WASHINGTON - Mutual fund yields could start dropping, thanks to a new SEC rule asking companies to disclose the true cost of their operating expenses to investors in their financial statements.
The Securities and Exchange Commission rule, expected shortly, would require mutual fund companies to show the cost of custodial services, printing and other expenses securities brokers routinely pick in return for business sent their way.
The drop in mutual fund yields will vary depending on the amount of trades funds rack up with brokers, and the extent to which brokers reciprocate by picking up the tab for funds' expenses.
But the impact on mutual fund yields probably will not be fully felt until next May, when most mutual funds come out with their annual prospectuses, said Robert E. Plaze, assistant director of disclosure and investment adviser regulation in the SEC's investment management division.
The SEC last August had drafted a rule requiring mutual fund companies to show these costs in their financial statements.
The agency proposed the rule because of concerns that mutual fund companies could be artificially inflating their returns by showing their expenses to be lower than what they really are.
Such "directed brokerage" arrangements, where brokers pick up the tab for various fund expenses in exchange for executing their trades, can be big business for the brokerage industry and account for more than one-third of all stock trading, according to some estimates.
Despite comments from some mutual fund companies opposing the SEC's proposal that they report their average brokerage commissions in their financial statements, the final rule also probably will ask funds to disclose this, according to Anthony S. Evangelista, assistant chief accountant at the SEC's investment management division.
While many of the country's largest mutual fund companies oppose the SEC's rule, the Investment Co. Institute and some other mutual funds wholeheartedly support the SEC's idea of disclosing all expenses.
"We have low (stock) turnover and low expenses so we think it's a swell idea everyone with higher turnover and high expenses should disclose them," said Peter W. Thayer, president of The Gateway Trust, Milford, Ohio, which runs three no-load index funds with more than $200 million in aggregate assets.
Not only does Mr. Thayer think disclosing average commissions is a good idea, but he also suggests the SEC go one step further and require mutual funds to report their total commissions as a percentage of the fund's assets. "If you want to turn your portfolio over 600 times a year, that's up to you. It's certainly an expense of doing business," he said.
"There are a lot of people claiming fund expense ratios (to assets) of under 1%, and if you are getting your broker to pay your custodial fees or whatever, you can artificially lower expenses," he said.
Harold S. Bradley, head trader of the Twentieth Century Mutual Fund Group in Kansas City, Mo., agrees.
"Our strong belief is if investors should have strong comparisons, (the expense table) should include all expenses paid for in cash, or soft dollars. Any argument to the contrary is to deceive investors," said Mr. Bradley, whose company manages $40 billion in assets. "Big commission payers have the advantage because they can use those to lower their expenses." But, in fact, their expenses are not lower, "they just look lower to the uninformed consumer," he noted.
Meanwhile, the Vanguard Group in Valley Forge, Pa., has included gross expenses in the financial statements for its Wellesley Income Fund since last year. Still, Vanguard's President John Brennan says arrangements where brokers pick up the tab for some of its expenses are beneficial to shareholders. Because such savings generally are no more than a few hundredths of a percentage point, Mr. Brennan suggests only funds that amass substantial savings - of 10 basis points or more - be required to show them in their financial statements.
But there also could be another surprise lurking for mutual funds in the SEC's new rule when it comes out in the next few weeks.
The agency also is expected to require funds to start disclosing as expenses any discounts they receive in custodial or transfer agent fees as part of fairly common arrangements that allow custodians or transfer agents short-term access to the funds' cash balances with them.
Typically in such arrangements, custodians or transfer agents invest the funds' overnight cash balances with custodians, and offset the fees they charge mutual funds against the income they earned on the cash. Transfer agents, for example, sometimes have access to mutual funds' cash for several days, between the time mutual funds transfer cash to them the transfer agents to pay out dividends and shareholders cash their checks.
But stating such costs is unlikely to have much impact on funds' yields, if at all, because the SEC also will likely ask funds to estimate the income they have lost by having their cash sit idle with custodians or transfer agents.
"You've lost the use of your money, so you've forgone some investment. On the other hand, you have canceled some expenses, so unless you have forgone more in yield than expenses paid by the custodian, it would probably be a wash," explained Tom S. Harman, partner at Fried, Frank, Harris, Shriver & Jacobson, and chief counsel at the SEC's division of investment management until last year.
John Montgomery, president of Bridgeway Capital Management, Houston, which manages the Bridgeway group of equity funds, thinks disclosing such arrangements could actually improve fund performance by prompting funds to take them into account when negotiating custodial contracts, and ensuring the funds don't have idle cash with custodians unless absolutely necessary.
