A Better Mutual Fund Reform
By James K. Glassman

The American mutual fund has been the most successful investment mechanism of all time. In 1970, there were 361 funds with a total of $48 billion in assets; at the end of 2003, there were 8,124 funds with $7.2 trillion in assets. That’s as much as all the mortgage loans outstanding in America. It’s the equivalent of $70,000 per household. It’s two thirds of the Gross Domestic Product.

 

Invented exactly 80 years ago this spring, the mutual fund is a simple idea: a company that owns a portfolio of stocks, bonds, or cash managed by a professional. Individuals purchase shares of the company and thus own pieces of the portfolio—perhaps 100 or so different stocks, in a typical case.

 

Few investors could construct such a portfolio on their own, and nearly all investors lack the time and expertise to manage it—buying and selling stocks, handling the bookkeeping, filing the reports. For these services, the average fund charges investors about $125 a year for every $10,000 in assets they own. Some funds also charge investors a one-time commission, usually around 5 percent, which goes to the broker or adviser who sells the fund.

 

For more than ten years, I’ve written a financial column geared to small investors, and I consider mutual funds an awfully good deal. The public thinks so too. There are lots of other places they could put their money, yet 91 million Americans in 53 million households own funds (roughly half the nation).

 

Given this success, it’s hard to believe that anyone would want to tamper with the industry, which has largely evolved on its own. But regulators on Capitol Hill, and their friends, can’t sit still.

 

In early September of last year, the attorney general of New York, Eliot Spitzer, announced that several mutual funds had allowed large investors to profit from practices that were either illegal or actively discouraged by the fund’s own published policies. The practices—called late trading and market timing—allowed privileged investors to benefit from all-but-certain price changes in stocks on foreign markets that close before the U.S. ones do. The harm to investors was negligible, but Spitzer was right to pursue them and unearth the scandal.

 

Now comes Stage Two—the part where the policymakers decide they need to add more and more rules. The Securities & Exchange Commission alone has proposed 17 of them, including requirements for absurdly detailed disclosures of fees and brokerage relationships, unnecessary changes in daily deadlines for buying and selling, new charges for redeeming shares, mandates for the composition of mutual fund boards, and on and on.

 

Like a similar rule-making stampede that last year produced the abomination called Sarbanes-Oxley (a new law that is costing investors billions of dollars in legal and accounting fees), the mutual-fund hysteria promises dubious benefits and high costs. More regulations, as the SEC and Congress are proposing, will only limit investors’ choices and reduce their returns.

 

Additional rules will also confuse investors. Which leads to one productive thing government could do in the wake of the scandals: The Treasury, Labor Department, and SEC need to get serious about educating investors. Our school systems do a lousy job teaching economics and finance, and Americans are thrust into a baffling environment where they can make expensive mistakes.

 

The good news is that the industry is viciously competitive, and investors themselves can discipline miscreants. The worst of the offenders in the scandals have been badly damaged as shareholders bailed out. Putnam, for example, lost $29 billion in assets last year.

 

This is the kind of pressure that should be encouraged. Bruce Bent, inventor of the money-market fund in 1970, proposes that investors be allowed to move their money between funds without incurring capital gains taxes, which tend to lock investors into funds with ethical or financial deficiencies.

 

I like Bent’s idea so much I think it should be extended. Any American should be able to move any investment from one vehicle to another—stocks, bonds, funds, perhaps even real estate—with a tax deferral until the money is actually taken out and used. Think of it as a universal, unlimited IRA.

 

If government wants to do something productive to improve the operation of mutual funds, this may be the best thing it could do.