingales (2004) concludes: “While the case for mandatory
disclosure is simple, the case for other forms of regulation is not.” With the
huge and increasing size of mutual fund assets, it is not cost effective to
depend just on regulatory prohibitions. Regulations have generally failed in
finding major causes and cases of fund adviser abuse. It is no accident that
adviser employee whistleblowers are most effective in spotlighting abuse.
This is not to say that regulators are ignorant of the need for
improved mutual fund disclosure. They have studied disclosure issue
numerous times. For example, in a presentation to Congress, R. J. Hillman
(2003) states:
The fees and other costs that mutual fund investors pay as
part of owning fund shares can significantly affect their
investment returns. As a result, it is appropriate to debate
whether the disclosures of mutual fund fees and fund
marketing practices are sufficiently transparent and fair to
investors.
The answer to the question raised is obviously in the negative.
The SEC’s P. F. Roye, in a statement to Congress, discusses the
need for improved mutual fund transparency. His pre-Spitzer testimony was
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 5
highly supportive of the proposed Mutual Funds Integrity and Fee
Transparency Act of 2003. Roye (2003) concludes: “The Commission
supports Congressional efforts to improve transparency in mutual fund
disclosure, to provide mutual fund investors with the information they need
to make informed investment decisions and enhance the mutual fund
governance framework.” However, achievement of this goal remains far
from realization.
In Professor Bicksler’s (2004) presentation to Congress, he identifies
the major necessary dimensions of public policy: (1) individual choice, (2)
competitive markets, and (3) transparency. He explains:
The role of government, including government regulation, is
limited except when…parties have sufficient market
economic power preventing the functioning of competitive
markets. Further, individual choice and its end results, the
efficiency of resource allocation is strengthened if there is
firm transparency where relevant investor informational
parameters are provided. This will, in turn, enhance investor
awareness and improve investor choice of mutual funds.
Hence, individual rational choice of mutual funds and
competitive markets are intertwined. Further, rational
investor choice of mutual funds is dependent upon
transparency of relevant investor choice parameters
provided by mutual funds. [Italics added.]
Bicksler (2004) also provides three specific mutual fund agent-
principal questions:
1. Do independent directors act in the best interests of fund
shareholders when negotiating the investment advisory fee
contract?
2. Is it in the best interest of shareholders for fund advisers to pay for
broker distribution to “grow” fund assets?
3. Are the fund industry’s soft-dollar practices in the best interests of
fund shareholders?
He answers each question in the negative. Further, he reports excessive
mutual fund fees cost shareholders an additional $10 billion per year. Fund
advisers are able to sell funds with excessive marketing expenses because
there are many less sophisticated investors who provide advisers with
financial incentives to sell inferior funds. Financial incentives also drive
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 6
advisers to use soft-dollar trades and similar arrangements that involve
undisclosed, unnecessary, improper, and excessive costs.
Normative Transparency of
Disclosure
In the broader scheme of things, transparency has become accepted
in its own right as an inherent component of good public and private
governance, and thus reinforces the need for independence, accountability,
and policy consistency among financial regulators. The key issue is no
longer whether transparency is desirable but rather how can domestic and
foreign publicly traded firms, nonprofit organizations, and governments
better achieve transparency.
At minimum, improvements in mutual fund transparency are called
for if only to be comparable to the requirements for corporate disclosure.
To accomplish this minimum disclosure and then to move toward normative
transparency, lawmakers and regulators and fund advisers and independent
directors must give shareholders their due as fund owners.
The transparency issue assumes particular importance because of the
principal-agent problem, which arises where work is delegated to others.
That is, a principal hires an agent to perform tasks on his behalf, but he
cannot be sure that the agent performs the tasks precisely as the principal
would like. The agent’s decisions and performance are expensive to
monitor, and the incentives of the two parties may well differ. The
principal-agent problem also exists in the mutual fund world, where fund
shareholders are principals and fund advisers their agents.
The general concept of transparency that applies to public and
private and domestic and international institutions and governments also
applies to mutual fund disclosure. The World Bank’s Vishwanath and
Kaufmann (1999) define transparency as the “increased flow of timely and
reliable economic, social and political information, which is accessible to
all relevant stakeholders.”
The World Bank’s Bellver and Kaufman (2005) add that for
information to be transparent it must be accessible, relevant, reliable, and of
good quality. Transparency thus captures institutional openness, which for
mutual funds requires that shareholders be able to monitor and evaluate the
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 7
actions of fund advisers. However, current fund disclosure falls far short of
meeting this transparency test. Fund shareholders cannot adequately
monitor and evaluate the actions of advisers.
While one of the major objectives of 1940 Act is to ensure mutual
fund shareholders receive adequate and accurate information, they have yet
to receive either in a normative fashion. It is “normative transparency of
disclosure” that provides a focus for the regulatory reform required to
facilitate identification of stewardship funds.
There are some exceptions to the need for normative transparency of
disclosure. Mutual fund sales loads (up front and deferred) are relatively
transparent on shareholder accounts. Investment advisory fees, 12b-1 fees,
and “other” expenses, however, are less readily transparent, being included
in fund expense ratios.
Transaction costs, which approximate expense ratios in size, are not
at all transparent. Transaction costs add to the costs of securities purchased
and reduce the net proceeds of securities sold, thereby adversely affecting
fund assets. Further, fund industry practice and regulatory disclosure
requirements all too often result in incorrect accounting and incomplete,
missing, misleading, or perfunctory disclosure.
Positive transparency of disclosure is the first and as-is approach to
mutual fund disclosure. The term refers to the relative degree of a particular
fund’s disclosure under current laws and regulations. A fund’s actual
transparency in disclosure must be identified relative to the industry
composite, which, of course, requires a transparency analysis of each fund.
The adequacy of positive transparency has long been debated, but the
recent fund scandal provides strong evidence that much more than positive
disclosure under current laws and regulation is required.
The second and necessary approach to defining mutual fund
transparency of disclosure is normative (“should be”). As defined,
normative transparency of disclosure refers to the degree of mutual fund
voluntary and proactive disclosure and also new and revised legal and
regulatory disclosure required for shareholders to be able to make
information efficient fund investment decisions. The acceptance and
requirement of this disclosure concept in public policy should also be the
guiding principle in fund disclosure. This disclosure is essential if fund
shareholders are to be able to identify stewardship funds—those stewards
of shareholders and their money.
The definition of normative transparency of disclosure provides a
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 8
goal consistent with the classic finance proposition of maximization of
share value. The goal of normative transparency is to provide information
efficient disclosure that enhances the ability of mutual fund investors to
make wealth enhancing buy/sell decisions. Normative transparency also
requires prohibition of disclosures that impede investors from making
information efficient fund decisions.
If Congress and the SEC were to enact laws and regulations that
provide normative transparency of disclosure, these mandates would
provide much of what is required. While additional regulatory disclosure
may be forthcoming, it is most unlikely that the political process will
achieve normative transparency.
However, the political obstacles to normative transparency of
disclosure are much more likely to be overcome if individual mutual fund
advisers, their directors, and the fund industry work vigorously, proactively,
and collectively in conjunction with Congress and the SEC to achieve
normative transparency. This effort is unlikely because of the political
influence of the large number of advisers who benefit from poor disclosure.
The achievement of normative transparency by individual mutual
funds should not be as difficult or expensive as they and the industry are
likely to claim. Funds are now required to have regulatory compliance
officers. And much of what is required for normative transparency is, or
should be, available in written or oral form, or such that it may be
reasonably generated within the scope of fund operations.
The record of the topics, deliberations, and decisions of mutual fund
directors and committees should include much of the information needed to
provide normative transparency of disclosure. What more that may be
needed in the way of disclosure information includes the analysis and
explanations for the decisions made.
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. Normative
transparency is also conducive to attracting investors who are prone to be
patient, long-term shareholders.
Mutual fund shareholders need to know whether portfolio managers
and independent directors are actually investing with them. In turn, patient
shareholders are more likely to favor funds with long-term focus and
transparency in disclosure. The result is that these funds are likely to have
fewer share redemptions during times of poor returns and when the
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 9
inevitable surprises occur along the way.
American Century Mutual Funds (2003) provides an example of a
mutual fund adviser on the right path to normative transparency. The
statement of additional information is well organized with solid,
informative disclosure printed in readable size font. American Century also
makes effective use of templates in numerous topic discussions:
1. Investment policy
2. Interested and independent directors (detailed and very well done)
3. Fund committees
4. Director compensation
5. Director ownership in each fund (dollar range)
6. Principal shareholders
7. Investment adviser (rates and dollars)
8. Multiple share classes (shareholder and distribution services and
dollars of fees)
9. Capital loss carry-forwards and before- and after-tax returns
10. Ratings of fixed income securities
More funds should join American Century in providing improved
disclosure.
Improved mutual funds transparency is also called for if only to be
more comparable to that disclosure required and provided by major publicly
held corporations. In a real sense, a fund’s degree of normative
transparency effectively projects how much confidence its managers have
that they are operating in the best interests of their shareholders as owners.
Many fund advisers oppose disclosure of portfolio manager holdings in
their portfolios based on the argument shareholders cannot make effective
use of this information.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 10
Disclosure Template
A disclosure template designed for each mutual fund should be
posted and regularly updated on the fund’s Web site, where it would be
readily accessible to thousands of investors. Among other benefits, online
access would facilitate investor searches for funds that are most dedicated
to their shareholders.
The disclosure template provides a tool to guide mutual fund
advisers on the road to absolute and normative transparency of disclosure to
investors. First, the template seeks to provide disclosure in an absolute
sense, not limited to current best practice. Second, it seeks to provide
transparency of disclosure in a normative sense, not limited to current laws,
regulations, fund practice, and disclosure. Some of the normative disclosure
may even be beyond that currently recognized as needed by objective
students of funds. The template thus seeks to provide item-by-item
normative transparency of that data and information that is essential for
meeting the information-efficient decision needs of fund investors.
The disclosure template is broadly organized around seven
categories:
1. Guide to Use
2. Disclosure of the Board of Directors
3. Board of Directors Disclosure: Actions and Approvals
4. Audit Committee Disclosure
5. Other Committee Disclosures
6. Portfolio Manager Disclosure
7. Portfolio Performance Disclosure
There are 69 numbered disclosure items in categories 2 to 7. Here is
a list of the first disclosure item (generalized) in each numbered category:
2. Thirteen descriptors of each director
3. Selection of fund chief executive officer (CEO)
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 11
4. Members of audit committee
5. Members of other committees
6. Eight descriptors of portfolio managers
7. Shareholder performance reports
For each disclosure item in the prospectus or financial reports to
shareholders, mutual fund mangers are called on to cite each and explain.
For full disclosure in the statement of additional information, fund advisers
are requested to copy each item and explain it.
However, if a mutual fund adviser declines to disclose a particular
item, it is requested that the item be cited and the reasons explained. The
decision not to disclose a particular item assumes, of course, that there is no
legal requirement to do so. But it is hoped that fund adviser refusals to
disclose will decline over time as they:
1. Become more enlightened and responsible as shareholder
fiduciaries
2. Experience that not doing so increasingly places them at
competitive disadvantages
3. Decide that disclosure beyond the requirements of current laws
and regulation benefits all participants
To that end, the disclosure template reflects judgment concerning
what represents normative transparency of disclosure for mutual fund
shareholders. The disclosure items are not written in stone but rather
provide a current guide to what constitutes normative transparency. But the
maintenance of normative transparency also requires constant monitoring
by the SEC and the fund industry to ensure it reflects changes in
shareholder needs, fund practices (proper and improper), and regulation.
Normative Transparency and the
Expense Ratio
The expense ratio and its stated components provide the primary
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 12
disclosure for shareholders to obtain needed cost information. Because of
its importance, this imperfect measure calls out urgently for disclosure that
provides normative transparency. The needed major changes include not
only expense ratio components but their categories and subcategories as
well. Current expense ratio components should be restated and defined, and
several new components should be added. Properly excluded are fund sales
loads (front end and back end) that are relatively transparent and paid
directly by investor purchasers.
The normative transparency and total expense ratio concepts and
regulatory and cost issues discussed herein evolved in Haslem (2003, 2004,
2006, 2007, 2008a, 2008b, 2008c, 2009a, 2009b). Stewardship funds were
developed in Bogle (2004) and further in Haslem (2005).
Current SEC Expense Ratio
Current mutual fund regulatory requirements call for three expense
ratio categories: (1) management fees, (2) distribution (12b-1) fees, and (3)
“other” expenses. But, in practice, strict uniformity in disclosure within is
lacking and requires urgent attention.
Management fees are the major category in the expense ratio. They
include investment advisory fees but also administrative and other fees paid
to the fund adviser or affiliates.
Distribution (12b-1) fees are paid out of mutual fund shareholder
assets and partly used by fund distributors to pay brokers for sales of fund
shares and distribution expenses, which include market support services and
servicing of customer accounts. Adviser payments of sales fees and/or asset
fees (discussed later in the chapter) and smaller front-end loads have
generally replaced traditional single use of front-end loads to reward
brokers for sales. Another use of 12b-1 fees is to pay for fund advertising
and promotion, printing and mailing prospectuses, and printing and mailing
sales literature.
“Other” expenses are residual expenses paid for transfer agent fees,
custodian fees, legal fees, accountant fees, auditor fees, legal counsel fees,
directors’ fees, shareholder brokerage fees, and perhaps 12b-1 customer
service fees.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 13
New Total Expense Ratio
The Total Expense Ratio has four categories: (1) management fees,
(2) distribution fees, (3) “other” expenses, and (4) transaction costs. The
ratio construct provides mutual fund investors with normative transparency
of disclosure of fund categories and subcategories of these fees and
expenses. This construct and its categories and subcategories are designed
as normative additions and improvements in the components of the current
SEC expense ratio, which does not provide a behind-the-curtain view of
these payments.
The dollar amounts of the Total Expense Ratio categories and
subcategories should be computed as percentages that provide comparison
with the regulatory expense ratio and its categories. The required use of this
construct would also provide standardized descriptors for uniform reporting
among funds. “Inside” distribution fee subcategories include payments to
fund advisers and, especially, brokers who distribute fund shares.
The Total Expense Ratio subcategory labels and descriptions (to be
discussed) are modeled after actual adviser/distributor accounts from which
payments are made. The stated subcategories are generalized and can be
matched by their descriptions to “inside” subcategory labels used by
specific advisers. “Inside” subcategories and descriptions also provide
investors with more disclosure than SEC fund categories for public use.
The Total Expense Ratio with its four categories and subcategories
are discussed next.
Management Fees
Management fees (%) include:
1. Investment advisory fees
2. Administrator expenses
3. Service provider fees to adviser/affiliates, listed using SEC terms
4. Adviser fall-out benefits
5. Rebates from soft-dollar trades.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 14
A brief discussion of management fees follows:
Investment Advisory Fees
These fees include payments to the fund adviser (including any
subadviser) for research and portfolio management services
consistent with fund investment objectives, policies, and stated
limitations.
Administrator Fees
Fees paid for fund management and regulatory oversight, evaluation
of performance of other service providers, and often expenses and general
accounting. Fund advisers often perform these functions.
Service Provider (Adviser/Affiliates) Fees
These fees include payments to:
Fund distributor for expenses of direct distribution of shares,
including fund advertising and marketing.
Custodian for safeguarding assets and settling portfolio and
shareholder transactions
Auditor and legal counsel for accounting, legal services, and
regulatory oversight
Transfer agent (servicing agent) for fulfilling shareholder
transaction requests, receiving and disbursing monies from
transactions, and providing wide range of customer services and
communications
“Other” fees, listed as SEC terms and definitions
Adviser Fall-out Benefits
These fees include agreed broker rebates paid directly to fund
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 15
advisers from “excess” revenue-sharing payments. However, fall-out
benefits should be repaid to the source, fund assets, which would negate the
use of fall-out benefits.
Rebates from Soft-Dollar Trades
These fees include agreed broker rebates paid directly to fund
advisers from the premium brokerage fees of soft-dollar trades.
The selling broker rebates are percentages of the brokerage fees
and paid in-kind as adviser selections of investment products and
services—the soft dollars.
Soft-dollar trades have higher brokerage commissions and possibly
higher trading costs than best-execution trades. The benefits to both
advisers and brokers of these high-cost trades encourage their use.
However, these rebates should be repaid in cash to the source, fund assets,
which would negate use of soft-dollar trades.
Distribution Fees
Distribution fees (12b-1 fees)(%) include:
1. Fund distributor “selling group payments:”
a. Broker concessions from front-end loads
b. Account servicing fees
2. Revenue-sharing payments, net of adviser fall-out benefits:
a. Broker marketing pools
b. Broker bonus compensation
c. Subtransfer agency fees
d. Networking fees
e. Syndicated distributions
3. Soft-dollar trades
A brief discussion of distribution fees follows.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 16
Selling Group Payments
Broker concessions are fund distributor payments from front-end
sales loads to brokers (to include financial advisors, traditional
(independent) brokers, wire house (often full service) brokers, broker-
dealers, and bank trust departments) for sales of adviser fund shares.
Account servicing fees are fund distributor payments to brokers for
continuing servicing of customer accounts holding adviser funds. Payments
are computed as approximately 5 to 15 basis points of adviser-allocated
broker sales targets and are computed as percentages of broker annual
dollar sales (sales fees) and/or dollar holdings (asset fees) of adviser fund
shares.
Revenue-Sharing Payments, Net of Adviser Fall-out
Benefits
Adviser fall-out benefits are agreed broker “rebates” paid directly to
fund advisers from “excess” revenue-sharing payments and are added to
normatively disclosed management fees. However, fall-out benefits should
be repaid to the source, fund assets, which would negate excess revenue
sharing payments with fall-out benefits.
Broker marketing pools are fund distributor-allocated pools for
payments to each major selling broker of adviser fund shares to defray costs
of marketing support services.
Broker (bonus) compensation is distributor-allocated “bonus”
compensation to very top-selling brokers of adviser fund shares to defray
costs of marketing support services.
While these two types of payments are stated to defray broker costs
of marketing support, the basis for the payments is broker sales of adviser
funds.
Subtransfer agency fees are distributor payments to brokers to defray
costs of transfer agency services for customer accounts holding adviser
fund shares.
Networking fees are distributor payments to brokers to defray costs
of transmitting account and transaction clearing information of customers
holding adviser funds through the Networking System of the National
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 17
Securities Clearing Corporation. The payments are approximately $6 to $10
per broker customer account holding adviser fund shares.
While these two types of payments are stated to defray broker costs
of marketing support, the basis for the payments is broker sales of adviser
funds.
Syndicated distributions of shares advisers receive in initial public
offerings may be assigned to brokers to reward major sales of fund shares.
These shares instead should be used to benefit the performance of adviser
funds.
Adviser Soft-Dollar Trades
Adviser securities trades with their selling brokers are characterized
by “premium” brokerage commissions and perhaps higher trading costs
than available from “best execution” trade brokers. Mutual fund soft-dollar
trades are thus more costly than routine trades.
Fund advisers receive direct in-kind broker “rebates” of some 70
percent of the brokerage fees in selected investment products and services.
Soft-dollar trades require additional fund assets to pay the higher brokerage
fees that provide “rebates” to fund advisers and higher net brokerage fees to
brokers. These financial benefits to advisers and brokers encourage both
parties to use soft-dollar trades to the detriment of fund assets and
shareholders.
“Other” Expenses (%)
“Other” expenses include:
1. Service provider fees paid to other than investment
adviser/affiliates, listed earlier using SEC terms
2. “Residual” fees and expenses, listed using SEC terms
A brief discussion of “other” expenses follows.
Service Provider Fees
These are fees paid to other than investment adviser/affiliates for
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 18
services listed in management fees using SEC terms.
Residual Fees
These are all other direct fund expenses, listed using SEC terms.
Securities Transaction Costs (%)
These costs include:
1. Total transaction costs, net of adviser shares of soft-dollar trade
transaction costs
2. Net “flow-induced” trade transaction costs
3. Net “discretionary” trade transaction costs
A brief discussion of transaction costs follows.
Total Transaction Costs, Net of Adviser Shares of Soft-
Dollar Trade Transaction Costs
These fees include total brokerage fees and trading costs paid in fund
portfolio transactions, but net of direct broker partial in-kind “rebates” to
advisers (added to management fees) of the high brokerage fees of soft-
dollar trades.
Net Flow-Induced Trade Transaction Costs
Flow-induced trades (“flow”) arise from cash inflows/outflows from
investor purchases/sales of fund shares. These “operational trades” have
much higher transaction costs than “discretionary trades.” Flow trade
transaction costs are net of direct broker in-kind “rebates” to fund advisers
(added to management fees) from any unlikely soft-dollar trades. Soft-
dollar trades increase adviser revenue and broker brokerage fees but reduce
fund and shareholder assets.
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 19
Net Discretionary Trade Transaction Costs
Discretionary portfolio trades arise from portfolio manager planning
and execution of fund investment strategy. Discretionary trade transaction
costs are net of direct broker in-kind “rebates” to fund advisers (added to
management fees) from soft-dollar trades. Soft-dollar trades increase
adviser revenue and broker brokerage fees but also reduce fund and
shareholder assets.
12b-1 Fees and Multiple Share
Classes
Rule 12b-1 fees facilitated the creation of multiple mutual fund share
classes. Each share class has a different mix of loads and 12b-1 fees, which
often makes investor choices of share classes a confusing and costly
exercise. Brokers have also used this confusion to their own advantage.
Class A shares typically have 5.75 percent front-end loads and
perpetual annual 0.25 percent shareholder servicing fees. In general, Class
A shares have the lowest cost to shareholders for holding periods in excess
of eight years. The front-end loads can be lowered if current shareholder
purchases or previous holdings are large enough to qualify for lower load
breakpoints.
Class B mutual fund shares do not have front-end loads, but rather
they have 5.00 percent contingent deferred sales charges that decline to
zero after eight years, and annual 1.00 percent 12b-1 fees that decline to
0.25 percent annually after eight years. Brokers have often sold Class B
shares as “no load” when, in fact, they are only free of front-end loads and
have higher annual 12b-1 fees. Under pressure, Class B shares now
normally convert to Class A shares after eight years to reduce costs to long-
term shareholders.
Class C shares do not have front-end loads but they have 1.00
percent contingent deferred service charges that decline to zero after one
year and perpetual annual 12b-1 fees of 1.00 percent. In general, Class C
shares have the lowest cost to shareholders for up to an eight-year holding
period.
Further, mutual fund shareholders who buy so-called no-transaction-
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 20
fee funds on fund supermarkets actually pay higher expense ratios, either as
fund 12b-1 fees or expenses.
Transaction Cost Issues
The mutual fund industry often opposes the disclosure of transaction
costs as too difficult to measure and, in any case, these costs need not be
disclosed. But this opposition is wrong on both counts. Normative
disclosure of transaction cost components should be a regulatory or, at
least, an industry “best practices” requirement, with definitional and
measurement standards of each cost, along with use of lowest-cost trading
strategies.
The definitions and measurements of trading costs is an active field
for research and service to mutual funds. As progress continues, the SEC
and the fund industry should follow with defined and specified trading cost
subcategories. Transaction costs are not “expenses,” but they do reduce
shareholder assets by adversely affecting the actual cost of security
purchases and the realized price of security sales. Transaction costs are
major costs and are often larger than management fees and expense ratios.
Measurement of the various components of transaction costs has
long been a challenge, but now much of this information is available.
Kissell (2006) discusses how proper assessment of trading costs requires an
understanding of its components and how they influence trading. Nine cost
components are defined in detail: brokerage commissions, trade taxes, trade
fees, bid-ask spreads, delayed trade cost, price appreciation, market impact,
timing risk, and opportunity cost. Of these, brokerage commissions and
trade taxes are fixed costs and the remaining are variable costs. The only
visible components are brokerage commissions, bid-ask spreads, and trade
taxes.
Kissel (2006) classifies transaction costs as investment costs (trade
taxes and trade delay cost), trading costs (brokerage commissions, trade
fees, and bid-ask spreads, price appreciation, market impact and timing
risk), and opportunity costs. Classification assists in determining where and
when each cost appears in the trade process, which then assists in
determining the party to the trade that is responsible for managing each
cost. Importantly, classification provides funds with the basis for managing
these costs so that trade execution strategies are consistent with fund
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 21
investment objectives.
Gastineau (2005) reports a Plexus Group transaction cost study. The
institutional costs of trading a $30 stock are estimated to include brokerage
commissions of 17 basis points per share (bps) and implicit trading costs of
140 bps. Implicit trading costs comprise market impact costs of 34 bps,
delayed-trade costs of 77 bps, and missed-trade costs of 29 bps. The largest
cost, delayed trades, is 52 percent of total trading costs. Chalmers, Edelen,
and Kadlec (2008) investigate mutual fund expense ratios and direct trading
costs, the latter defined to include bid-ask spreads and brokerage
commissions. As percentages of fund assets, these costs are estimated as:
expense ratio (1.07 percent), spread costs (0.47 percent), brokerage
commissions (0.31 percent), and total fund expenditures (1.85 percent).
Direct trading costs are thus estimated as 73 percent of the size of the
expense ratio and 42 percent of total expenditures.
In a major study, Edelen, Evans, and Kadlec (2008) find that scale
effects in mutual fund trading are the primary cause of diminishing returns
to scale. Trading costs are larger on average than expense ratios and have a
higher cross-sectional variation related to trade size. Annual average fund
trading costs are 1.44 percent while expense ratios are 1.21 percent.
Mutual fund trades of relatively large (small) size have a negative
(positive) impact on performance. By adjusting for trading costs, fund
performance is not related to fund asset size, which says that trading costs
are the major source of diseconomies of scale.
Flow-induced trades arise from cash inflows/outflows from investor
purchases/sales of mutual fund shares. These operational trades are much
more costly than discretionary trades, which portfolio managers plan to
execute fund investment strategy. However, operational trades do not
explain all negative effects of trade size on mutual fund performance. By
controlling for flow and scale effects, discretionary trades have a small
positive impact on fund performance, but relatively large trades have a
negative relation.
Relatively large mutual fund trade sizes are beyond the point of cost
recovery. Two motives for excess trading are flow and agency conflicted
soft-dollar trades, the latter benefiting fund advisers and brokers at the
expense of shareholders. However, neither flow nor soft-dollar trades
explains all excess trading.
The negative impact of large size trades on fund performance is due
to trade size scale diseconomies and also to operational flow trades and
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 22
agency-related soft-dollar trades.
Conclusions: Normative
Disclosure, the Total Expense
Ratio, and Regulatory Change
The 40 Act 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 act’s major objectives is to ensure investors receive
adequate and accurate information. They do not. For this reason, Congress,
the SEC, fund advisers and independent directors, and the fund industry
must focus on the goal of requiring across the board normative transparency
of disclosure. This disclosure includes adoption of “best practices” over the
current focus on rule-making, which allows incorrect accounting and
incomplete, missing, misleading and perfunctory disclosure.
Adoption of the Total Expense Ratio construct and its components
would provide a major portion of what is needed in the way of normative
transparency of disclosure by placing up front its four major categories of
fees and their subcategories. In so doing, current indirect fund shareholder
payments by advisers/distributors would no longer be behind the mutual
fund curtain. There would also be continual need to benchmark.
By making these payments behind the mutual fund curtain up front
and transparent, there will be increased pressure on fund advisers and
independent directors, the fund industry, Congress, and the SEC to prohibit
inappropriate fund practices and actions, most important of which includes
selling group payments of dealer concessions and 12b-1 fees, the several
types of revenue-sharing payments, and costly soft-dollar trades. If
successful, there would also be continual need to benchmark normative
transparency if it is to be maintained with future changing conditions.
But while improvements in regulatory disclosure are likely to occur
over time, it is most unlikely that the political process will achieve complete
normative transparency of disclosure. However, industry and political
obstacles for reform are more likely to be overcome if major shareholder-
friendly fund advisers and dedicated independent directors work
collectively, vigorously, and proactively for congressional and SEC legal
Haslem (Kolb Series)/Mutual Funds Chapter 17, Page 23
and regulatory action. However, such success will be difficult to attain
because of the powerful influence of many major mutual fund advisers who
benefit greatly from the regulatory status quo, and at the great expense of
fund shareholders.
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About the Author
John A. Haslem is Professor Emeritus of Finance in the Robert H. Smith
School of Business at the University of Maryland. He served as founding
academic affairs dean and founding chair of the finance department. He
received the Panhellenic Association's "Outstanding Teacher Award" for his
first-of-a-kind mutual funds course. Professor Haslem studied at Duke
University, Harvard University, and the University of North Carolina, and
he taught at the University of North Carolina and on the faculty of the
University of Wisconsin. His research has appeared in the Journal of
Finance, Journal of Business, Journal of Financial and Quantitative
Analysis, Journal of Money, Credit and Banking, Financial Analysts
Journal, and Journal of Investing, among numerous others. He also has
contributed five books, including Mutual Funds: Risk and Performance
Analysis for Decision Making. Professor Haslem served as personal
financial consultant to the director of Supersonic Transport, U.S.
Department of Transportation; and consultant and expert witness to two
divisions of the U.S. Department of Justice (including the Supreme Court
case U.S. v. State of Louisiana).
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