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Before the Subcommittee on Financial Management, the Budget and 
International Security, Committee on Governmental Affairs, U.S. Senate:

United States General Accounting Office:


For Release on Delivery Expected at 10:00 a.m. EST:

Tuesday, January 27, 2004:

Mutual Funds:

Additional Disclosures Could Increase Transparency of Fees and Other 

Statement of Richard J. Hillman, Director, Financial Markets and 
Community Investment:


GAO Highlights:

Highlights of GAO-04-317T, a testimony to the Chairman, Subcommittee 
on Financial Management, the Budget and International Security, 
Committee on Governmental Affairs, U.S. Senate 

Why GAO Did This Study:

Concerns have been raised over whether the disclosures of mutual fund 
fees and other fund practices are sufficiently fair and transparent to 
investors. Our June 2003 report, Mutual Funds: Greater Transparency 
Needed in Disclosures to Investors, GAO-03-763, reviewed (1) how 
mutual funds disclose their fees and related trading costs and options 
for improving these disclosures, (2) changes in how mutual funds pay 
for the sale of fund shares and how the changes in these practices are 
affecting investors, and (3) the benefits of and the concerns over 
mutual funds’ use of soft dollars. This testimony summarizes the 
results of our report and discusses certain events that have occurred 
since it was issued.

What GAO Found:

Although mutual funds disclose considerable information about their 
costs to investors, the amount of fees and expenses that each investor 
specifically pays on their mutual fund shares are currently disclosed 
as percentages of fund assets, whereas most other financial services 
disclose the actual costs to the purchaser in dollar terms. SEC staff 
has proposed requiring funds to disclose additional information that 
could be used to compare fees across funds. However, SEC is not 
proposing that funds disclose the specific dollar amount of fees paid 
by each investor nor is it proposing to require that any fee 
disclosures be made in the account statements that investors receive. 
Although some of these additional disclosures could be costly and data 
on their benefits to investors was not generally available, less 
costly alternatives exist that could increase the transparency and 
investor awareness of mutual funds fees, making consideration of 
additional fee disclosures worthwhile.

Changes in how mutual funds pay intermediaries to sell fund shares 
have benefited investors but have also raised concerns. Since 1980, 
mutual funds, under SEC Rule 12b-1, have been allowed to use fund 
assets to pay for certain marketing expenses. Over time the use of 
these fees has evolved to provide investors greater flexibility in 
choosing how to pay for the services of individual financial 
professionals that advise them on fund purchases. Another increasingly 
common marketing practice called revenue sharing involves fund 
investment advisers making additional payments to the broker-dealers 
that distribute their funds’ shares. However, these payments may cause 
the broker-dealers receiving them to limit the fund choices they offer 
to investors and conflict with their obligation to recommend the most 
suitable funds. Regulators acknowledged that the current disclosure 
regulations might not always result in complete information about 
these payments being disclosed to investors.

Under soft dollar arrangements, mutual fund investment advisers use 
part of the brokerage commissions they pay to broker-dealers for 
executing trades to obtain research and other services. Although 
industry participants said that soft dollars allow fund advisers 
access to a wider range of research than may otherwise be available 
and provide other benefits, these arrangements also can create 
incentives for investment advisers to trade excessively to obtain more 
soft dollar services, thereby increasing fund shareholders’ costs. SEC 
staff has recommended various changes that would increase transparency 
by expanding advisers’ disclosure of their use of soft dollars. By 
acting on the staff’s recommendations, SEC would provide fund 
investors and directors with needed information about how their funds’ 
advisers are using soft dollars. 

What GAO Recommends:

GAO recommends that SEC consider the benefits of requiring additional 
disclosure relating to mutual fund fees and evaluate ways to provide 
more information that investors could use to evaluate the conflicts of 
interest arising from payments funds make to broker-dealers and fund 
advisers’ use of soft dollars. SEC generally agreed with the contents 
of our report and indicated that it will consider the recommendations 
in this report carefully in determining how best to inform investors 
about the importance of fees and other disclosures.

To view the full report, including the scope and methodology, click on 
the link above. For more information, contact Richard Hillman at (202) 
512-8678 or

[End of section]

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here to discuss GAO's work on the disclosure of 
mutual fund fees and the need for other disclosures of mutual fund 
practices. The fees and other costs that mutual fund investors pay as 
part of owning fund shares can significantly affect their investment 
returns. In addition, changes over time in how mutual funds pay 
intermediaries to sell fund shares have also raised concerns. As a 
result, it is appropriate to debate whether the disclosures of mutual 
fund fees and fund marketing practices are sufficiently transparent and 
fair to investors.

Today, I will summarize the results from our report entitled Mutual 
Funds: Greater Transparency Needed in Disclosures to Investors, GAO-03-
763 (Washington, D.C.: June 9, 2003). Specifically, I will discuss (1) 
mutual fund fee disclosures and opportunities for improving these 
disclosures, (2) the potential conflicts that arise when mutual fund 
advisers pay broker-dealers to sell fund shares, and (3) the benefits 
and concerns over fund advisers' use of soft dollars. I will also 
provide information relating to certain events that have occurred since 
our June 2003 report was issued.

In summary:

The results of our work suggest a need to consider ways to increase the 
transparency of mutual fund fees and other fund practices. Mutual funds 
disclose considerable information about their costs to investors, 
including presenting the operating expense fees that they charge 
investors as a percentage of fund assets and providing hypothetical 
examples of the amount of fees that an investor can expect to pay over 
various time periods. However, unlike many other financial products and 
services, mutual funds do not disclose to individual investors the 
specific dollar amount of fees that are paid on their fund shares. The 
Securities and Exchange Commission (SEC) has proposed that mutual funds 
make additional disclosures to investors that would provide more 
information that investors could use to compare fees across funds. 
However, SEC is not proposing that funds disclose the specific dollar 
amount of fees paid by each investor nor is it proposing to require 
that any fee disclosures be made in the account statements that inform 
investors of the number and value of the mutual fund shares they own. 
Our report recommends that SEC consider requiring mutual funds to make 
additional disclosures to investors, including considering requiring 
funds to specifically disclose fees in dollars to each investor in 
quarterly account statements. SEC has agreed to consider requiring such 
disclosures but was unsure that the benefits of implementing specific 
dollar disclosures outweighed the costs to produce such disclosures. 
However, we estimate that spreading these implementation costs across 
all investor accounts might not represent a large outlay on a per 
investor basis. Our report also discusses less costly alternatives that 
could also prove beneficial to investors and spur increased competition 
among mutual funds on the basis of fees.

The work that we conducted for our report also found that 12b-1 fees, 
which allow fund companies to deduct certain distribution expenses such 
as sales commissions from fund assets, can raise costs to investors but 
also provide additional ways for investors to pay for investment 
advice. Our work also found that mutual fund advisers have been 
increasingly engaged in a practice known as revenue sharing under which 
they make additional payments to the broker-dealers that sell their 
fund shares. Although we found that the impact of these payments on the 
expenses of fund investors was uncertain, these payments can create 
conflicts between the interests of broker-dealers and their customers 
that could limit the choices of funds that these broker-dealers offer 
investors. However, under current disclosure requirements investors may 
not always be explicitly informed that their broker-dealer, who is 
obligated to recommend only suitable investments based on the 
investor's financial condition, is also receiving payments to sell 
particular funds. Our report recommends that more disclosure be made to 
investors about any revenue sharing payments their broker-dealers are 
receiving. On January 14, 2004, SEC proposed new rules and rule 
amendments designed to enhance the information that broker-dealers 
provide to their customers concerning conflicts of interest that arise 
from the sale of mutual funds.

We also reviewed a practice known as soft dollars, in which a mutual 
fund adviser uses fund assets to pay commissions to broker-dealers for 
executing trades in securities for the mutual fund's portfolio but also 
receives research or other brokerage services as part of the 
transaction. These soft dollar arrangements can result in mutual fund 
advisers obtaining research or other services, including research from 
third party independent research firms, that can benefit the investors 
in their funds. However, these arrangements also create a conflict of 
interest that could result in increased expenses to fund shareholders 
if a fund adviser trades excessively to obtain additional soft dollar 
research or chooses broker-dealers more on the basis of their soft 
dollar offerings than their ability to execute trades efficiently. SEC 
has addressed soft dollar practices in the past and recommended actions 
could provide additional information to fund directors and investors, 
but has not yet acted on some of its own recommendations. Our report 
recommends that more disclosure be made to mutual fund directors and 
investors to allow them to better evaluate the benefits and potential 
disadvantages of their fund adviser's use of soft dollars.

Finally, since September 2003, federal and state authorities' widening 
investigation of illegal late trading and improper timing of fund 
trades has involved a growing number of prominent mutual fund companies 
and brokerage firms. To address these abusive practices, regulators are 
considering the merits of various proposals that have been put forth. 
In addition, in November 2003, the House of Representatives acted on 
legislation that addresses abusive trading and various other mutual 
fund issues and legislation was introduced in the Senate. The House of 
Representatives passed H.R. 2420, the Mutual Funds Integrity and Fee 
Transparency Act of 2003. H.R. 2420's purpose is to (1) improve 
transparency of mutual fund fees and costs and (2) improve corporate 
governance and management integrity of mutual funds. Also in November 
2003, three bills addressing mutual fund concerns were introduced in 
the Senate. The Mutual Fund Transparency Act of 2003, S. 1822, would 
require disclosure of financial relationships between brokers and 
mutual fund companies and of certain brokerage commissions paid by 
mutual fund companies. S. 1958, the Mutual Fund Investor Protection Act 
of 2003, was introduced to prevent the practice of late trading by 
mutual funds, and for other purposes. S. 1971, the Mutual Fund Investor 
Confidence Restoration Act of 2003 seeks to improve transparency 
relating to the fees and costs that mutual fund investors incur and to 
improve corporate governance of mutual funds.

Additional Disclosure of Mutual Fund Costs Might Benefit Investors:

Although mutual funds already disclose considerable information about 
the fees they charge, our report recommends that SEC consider requiring 
that mutual funds make additional disclosures to investors about fees 
in the account statements that investors receive. Mutual funds 
currently provide information about the fees they charge investors as 
an operating expense ratio that shows as a percentage of fund assets 
all the fees and other expenses that the fund adviser deducts from the 
assets of the fund. Mutual funds also are required to present a 
hypothetical example that shows in dollar terms what investors could 
expect to pay in fees if they invested $10,000 in a fund and held it 
for various periods. It is important to understand the fees charged by 
a mutual fund because fees can significantly affect investment returns 
of the fund over the long term. For example, over a 20-year period a 
$10,000 investment in a fund earning 8 percent annually, with a 1-
percent expense ratio, would be worth $38,122; but with a 2-percent 
expense ratio it would be worth $31,117--over $7,000 less.

Unlike many other financial products, mutual funds do not provide 
investors with information about the specific dollar amounts of the 
fees that have been deducted from the value of their shares. Table 1 
shows that many other financial products do present their costs in 
specific dollar amounts.

Table 1: Fee Disclosure Practices for Selected Financial Services or 

Type of product or service: Mutual funds; Disclosure requirement: 
Mutual funds show the operating expenses as percentages of fund assets 
and dollar amounts for hypothetical investment amounts based on 
estimated future expenses in the prospectus.

Type of product or service: Deposit accounts; Disclosure requirement: 
Depository institutions are required to disclose itemized fees, in 
dollar amounts, on periodic statements.

Type of product or service: Bank trust services; Disclosure 
requirement: Although covered by varying state laws, regulatory and 
association officials for banks indicated that trust service charges 
are generally shown as specific dollar amounts.

Type of product or service: Investment services provided to individual 
investment accounts (such as those managed by a financial planner); 
Disclosure requirement: When the provider has the right to deduct fees 
and other charges directly from the investor's account, the dollar 
amounts of such charges are required to be disclosed to the investor.

Type of product or service: Wrap accounts[A]; Disclosure requirement: 
Provider is required to disclose dollar amount of fees on investors' 

Type of product or service: Stock purchases; Disclosure requirement: 
Broker-dealers are required to report specific dollar amounts charged 
as commissions to investors.

Type of product or service: Mortgage financing; Disclosure 
requirement: Mortgage lenders are required to provide at time of 
settlement a statement containing information on the annual percentage 
rate paid on the outstanding balance, and the total dollar amount of 
any finance charges, the amount financed, and the total of all 
payments required.

Type of product or service: Credit cards; Disclosure requirement: 
Lenders are required to disclose the annual percentage rate paid for 
purchases and cash advances, and the dollar amounts of these charges 
appear on cardholder statements. 

Source: GAO analysis of applicable disclosure regulations, rules, and 
industry practices.

[A] In a wrap account, a customer receives investment advisory and 
brokerage execution services from a broker-dealer or other financial 
intermediary for a "wrapped" fee that is not based on transactions in 
the customer's account.

[End of table]

Although mutual funds do not disclose their costs to each individual 
investor in specific dollars, the disclosures that they make do exceed 
those of many products. For example, purchasers of fixed annuities are 
not told of the expenses associated with investing in such products. 
Some industry participants and others including SEC also cite the 
example of bank savings accounts, which pay stated interest rates to 
their holders but do not explain how much profit or expenses the bank 
incurs to offer such products. While this is true, we do not believe 
this is an analogous comparison to mutual fund fees because the 
operating expenses of the bank are not paid using the funds of the 
savings account holder and are therefore not explicit costs to the 
investor like the fees on a mutual fund.

A number of alternatives have been proposed for improving the 
disclosure of mutual fund fees, that could provide additional 
information to fund investors. In December 2002, SEC released proposed 
rule amendments, which include a requirement that mutual funds make 
additional disclosures about their expenses.[Footnote 1] This 
information would be presented to investors in the annual and 
semiannual reports prepared by mutual funds. Specifically, mutual funds 
would be required to disclose the cost in dollars associated with an 
investment of $10,000 that earned the fund's actual return and incurred 
the fund's actual expenses paid during the period. In addition, SEC 
also proposed that mutual funds be required to disclose the cost in 
dollars, based on the fund's actual expenses, of a $10,000 investment 
that earned a standardized return of 5 percent. If these disclosures 
become mandatory, investors will have additional information that could 
be directly compared across funds. By placing the disclosures in funds' 
annual and semiannual reports, SEC staff also indicated that it will 
facilitate prospective investors comparing funds' expenses before 
making a purchase decision.

However, SEC's proposal would not require mutual funds to disclose to 
each investor the specific amount of fees in dollars that are paid on 
the shares they own. As result, investors will not receive information 
on the costs of mutual fund investing in the same way they see the 
costs of many other financial products and services that they may use. 
In addition, SEC did not propose that mutual funds provide information 
relating to fees in the quarterly or even more frequent account 
statements that provide investors with the number and value of their 
mutual fund shares. In a 1997 survey of how investors obtain 
information about their funds, Investment Company Institute (ICI) 
indicated that, to shareholders, the account statement is probably the 
most important communication that they receive from a mutual fund 
company and that nearly all shareholders use such statements to monitor 
their mutual funds.

SEC and industry participants have indicated that the total cost of 
providing specific dollar fee disclosures might be significant; 
however, we found that the cost might not represent a large outlay on a 
per investor basis. As we reported in our March 2003 statement for the 
record to the Subcommittee on Capital Markets, Insurance, and 
Government Sponsored Enterprises, House Committee on Financial 
Services, ICI commissioned a large accounting firm to survey mutual 
fund companies about the costs of producing such disclosures. [Footnote 
2] Receiving responses from broker-dealers, mutual fund service 
providers, and fund companies representing approximately 77 percent of 
total industry assets as of June 30, 2000, this study estimated that 
the aggregated estimated costs for the survey respondents to implement 
specific dollar disclosures in shareholder account statements would 
exceed $200 million, and the annual costs of compliance would be about 
$66 million. Although the ICI study included information from some 
broker-dealers and fund service providers, it did not include the 
reportedly significant costs that all broker-dealers and other third-
party financial institutions that maintain accounts on behalf of 
individual mutual fund shareholders could incur. However, using 
available information on mutual fund assets and accounts from ICI and 
spreading such costs across all investor accounts indicates that the 
additional expenses to any one investor are minimal. Specifically, at 
the end of 2001, ICI reported that mutual fund assets totaled $6.975 
trillion. If mutual fund companies charged, for example, the entire 
$266 million cost of implementing the disclosures to investors in the 
first year, then dividing this additional cost by the total assets 
outstanding at the end of 2001 would increase the average fee by 0.0038 
percent or about one-third of a basis point. In addition, ICI reported 
that the $6.975 trillion in total assets was held in over 248 million 
mutual fund accounts, equating to an average account of just over 
$28,000. Therefore, implementing these disclosures would add $1.07 to 
the average $184 that these accounts would pay in total operating 
expense fees each year--an increase of six-tenths of a 
percent.[Footnote 3]

In addition, other less costly alternatives are also available that 
could increase investor awareness of the fees they are paying on their 
mutual funds by providing them with information on the fees they pay in 
the quarterly statements that provide information on an investor's 
share balance and account value. For example, one alternative that 
would not likely be overly expensive would be to require these 
quarterly statements to present the information--the dollar amount of a 
fund's fees based on a set investment amount--that SEC has proposed be 
added to mutual fund semiannual reports. Doing so would place this 
additional fee disclosure in the document generally considered to be of 
the most interest to investors. An even less costly alternative could 
be to require quarterly statements to also include a notice that 
reminds investors that they pay fees and to check their prospectus and 
with their financial adviser for more information. In September 2003, 
SEC amended fund advertising rules, which require funds to state in 
advertisements that investors should consider a fund's fees before 
investing and directs investors to consult their funds' 
prospectus.[Footnote 4] However, also including this information in the 
quarterly statement could increase investor awareness of the impact 
that fees have on their mutual fund's returns. H.R. 2420 would require 
that funds disclose in the quarterly statement or other appropriate 
shareholder report an estimated amount of the fees an investor would 
have to pay on each investment of $1,000. S. 1958, like H.R. 2420, 
would require disclosure of fees paid on each $1,000 invested. S. 1971, 
among other disclosures, would require that funds disclose the actual 
cost borne by each shareholder for the operating expenses of the fund.

SEC's current proposal, while offering some advantages, does not make 
mutual funds comparable to other products and provide information in 
the document that is most relevant to investors--the quarterly account 
statement. Our report recommends that SEC consider requiring additional 
disclosures relating to fees be made to investors in the account 
statement. In addition to providing specific dollar disclosures, we 
also noted that investors could be provided with a variety of other 
disclosures about the fees they pay on mutual funds that would have a 
range of implementation costs, including some that would be less costly 
than providing specific dollar disclosures. However, seeing the 
specific dollar amount paid on shares owned could be the incentive that 
some investors need to take action to compare their fund's expenses to 
those of other funds and make more informed investment decisions on 
this basis. Such disclosures may also increasingly motivate fund 
companies to respond competitively by lowering fees. Because the 
disclosures that SEC is currently proposing be included in mutual fund 
annual and semiannual reports could also prove beneficial, it could 
choose to require disclosures in these documents and the account 
statements, which would provide both prospective and existing investors 
in mutual funds access to valuable information about the costs of 
investing in funds.

Disclosures of Trading Costs Could Benefit Investors:

Academics and other industry observers have also called for increased 
disclosure of mutual fund brokerage commissions and other trading costs 
that are not currently included in fund expense ratios. In an academic 
study we reviewed that looked at brokerage commission costs, the 
authors urged that investors pay increased attention to such 
costs.[Footnote 5] For example, the study noted that investors seeking 
to choose their funds on the basis of expenses should also consider 
reviewing trading costs as relevant information because the impact of 
these unobservable trading costs is comparable to the more observable 
expense ratio. The authors of another study noted that research shows 
that all expenses can reduce returns so attention should be paid to 
fund trading costs, including brokerage commissions, and that these 
costs should not be relegated to being disclosed only in mutual funds' 
Statement of Additional Information.[Footnote 6]

Mutual fund officials raised various concerns about expanding the 
disclosure of brokerage commissions and trading costs in general. Some 
officials said that requiring funds to present additional information 
about brokerage commissions by including such costs in the fund's 
operating expense ratios would not present information to investors 
that could be easily compared across funds. For example, funds that 
invest in securities on the New York Stock Exchange (NYSE), for which 
commissions are usually paid, would pay more in total commissions than 
would funds that invest primarily in securities listed on NASDAQ 
because the broker-dealers offering such securities are usually 
compensated by spreads rather than explicit commissions. Similarly, 
most bond fund transactions are subject to markups rather than explicit 
commissions. If funds were required to disclose the costs of trades 
that involve spreads, officials noted that such amounts would be 
subject to estimation errors. Officials at one fund company told us 
that it would be difficult for fund companies to produce a percentage 
figure for other trading costs outside of commissions because no agreed 
upon methodology for quantifying market impact costs, spreads, and 
markup costs exists within the industry. Other industry participants 
told us that due to the complexity of calculating such figures, trading 
cost disclosure is likely to confuse investors. For example funds that 
attempt to mimic the performance of certain stock indexes, such as the 
Standard & Poors 500 stock index, and thus limit their investments to 
just these securities have lower brokerage commissions because they 
trade less. In contrast, other funds may employ a strategy that 
requires them to trade frequently and thus would have higher brokerage 
commissions. However, choosing among these funds on the basis of their 
relative trading costs may not be the best approach for an investor 
because of the differences in these two types of strategies.

To improve the disclosure of trading costs to investors, the House-
passed H.R. 2420 would require mutual fund companies to make more 
prominent their portfolio turnover disclosure which, by measuring the 
extent to which the assets in a fund are bought and sold, provides an 
indirect measure of transaction costs for a fund. The bill directs 
funds to include this disclosure in a document that is more widely read 
than the prospectus or Statement of Additional Information, and would 
require fund companies to provide a description of the effect of high 
portfolio turnover rates on fund expenses and performance. H.R 2420 
also requires SEC to issue a concept release examining the issue of 
portfolio transaction costs. S. 1822 would require mutual funds to 
disclose brokerage commissions as part of fund expenses. S. 1958 would 
require SEC to issue a concept release on disclosure of portfolio 
transaction costs. S. 1971 would require funds to disclose the 
estimated expenses paid for costs associated with management of the 
fund that reduces the funds overall value, including brokerage 
commissions, revenue sharing and directed brokerage arrangements, 
transactions costs and other fees. In December 2003, SEC issued a 
concept release to solicit views on how SEC could improve the 
information that mutual funds disclose about their portfolio 
transaction costs.[Footnote 7]

Changes in Some Fund Distribution Practices Likely Beneficial But 
Others Raise Potential Conflicts of Interest:

The way that investors pay for the advice of financial professionals 
about their mutual funds has evolved over time. Approximately 80 
percent of mutual fund purchases are made through broker-dealers or 
other financial professionals, such as financial planners and pension 
plan administrators. Previously, the compensation that these financial 
professionals received for assisting investors with mutual fund 
purchases were paid by either charging investors a sales charge or load 
or by paying for such expenses out of the investment adviser's own 

However, in 1980, SEC adopted rule 12b-1 under the Investment Company 
Act to help funds counter a period of net redemptions by allowing them 
to use fund assets to pay the expenses associated with the distribution 
of fund shares. Rule 12b-1 plans were envisioned as temporary measures 
to be used during periods of declining assets. Any activity that is 
primarily intended to result in the sale of mutual fund shares must be 
included as a 12b-1 expense and can include advertising; compensation 
of underwriters, dealers, and sales personnel; printing and mailing 
prospectuses to persons other than current shareholders; and printing 
and mailing sales literature. These fees are called 12b-1 fees after 
the rule that allows fund assets to be used to pay for fund marketing 
and distribution expenses.

NASD, whose rules govern the distribution of fund shares by broker 
dealers, limits the annual rate at which 12b-1 fees may be paid to 
broker-dealers to no more than 0.75 percent of a fund's average net 
assets per year. Funds are allowed to include an additional service fee 
of up to 0.25 percent of average net assets each year to compensate 
sales professionals for providing ongoing services to investors or for 
maintaining their accounts. Therefore, 12b-1 fees included in a fund's 
total expense ratio are limited to a maximum of 1 percent per year. 
Rule 12b-1 provides investors an alternative way of paying for 
investment advice and purchases of fund shares. Apart from 12b-1 fees, 
brokers can be paid with sales charges called "loads"; "front-end" 
loads are applied when shares in a fund are purchased and "back-end" 
loads when shares are redeemed. With a 12b-1 plan, the fund can finance 
the broker's compensation with installments deducted from fund assets 
over a period of several years. Thus, 12b-1 plans allow investors to 
consider the time-related objectives of their investment and possibly 
earn returns on the full amount of the money they have to invest, 
rather than have a portion of their investment immediately deducted to 
pay their broker.

Rule 12b-1 has also made it possible for fund companies to market fund 
shares through a variety of share classes designed to help meet the 
different objectives of investors. For example, Class A shares might 
charge front-end loads to compensate brokers and may offer discounts 
called breakpoints for larger purchases of fund shares. Class B shares, 
alternatively, might not have front-end loads, but would impose asset-
based 12b-1 fees to finance broker compensation over several years. 
Class B shares also might have deferred back-end loads if shares are 
redeemed within a certain number of years and might convert to Class A 
shares if held a certain number of years, such as 7 or 8 years. Class C 
shares might have a higher 12b-1 fee, but generally would not impose 
any front-end or back-end loads. While Class A shares might be more 
attractive to larger, more sophisticated investors who wanted to take 
advantage of the breakpoints, smaller investors, depending on how long 
they plan to hold the shares, might prefer Class B or C shares because 
no sales charges would be deducted from their initial investments.

Although providing alternative means for investors to pay for the 
advice of financial professionals, some concerns exist over the impact 
of 12b-1 fees on investors' costs. For example, our June 2003 report 
discussed academic studies that found that funds with 12b-1 plans had 
higher management fees and expenses. Questions involving funds with 
12b-1 fees have also been raised over whether some investors are paying 
too much for their funds depending on which share class they purchase. 
For example, SEC recently brought a case against a major broker dealer 
that it accused of inappropriately selling mutual fund B shares, which 
have higher 12b-1 fees, to investors who would have been better off 
purchasing A shares that had much lower 12b-1 fees. Also, in March 
2003, NASD, NYSE, and SEC staff reported on the results of jointly 
administered examinations of 43 registered broker-dealers that sell 
mutual funds with a front-end load. The examinations found that most of 
the brokerage firms examined, in some instances, did not provide 
customers with breakpoint discounts for which they appeared to have 
been eligible.

Revenue Sharing Raises Conflict of Interest Concerns:

One mutual fund distribution practice--called revenue sharing--that has 
become increasingly common raises potential conflicts of interest 
between broker-dealers and their mutual fund investor customers. 
Broker-dealers, whose extensive distribution networks and large staffs 
of financial professionals who work directly with and make investment 
recommendations to investors, have increasingly required mutual funds 
to make additional payments to compensate their firms beyond the sales 
loads and 12b-1 fees. These payments, called revenue sharing payments, 
come from the adviser's profits and may supplement distribution-related 
payments from fund assets. According to an article in one trade 
journal, revenue sharing payments made by major fund companies to 
broker-dealers may total as much as $2 billion per year. According to 
the officials of a mutual fund research organization, about 80 percent 
of fund companies that partner with major broker-dealers make cash 
revenue sharing payments. For example, some broker-dealers have 
narrowed their offerings of funds or created preferred lists that 
include the funds of just six or seven fund companies that then become 
the funds that receive the most marketing by these broker-dealers. In 
order to be selected as one of the preferred fund families on these 
lists, the mutual fund adviser often is required to compensate the 
broker-dealer firms with revenue sharing payments.

One of the concerns raised about revenue sharing payments is the effect 
on overall fund expenses. A 2001 research organization report on fund 
distribution practices noted that the extent to which revenue sharing 
might affect other fees that funds charge, such as 12b-1 fees or 
management fees, was uncertain. For example, the report noted that it 
was not clear whether the increase in revenue sharing payments 
increased any fund's fees, but also noted that by reducing fund adviser 
profits, revenue sharing would likely prevent advisers from lowering 
their fees. In addition, fund directors normally would not question 
revenue sharing arrangements paid from the adviser's profits. In the 
course of reviewing advisory contracts, fund directors consider the 
adviser's profits not taking into account marketing and distribution 
expenses, which also could prevent advisers from shifting these costs 
to the fund.

Revenue sharing payments may also create conflicts of interest between 
broker-dealers and their customers. By receiving compensation to 
emphasize the marketing of particular funds, broker-dealers and their 
sales representatives may have incentives to offer funds for reasons 
other than the needs of the investor. For example, revenue sharing 
arrangements might unduly focus the attention of broker-dealers on 
particular mutual funds, reducing the number of funds considered as 
part of an investment decision-potentially leading to inferior 
investment choices and potentially reducing fee competition among 
funds. Finally, concerns have been raised that revenue sharing 
arrangements might conflict with securities self-regulatory 
organization rules requiring that brokers recommend purchasing a 
security only after ensuring that the investment is suitable given the 
investor's financial situation and risk profile.

Although revenue sharing payments can create conflicts of interest 
between broker-dealers and their clients, the extent to which broker-
dealers disclose to their clients that their firms receive such 
payments from fund advisers is not clear. Rule 10b-10 under the 
Securities Exchange Act of 1934 requires, among other things, that 
broker-dealers provide customers with information about third-party 
compensation that broker-dealers receive in connection with securities 
transactions. While broker-dealers generally satisfy the 10b-10 
requirements by providing customers with written "confirmations," the 
rule does not specifically require broker-dealers to provide the 
required information about third-party compensation related to mutual 
fund purchases in any particular document. SEC staff told us that they 
interpret rule 10b-10 to permit broker-dealers to disclose third-party 
compensation related to mutual fund purchases through delivery of a 
fund prospectus that discusses the compensation. However, investors 
would not receive a confirmation and might not view a prospectus until 
after purchasing mutual fund shares.

As a result of these concerns, our report recommends that SEC evaluate 
ways to provide more information to investors about the revenue sharing 
payments that funds make to broker-dealers. Having additional 
disclosures made at the time that fund shares are recommended about the 
compensation that a broker-dealer receives from fund companies could 
provide investors with more complete information to consider when 
making their investment decision. To address revenue sharing issues, we 
were pleased to see that a recent NASD rule proposal would require 
broker-dealers to disclose in writing when the customer first opens an 
account or purchases mutual fund shares compensation that they receive 
from fund companies for providing their funds "shelf space" or 
preference over other funds. On January 14, 2004, SEC proposed new 
rules and rule amendments designed to enhance the information that 
broker-dealers provide to their customers. H.R. 2420 would require fund 
directors to review revenue sharing arrangements consistent with their 
fiduciary duty to the fund. H.R. 2420 also would require funds to 
disclose revenue sharing arrangements and require brokers to disclose 
whether they have received any financial incentives to sell a 
particular fund or class of shares. S. 1822 would require brokers to 
disclose in writing any compensation received in connection with a 
customer's purchase of mutual fund shares. S. 1971 would require fund 
companies and investment advisers to fully disclose certain sales 
practices, including revenue sharing and directed brokerage 
arrangements, shareholder eligibility for breakpoint discounts, and the 
value of research and other services paid for as part of brokerage 

Soft Dollar Arrangements Provide Benefits, but Could Adversely Impact 

Soft dollar arrangements allow fund investment advisers to obtain 
research and brokerage services that could potentially benefit fund 
investors but could also increase investors' costs. When investment 
advisers buy or sell securities for a fund, they may have to pay the 
broker-dealers that execute these trades a commission using fund 
assets. In return for these brokerage commissions, many broker-dealers 
provide advisers with a bundle of services, including trade execution, 
access to analysts and traders, and research products.

Some industry participants argue that the use of soft dollars benefits 
investors in various ways. The research that the fund adviser obtains 
can directly benefit a fund's investors if the adviser uses it to 
select securities for purchase or sale by the fund. The prevalence of 
soft dollar arrangements also allows specialized, independent research 
to flourish, thereby providing money managers a wider choice of 
investment ideas. As a result, this research could contribute to better 
fund performance. The proliferation of research available as a result 
of soft dollars might also have other benefits. For example, an 
investment adviser official told us that the research on smaller 
companies helps create a more efficient market for such companies' 
securities, resulting in greater market liquidity and lower spreads, 
which would benefit all investors including those in mutual funds.

Although the research and brokerage services that fund advisers obtain 
through the use of soft dollars could benefit a mutual fund investor, 
this practice also could increase investors' costs and create potential 
conflicts of interest that could harm fund investors. For example, soft 
dollars could cause investors to pay higher brokerage commissions than 
they otherwise would, because advisers might choose broker-dealers on 
the basis of soft dollar products and services, not trade execution 
quality. One academic study shows that trades executed by broker-
dealers that specialize in providing soft dollar products and services 
tend to be more expensive than those executed through other broker-
dealers, including full-service broker-dealers.[Footnote 8] Soft 
dollar arrangements could also encourage advisers to trade more in 
order to pay for more soft dollar products and services. Overtrading 
would cause investors to pay more in brokerage commissions than they 
otherwise would. These arrangements might also tempt advisers to "over-
consume" research because they are not paying for it directly. In turn, 
advisers might have less incentive to negotiate lower commissions, 
resulting in investors paying more for trades.

Under the Investment Advisers Act of 1940, advisers must disclose 
details of their soft dollar arrangements in Part II of Form ADV, which 
investment advisers use to register with SEC and must send to their 
advisory clients. However, this form is not provided to the 
shareholders of a mutual fund, although the information about the soft 
dollar practices that the adviser uses for particular funds are 
required to be included in the Statement of Additional Information that 
funds prepare, which is available to investors upon request. 
Specifically, Form ADV requires advisers to describe the factors 
considered in selecting brokers and determining the reasonableness of 
their commissions. If the value of the products, research, and services 
given to the adviser affects the choice of brokers or the brokerage 
commission paid, the adviser must also describe the products, research 
and services and whether clients might pay commissions higher than 
those obtainable from other brokers in return for those products.

In a series of regulatory examinations performed in 1998, SEC staff 
found examples of problems relating to investment advisers' use of soft 
dollars, although far fewer problems were attributable to mutual fund 
advisers. In response, SEC staff issued a report that included 
proposals to address the potential conflicts created by these 
arrangements, including recommending that investment advisers keep 
better records and disclose more information about their use of soft 
dollars. Although the recommendations could increase the transparency 
of these arrangements and help fund directors and investors better 
evaluate advisers' use of soft dollars, SEC has yet to take action on 
some of its proposed recommendations.

As a result, our June 2003 report recommends that SEC evaluate ways to 
provide additional information to fund directors and investors on their 
fund advisers' use of soft dollars. SEC relies on disclosure of 
information as a primary means of addressing potential conflicts 
between investors and financial professionals. However, because SEC has 
not acted to more fully address soft dollar-related concerns, investors 
and mutual fund directors have less complete and transparent 
information with which to evaluate the benefits and potential 
disadvantages of their fund adviser's use of soft dollars.

To address the inherent conflicts of interest with respect to soft 
dollar arrangements, H.R. 2420 would:

* require SEC to issue rules mandating disclosure of information about 
soft dollar arrangements;

* require fund advisers to submit to the fund's board of directors an 
annual report on these arrangements, and require the fund to provide 
shareholders with a summary of that report in its annual report to 

* impose a fiduciary duty on the fund's board of directors to review 
soft dollar arrangements;

* direct SEC to issue rules to require enhanced recordkeeping of soft 
dollar arrangements; and:

* require SEC to conduct a study of soft-dollar arrangements, including 
the trends in the average amounts of soft dollar commissions, the types 
of services provided through these arrangements, the benefits and 
disadvantages of the use of soft dollar arrangements, the impact of 
soft dollar arrangements on investors' ability to compare the expenses 
of mutual funds, the conflicts of interest created by these 
arrangements and the effectiveness of the board of directors in 
managing such conflicts, and the transparency of soft dollar 

S. 1822 would discourage use of soft dollars by requiring that funds 
calculate their value and disclose it along with other fund expenses. 
S. 1971 also would require disclosure of soft dollar arrangements and 
the value of the services provided. Also, it would require that SEC 
conduct a study of the use of soft dollar arrangements by investment 

Various Scandals Involving Mutual Funds Surfaced in 2003:

Since we issued our report in June 2003, various allegations of 
misconduct and abusive practices involving mutual funds have come to 
light. In early September 2003, the Attorney General of the State of 
New York filed charges against a hedge fund manager for arranging with 
several mutual fund companies to improperly trade in fund shares and 
profiting at the expense of other fund shareholders. Since then federal 
and state authorities' widening investigation of illegal late trading 
and improper timing of fund trades has involved a growing number of 
prominent mutual fund companies and brokerage firms.

The problems involving late trading arise when some investors are able 
to purchase or sell mutual fund shares after the 4:00 pm Eastern Time 
close of U.S. securities markets, the time at which funds price their 
shares. Under current mutual fund regulations, orders for mutual fund 
shares received after 4:00 pm are required by regulation to be priced 
at the next day's price.[Footnote 9] An investor permitted to engage in 
late trading could be buying or selling shares at the 4:00 pm price 
knowing of developments in the financial markets that occurred after 
4:00 pm, thus unfairly taking advantage of opportunities not available 
to other fund shareholders. Clearly, to ensure compliance with the law, 
funds should have effective internal controls in place to prevent 
abusive late trading. Regulators are considering a rule change 
requiring that an order to purchase or redeem fund shares be received 
by the fund, its designated transfer agent, or a registered securities 
clearing agency, by the time that the fund establishes for calculating 
its net asset value in order to receive that day's price.

The problems involving market timing occur when certain fund investors 
are able to take advantage of temporary disparities between the share 
value of a fund and the values of the underlying assets in the fund's 
portfolio. For example, such disparities can arise when U.S. mutual 
funds use old prices for their foreign assets even though events have 
occurred overseas that will likely cause significant movements in the 
prices of those assets when their home markets open. Market timing, 
although not illegal, can be unfair to funds' long-term investors 
because it provides the opportunity for selected fund investors to 
profit from fund assets at the expense of fund long-term investors. To 
address these issues, regulators are considering the merits of various 
proposals that have been put forth to discourage market timing, such as 
mandatory redemption fees or fair value pricing of fund 
shares.[Footnote 10]

To protect fund investors from such unfair trading practices H.R. 2420 
would, with limited exceptions, require that all trades be placed with 
funds by 4:00 pm and includes provisions to eliminate conflicts of 
interest in portfolio management, ban short-term trading by insiders, 
allow higher redemption fees to discourage short-term trading, and 
encourage wider use of fair value pricing to eliminate stale prices 
that makes market timing profitable. S. 1958 would require that fund 
companies receive orders prior to the time they price their shares. S. 
1958 would also increase penalties for late trading and require funds 
to explicitly disclose their market timing policies and procedures. 
S.1971 also would restrict the placing of trades after hours, require 
funds to have internal controls in place and compliance programs to 
prevent abusive trading, and require wider use of fair value pricing.

In conclusion, GAO believes that various changes to current disclosures 
and other practices would benefit fund investors. Additional 
disclosures of mutual fund fees could help increase the awareness of 
investors of the fees they pay and encourage greater competition among 
funds on the basis of these fees. Likewise, better disclosure of the 
costs funds incur to distribute their shares and of the costs and 
benefits of funds' use of soft dollar research activities could provide 
investors with more complete information to consider when making their 
investment decision. In light of recent scandals involving late trading 
and market timing, various reforms to mutual fund rules will also 
likely be necessary to better protect the interests of all mutual fund 

This concludes my prepared statement and I would be happy to respond to 

Contacts and Acknowledgements:

For further information regarding this testimony, please contact Cody 
J. Goebel at (202) 512-8678. Individuals making key contributions to 
this testimony include Toayoa Aldridge and David Tarosky.


[1] "Shareholder Reports and Quarterly Portfolio Disclosure of 
Registered Management Investment Companies, Securities and Exchange 
Commission," Release Nos. 33-8164; 34-47023; IC-2587068 (Dec. 18, 

[2] U.S. General Accounting Office, Mutual Funds: Information on Trends 
in Fees and Their Related Disclosure, GAO-03-551T (Washington, D.C.: 
Mar. 12, 2003).

[3] To determine these amounts, we used the operating expense ratios 
that ICI estimated in its September 2002 fee study--which reported 
average expense ratios of 0.88 percent for equity funds, 0.57 percent 
for bond funds, and 0.32 percent for money market funds. By weighting 
each of these by the total assets invested in each fund type, we 
calculated that the weighted average expense ratio for all funds was 
0.66 percent. Using this average expense ratio, the average account 
size of $28,000 would pay $184 in fees. The additional expense of 
implementing specific dollar disclosures of 0.0038 percent would 
therefore add $1.07 to this amount. 

[4] Final Rule: Amendments to Investment Company Advertising Rules, 
Securities and Exchange Commission, Release Nos. 33-8294; 34-48558; IC-
26195 (Sep. 29, 2003).

[5] J.M.R. Chalmers, R.M. Edelen, and G.B. Kadlec, "Mutual Fund Trading 
Costs," Rodney L. White Center for Financial Research, The Wharton 
School, University of Pennsylvania (Nov. 2, 1999).

[6] M. Livingston and E.S. O'Neal, "Mutual Fund Brokerage Commissions," 
Journal of Financial Research (Summer 1996).

[7] Concept Release: Request for Comments on Measures to Improve 
Disclosure of Mutual Fund Transaction Costs, release Nos. 33-8349; 34-
48952; IC-26313; File No. S7-29-03 (Dec. 19, 2003).

[8] J.S. Conrad, K.M Johnson, and S. Wahal, "Institutional Trading and 
Soft Dollars," Journal of Finance (February 2001).

[9] SEC rule 22c-1, promulgated under the Investment Company Act of 
1940, prohibits the purchase or sale of mutual fund shares except at a 
price based on current net asset value of such shares that is next 
calculated after receipt of a buy or sell order.

[10] Fair value pricing is a process that mutual funds use to value 
fund shares in the absence of current market values, such as for assets 
traded in foreign markets.