Fund Industry Urges Reforms

In an effort to stop regulators from ordering an even broader overhaul of its business, the mutual fund industry proposed reforms Monday that could lead to lower costs for investors.

The Investment Company Institute, the fund industry’s main trade group, urged the Securities and Exchange Commission to toughen rules governing deals that many fund companies strike with the brokerage firms that market their funds and execute their stock trades.

The practices have been highly controversial in mutual fund circles for years, with critics estimating that they have tagged investors with billions of dollars in hidden charges.

The trade group’s proposal is notable in part because it goes beyond the twin issues of mutual fund market timing and late trading that have been at the heart of the scandal roiling the industry and deals with practices that experts say are far more harmful to investors.

“That is the first proposal I’ve seen this year that would genuinely get to the corruption in mutual funds,” said Lou Harvey, president of Dalbar Inc., a financial services research firm.

The proposal calls for the SEC to restrict the use of so-called soft dollars. This is a practice in which brokerage firms provide research and other items to mutual funds based on how much stock trading the funds do with the firms.

The services are actually paid for with a portion of the commissions that fund companies pay to the brokerages to trade stocks and bonds on the funds’ behalf. Critics describe the practice as a kickback in which fund companies pay unnecessarily high commissions to receive items such as computers from brokerages. The cost ultimately is passed on to fund investors.

Fund companies are willing to pay excessive commissions, experts say, because trading fees don’t have to be explicitly reported to investors.

The ICI stopped short Monday of calling for a total soft-money ban.

The group’s proposal recommends banning directed brokerage, in which fund managers trade through brokerages that aggressively market their funds. The practice not only raises costs for fund shareholders, critics say, but also causes brokers to recommend funds based on how much trading revenue they get from the fund companies.

If enacted by the SEC, the proposal could lead to higher costs for fund companies and could crimp their ability to lure new investors. It could, however, result in reduced trading commissions, thus helping investors.

An SEC spokesman declined to comment.

Industry experts said the ICI made the proposal because it feared the SEC would impose even greater restrictions, such as a complete soft-dollar ban.

“That’s clearly the direction the regulators were going in, so why stand in the road when the train is coming in your direction?” said industry consultant Geoffrey Bobroff.

Brokerage giant Morgan Stanley agreed last month to pay $50 million to settle an SEC case alleging improper directed brokerage arrangements with 14 large mutual fund companies. The SEC now is investigating the 14 fund companies, including Capital Research & Management Co. of Los Angeles, which runs the American Funds group.

Paul G. Haaga, chairman of the ICI and executive vice president of Capital Research, said the reforms could help restore investor faith in the industry.

“Shareholders come first, and we are going to go as far as we can to eliminate things that even appear to involve conflicts.”

Several of the nation’s largest mutual funds said they were supportive of the proposal package.

“This area of soft dollars is a practice that people don’t understand, and it doesn’t look good,” said Jim Riepe, vice chairman of T. Rowe Price Group Inc. “It’s certainly a practice that can be abused. In this current environment, it seems a logical step to eliminate any possibility of abuse.”

Added Brian Mattes, a spokesman for Vanguard Group: “Anything that assures shareholders that their interests are coming first will be very beneficial to our industry.”

Vanguard has made limited use of directed brokerage arrangements, Mattes said. However, it directed trades only to firms that agreed to provide the best price and execution -- and then rebate some of their fees to the funds paying the bill. Vanguard has disclosed these transactions in annual reports.

Some critics worry that many fund companies do the opposite -- overpay for brokerage services in order to get some other benefit, such as preferential treatment from investment advisors in selling their funds.

“I was pleasantly surprised and impressed with the ICI,” said John Montgomery, founder of fund provider Bridgeway Capital Management.

“I testified in Congress nine months ago that we should kill [soft-dollar deals] -- that disclosing them wasn’t enough. But I thought the possibility was pretty remote because so much of the compensation in this industry is contingent on it.”

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Hamilton reported from New York, Kristof from Los Angeles.