Seven Questions with Mercer Bullard -- Questions on how to fix Mutual fund regulation

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Seven Questions with Mercer Bullard

We spoke with Fund Democracy's founder on how to fix mutual fund regulation.





By Russel Kinnel | 01-20-09 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints | Russel's Monthly Newsletter


With a new SEC chairman on the way and no doubt a new approach in regulating funds, I asked Mercer Bullard about the state of fund regulation and how it can be improved. Bullard is the founder of Fund Democracy, a professor at the University of Mississippi Law School, and a former SEC staffer.


Q. What should be at the top of Mary Schapiro's agenda for investment management?
A. First, Schapiro should re-establish the risk-assessment office created by chairman Donaldson that conducts ongoing strategic assessment of systemic risk in the financial-services industry. Second, she should become an active participant in the debate about the future structure of America's retirement system. Third, she should see that the Division of Investment Management clears its backlog of pending issues (e.g., 12b-1 fees) or replace its senior ranks. Fourth, she should implement a plan to reduce mutual fund costs through regulatory reform. Lastly, she should reverse her longstanding opposition to a fiduciary standard for those who provide personalized investment advice. She has preferred instead a suitability standard under which there is no requirement, for example, that a broker tell a client that the funds recommended by the broker are paying him more compensation than other funds.

Q. Opponents of the independent chairman rule argued that it was unnecessary as hedge funds and European funds were doing just fine without them. Does the Madoff scandal and other hedge fund debacles put an end to that argument?
A. The Madoff fraud and hedge fund collapses provide two excellent illustrations of the primary advantage of mutual funds. They provide an investment vehicle with a simple set of default rules that minimize the likelihood of disappearing assets and complete failures (although some of Bill Miller's funds have lost more than 60% of their value). Board oversight is certainly one of those rules, and an independent chair can only strengthen such oversight, so in this sense Madoff and hedge funds have bolstered the case for an independent chair. Unfortunately, they haven't put an end to that argument.

Q. Although mutual funds didn't commit fraud or go to zero, they did suffer big losses in 2008. What were the key strengths and weaknesses of fund regulation on display in 2008?
A. For the most part, the mutual funds that experienced big losses were supposed to experience big losses. Stock funds are primarily designed to provide investors with as much of the performance of the market as possible. They generally did that. Granted, managed funds promise alpha in excess of their management fees, but only relative to the performance of the market. Some funds that suffered big losses performed extraordinarily well. Even those managed funds that underperformed (see Bill Miller, supra) gave their investors what was promised: the risk of underperformance (which index funds remove).

Much of the criticism of big losses is probably coming from investors who should not have been in those funds in the first place, such as retirees who needed access to their money within a few years. Regulators do bear some responsibility for this problem because they have never attempted to require that fund disclosures state prominently the holding period for which they are appropriate. When the SEC required funds to provide quantitative risk disclosure some years ago, it settled on a bar chart showing the fund's year-by-year return over a 10-year period. Investors should read such charts (especially for stock funds from 1999 to 2008) as a signal that the fund should be a long-term investment, but many do not. This message should be more explicit. The most prominent feature of fund disclosure should be a chart showing the time period for which the fund would and would not be a suitable investment.

To emphasize, a dramatic, even historic downturn in the markets and the attendant big losses experienced by many funds are more a reflection on the markets than on mutual funds and their regulatory regime.

Q. It's been six years since the market-timing scandal broke. What lessons have regulators and directors applied well, and which ones have they forgotten or failed to understand?
A. Six years, and an occasional SEC settlement still occasionally pops up. The market-timing scandal has certainly shown amazing staying power. The Madoff fraud and hedge fund failures have placed the relatively minor market-timing violations in context. The worst scandal in the history of the mutual fund industry generally cost affected shareholders only pennies on the dollar. Similarly, the worst mutual fund scandal arising out of the current crisis is the failure of the Reserve Funds, again costing investors only a few pennies on the dollar.

But I digress. Regulators still don't understand stale pricing. They repeatedly focused on trading issues rather than the underlying cause of the problem: mispriced fund shares. And many of their solutions for stale pricing created significant and unnecessary administrative burdens. Their ignoring of pricing issues continues to create problems. Fund Democracy and others asked the SEC to improve pricing oversight of money market funds last January out of concern that the then-percolating financial crisis might bring down a money market fund. The SEC did nothing and there is no indication, even after the failure of the Reserve Funds, that it is going to do anything in the near future. Regulators did get it with respect to late trading. Their response was a bit ham-handed, but it directly addressed the problem.

. There's been a lot of criticism of 401(k) plans after 2008's losses. Are they a bad idea, or do they just need improvement?
A. I think losses in 401(k)s do not tell us much [about] their pros and cons as an investment vehicle. The issue is how they compare to the alternatives. Company pension underfunding is a bigger problem than ever, and that system relies on government-sponsored insurance. Where 401(k)s compare unfavorably is the poor allocation decisions made by beneficiaries. If a 64-year-old in a 401(k) lost 40% of his assets this year, which implies a heavy if not 100% allocation to equities, then the 64-year-old was misallocating his investments. 401(k)s are a bad idea as long as they permit beneficiaries to make extremely unsuitable allocations. Congress should require that 401(k) options reflect broadly diversified portfolios and that participants allocate their contributions within an age-appropriate range. (The argument for this requirement is even stronger in the 529 plan context.) But this is the same Congress that a few years ago balked at prohibiting 100% plan allocations to an employer's stock, so we should not expect much. As for the 25-year-old whose 401(k) lost 40%, I would say the 401(k) is working just fine, and that the problem, if any, is the market, not the investment vehicle.


Q. 529 plans are also under fire in the wake of Oppenheimer's big losses. You've argued that 529 plans should not be left to the states. Could you explain why, and does the Oppenheimer problem illustrate that point?
A. The states invested in the Oppenheimer funds were responsible for choosing funds that would produce results consistent with a certain allocation. Some made terrible choices, and nowhere is the impact of this kind of mistake greater than in 529 plans. Even in retirement, investors often have 25 or 30 years to weather unexpected variability in their returns, but the beneficiaries of 529 plans do not. When your child is ready for college, the cash needs to be there. Private enterprise often makes the same mistakes as those made by politicians in Oregon, Texas, Maine, and New Mexico, but these mistakes are less likely to be made when subject to the discipline of free market competition on a level playing field. Private firms are not allowed to offer 529 plans, and states unfairly compete for 529 business by limiting (unconstitutionally) state tax benefits to the in-state plan. In addition, investors have fewer rights when investing in municipal securities, and they therefore may be unable to obtain recoveries in the 529 plan context. Direct investors in the Oppenheimer funds would have claims that will not be available to those who invested through a 529 plan. Although government stakes in financial-services firms seem recently to have become the rule rather than the exception, this is still a bad idea. Let the politicians do the politics and leave the money managers to the professionals. States should not be in this business, but if they must be, let's at least allow private firms to compete with them.

Q. How can we make fund directors better representatives of fundholders' interests?
A. There is a limit to what fund directors can do, but their full potential is not being realized. Fund chairmen should be required to be independent of the fund manager. The SEC has invested an enormous amount of time in attempting to make this the law, but it seems to lack the will to reach a final resolution. The most outrageous aspect of this is that the courts ultimately gave the SEC the green light on the independent chairman rule, but chairman Cox has not had the backbone to make a final decision one way or another. Such fence-sitting and inaction has become the Commission's trademark. I hope that that will change under a new chair.