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Mutual fund system in need of repair

By DAR HADDIX, UPI Business Correspondent

WASHINGTON, Jan. 28 (UPI) -- Illinois Democratic Senator Peter Fitzgerald says it's high time Congress gave other Americans the same high-quality mutual fund system it has given itself.

During a Senate hearing Tuesday on the mutual fund scandal, Fitzgerald said that unlike most Americans, members of Congress "don't have to worry about excessive fees, directed brokerage, revenue sharing arrangements or soft dollar payments eating away at your savings."

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Fitzgerald pointed out that the federal government's version of the 401k, the Thrift Savings Plan (TSP), only costs shareholders 11 cents per $100 invested, whereas the average expense ratio for private sector index funds is 63 cents per $100 invested -- which adds up to large differences over the long-term, he said.

And, that's not even including transaction fees.

"Expense ratios fail to take into account the costs of commissions in the purchase and sale of securities," said Sen. Daniel Akaka, D-Hawaii.

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"A senator or congressman ... who participates in the TSP will have more money at retirement than a member of the general public," with comparable investments, Fitzgerald said.

But for those not lucky enough to work for Uncle Sam, Fitzgerald said, "The mutual fund industry is indeed the world's largest skimming operation -- a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off ... the country's household, college, and retirement savings."

Ironically, a study commissioned by the Investment Company Institute, a national association of the U.S. investment company industry, estimated that it would only cost each investor an extra $1.07 per year for better disclosure, according to a report by the General Accounting Office.

Some of this siphoning comes from revenue sharing. The practice, where fund advisers give commissions to brokers who bring in new customers for the fund, skims $2 billion a year off investor earnings, said University of North Carolina law professor John Freeman. Revenue sharing can also create a conflict of interest that could cause brokers only to offer the funds that get them a profit, according to the GAO report. About 80 percent of fund companies that partner with brokers do revenue sharing, according to the report

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Another issue is "soft-dollar" arrangements, where fund advisers and others who provide services to investors arrange to pay brokers a commission in exchange for a bundle of services like trade execution and research. Here, the fees also come out of investors' pockets.

According to Roy Weitz, the publisher of FundAlarm.com, the culprit here is a loophole in SEC Rule 12b-1, which says that funds can charge shareholders for commissions. Weitz suggested that companies should describe the services or value shareholders received from 12b-1 fees, as well as a description of how the fees are being used to help lower expenses.

While the GAO report said that soft dollars pay for research which benefits all investors, it also pointed out that trades executed by brokers who provide soft-dollar products are usually more expensive than trades executed through other brokers. And, advisers could do excessive trading to pay for more soft-dollar services. This all adds up to more costs and less profit for investors.

"These types of secret commissions ... mean investors can't rely on getting objective investment advice," said Sen. Carl Levin, D-Mich.

Levin also called for expense ratios to disclose all costs. "According to consumer groups, these portfolio transaction costs sometimes exceed all other costs combined that currently are in the expense ratio," Levin said.

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The root of the problem seems to be that external management of mutual funds leads to high fees that subtract from investor earnings, according to John Bogle, founder and former CEO of Vanguard Group. Most mutual funds are in fact not really mutual funds, since true mutual funds are managed by their own trustees, and "compensated not on the basis of the trust's principal, but ... its income," Bogle said.

So, the Congress TSP fund and Vanguard are two of the only real mutual funds in the nation, according to this definition. Bogle pointed out that Vanguard's costs are the lowest in the industry and its stock has risen for the last 20 years straight. But for the most part, "We are running this [mutual fund] industry in the interests of fund managers," Bogle said at the hearing.

What fee information is available is usually only found in fund prospectuses. "Brokerage commissions are only disclosed to the investor upon request in the 'Statement of Additional Information.' ... Commissions must be disclosed in a document and in a format that investors actually have access to and utilize," Akaka said.

Sen. Susan Collins, R-Maine, suggested that the information be included on investors' monthly or quarterly statements.

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But the information isn't only hard to find, it's hard to understand. For example, funds use percentages instead of actual dollar costs to explain operating expenses that come out of investment returns.

Even investment veteran Peter Kugi of Grafton, Wis., who said he's been investing for 20 years and reads all his fund prospectuses religiously, complained that "Fees and charges simply aren't clear and defined in a consistent fashion to the extent an average investor can discern them."

Understanding the financial details of a fund is important since what might seem like small fee differences in fact can amount to a lot of money over time. The GAO study shows that for a $10,000 investment at 8 percent return annually, the difference between a 1 percent fee or a 2 percent fee can amount to a $7,000 difference over 20 years. Also, when fees are expressed as a percent of assets, it's difficult for an investor to compare fees for a $500,000 fund and a $100 million fund.

Investors also need to pay more attention to fees and less attention to the historical performance of a fund, since choosing a high-performing fund with a high expense ratio could result in far less returns than picking an average earner with a lower expense ratio, Collins warned.

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Paul Stevens, a lawyer and spokesperson for the Investment Company Institute, said that it supports reforms including restricting soft dollar arrangements, disclosure of the dollar amount of expenses, and better disclosure of transaction costs.

To "rebalance the scale" between the interests of fund managers and shareholders, Bogle suggested the "mutualization" of at least some pseudo-mutual funds. Then, "the huge profits now earned by external managers would be diverted to the shareholders ...[and] they wouldn't waste money on costly marketing companies designed to bring in new investors at the expense of existing investors."

Bogle quoted economist Peter Bernstein: "What happens to the wealth of individual investors cannot be separated from the structure of the industry that manages those assets."

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