WASHINGTON - Pressure is mounting on securities regulators to require mutual fund companies to spotlight hidden soft-dollar arrangements between their money managers and brokerage firms.
Mutual funds might be required to include the cost of brokerage commissions in the expense ratio, or even the total brokerage cost, including estimates of the market impact of trades. William Donaldson, chairman of the Securities and Exchange Commission, has a June 11 deadline to respond to a request by Republican and Democratic lawmakers with proposals to tackle soft dollars, as well as a laundry list of other issues.
Also on the table: requiring investment advisers to mutual funds to "gross up" their management fees. That would require mutual fund advisers to add into their management fees the value of the research and other services they receive from brokerage houses in exchange for buying and selling securities through them.
"We could do it on our own, sure," said Douglas J. Scheidt, associate director and chief counsel at the SEC's division of investment management. He is drafting the agency's responses to the congressional requests.
More likely, though, is that Congress will direct the SEC to issue new disclosure rules, he said, noting the agency some years ago overhauled the information mutual funds must provide investors in prospectuses and other documents.
Under current securities rules, mutual funds need disclose only investment management fees, distribution and marketing expenses and administrative operating expenses as a percentage of net assets in the expense ratio, the benchmark by which investors gauge the cost of mutual funds.
Investment managers of mutual funds - both internal managers and subadvisers - are not required to disclose the value of the soft-dollar research and other services they receive from brokers. The SEC proposed such a rule in 1993, but abandoned it after being deluged with negative comments.
Now, the heat is on the SEC again, prompted in part by reports of rising mutual fund expenses when trading volumes and stock prices are lower, plus the widespread expectation that the move toward reporting stock prices in decimals would lower spreads and squeeze commissions.
Even though the average stock price dropped to $30 in the third quarter of 2002 from about $50 in the third quarter of 1997, the commission per share rose to 16 basis points from 12, and the total brokerage cost including market impact rose to 147 basis points from 101, according to the latest data from Plexus Group Inc., Los Angeles.
Even more damning, a recent report by the General Accounting Office commissioned by Rep. Michael Oxley, R-Ohio, chairman of the House Financial Services Committee, found that the average expense ratio for large stock funds rose about 8% between 1998 and 2001, to 0.70% in 2001 from 0.65%, while the average expense ratio for bond funds declined.
The SEC also faces pressure from regulatory action being considered by the Financial Services Authority in the United Kingdom. The authority last month proposed banning money managers from using soft dollars to purchase stock quotation screens, and requiring money managers to get express approval from their clients before engaging in soft-dollar arrangements.
"It feels like the momentum is building," said Stephanie Monaco, a partner in the Washington law firm of Crowell and Moring, and a former SEC official. "I think the commission is going to have to do something to be responsive to congressional pressure," said Ms. Monaco, who discussed the issue at a recent investment management conference in Washington.
Harold Bradley, senior vice president at American Century Investments in Kansas City, Mo., has railed against soft dollars for years. He believes the reasons for disclosing such arrangements are compelling: Mutual fund advisers already charge mutual funds a management fee, which they can spend on research, stock quotation machines and other tools of investment management. American Century, which shuns soft dollars, charges a 1% management fee for all domestic equity funds
"Commissions used by investment managers to pay for goods and services customarily available to the general public for cash should be explicitly carried as a cost of managing money in a mutual fund's expense ratio," Mr. Bradley testified before a hearing on mutual fund fees two months ago.
Reps. Richard Baker, R-La.; Paul E. Kanjorski, D-Pa.; and Robert W. Ney, R-Ohio, all have asked the SEC to comment on whether investors should receive better information on brokerage expenses and soft dollars.
Mercer Bullard, head of Fund Democracy, Oxford, Miss., and a former assistant chief counsel in the SEC's investment management division, said forcing mutual funds to put soft dollars on the books by including them in the expense ratio would reveal their true costs because of the tendency by funds to conceal expenses by paying for them off the books.
But Mr. Bullard, a vocal critic of the SEC, rates the chances of the agency proposing such a rule as "less than 50-50."
Gary Gensler, a former senior Treasury Department official in the Clinton administration and author of "The Great Mutual Fund Trap," believes the most likely proposal will require investment managers to gross up their management fees to reflect the cost of soft-dollar services they receive.
"What's hard to figure out is how soft-dollar payments can ever be for the clients' benefits when they might otherwise have to be paid for by the adviser," he said.
Not surprisingly, the mutual fund industry fiercely opposes any attempt to broaden disclosures, and is expected to lobby hard against any proposals.
Mr. Bradley worries the proposals would handicap active mutual funds that trade more frequently than index funds. "I want to make sure we don't strip away the good things about active management," he said. n