Compensation Practices for Retail Sale of Mutual Funds: the Need for Transparency and Disclosure

I. Introduction Mutual fund firms, also known as investment companies or investment trusts, buy and sell stocks, bonds, and other securities.2 A fund raises money to make its purchases by selling shares in itself. The fund pools the money of many investors - its shareholders - to invest in the securities.3 Those securities are professionally managed by fund managers on behalf of the shareholders. After the trading costs and expenses of managing and administering the fund are subtracted, the earnings realized by the fund on its investment portfolio are paid out pro-rata to the fund's shareholders. Shareholders may also realize investment gains by selling (or redeeming) their shares back to the fund at the shares' net asset value (the total value of the fund's assets divided by the number of shares outstanding). Mutual have recently become increasingly popular vehicles for individual investors in the United States. In 1980 there were 564 with assets totaling $134.8 billion.4 As of the end of December 2005 there were 7,977 with combined assets of $8,905 trillion.5 Similarly, in 1980, 4.6 million households owned mutual fund shares, representing only 5.7% of all households in the United States.6 As of 2005, 91 million individuals in 54 million households (nearly half of all households) owned mutual funds.7 It should be noted that the majority of household investments in mutual occur through employee retirement plans.8 A healthy percentage, however, is purchased by the investors themselves, and of those purchases, more than 80% are made through financial professionals.9 Individual investors can purchase mutual fund shares on the retail market in one of two ways, either directly from the fund, or through an intermediary seller. In the first case, investors purchase directmarketed funds via phone, mail, or the internet. In the second instance, the fund's underwriter acts as a wholesaler or distributor to an intermediary firm, (e.g. a brokerage firm, an asset management company, a financial planning firm, an insurance agency, or a bank) which in turn sells to the individual investor via a sales force. 10 Some brokerage firms also sell their own private-label funds. The typical retail shopper who purchases shares through a financial adviser will be given a fund prospectus. The prospectus includes information regarding the investment objective of the fund, the historical investment performance of the fund, and the costs and expenses the shareholder will pay. The compensation received by the financial adviser for recommending or selling the shares is included in the fee table in the prospectus; however, in most cases it is not identified explicitly. Adviser compensation information is required to be presented explicitly in the Statement of Additional Information (SAI). The SAI must also include a description of potential conflicts of interest which the adviser's method of compensation might create. Notable, however, is the fact that the SAI is provided to the potential shareholders only if they specifically request it. Brokerage firms and the various financial advisers who sell mutual to retail purchasers may be compensated in a variety of ways, including (1) loads, or sales charges paid directly by the purchaser; (2) marketing fees, also known as 12b-(11) fees; and (3) fund servicing and operating expenses.12 Both 12b-l and fund expense fees are paid out of the assets of the fund, and thus are ultimately paid by the shareholders. Payments from each of these sources compensate financial advising firms and their personnel for providing a wide range of services, including the administering of shareholder records, processing transactions, training the advisers who sell the funds, and investor education. While fund firms assert that these services provide advisers and investors with valuable benefits, others, including regulators, criticize the lack of transparency in brokerage firm compensation, since it is practically impossible for investors to know precisely if, and how, financial advisers are paid out of fund assets. …