Overview of Industry Structure 53 is funded by membership dues and proceeds from the conferences and semi- nars it sponsors.
NICSA describes its mission as that of providing educational networking and programming, as well as a forum for the discussion and distribution of information. It does this through an annual meeting and a series of regional meetings of the membership, specialized seminars of specifi c topics, and pub- lications. Standing committees in such areas as distribution, fund accounting, transfer agency, retirement services, and technology address industry issues via presentations and publications.
Mutual Fund Directors Forum
Former SEC Chairman Arthur Levitt encouraged the creation of an indepen- dent directors forum that would serve to educate independent directors, offer them the opportunity to network among themselves, develop best practices for the independent directors, and provide them a voice with which to speak on emerging issues of importance to fund directors and fund shareholders.
The Mutual Fund Directors Forum is supported by a number of indepen- dent legal counselors and auditors who serve on its advisory board. This organization is seeking to achieve economic scale to support its policy and education missions.
No-Action Letters
Management companies and other industry fi rms can seek informal interpretive advice from the SEC in the form of “no-action” letters. The requesting organization writes a letter to the SEC, essentially saying, “Will you take any action if we do so-and-so?” describing some activity they would like to undertake but aren’t sure is permitted. The SEC staff studies the proposed action, and, if they feel that it does not violate a statute or rule, the Offi ce of General Counsel issues a “no-action” letter. The letter generally says that the staff “will not recommend to the Commission that it take enforcement action” related to the proposed activity.28 These letters, while not legally binding, serve to alleviate concerns on the part of requesting organizations that their proposed action might lead to enforcement activity.
For example, in a few of the no-action letters it has issued, the SEC has stated that its staff would not recommend enforcement action if…
• investment advisors and their representatives use in their advertisements service quality ratings compiled by DALBAR, an industry consultant (provided they meet stated criteria designed to ensure the integrity of the ratings);
president of the United States appoints the fi ve SEC commissioners to fi xed, fi ve-year terms, one of which expires each year. To ensure bipartisanship, no more than three serving commissioners may be of the same political party.
The SEC’s Division of Investment Management administers the Invest- ment Company Act of 1940, as well as the Investment Advisors Act of 1940 and the Public Utility Holding Company Act of 1936. Like the rest of the SEC, it is staffed by lawyers, accountants, fi nancial analysts, examiners, investiga- tors, economists, and other professionals. In early 2004, the Division had about 167 employees.26
The Investment Management Division’s staff reviews and processes regis- tration statements, proxy statements, and other reports the funds are required by law to fi le. It also monitors industry activity to ensure compliance with regula- tions concerning registration, fi nancial responsibility, sales practices, and adver- tising. When SEC management deems it appropriate, the Division sponsors or conducts studies of particular issues in the industry as a basis for recommenda- tions for regulation or legislation. For example, in early 2004 a staff economist of the SEC rendered a report of the impact of Rule 12b-1 on achieving econo- mies of scale within funds that would result in lower expenses for fund share- holders. The conclusion of the study is that fund shareholders have not seen the benefi ts of economies of scale that would result in lower expenses and that the primary benefi ciary of Rule 12b-1 has been the fund management companies that have had assets under management grow with a commensurate increase in fee revenues.27
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Overview of Industry Structure 55
NASD
The Securities Exchange Act of 1934 empowered the SEC to regulate only the exchange markets. The Maloney Act of 1938 amended the 1934 Act to authorize the registration of national securities associations to regulate the activities of their broker dealer members in other markets. NASD, the only national securities association registered in accordance with these provisions, now regulates all broker dealers that do business with the U.S. public.
For mutual funds, NASD regulates much of the distribution activity. It regulates all brokers, including licensing those that sell only mutual funds (Series 6), those that sell mutual funds and other securities (Series 7), and the supervisors of the selling brokers. NASD reviews almost all sales and adver- tising materials produced by the funds, and may bring disciplinary proceed- ings against fi rms or individuals for violations of fund advertising or sales rules. NASD also has authority to establish a maximum limit on sales charges
• a money market fund acquires a note designed by Goldman Sachs with an extensible maturity and quarterly rate reset (provided they treat each extension of the note’s maturity as a separate acquisition and treat the note as a short-term variable-rate security);
• the John Hancock Funds use a greatly simplifi ed and more readable prospectus as a prototype for simplifi ed prospectuses across the fund complex;
• Nicholas Applegate includes in each of its funds’ prospectus information concerning the performance of the investment advisor’s similarly managed noninvestment company accounts (provided they meet a number of rules about how the information is presented);
• Munder Capital Management provides information via the Internet refl ecting all new portfolio positions added or eliminated during the month, information about each portfolio company’s business, and why the advisor made its recommendation regarding securities purchased or sold;
• a partner in a law fi rm serves as one of a fund’s unaffi liated directors, even though one of his partners rendered legal advice to a bank that was a subsidiary of the parent company of the fund’s investment advisor.
These summaries oversimplify letters that are usually several pages long, and fi lled with detailed provisions and references to statutes and regulations. Most no-action letters address such subtle or arcane issues in the interpretation of the regulations that they defy easy summarization. Nevertheless, no-action letters provide the industry and the SEC with a valuable tool for resolving the inevitable ambiguity associated with complex securities laws.
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on securities that its broker dealer members sell, which effectively enables it to set maximum limits for the sales loads the funds levy.
State Regulatory Bodies
Until 1996, state level regulation of mutual funds was far from uniform.
In testimony to Congress in 1995, the ICI stated that it had identifi ed 18 variants on mutual fund regulation at the state level, which it termed “a crazy-quilt of duplicative, confl icting, and inconsistent regulation.”29 In 1996, Congress enacted the National Securities Markets Improvement Act (NSMIA), which preempted state authority in three areas of regulation of investment companies.
1. Registration. Mutual funds need only comply with SEC registration requirements—all state-specifi c requirements are invalidated. The states can still require funds to submit copies of the documents they fi le with the SEC, and they can still levy fees on the funds for selling within the state, but they cannot impose any requirements concerning the format or content of the registration documents.
2. Regulation of various offering documents. States are precluded from directly or indirectly prohibiting, limiting, or imposing any conditions on various fund documents, including prospectuses, proxy statements, reports to shareholders, and others. The SEC remains the sole arbiter of mutual fund documents through which the funds disclose information to the public.
3. Merit or substantive regulation. States cannot regulate the way mutual funds operate, such as by imposing limits on portfolio investments or expenses.
The NSMIA explicitly preserved state law concerning mutual funds in three specifi c areas: (1) regulations against fraud; (2) requirements for notice fi lings; and (3) imposition of fees. This Act relieved the funds of a consid- erable burden in responding to fragmented and confl icting state regulatory requirements, and left the state securities regulatory offi ces mainly as fee collectors.
In 2003 and 2004, district attorneys in a number of states—including Cal- ifornia, Massachusetts, and New York—have brought suits against manage- ment companies and others alleging that they committed fraud in connection with the market timing and late trading revelations that came to light in 2003.
A number of these suits have resulted in management companies agreeing to lower their fees for a period of years to the benefi t of present and future share- holders in the funds that they manage.
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57 The unprecedented fl ood of cash . . . has spawned a tidal wave of highly specialized mutual funds. . . . One of the most successful new offerings is the Unpleasant Fund, which currently has stakes in barium enema companies, privately owned prisons, nuclear- waste disposers, and Yugoslavian cruise lines. The fund hedges its positions by shorting stocks that sound happy: Joy Tech, Merry-Go- Round Enterprises, Pep Boys.
—Joe Queenan1 The growth of the industry in the early 1990s to 3,000 funds prompted Joe Queenan to write his satiric article about the specialized niches many of them fi lled. Since then, the number of funds has almost tripled. At the end of 2003, it rivaled that of the total number of common stocks traded on the major exchanges—over 8,000 open-end funds as com- pared to about 2,800 stocks listed on the NYSE, 1,200 on the American Stock Exchange, and around 3,300 on the NAS- DAQ National Market.
Why are there so many funds? Three interrelated factors are responsible.
1. Investment objectives. Investors pursue a variety of objectives in holding mutual funds. For example, some seek current income; some seek capital preservation or appreciation; many seek a combination. They have dif- ferent horizons for their investments, and varying appe- tites for risk. Their sensitivities to taxes, federal and state, differ. No fund can be all things to all investors. A fund manager must pick a particular investment objec- tive to pursue (tax-free current income, for example), and operate the fund accordingly. As of 2004, the ICI rec- ognized 33 broad categories of investment objectives for funds; other observers recognized even more.
chapter 4 | The Mutual Fund—
Product Defi nition
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2. Investment philosophy. Different investment managers bring different philosophies of investing to their funds. Given an investment objective of aggressive growth, for example, two investment managers can differ dra- matically in how they go about picking the securities to get that growth.
Active versus passive management (discussed later in this chapter), for example, represents one great dichotomy in investment philoso- phy that has generated (and continues to generate) heated controversy.
Among actively managed funds, different managers take widely differing approaches to determining which securities to buy and sell. This yields more variety—multiple funds will address a given objective in mul- tiple ways.
3. Competition. The profi t to be made in managing mutual funds has attracted many players into the market, and has spurred existing management com- panies to expand their product line. Banks, insurance companies, bro- kerage fi rms, and others entering the industry have swelled the number of fund families from just over 300 in 1988 to over 630 in 2004. While some fund companies are content to occupy a niche, many offer full lines of funds to capture as much of the investor’s business as possible. For a given investment objective and philosophy, competing vendors will offer multiple products.
In short, the evolution of investment objectives and investment philoso- phies, and the increasing competition for investor dollars have fueled a fund explosion. The number of funds on the market grew by more than an order of magnitude during the last 20 years of the twentieth century.
Figure 4.1 illustrates the relationships among investor objectives and investment philosophy, how the fund ultimately operates, and how it performs.
It also illustrates how this book parts company with almost every other book about mutual funds. Most of the hundreds of books that have been published in recent years focus on the left and right sides of Figure 4.1, ignoring the middle.
They address some combination of (1) what the investor’s objectives ought to be, (2) what the “correct” investment philosophy is, and (3) how to evaluate fund performance to pick funds that best meet these criteria. They prescribe how to select and use mutual funds, treating the fund operations in the middle as a black box.
This book opens that box and concentrates on the middle of Figure 4.1.
It acknowledges that investors have differing objectives and fund managers have differing strategies and philosophies. It recognizes that these determine fund investment policies, which then drive investment operations—what asset types the fund holds and the way the manager goes about managing the port- folio. It does not attempt to advise anyone as to how to evaluate a fund’s
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The Mutual Fund—Product Defi nition 59
investment strategy or performance. Instead it focuses on what it takes to produce a mutual fund, given target customers, their objectives, an investment strategy, and the regulatory environment. This book describes how mutual funds, whatever their objective or style, actually work—how they are pro- duced, how they are sold, and how they provide customer service.
This chapter sets the context for the discussion of the manufacturing component of fund management—the process of making and carrying out investment management decisions. It starts by reviewing how funds defi ne themselves through the prospectus and statement of additional information. It illustrates the diversity of funds today by looking at several commonly encoun- tered fund categorization schemes. It uses a sampling of different investment philosophies and styles to illustrate the dimension these add to fund variety.
Finally, it discusses how these structural components of the fund drive the operations of the investment advisory and fund administrative organizations.