For the most part, I'm not a big fan of government regulation and oversight. Typically, the entire process is marred by inefficiencies and decision-making that is completely removed from the day-to-day realities of the situation in question. However, there are exceptions to this rule, when I think the government agency in question is right on track. And the recent announcement from the SEC on its agenda for mutual fund reform is one such example.
Independence is a good thing
The first issue on the Securities and Exchange Commission's radar screen is to revisit a fund governance rule that would require that 75% of a fund's board of directors, including its chairman, be independent from fund management. The commission actually approved this provision twice in years past and swiftly encountered opposition from the Investment Company Institute and several prominent fund companies, who said it would be too costly to implement. Both times this proposal was slapped down by a federal appeals court for lack of a proper cost-benefit analysis. This time, the SEC released such an analysis in December, and it's looking at responses to the report. The SEC hopes that this time it can make the proposal stick.
So how does having an independent board of directors help you as a mutual fund investor? Well, because the board sets all fees and expenses for the fund, having a board that is separate from management helps to ensure that fees are low, rather than being artificially inflated to benefit management. The same goes for the other operational details the board deals with on a day-to-day basis. An independent board is there to ensure that any decisions are made to benefit the shareholders, and not the fund company's management. The idea is to eliminate, or at least minimize, any potential conflicts of interest.
The whole concept of creating an independent board began several years ago in the wake of the mutual fund scandals that seemed to make headlines day after day. The scandal rocked many fund management companies, including Janus Capital (NYSE:JNS) and Franklin Resources (NYSE:BEN), and Marsh & McLennan's (NYSE:MMC) Putnam unit. Many believed that an independent board would act as a safeguard to ensure that these types of scandals and misdeeds would not occur again. However, in my opinion, even if every mutual fund out there had been in compliance with the independent board directive in 2003, the outcome would still have been pretty much the same. These scandals resulted from a much more widespread and systemic breakdown of oversight at the fund board level, and requiring the board to be independent would not have been sufficient to address this breach. Yet while changes like these probably wouldn't have actually prevented the scandals, that doesn't mean the whole idea should be tossed. A move toward greater independence on the part of mutual fund boards is a move in the right direction, despite the initial upfront costs of time and money many funds will face to bring their boards into compliance. To be sure, fund companies will whine if this proposal becomes law, but in the end their job is to take actions that benefit the shareholders of the fund, and it's hard to see how this change would not ultimately be to their benefit.
12b-1 fees on the table
The second item on the SEC's to-do list is to revisit 12b-1 fees for mutual funds. The fund company charges these fees, ostensibly to cover sales and marketing expenses. The SEC originally approved these fees more than 25 years ago, thinking that they would be a temporary measure for funds to attract new investors by spreading their marketing costs across a larger asset base. However, these fees still exist today, when the mutual fund industry faces little danger of consolidation in comparison with the early 1980s.
The problem here is that even as many funds have grown substantially in size, 12b-1 fees have not gone away. In fact, more often that not, these fees are used as a backdoor method for compensating brokers who sell the funds. It's not uncommon for more of the 12b-1 fee to go toward compensating broker-dealers than is actually used in marketing the fund. A quick search in Morningstar (NASDAQ:MORN) reveals that of the 1,047 funds that are closed to new investment now, 669 of these funds still charge a 12b-1 fee. These funds are obviously not trying to attract new investment anymore, yet are still charging a fee that was designed to help them do just that!
I think it makes sense for Fools to try to avoid funds with 12b-1 fees, if at all possible. These are basically another "load" on the fund, and there are plenty of true no-load funds out there vying for your investment dollars. But the fact that the SEC wants to review fund companies' use of these fees is a positive development. In the end, nothing much may change, but if all that comes of their analysis is that investors are made more aware of the existence of 12b-1 fees and how they affect their returns, that's not necessarily a bad thing.
The bottom line is that both of these SEC agenda items are positive actions, and are addressing legitimate concerns within the mutual fund industry. It remains to be seen if the SEC will actually make any significant changes and, if so, how smoothly their implementation goes, but this is one time I can't complain about governmental oversight. This time, the SEC has gotten it right.
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Fool contributor Amanda Kish lives in Rochester, N.Y., and appreciates your feedback. She doesn't own shares of any company mentioned in this article. The Fool has a disclosure policy.
