AEI-Brookings Joint Center Policy Matters 04-04


Make Mutual Funds Bare All! Susan Woodward. January 2004.

Eliot Spitzer's courage in pursuing mutual fund abuses is inspiring. His new focus on expenses is thrilling. But we need much more than to strong-arm a few badly behaved funds. We need the market force of choices by well-informed investors. At present, the knowledge of the average investor is falling, not rising. As of 1980, only about 10% of adult Americans had ever had any direct contact with the securities markets. Now that figure is over 50%, mainly due to the replacement of traditional pension plans by individual 401k plans. As more people must make their own investment choices, the average level of investing experience declines. It's no surprise that average fund expenses have been rising, not falling.

We will not get better-informed choices until we provide investors with better fund disclosures. Here are the facts investors need to know: (1) The average mutual fund does worse than the market. (2) The more a fund spends on research and trading, the worse its performance on average. (3) A fund's past performance provides zero guidance about its future performance. (4) Seemingly small differences in the level of fund expenses have a profound impact on an investor's retirement income.

The first three are facts learned in the original study of risk-adjusted mutual fund performance in 1969. They have been confirmed in subsequent studies, each time with additional data and more elaborate analysis. The fourth is just math, but tremendously important math.

The overwhelming conclusion is that mutual funds cannot deliver superior performance, they cannot beat the market. What they can deliver is diversified investing at low cost, much lower than small investors could obtain themselves. Bottom line? Investors are better off in funds only if expenses are low. Deluded by fund advertising into chasing performance, investors fail to select funds with low expenses.

Chasing performance costs investors far more than they ever imagine. Many think the difference between a fund with expenses 0.5% of net assets vs. 1.5% is no big deal. They are gravely mistaken. Choosing the lower figure early in life will, other things equal, raise the level of the investor's retirement income by 35% to 40%.

The prevailing SEC-mandated disclosures mislead investors. An exhaustive 1995 SEC survey of fund investors confirmed that few know the important facts above. Indeed, the statement required to accompany any performance statistics -- "Past performance is no guarantee of future results" -- is taken by most to mean "Past performance, while not an absolute guarantee, is highly indicative of how a fund will do in the future." But the truth is that the fund with above-market returns is no more likely than the average fund to deliver this performance again.

The typical prospectus, with 20 pages of tiny type, conveys the message that investing is hopelessly complex, and it should only be attempted by well-compensated professionals. When asked, investors insist they need the prospectus to make an informed decision (otherwise why would it be required?), yet they learn nothing from it. Investors need a standardized, one-page disclosure that focuses on expenses, risk, and diversification. Reported expenses should include trading costs. Funds are able to report expenses far below what they actually spend because trading costs are not included in fund expenses. This situation is exacerbated by soft-dollar accounting that turns expenses into brokerage commissions by having the broker buy the new computers for the office (or whatever) in exchange for higher commissions. By these tricks, mutual funds avoid reporting their true expenses. All brokerage fees should be expensed. Period.

The designers of the new disclosure must test format scientifically. All the details matter -- placement, typeface, type size, borders. To see how important format is, pick up several prospectuses and look at the fee tables. Fee descriptions, in small type, are justified to the far left, the numbers to the far right, and long lines of dots connect them. On many you will find numerous components to expenses, and a total in the same typeface, some without even a line suggesting the total is a total. Designed to comply with the law but to escape the reader's interest!

Expect fearsome opposition to an effective disclosure. The funds have done the research already, and discovered what averts investors' interest from their bottom lines. They know what there is to lose.

Responsibility for designing a new disclosure should not reside with the SEC. The staff in the mutual fund division know better than anyone else that their future employment opportunities outside the SEC lie with a fund or a law firm that serves funds. They will feel the pressure to subvert the effort. Instead, turn to a consumer-sympathetic agency with the research skills to design disclosures. My nominee is the Federal Trade Commission.

Helping those who did not go to college and study business to a more comfortable retirement is not just the decent thing to do, it's efficient! By allowing confusion to reign, we encourage funds to expend resources to search out, further misinform, and overcharge poorly informed investors. Confident, better-informed investors could choose for themselves, and the market would redirect these perverse sales efforts. The fewer resources we squander promoting and exploiting confusion, the better off we surely are. We have a unique opportunity to help a new generation learn to understand their options and choose more wisely. When disclosure was studied at the SEC in 1994-95, proposals for improving disclosures and expensing brokerage commissions were successfully scuttled by the mutual fund industry. But the funds no longer have noses clean enough to be credible when they insist there is no problem. Seize the day!

Another suggestion -- an appropriate response from Congress to the fund abuses is tax-free rollover. Allow investors to move from one fund to another without paying capital gains tax at the time they move. Under current law, investors are locked into funds by the tax. It is outrageous that tax law should hold investors hostage to fund managers who steal from them.

Ms. Woodward, chief economist at the SEC from 1992-95, heads Sand Hill Econometrics, which publishes an index for venture capital.

This article appeared in the Wall Street Journal on January 16, 2004.