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Wednesday, March 12, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance and,
Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:07 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.

    Present: Representatives Baker, Ose, Gillmor, Castle, Royce, Manzullo, Oxley, Kelly, Ney, Fossella, Biggert, Kennedy, Tiberi, Harris, Kanjorski, Sherman, Meeks, Inslee, Frank, Lucas of Kentucky, Ross, Clay, Baca, Matheson, Lynch and Scott.
    Chairman BAKER. [Presiding.] I would like to call this meeting of the Subcommittee on Capital Markets to order, and welcome those who are here in attendance today.
    Today, the subcommittee will examine mutual fund industry practices and the potential effects on individual investors. This hearing is a next step in the committee's continuing efforts to protect America's investors and help in the restoration of public confidence in the performance of the capital markets. This effort began some time ago in the last Congress, with hearings in this subcommittee on the conduct of securities analysts and a series of others, culminating in the passage of the Sarbanes-Oxley legislation. The statute once adopted addressed not only analysts' conduct, but strengthened oversight and the responsibilities of accountants, attorneys and corporate officers. It was a very important beginning.
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    Last month, we examined the collection and investor restitution efforts by the SEC. I am personally anxiously awaiting the outcome of the global settlement, hoping that it will make significant provision for investor restitution. The committee will continue this work. For example, it is my hope in the near term to visit the credit rating agencies and determine how their performance fared during the disappointing market periods.
    These actions are not without justification. Ninety-five million Americans are now investors in mutual funds, with many depending on long-term performance for their retirement. The point needs to be made clearly. The responsible performance of the markets and the equitable treatment of all investors is essential for the economic vitality of the country. This committee, and I hope this Congress, will take all appropriate steps to restore efficient performance and ensure fair functioning of the capital market allocations.
    Today, we turn our attention to the mutual funds, a sector of the market which during the 1990s experienced unprecedented growth. We should examine whether investors really get what they pay for, and determine whether investors know what fees and costs they are paying, and then examine how the current regulatory system either succeeds or fails in investor protection. It is not, at least with my current understanding, clear to me that all is well. The recent GAO report, which was by the way initiated by request of this committee many months ago, has reached a conclusion only yesterday that fees are up. More troubling, investors are paying higher fees while suffering from troubling fund performances.
    According to the information reviewed in the last few days, in the last 15 years the S&P index has outperformed almost 60 percent of the diversified equity funds. Another trend in the industry which is alarming is the turnover rates in portfolios. Currently, the average portfolio turnover for a fund is 110 percent, with average fund holding periods of 11 months. Obviously, these are not investments made for the long haul. This continual churning increases cost to the investor and potentially generates additional tax liabilities. This short-term, roll-them-in and roll-them-out strategy, as I call it, certainly does not enhance the building of corporate wealth or shareholder return, but appears to generate significant cash flow in fees for somebody.
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    As troubling as the facts appear today, really they are not that easy to get at. So I am, just like everyone else, hoping to learn today about how to better understand how the market functions. This lack of transparency certainly leaves the average investor without an ability to determine what action is in his own best interest.
    Current disclosure in the prospectus that shows fees as a percentage of assets, which is based on a hypothetical dollar amount, may be somewhat instructional. But I am very hopeful that the SEC will soon move forward on an enhanced disclosure requirement and also give final approval to the pending proxy voting disclosure rule. I think such changes will provide the initial and necessary steps to strengthen the position of individuals and certainly help build confidence in market performance. But know from my perspective that these two steps are really very rudimentary. They are only small steps down what is, I think, going to be a long road.
    I hope we can turn to the industry leaders to assist in this effort. At the end of the day, everyone from the director of a large fund to the smallest investor will benefit from a market structure which is transparent, efficient and fair. We must have a platform in which investors are willing to return to the market with their dollars. Our economy and our nation, will benefit from such enhancements. I, for one, will not conclude my efforts until we have attained that goal.
    Mr. Kanjorski, do you have an opening statement?
    Mr. KANJORSKI. Mr. Chairman, thank you for the opportunity to offer my initial thoughts about mutual funds before we hear from our witnesses. I want each of them, and you, to know that I approach today's hearing and future discussions on mutual fund issues with an open mind.
    As we begin our examination of mutual funds in the 108th Congress, I feel it is important to review some of the basic facts about this dynamic industry. According to the Securities and Exchange Commission, at the end of fiscal year 2002 mutual funds managed $6.1 trillion dollars in investments, significantly more than the $3.7 trillion deposited at commercial banks. Additionally, the SEC calculated that 93 million investors living in 54 million households owned mutual funds. The mutual fund industry has also evolved dramatically in the last several decades. The number of mutual funds has grown from 564 in 1980 to nearly 8,300 today. In addition, the assets in mutual funds portfolios totaled just $56 billion in 1978. By 1990, this figure increased to $1.1 trillion, and by the turn of the century mutual fund assets had expanded another six-fold.
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    Today, mutual funds also represent about 20 percent of our nation's equities market. Without question, we can therefore conclude that mutual funds constitute a major sector of our nation's economy.
    As the mutual fund industry has grown, it has worked to bring the benefits of securities ownership to millions of hard-working Americans. Many securities experts have noted that the typical investor would find it expensive and difficult to construct a portfolio as diverse as that of a mutual fund. I wholeheartedly agree. Mutual funds have clearly provided an economical way for middle-class Americans to obtain the same kind of professional management and investment diversification that was previously available only to large-scale institutions and wealthy investors. In short, mutual funds have worked to democratize investing.
    Despite this tremendous success, securities experts continue to examine how we can improve the performance of the mutual fund industry and advance the interests of U.S. investors. Some recent public policy debates in this area have focused on disclosing proxy votes to mutual fund shareholders, modifying industry oversight through the creation of self-regulatory organizations, and increasing the frequency of mutual fund holdings disclosures. Although each of these issues is important, today we will generally focus our examinations on the cost of mutual fund ownership—an issue that many consider is the most consequential.
    As you know, Mr. Chairman, I have made investor protection one of my top priorities for work on this committee. Understanding the cost of operating a mutual fund and learning how such expenditures affect investing is, in my view, therefore very important. These fees and loads will, after all, have a significant effect on investors' returns. A recent story in USA Today, for example, determined that for government securities mutual funds, the group with the lowest expense ratios averaged a 43 percent gain over five years, while those with the highest expense ratios grew by 34 percent during the same time frame. Small differences in annual fees will ultimately result in major differences in long-term returns.
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    During our deliberations today, I expect we will hear many conflicting views on the issue of mutual fund fees. Some of our witnesses will cite studies showing that these expenses have increased in recent years, while other panelists will refer to analyses demonstrating a gradual decrease in such fees. Although each side in this debate will seek to use statistics to its advantage, our job should be to learn more about the industry today so that we can work to improve public policy in the future.
    For my part, I hope that these experts will answer a number of questions that I have about mutual fund fees. I would like to determine whether investors have obtained the benefits of economies of scale as the size and scope of the mutual industry has grown. I also want to learn more about the calculation of 12(b)(1) fees, the use of soft dollar arrangements, and the effects of portfolio transaction expenses.
    In closing, Mr. Chairman, I look forward to hearing from our expert witnesses on these important issues. Mutual funds have successfully worked to help middle-income American families to save for an early retirement, higher education and a new home. We need to ensure that this success continues. I therefore look forward to working with you to examine these and other matters related to the mutual fund industry in the weeks and months ahead.
    Thank you, Mr. Chairman.

    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 68 in the appendix.]

    Chairman BAKER. I thank the gentleman for his statement.
    Chairman Oxley?
    Mr. OXLEY. Thank you, Chairman Baker, for holding this important and timely hearing. This morning, we will discuss the state of the mutual fund business. Our inquiry is simple: Are investors getting a fair shake? At last count, there were 95 million mutual fund investors in the United States. For most Americans, mutual funds are the primary vehicle for accessing the capital markets and building wealth. The rapid growth in fund ownership over the past 20 years is unquestionably a positive development. Mutual funds provide the opportunity to invest small sums of money in return for a diversified investment in stocks, bonds, and other securities. Selecting a suitable fund can be a challenge for many investors. Some funds buy large capitalization stocks; others buy small or mid-caps. Some buy foreign companies or corporate or municipal bonds. Still other funds invest entirely in one sector of the economy. There are multiples classes of shares, different investment styles and so on. Add to this the fact that there are now almost 5,000 stock mutual funds.
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    All these funds are competing for investor dollars. While there is clearly competition in the fund industry, some question whether it is working the way it does in other industries. That is to say, are costs going down for investors? Recent data indicate that the answer is no. Fees and expenses in fact are going up, and this despite the efficiencies created by these enormous economies of scale. While investors have become sensitive to certain fees like sales loads, other fees are either hidden or opaque, escaping the attention of even savvy fund investors. This precludes them from comparison shopping—a strong market influence that would encourage fee-based competition and would likely bring down costs.
    What are investors getting in return for these increasing costs? The evidence is troubling. Noted financial commentator Jim Glassman has said, what is truly remarkable is that hundreds of funds do worse than the rules of chance would seem to allow. He adds that the low-cost Vanguard 500 index fund has beaten 76 percent of its managed fund peers over the past 10 years, according to Morningstar. Even worse, the NASD and the SEC have recently discovered widespread evidence that fund investors are not even receiving the discounts on sales loads that funds promised in their prospectuses. While preliminary reports indicate this failure to provide break-point discounts does not appear to be the result of fraudulent behavior, one commentator is reported as attributing the problem to laziness or sloppiness. That is simply unacceptable. I am pleased that the regulators are acting quickly, and I urge them and fund directors to take steps immediately to repair this breakdown and to make investors whole.
    Along with rising fees that are often hidden or not easily understood, and chronic under-performance, this committee intends to examine the role of mutual funds in corporate governance. Last year, Congress passed the Sarbanes-Oxley Act in an effort to help rebuild investor confidence in public companies. New and mostly sensible regulations have been enacted for accountants, corporate executives and directors, investment bankers, research analysts, and attorneys. Until very recently, though, mutual funds have not been the focus of regulators and lawmakers, despite the fact that funds own about 20 percent of U.S. equities. The voting power represented by these securities carriers carries great potential to influence U.S. corporate governance. Whether mutual funds have used their powerful position to do so is an important question that merits attention.
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    Another important issue to this committee concerns the role of independent fund directors. Are they looking out for the best interests of shareholders in the fund, as is their fiduciary duty? At least one prominent investor emphatically says no. In his recent letter to Berkshire Hathaway shareholders, Warren Buffett said that fund directors had an absolutely pathetic record, particularly with regard to removing under-performing portfolio managers and lowering fees charged to investors. Some have asked, where were directors during the frenzied creation of a multitude of tech funds during the bubble of the 1990s that left so many investors holding the bag? An article in yesterdays Wall Street Journal observed that during the tech bubble, stewardship often gave way to salesmanship. Borrowing a phrase from one of our distinguished witnesses here today, Vanguard founder, Jack Bogle.
    In recent months, the SEC has acted on a number of important mutual fund initiatives, often in the face of fierce industry opposition, I might add. Last December, the commission issued a proposed rule that would enhance portfolio disclosure and help clarify fund fees. The commission also recently required funds to disclose both their proxy voting policies and procedures and their actual proxy votes. These are good steps, but more needs to be done. I have the utmost confidence that we can count on Chairman Donaldson to continue Harvey Pitt's fine work on behalf of fund investors.
    Mr. Chairman, I look forward to hearing the testimony of this distinguished panel, and I yield back the balance of my time.
    Chairman BAKER. Thank you, Mr. Chairman, for your statement and your participation today.
    [The prepared statement of Hon. Michael G. Oxley can be found on page 60 in the appendix.]
    Mr. Scott?
    Mr. SCOTT. Thank you very much, Chairman Baker. I want to thank you and the ranking member, Mr. Kanjorski, for holding this hearing today regarding the mutual funds industry. I also want to thank this distinguished panel of witnesses today for their testimony.
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    Given that more than half of all households in the United States now hold shares in mutual funds, any discussion today will have an enormous impact on millions of investors and billions of dollars. I firmly believe that the individual investor is empowered when given the tools to compare varying investment funds. Hopefully, this hearing will help us understand whether mutual funds investors are receiving fair value in return for the fees that they pay.
    There are some serious issues and some troubling questions that the American people certainly want answers to. For example, how can mutual funds empower individual investors to make the best decision about their money today? Some funds are able to get away with overly high fees because investors do not understand how fees can reduce their returns. We need to find answers and make recommendations to clearly explain the potential cost of fees to investors up front.
    Another troubling issue is sloppy recordkeeping at brokerage firms. What cost is that for mutual fund customers? There is a cost that is estimated at more than $600,000 in overcharges in one year alone. How can we get the mutual fund industry to ensure that they have the capacity to charge customers the right amount? These are questions I think that the American people certainly want answers to, and I would hope with our deliberations today that we can get some of those answers.
    Again, I look forward to this very important discussion. Mr. Chairman, I yield back the balance of my time.
    Chairman BAKER. Thank you, Mr. Scott.
    Mrs. Kelly?
    Mrs. KELLY. Thank you, Mr. Chairman.
    For many years, the public looked at the stock market as a sophisticated, obscure type of crap shoot. When mutual funds came into existence, the mutuals gave some investors the sense that there was stability somehow, and that in unity they would make out better. And they invested, and that was a good thing. Those were the vehicles that brought a lot of investors into the market. But recently, the public has been painting the mutual funds with the same kind of distrust that they are painting corporations and the stock market. I think that they are looking at things like hyperactive turnover. They are looking at sales techniques that are producing increases in fees.
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    Personally, I think that if we can get some transparency into some of these things, it will help investors make intelligent decisions and it will bring people back into the market. So I applaud you, Mr. Chairman, for having this hearing. I look forward to the witnesses' testimony today.
    Chairman BAKER. Thank you, Mrs. Kelly.
    Mr. Castle, do you have a statement? Ms. Biggert? Does any other Member have an opening statement? Ms. Harris?
    Ms. HARRIS. Thank you, Mr. Chairman.
    I wish to express my appreciation for this panel today and for the panel's testimony that is going to contribute greatly, I am certain, to helping us understand and secure investor confidence in the mutual fund industry.
    Mutual funds have become a vital tool that millions of Americans rely upon to ensure the safety of their investments in U.S. capital markets. In fact, nearly half of all U.S. households hold a stake in some type of mutual funds. Reflecting on that dramatic shift in recent decades towards investment alternatives, mutual fund industry assets raised dramatically from $56 billion in 1978 to $6.4 trillion in 2002.
    So as our nation confronts an array of daunting challenges to restore and safeguard the economic security of every American, that has to stay at the top of our priorities. We cannot achieve this goal without examining the basic practices of the mutual fund industry and the affect upon individual investors. So in particular, we must verify the legitimacy of the various charges that the industry levies, guaranteeing their relation to the substantial overhead costs that mutual funds encounter. Moreover, we must determine what action, if any, is necessary to guarantee an adequate level of disclosure and transparency so investors can make informed choices.
    I look forward to your testimony this morning. Thank you.
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    Chairman BAKER. Thank you, Ms. Harris.
    I have been informed that we might expect a series of votes about 11 o'clock. Certainly, any other member would be recognized for a statement if you choose to make it, but let me request you to do it briefly so we can give our panelists an opportunity before the committee's work is interrupted.
    Mr. Ney?
    Mr. NEY. I am going to submit for the record.
    Chairman BAKER. Thank you, Mr. Ney.
    [The prepared statement of Hon. Robert W. Ney can be found on page 70 in the appendix.]
    All other Members' statements will be submitted for the record.
    Without any other requests, I would move now to our witnesses this morning, and call first Mr. John C. Bogle, Founder of the Vanguard Group. Welcome, Mr. Bogle.


    Mr. BOGLE. Thank you very much, Chairman Baker, and good morning. Thank you, Chairman Oxley. Thank you, Ranking Member Kanjorski and thank you Members of the committee for coming out.
    I hope that my long experience in the mutual fund industry will be of some help to you in considering the issues that lie before you today.
    Vanguard operates under a mutual structure in which our management company is owned by the shareholders of our mutual funds and operates on an at-cost basis. This is a unique form of shareholder-oriented organization and has enabled us to emerge as the lowest cost provider of services in our field. As you see in the chart, the expenses of the average Vanguard fund today come to just 26 hundredths of 1 percent of assets, a reduction of 65 percent since we began in 1974, while the expense ratio of the average mutual fund was 1.36 percent last year, up almost 50 percent in that period.
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    Does this difference matter? Our cost advantage of 1.10 percentage points applied to our fund assets, presently at $550 billion, now results in annual savings for our fund shareholders of $6 billion. Lower costs mean higher returns, for what investors must earn and do earn is whatever returns the financial markets are generous enough to provide, minus the cost of financial intermediation. It is not very complicated. The returns therefore earned by mutual funds as a group inevitably equal the market returns, less the costs funds incur, most obviously in money market funds.
    Over the past five years, the money market funds with the lowest costs earned a gross return of 4.8 percent, costs of 0.37 percent, net yield a little over 4.4 percent. The highest cost funds earned 4.7 percent—not very different from the lowest cost group—deducted cost of more than 1.7 percentage points and provided a net yield of just 2.9 percent. Result? Just by owning the lowest cost group, fund investors could have increased their income by 51 percent, without any increase in risk whatsoever.
    While less obvious, the same relationship prevails in equity mutual funds. Over the 10 years ended June 30, the risk-adjusted annual return for the lowest cost quartile of equity funds was 13.8 percent—three full percentage points higher than the highest-cost quartile. This relationship, as you see in the chart, appears to be universal, prevailing in each one of the nine Morningstar so-called ''style'' boxes—large-cap growth funds, small-cap value funds and so on. Great consistency of advantage around the 3 percentage point level by each of the nine style boxes.
    In the long run, Mr. Chairman and members of the committee, costs make the difference between investment failure and investment success. Over the past two decades, and even after the recent decline, the stock market provided an annual return of 13.1 percent compared to a 10.0 percent return reported by the average equity fund. For the full period, therefore, $10,000 invested in the market itself grew by $105,000, while the same $10,000 invested in the average equity fund grew by $57,000—just half as much. That 3.1 percentage point difference is largely a reflection of the costs that investors incur. So yes, costs matter.
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    In the interest of time, I am going to skip chart five and go to looking at costs in dollars rather than expense ratio terms. That is a very important thing the committee ought to consider. In 2000, for example, the actual cost of providing portfolio management services for all of Vanguard's money market funds, as shown in chart number six, came to $15 million. That is our known cost. Yet in another firm's money market funds with the same $65 billion in assets, the funds paid the investment manager for investment management services only, $257 million. It is high time we looked into these issues and had a government-sponsored economic study that follows the money in the mutual fund industry.
    That such a fee was approved by that fund's directors suggests a monumental shortfall in the shareholder protections sought by the Investment Company Act of 1940, which clearly states that funds should be operated and managed in the interests of their shareholders, rather than the interest of their investment advisers, and subjected to adequate independent scrutiny.
    What is the case? Well, fund directors have two important responsibilities: obtaining the best possible manager and negotiating for the lowest possible fee. Yet their record has been absolutely pathetic. They follow a zombie-like process that makes a mockery of stewardship. Able but greedy managers have overreached and tried to dip too deeply into the shareholders' pockets and the directors have failed to slap their hands. Independent directors over more than six decades have failed miserably. I would not have the temerity, Mr. Chairman, to use those words, so they are all a direct quotation from Warren Buffett in his recent annual report.
    One reason for the failure of directors is that the head of the fund's management company is typically the chairman of the fund's board as well. As Mr. Buffett has observed, negotiating with oneself seldom produces a barroom brawl. So we need to require that the fund chairman be an independent director. Would it matter? Let me give you one example. That is the way we operate at Vanguard, and since we began in 1974, the fee rates that our Wellington Fund has negotiated at arms length with its external investment adviser, Wellington Management, have been reduced six times. Last year's management fee in this $22 billion fund was 0.04 percent—four one-hundredths of one percent of assets or $8.5 million. Without those reductions over the years, that fee would have otherwise been $92.2 million. Active fee negotiations therefore saved the fund's shareholders $85 million for that one fund, and enabled the fund to catapult its returns over 90 percent of its balanced fund peers. Yes, again, costs matter.
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    We need to awaken investors to the critical importance of lower costs. We need information that encompasses all of the costs of fund ownership, presented forthrightly in fund prospectuses and annual reports, and we need to show each shareholder the dollar costs that he or she is incurring in their statements.
    At the same time, we have got to empower independent directors to live up to the standards of the law of the land and protect the interest of the fund shareholders that they are honor-bound to represent.
    Thank you, Mr. Chairman.

    [The prepared statement of John C. Bogle can be found on page 72 in the appendix.]

    Chairman BAKER. Thank you very much, Mr. Bogle, for your appearance and your testimony.
    I failed to say it at the outset, but all witnesses' formal statements will be incorporated into the official record, and to the extent possible, if you can keep your prepared remarks to five minutes, it would be helpful in getting to our question and answer period. We appreciate your courtesy in being here.
    Our next witness is Mr. Wayne H. Wagner, Chairman of the Plexus Group, Inc. Welcome, Mr. Wagner.


    Mr. WAGNER. Thank you, Mr. Chairman and Committee Members.
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    I want to talk about the transaction costs associated with the management of mutual funds here. Several points—Are these costs significant? How should they be evaluated? Should they be disclosed to fund participants? And are the markets—a little farther afield—are the markets optimally organized to keep these costs low?
    Bottom line, as Jack has said, costs hurt performance here. They immediately reduce investor assets. They do not stay in the portfolio to continue to perform. They impede the ability to capture the benefit of research. They reduce liquidity and interfere with capital formation. Congress and the SEC have repeatedly attacked these issues here to make these better in general here.
    To me, it is impossible to argue that uninformed investors are better investors. More information is better, as Congressman Scott said. It is empowering for investors to know the correct information here. As long as that information is not misleading, of course, and when we are talking about transaction costs, in particular, that can be a little bit problematic here.
    How important are these transaction costs? Very. I believe they account for the difference as to why active managers have such difficulty in maintaining performance to Mr. Bogle's fund here. We have measured those on a regular basis for 17 years. We measure them for 2002 as 1.5 percent, one-way transaction costs. Multiply that by a buy and sell, multiply that by 110 percent turnover, and you can see we are talking about a great deal of money.
    I personally believe that these are the largest costs which are borne by investors over time. Now, that may sound like a very large number to you, and it is surprisingly large. To the retail investor, the market looks like a vending machine. You put your coins in, you push the button, and out comes your selection. That is not true for institutional trading. It is not true for mutual funds trading.
    Could I have my first slide please? Thank you. We took a look at our universal, which represents about 25 percent of exchange volume. We divided it into five groups, where each of the groups was sorted on the size of the trade. So the first line on there is the smallest trades. There are three groups omitted, and the last line is the largest trades that were put out by mutual funds in their investing process. Each of these is of equal importance to investors because each of them represents the same amount of dollars being invested.
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    The top group is the smallest trades, and they are really not that different from the retail market here. They are the vast bulk of every trade, representing 11 out of every 12, averaging 2000 shares, $53,000 in principal and less than half of 1 percent of the daily volume. They cost about a quarter of 1 percent, but they are only one-fifth of the trading.
    Concentrate for a moment on the largest trades here. This is only one out of every 400 trades, yet it makes the same impact on the performance of the funds here. They average two million shares apiece, $77 million in principal, and over half a day's volume. They cost in excess of 1 percent here.
    Clearly, the vending machine analogy does not work for these large trades. These are not trading events. They are a trading process that links the portfolio manager and his decisions to the trader, to the broker, and to the exchange. They are really orchestrated into the market, and because of their size they may take many days to complete. This stretched-out process leads to delay in opportunity costs.
    If I may have the other slide please? We have measured these on a regular basis. This iceberg shows that not only the costs are very obvious, the commission on the top of the iceberg is very obvious and we all see what that is. The impact cost is the cost of hitting in the marketplace. The delay in opportunity costs down below stem from this orchestration process where it is difficult to get the size through the marketplace.
    To our mind, this total cost is what investors need to know, because you cannot ignore that 75 to 80 percent of the cost, which is coming out of performance, and yet is really not available in something simple like the commissions here.
    Saying that, revealing the commission is sufficient to reflect the cost, I do think is not enough. It is only 10 percent of the cost. It sends the wrong message that costs are trivial, and that costs are comprised of broker payments, rather than a measure of overall management effectiveness here.
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    Investors need to know basically which firms are efficient; which ones are doing a good job of using their resources here. This was the conclusion of the AIMR trade management guidelines. I have a thousand copies coming. I will send copies for the committee here. It defines best execution as the trading process firms apply to maximize the value of client portfolios. Rather than focus on costs in isolation, the definition focuses on a cost-to-benefit ratio of trading. May I suggest that this is a useful definition for the committee to keep in mind.
    With that in mind, I have overrun my time and I will cede the mike.

    [The prepared statement of Wayne H. Wagner can be found on page 202 in the appendix.]

    Chairman BAKER. Thank you, Mr. Wagner. We appreciate your participation today.
    Our next witness is Mr. John Montgomery, Founder and President of Bridgeway Funds. Welcome, Mr. Montgomery.


    Mr. MONTGOMERY. Chairman Baker, Ranking Member Kanjorski, and Members of the Subcommittee, from a recent news article, I quote, ''Mutual funds exist in a culture that thrives on hype and withholds important information in a cutthroat business that regularly misleads investors.''
    While I hardly think that this reflects the environment at Bridgeway Funds, and while I believe that the mutual fund industry is on the cleaner end of the spectrum in the investment community, major criticism is well-deserved. As an industry, we must do better if we are to serve the long-term needs of this country's smallest investors.
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    After the most extended bear market since before World War II, investors are starting to look under the hood of their mutual funds, and they do not like some of what they see, especially some of what they do not see and cannot find. Access to key information is crucial to fair competition on which our free enterprise system is based.
    To be sure, progress has been made with the plain English prospectus, simple and standardized fee tables, better standards of performance evaluation, disclosure of the effect of taxes on returns, and much more detailed information available through the Internet. Soon, we will have disclosure of proxy voting and more frequent disclosure of mutual fund holdings.
    My written testimony outlines better disclosure in 13 areas, but I would like to comment now on just four of these: soft-dollar commissions, standardized industry operating information, manager salaries, and board decisions on management contract approvals.
    First, disclosure of soft-dollar commissions. Apart from the affiliated brokerage and directed brokerage, the practice of soft-dollar commissions is one of the worst examples of undisclosed conflicts of interest in the mutual fund industry. The term ''soft-dollar commissions'' refers to an agreement between a broker and investment adviser by which the broker supplies a variety of products or services from research to software, hardware, data or other services, in return for a certain volume of business to the broker. The problem with this legal arrangement is that the adviser receives the immediate benefit, while the shareholder pays. There is inadequate incentive for the adviser to keep soft-dollar commissions low.
    A confirmation of this situation is the response of vendors when we tell them that Bridgeway will be paying with our own hard dollars. One salesman, a software salesman, looked at me incredulously and asked, why on earth would you pay with your own money when you could pay for it in soft dollars? The problem with soft dollars, then, is that they are really hard dollars. They just belong to somebody else. As a fellow Texan said, if you see a snake, just kill it; do not appoint a committee on snakes.
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    This would be one snake we should not disclose. We should just kill.
    Second, standardized industry operating information. When I worked in the urban mass transit industry, there was uniform data on system expenses, passengers and other very helpful operating data, with enough detail to establish some best industry practices. Twenty years later, there is no similar, easily accessible database for the mutual fund industry. Some information is in the SEC-EDGAR system, but it is not down-loadable, expense categories are not standardized, and it is terribly time-intensive to access information across fund families. While this level of detail is not generally sought by individual investors, use and analysis by academia, authors such as Mr. Gensler, media, consultants and fund boards of directors could greatly spur industry competition and efficiency. The federal government is in the best position to take the lead on this disclosure.
    Third, disclosure of manager salaries. When we invest in individual companies, we have the right to know the compensation of the company leaders. When we invest in mutual funds, we are in the dark. To the best of my knowledge, Bridgeway is the only mutual fund company that voluntarily discloses portfolio manager pay in its statement of additional information. Compensation level, and especially structure, do affect portfolio manager incentives and fund decisions. Our industry's refusal to disclose it contributes to the aura of withholding important information and misleading shareholders, that some shareholders perceive in the current environment. This disclosure would be easy and costless.
    Finally, number four—board disclosure. Over the years, I have examined the record of some of the consistently worst-performing mutual funds and wondered, ''where are their boards of directors?'' Unlike the boards of privately held firms, nonprofit organizations and even publicly traded companies with multiple constituencies, a mutual fund board exists only to protect shareholder interests. Studying the worst-performing funds over the last five years, for example, I identified some funds that were poor performers for some years before. Their average costs exceeded the entire average historical return on the stock market. How can these funds hope to make any return for their shareholders? Why doesn't somebody put them out of their misery?
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    Each year, the independent members of the fund's board must actively consider a number of factors before approving a management contract. Why not disclose to shareholders the basis for their decision? Here is an even more radical, but serious idea: Require fund boards to consider alternative bids for service when both fund under-performance versus a market benchmark, and fund expenses, exceed extreme levels.
    In conclusion, if mutual funds are going to address increasing public distrust in the environment of a bear market and if we are going to continue to play a major role in giving access to the wealth of this nation through the fund structure, we are going to have to earn it. We need to pursue the interests of shareholders relentlessly, and we need to ensure that adequate information is available for shareholders and their advisers to make informed decisions.
    Finally, I want to thank the committee for the opportunity to testify this morning.

    [The prepared statement of John Montgomery can be found on page 193 in the appendix.]

    Chairman BAKER. Thank you, Mr. Montgomery.
    Our next witness is Mr. Harold S. Bradley, Senior Vice President, American Century Investments. Welcome, sir.


    Mr. BRADLEY. Thank you. Chairman Oxley, Chairman Baker, Ranking Member Kanjorski, and all the Members of the Subcommittee, I appreciate the opportunity to be here today and talk. Some of my remarks, limited to soft-dollars, mostly, and the use of commission dollars by investors, have been taken by my colleague to the right of me. So what I would like to do is walk through how it looks, but to say first that I am proud to be associated with the fund industry and its strong record as an effectively regulated and affordable place for investors. I have been a trader and a portfolio manager and virtually all of my investments are in a mutual fund, none of which are index funds. The three-year bear market has been hard on all of us. Me, too.
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    I represent American Century Investment Management. Along with our industry, we are now looking in the mirror to see what things we might do better. We have a long record of working with the staff at the SEC of advocating more transparency regarding market structure and trading practices, specifically in the area of soft-dollar disclosures. We think Congress should work to understand how its law, section 28(e) of the 1975 amendments to the Securities Exchange Act actually encourages investment managers, through expansive interpretation by the SEC, to use commissions paid by investors as a source of unreported income to pay unreported expenses of the managers. I would like to try and explain.
    This is a picture of the typical five-cent-a-share commission paid by the typical investor. That rate is negotiated by the investment manager. The blue bar represents our best guess, based on our experience, of what commissions pay for in execution-only services, based on fees charged by electronic venues, such as Archipelago or Instinct. The red bar on top represents what is called paying up, or the value of soft dollars in the commission's pot. It includes things like broker research, fund expenses, access to IPOs, and in some cases normal and customary business expenses, as in the expansive definition now allowed by the SEC.
    I am guessing when I estimate the size of these practices. Some have called these largely undocumented practices the frequent flyer program of the money management industry. Both the number of miles, which equates to trading volume, and the premium prices paid create cash-back rebates, or the free travel equivalent for the investment manager. We need to better understand the tangible benefit for the investors. I am told there is far less documentation of soft dollar use and utility since the 1997 SEC soft dollar sweep in this area. Furthermore, I am told by our accountants that our auditors have told us that if soft dollar deals were documented, it would likely trigger accounting treatment on the investment adviser's books. We do need some notion of fair value assessment here.
    I will restrict my remarks specifically to third-party payment of soft dollars and to the use of soft dollars to obtain IPOs. Chart two, is a picture that shows the long-term average commission rate paid by investment managers on behalf of investors. It goes back 12 years. You can see on the top line, the average commission rate paid by managers per share traded that there has been little movement in a decade. It looks a little bit like a flat line on a cardiac patient. It does not move because of the embedded economics—it is not in the investment managers economic interest to negotiate lower rates. In other industry surveys, the average commission rate remains above five cents per share traded. Meanwhile travel—trading volume—is the chart that is increasing six-fold during the past decade. The current situation is not unlike fixed commissions that existed prior to 1975. The value of the unreported and mostly uncategorized or un-catalogued ''research'' services obtained by money managers, provides strong incentive to keep per-share charges high.
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    Chart three. This is a busy chart that requires study. It takes a simplistic example and shows the strong positive effect of soft dollars on an investment manager's profits. They are a powerful form of economic incentive. Furthermore, since fund boards can only benchmark a fund's negotiated rates against industry averages, there is little competition. If you are paying a lot of soft dollars, you just do not want to be too far under the industry average or too far above.
    I think that there is a list of about 1,200 vendors in your attachment, called third-party vendors, where commissions can be used to pay for services through the commissions stream—1,200. If you look at them, they include telephone companies. It includes hardware vendors like Dell Computer, quote vendors, the New York Stock Exchange. I would think that most investors believe the management fee they say should be sufficient to pay for stock quotes—a basic requirement to be in the business. We think there is a problem, and it is a transparency problem. We think specifically that commissions should be negotiated and disclosed as a percent of principal, as it is done in markets across the world. This will create more competition and transparency, and meaningful measurement of trading costs.
    Fund managers should identify and disclose the execution only rate for each broker they use, to make explicit the perceived value of services provided. The little blue bar on that first slide, that is the real execution rate. We must make explicit money manager use of commissions to pay third parties for goods and services available to the public for cash, like my Wall Street Journal.
    Now, of course, these things that are paid for cash like the Wall Street Journal, if in fact these were explicit contractual commitments on paper as agreements for soft dollars, they would show up as expense items already. They are just not ''real'' today because they are not recorded.
    We also think Congress should look at considering a new law or rulemaking that removes the structural incentives based on commission flows that have contributed, we believe, to the IPO pricing and allocation scandals. We also believe that underwriters should publish the size and identity of the 50 largest IPO allocations so that our investors can be assured when they are told that by paying more, we get access to those IPO allocations, that we really do. There is no transparency there. We need transparency and we need accountability in these poorly understood areas.
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    I really do believe that if we start to make progress a little bit at a time, we will more quickly restore investor confidence across all of our markets.
    Thank you very much.

    [The prepared statement of Harold S. Bradley can be found on page 134 in the appendix.]

    Chairman BAKER. Thank you, Mr. Bradley.
    Our next participant is Mr. Paul Haaga, Jr., Executive Vice President, Capital Research and Management Company. Welcome, Mr. Haaga.


    Mr. HAAGA. Thank you, Chairman Baker, Chairman Oxley, Ranking Member Kanjorski, Members of the Subcommittee, I am pleased to be here.
    I am Chairman of the Investment Company Institute's Board of Governors, and I am a member of the executive committee, and I am here testifying on behalf of the institute. My own firm is the investment adviser to the American Fund, which manages $350 billion on behalf of about 12 million mutual fund investors. We are the third largest mutual fund family in the United States and the largest that sells exclusively through financial intermediaries.
    I appreciate the opportunity to continue to work with Chairman Oxley, who first chaired a hearing on the fund industry in 1998, as well as Chairman Baker and their staffs, as the committee examines additional ways to bolster investor confidence in our financial markets. With half of all Americans owning mutual funds, fund companies can play a key role in helping millions of middle-American investors to gain confidence in long-term investing. Following today's hearing, the ICI and the fund industry look forward to addressing any questions or concerns members of the committee may have as we continue to reinforce our commitment to meeting the needs of the 95 million fund investors.
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    You have asked how the fund industry is serving individual Americans who invest in our funds. We believe the answer is very clear. At a particularly difficult and challenging time in the history of our financial markets, we are serving 95 million investors very well. We provide useful information, multiple investment options, and valuable services to our shareholders, and at much lower cost than ever before. We believe the cost of mutual funds and the services they provide to investors are lower than any other alternative financial services used by investors.
    I was at a press briefing this morning, and I was asked the question, do you think that the hearings today will destroy confidence in mutual funds? My answer would be a resounding no. I think they will increase confidence in mutual funds. We welcome them. We welcome regulation and we think investor confidence will increase as they know that people are watching. So thank you again for having this hearing.
    We view strict federal regulation as an asset, not a liability. Under the SEC's watchful eye and the effective oversight of our independent directors, mutual funds have remained free of major scandal for more than 60 years. We do not think that it is an accident that historically mutual funds have enjoyed unusually high levels of trust and support from fund investors.
    The hearing occurs as we approach the 37th month of one of the worst bear markets in modern history. Our memory of costly accounting scandals and corporate abuses is also still vivid. Most individual investors holding stocks and stock mutual funds have lost money over the last few years. Some have also lost confidence. While stock mutual funds are not the cause of the scandals or abuses, our responsibility to serve and protect the millions of individual investors makes it imperative that we work to devise and support solutions.
    For this reason, we strongly supported the Sarbanes-Oxley Act and many other reforms to our financial reporting and oversight system, and in fact many of the corporate governance reforms that were in the Sarbanes-Oxley Act and the follow-up regulations came directly from mutual fund's longstanding practices.
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    Let me turn to the issue of mutual fund fees. It is frequently reported that the average stock mutual fund charges fees at an annual rate of about 1.6 percent of assets. By itself, that statistic is essentially true. But by itself, that statistic is also very misleading. Although the average stock mutual fund charges 1.6 percent in fees, an overwhelming majority of stock mutual fund investors pay far less. At the end of 2001, the average investors stock mutual fund had annual fees of .99 percent, just under 1 percent. As illustrated in the chart we brought with us, 79 percent of all mutual fund accounts are in lower-cost stock funds. These lower costs hold 87 percent of all stock fund assets.
    At first, it may not seem apparent that the average investor could pay less than the average fund charges. But consider a business that has two cars for sale—one for $20,000 and the other for $40,000. The average selling price of the cars is obviously $30,000. But if 80 people buy the less expensive car, and only 20 choose the more expensive car, the typical buyer clearly does not pay the average price charged by the seller. The typical buyer pays $24,000. This is 20 percent less than the $30,000 average price charged by the seller.
    Now, what do cars cost, I ask? Industry critics would say $30,000, and they would point the finger at the cars that cost $40,000. We would say they cost $24,000, and so would the GAO and the SEC in their studies, which are asset-weighted, because that is what the majority or the average of what shareholders are paying. If you walk down the street and find somebody who owns a car, the likelihood is that they will tell you that their car cost $20,000, because that is what they paid.
    The committee also expressed interest in the trend in mutual fund fees and expenses. Since 1998, major fee studies have been completed by the ICI, the General Accounting Office and the Securities Exchange Commission. My written testimony points out that these studies share many common attributes and conclusions. Perhaps the single most important conclusion is the finding that as mutual funds grow, their fees generally decline, with the sharpest reductions apparent at the funds that grew the most. The ICI study found that 74 percent of the 497 funds that they reviewed lowered their fees as they grew. The average reduction amounted to 28 percent. The GAO study of 46 large funds found that 85 percent reduced their fee levels and the average reduction was 20 percent. The SEC study found that 76 of the 100 funds they looked at had contracts that automatically reduced fee levels. They also found that stock funds that had grown to exceed $1 billion in assets had fee levels substantially lower than smaller funds. In fact, the SEC found specifically that as fund assets increased, the operating expense ratio declined.
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    We are pleased that all three studies on this subject—the ICI, the GAO and the SEC—recognized that cost savings from mutual fund asset growth can only be realized by individual funds, not by industries.
    It is equally important to understand that mutual fund fees schedules cannot be increased without three separate actions being taken. First, the fund's board must approve the increase. Second, the board's independent directors must separately approve the increase. And third, the fund's shareholders must vote to approve it.
    This positive news hardly means that our job is complete. This is especially true in the wake of the corporate scandals and abuses that have been revealed over the last 18 months. The challenge of educating investors about diversification, asset allocation, various types of risk and the impact of fees and taxes, the need for realistic expectations and a long-term focus is our constant responsibility and an essential element in reinforcing confidence in our markets.
    Thank you very much for helping us to ensure that we will do that.

    [The prepared statement of Paul Haaga, Jr., can be found on page 168 in the appendix.]

    Chairman BAKER. Thank you, Mr. Haaga.
    Our next witness is Mr. Gary Gensler, no stranger to the committee as former Under Secretary for Domestic Finance, Department of the Treasury, and the author of The Great Mutual Fund Trap. Welcome.

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    Mr. GENSLER. Thank you, Chairman Baker, Chairman Oxley, Ranking Member Kanjorski. Thank you for having me here today. It is a great honor to be back with you. It looks like there are more seats, though, here in the front since I was last here.
    Needless to say, as the author of The Great Mutual Fund Trap, I applaud this committee's willingness to look at the mutual fund industry closely. There are great statistics that have been named, but in each of your congressional districts there are 125,000 households that own mutual funds. Middle income, generally married, median age 46—sounds like I might be a pollster, but I am not—but 125,000 households in each of your districts. It counts to middle-income Americans what this committee is talking about here today.
    By any objective measure, however, mutual funds have been failing millions of those investors, or hundreds of thousands in each of your districts. That is understandable given $70 billion of annual costs—$70 billion—not small amounts of money. In any other industry, we would take a close look at that, and I think Congress would, and I am glad you are today.
    Investors can expect costs totaling about 3 percent of their money each year for investing in mutual funds. I actually agree with the testimony to my right. It is about 1 percent a year on average for the management fee. Where is the other 2 percent, you might ask? Well, it also comes in what is called sales loads. About half of mutual funds are sold today with a commission up front or at the back end, which is 4 percent. Given our American nature of turning things over so often, which is once every two and a half or three years, that adds about 1 percent to 1.5 percent more cost.
    Then there is the undisclosed cost, and those are dramatic. Portfolio trading costs add about .05 percent of your money a year, because these portfolios turn over on average pretty quickly. I would use the median, and they on a median turn over once every 15 months. That is pretty fast trading, and that fast trading runs up short-term capital gains taxes—good for the budget deficit, good for Treasury where I once served, but not good for Americans. Better to go back to a buy and hold strategy. Short-term capital gains taxes when markets are at least modestly going up add 1 to 2 percent of your money every year.
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    Take out 3 percent of your money each year, what happens after 40 years of savings? You give up 42 percent of your savings. We wonder about savings in America, and the retirement of the baby boom generation, and the mutual fund industry has done a tremendous job, but can do better if costs are lower.
    I would also note that many Americans complain about their $1.50 ATM charges, because they see it. It is direct. Mutual fund charges, it is a wonderful thing—we do not see it. It is just taken out and we do not have to write a check like we do to our plumber or our mortgages.
    What happens to the average? As you heard Mr. Bogle's averages, I will not repeat them, but over the last 10 years, Morningstar reports the average diversified fund is behind by 2.2 percent the S&P. But that does not count all the funds that went out of business. About 5 percent of funds go out of business every year. Add them, you are about 3.5 percent behind, similar to the cost structure, as we have just noted.
    Many Americans think, well, if I just buy yesterday's hot fund, I will be able to do well in the future. The mutual fund industry has figured out to advertise yesterday's hot fund in all those January and February Money magazines, and Smart Money magazine advertisements of the hot fund of yesterday. But yesterday's hot fund usually does not do well in the future—just a little bit better than random chads.
    You have heard a lot about fund directors. Whose fund is it anyway? It is the investors' fund, and the Investment Company Act of 1940 set up a structure whereby investors actually have a board of directors control that fund, and can fire the fund manager—at least in theory, that is. In practice, when does it ever happen? In fact, fund governance leads to the problem you have heard about today—soft dollars. While I too am recommending that you ban soft dollars, I am not suggesting that you once again take up McCain-Feingold. This is not that type of soft dollars.
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    These soft dollars are saying that fund companies, which are distinct from funds, make profits, because the fund companies ask Wall Street to pick up their expenses and then charge them through higher commissions, as was earlier shown, that nickel a share, the higher commissions, directly to the fund companies. In fact, many fund companies who get the benefit and have higher profits, direct commissions to Wall Street's biggest houses. I would say ban soft dollars. I think there is no room for it, no excuses for it.
    The other recommendations that I outline in the testimony, I would say start with the belief that Americans really have a choice. I wrote a book for Americans to choose. If Americans wish to choose the high-cost funds, that is their choice. But I think transparency would add something. While I say six recommendations in the testimony, let me just highlight a few.
    One is to disclose portfolio trading costs. A hard job to do, but important costs. Two, I think survivorship buys, as tough as it is—all those funds that go out of business—it would be helpful if fund companies put on their Web sites the ones that went out of business and report their averages including the failed funds. It would be sort of like asking about those reality TV shows and forgetting about all the ones that are kicked off the island. I think we need to know a little bit about those as well. Thirdly, I think disclosure with regard to all the revenue sharing arrangements, all the conflicts that are inherent in the market, would do us well. That is with brokers, as well as with corporations around 401(k) plans.
    I too think that the SEC and Congress should consider taking a close look as to why funds do not go out and try to hire new fund managers. Seven thousand funds in America, and can we name one that in 2002 fired their fund company? Can we name one that went out to competitive bid? That is 7,000 companies. Would not we think that there would be five, ten, fifty of them that might have, if fund directors actually were fulfilling their fiduciary responsibilities?
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    Lastly, as you consider new 401(k) legislation, I know that many in Congress think that there is a need for investment advisers to be giving advice—that, too, raises new conflicts of interest. As you grapple with that, you might want to consider I would suggest adding that all 401(k)s and 403(b)s have at least an alternative which Congress has for federal workers—an index fund to add to the choice of investors so that if they get this new investment advice, at least they have one low-cost alternative in their portfolio.
    I thank you for considering my thoughts.

    [The prepared statement of Gary Gensler can be found on page 155 in the appendix.]

    Chairman BAKER. Thank you for your participation, Mr. Gensler. We are glad to have you here.
    Our next witness is James S. Riepe, Chairman, T. Rowe Price Associates.
    Just by way of announcement, we do have a series of votes on the floor. It would be my intent after Mr. Riepe concludes his remarks that the committee would recess for about 15 minutes to go make the votes and come back.
    Mr. Riepe?


    Mr. RIEPE. Thank you, Chairman Baker, Chairman Oxley, Ranking Member Kanjorski, and all the other Members of the Subcommittee.
    T. Rowe Price is a Baltimore-based investment management firm. We manage over $140 billion of assets. About $90 billion of that is in mutual funds, and we have been at it for about 70 years. Personally, I have been in the fund management business for about 34 years, and I am happy to be here with you all today to talk about this important subject.
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    Before I start, I want to note that as you conduct your review of the fund industry, it is important to remember that stock funds, although they get all the headlines—particularly after three years of a severe bear market, represent less than one half of the mutual fund industry assets, about 41 percent specifically. The balance are in fixed income funds and money market funds. Even when we look at just the equity fund portion of the industry, less than one-fifth of those assets are in aggressive growth funds—again the ones that get the most headlines. So that means when we look at the mutual fund industry assets, only about 6 to 7 percent of the entire industry is in this aggressive end, which enjoyed the upward volatility of the late 1990s and now suffered the downward volatility of the last three years. I think just putting that in context, that this is much more than just a growth stock business. It also means that the vast majority of investors have benefited from mutual funds in a very substantial way, when one considers all the other kinds of funds in which they are invested.
    Individual investors do not typically trust all their assets to just one fund or even one manager. The average T. Rowe Price investor, for example, owns at least three of our funds, and they also own funds offered by two or three other managers as well. So clearly, investors understand the idea that diversification is important, not only diversification among funds and within funds, but among managers as well.
    That has come across in the defined-contribution side of the business. Again using our example, our typical 401(k) investor has seven different investment accounts and about 50 percent of the assets are in equities, and then some more in company stock, and then fixed income options. So as a result, the 401(k) investor has done relatively well in terms of his or her risk-adjusted performance during this recent down period, and did well during the later years of the bull market as well.
    Our panel has covered a range of subjects today, and I just want to touch on a few of them. Several issues we are a bit uncertain about, and others we view with some certainty. With respect to disclosure, I do not know if mandating more disclosure is the answer. I think we need to work harder in determining what disclosure is illuminating to the investor and what disclosure is obfuscating. As an industry, we are committed to educating investors, and I think the evidence is very clear that we have done that, both collectively and as individual firms. We have done it quite frankly, because it is in our self-interest to have investors who understand their investment.
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    But disclosure for the sake of disclosure is not good. I would use the example of owners manuals. Studies show that people do not read owners manuals. One of their problems is that the first 10 pages tend to be filled with disclaimers and warnings, and then the book is too thick. If we do the same to mutual funds, then we are going to turn away the average mutual fund investor. So we need good, useful, focused disclosure; we do not need simply more disclosure.
    When we get into the world of trading cost evaluations, you can tell from listening to a couple of the comments here, it is incredibly complex, and very difficult to measure. There are multiple ways to measure transaction costs, but there is no consensus on which is best. And all the measurement models are at their base speculative. I think we can be comforted in the fund industry that however such costs are measured, we know that the fund investor's return is net of all costs. I think that is very, very important.
    Some things we do know. The fundamental qualities of mutual funds—diversification, professional management, relatively low cost—have proven their merit during this bear market. Being able to gain access to a diversified portfolio is critically important for investors. When they invest individually in individual stocks, they do not have such diversification. Morningstar and all the critics have pointed out the value of fund investments from a diversification perspective.
    Mutual funds also provide better and much more useful and more transparent disclosure than any other financial product we service. As Mr. Gensler suggested, the disclosure always could be better in mutual funds. But let's compare mutual funds to other financial services. If I buy a certificate of deposit at my bank, they tell me I am going to get 3 percent. They do not tell me that they are going to lend that money out at 8 percent, use 400 basis points to cover their expenses, and keep 100 basis points of profit. That is the reason, ironically, that you could not have hearings on the expenses of those products in the way you can have hearings on mutual funds. Because funds spell out all the expenses that investors incur, and they spell out the bottom line, which is the net return the investor receives after these expenses.
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    I think, too, there is an impression being left that mutual fund investors panic easily, that they are skittish, et cetera. One has to look under the aggregate redemption numbers, to find that most fund investors are long-term investors. There are certainly those investors who follow trends. There are investors who think they can out-guess the market. They are not the majority. They are not even in many cases a significant minority, but they trade often enough that they affect the overall redemption numbers. So I think it is misleading, frankly, to look at aggregate numbers and try and draw conclusion about 95 million investors. Mutual fund investors are intelligent when they make their investments, and they hold their investments longer than aggregate redemption ratios might indicate.
    Unlike many other financial relationships, and in contrast to Mr. Bogle's suggestion, the interests of fund companies and mutual fund investors are, in my view, very well aligned. Investors and fund managers, they want good performance. We all want good performance. That is how we thrive. That is how as mangers we thrive and prosper. We want good service. We have to have good service to be competitive and we are an incredibly competitive industry. We also need to provide helpful guidance. Investors select us on the basis of the kind of guidance and intelligent advice we can give them. And they want all of that at a reasonable cost.
    As to the suggestion that almost no one beats ''the index,'' nearly 80 percent of T. Rowe Price equity funds beat the competitor Lipper Group and the S&P 500 over the last five years. Almost two-thirds have beaten the market index over the last 10 years. So the fact is, there are many funds out there that have been successful in beating the indices. There are many investors who would rather bet on health care or on financial services, or on technology, than buy an index fund that is going to provide them with the overall market performance.
    Having said that, T. Rowe Price manages billions of dollars of index funds, along with our actively managed products. This is not about religion. This is a matter of choice. Selection depends on an investor's objectives and how he or she believes they can best achieve them. Index funds are out there for all those investors who want them.
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    Let me just say very quickly a word on governance. Sarbanes-Oxley adopted governance practices that have existed for mutual funds for many, many years. So we feel the corporate world is coming closer to where we are now, and not vice versa. Fund investors do not invest in boards of directors. They invest in a fund manager—a company they know, a company they have read about, a company they have talked to their friends about, a company they have read in Morningstar or Lipper or Money magazine. They do not expect directors whom they do not know, and who do not necessarily have an investment expertise, to decide to replace the manager they have picked. What they do expect those directors to do is to monitor the funds's results and make sure the managers act in a prudent way. If there are funds that they believe have not performed up to reasonable standard, they should urge the management to make appropriate changes. But the idea that independent directors should start replacing managers and putting out to bid contracts, when the investor has already made the decision to invest with that company, I think is neither appropriate nor expected.
    In closing, when you ask about the effects that funds have had on investors, the answer is that the mutual fund as an investment vehicle for individual investors has been arguably the most successful financial service in the 20th century.
    Chairman BAKER. Mr. Riepe, I hate to interrupt you, but we are down to two minutes left on this vote, and members are going to have to excuse themselves. We will pick up your train of thought when we get back in probably 15 or 20 minutes.
    Mr. RIEPE. Great. Thank you.
    Chairman BAKER. If I can ask everyone to take seats, we will reconvene our hearing.
    Before we took our recess, Mr. Riepe was concluding his remarks. Members will be returning momentarily. I expedited my trip. So Mr. Riepe, if you would, please?
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    Mr. RIEPE. I appreciate the opportunity, and I will just give you my closing remarks, Mr. Chairman.
    When you ask about the effects funds have had on investors, the answer is that the mutual fund—as an investment vehicle for individual investors—has been arguably the most successful financial service of the 20th Century. It has succeeded because investors see value in it as an investment vehicle. Funds have provided tens of millions of investors with diversified and professionally managed access to stock, bond and money market securities invested around the globe in every way, shape and form that investors could want. Mutual funds have succeeded without incurring major scandals or frauds during their long history—a statement that not many industries could make, and certainly not any other financial services.
    That success, in my view, is attributable to a number of factors, including the intensive regulatory scheme under which funds operate. But most important to their success is the transparency which our panel has talked about and which is inherent in funds. And that transparency has been critical in creating trust between tens of millions of investors and the managers responsible for investing their hard-earned dollars in these funds. It is a trust that all of us in the business know could be lost very easily if we do not continue to earn it every single day.
    What you see is what you get in a mutual fund. The net return on a fund is just that, return net of all the expenses—whether they are in fact, the measurable ones or the more difficult ones to measure. Our fund is measured every single day. The results are posted in the paper, and are seen by everyone. The evidence clearly indicates that investors value this combination of transparency, diversification, and professional management—all at a relatively low cost.
    Thanks very much for the opportunity to express my views. I appreciate it.
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    Chairman BAKER. Thank you, Mr. Riepe. We also appreciate your participation here today.
    I will start off with questions to you, Mr. Haaga, and you, Mr. Riepe, centered around a comment which you made about performance of funds generally as contrasted with the S&P. When we passed Sarbanes-Oxley, we had what I called—and this is a congressional term—a coloring book requirement which posted the individual stocks that an analyst would cover against his upgrades, downgrades and price targets. That is required to be prepared by the firm for whom he is employed on an annual basis so that a shareholder interested in that analyst's performance can look back at that coloring book illustration and understand how his recommendations fared against the actual performance. That leads me to conclude this, that current disclosure requirements are not necessarily crystal clear. They are not opaque. They are somewhere in the translucent range, in order to help facilitate an individual investor's understanding of fund performance. Also with the disclaimer, past performance is not an indication of future, blah, blah, blah.
    Would either of you object to a requirement on an annual basis to have a disclosure of individual funds' performance as cast against either the Wilshire, the S&P—you pick out the standard index against the fund, so you could make a judgment of that sort from the graph, without having to dig through numbers and post it yourself. Is that an unreasonable request?
    Mr. HAAGA. Actually, we already have it. There is an SEC requirement that our annual reports include our results in comparison, and of course net of fees, in comparison with a recognized stock index of our choice—Wilshire, S&P—
    Chairman BAKER. But is there an industry standard that everybody does it against the Wilshire?
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    Mr. HAAGA. All the funds do not seek to mimic the Wilshire. There are many balanced funds, funds with—
    Chairman BAKER. Well, do we require multiple—
    Mr. HAAGA. Nearly all of them use the S&P—nearly all the large, broad-based equity funds use it. We also can in those disclosures compare against the Lipper averages, the averages of other funds, and many funds do. So they will say, we were up X amount; the Lipper average for our type of fund was up Y amount, and the S&P was up Z amount. I think bringing it down to a single comparative number would probably be misleading for some of the funds. There really is a vast range of funds and there is a vast range of what they do. Having said that, there are only three or four recognized indexes that we use. So we are almost there.
    Chairman BAKER Do either of you think there is any additional disclosure standard required from your perspective at this time, based on what you have heard from other folks this morning?
    Mr. RIEPE. With respect to performance?
    Chairman BAKER. Fees, performance—you pick. We have about five or six different topics that others have elicited comment on. But generally from the read of your remarks, and do not let me mischaracterize it, you feel generally the industry on balance is performing well, and that investors have access to the information they need to make informed judgments. If that is your position, then do you think any additional standards or disclosures are required, based on what you have heard this morning?
    Mr. HAAGA. Yes, and in fact we have got that in writing, because there are two SEC proposals out there. One is a requirement that any mutual fund advertising or anything you see in the paper include a cross-reference directing the shareholder to go to the prospectus to find the fees and expenses. That has not been there in the past, and we support that. The other is an additional fee table. There is, as you know, and several have mentioned, there is a fee table in the prospectus that takes all the fees and combines them and puts them in a standardized dollar amount. The SEC has proposed that that be extended to the shareholder reports, and that in the shareholder reports, unlike the fee table in the prospectus, the actual investment results of the fund be used against a standardized dollar amount to give the total. We support that as well, so there are two additional changes we would like to see.
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    Chairman BAKER. And my last point, because I am going to run out of time.
    Yes, quickly.
    Mr. RIEPE. Mr. Chairman, I think the problem is not additional disclosure, as much as it is getting people—it is my owners manual analysis. It is getting people to look at what is there, and having a better understanding of what the characteristics of that particular investment are.
    Chairman BAKER. I liken it to the privacy disclosure statement by financial institutions. By the time you read it, you do not know what bank you are doing business with, much less what your rights are.
    Mr. RIEPE. And after the first couple, you just throw the envelope right out.
    Chairman BAKER. And what you are looking for is something that says, if you give it to us, we are not going to do anything bad with it, but lawyers will not let you do that. But there ought to be some good faith disclosure which I do not think, frankly—I do not any longer invest in mutual funds or have any holdings in the stock market for a lot of reasons—but I have looked at my son's.
    I have got to tell you—I know I am a Congressman and that puts me on the low end of the food chain—but I could not make much out of his mutual fund statement to tell him really where he was. That is what is troubling. I do not think people can, despite good faith effort and a lot of expert counsel, on their own take their information and determine what their actual costs are, not to allege that the costs are inappropriate or that you are not getting good service for the fees you pay. Those are different issues. Right now, I think the question is, can the average investor understand where he is with his piece of paper and the holdings he has? T. Rowe Price is a great firm, does a good job, makes money for people. I have no complaint. But there are a lot of funds out there that do not exactly have your model, and that is the troubling part.
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    I know I am over my time, but I am at least going to get Mr. Bogle and Mr. Wagner in, because the representations made on the other side are that your calculations of costs are not exactly on target, and that somebody here is not—from my view of the representations at the table, there are two pretty clear distinct representations about fees and charges. I am leaning toward writing my own letter. I have not had a chance to talk to Mr. Kanjorski to see if he would sign onto it, but at least from my own initiative, and we will ask other members if they choose to do so, to sign onto a letter to the SEC outlining the points made here today, and asking them for professional guidance in sorting this out, and maybe reporting back to the committee in some length of time to give us a real insight into the issues raised.
    If you were in our position, give me some good investment advice. Where do we go to get this resolved in an impartial courtroom?
    Mr. BOGLE. I think going to the SEC or an independent consulting firm to look into the cost issue is a perfectly good thing to do, a perfectly intelligent thing to do. I would definitely tend to lean toward the SEC. They have a very good staff. Although I have had a lot of trouble trying over the years to get the SEC to do an economic study of this industry that is really on thing that ought to be central to the work of your committee. We need to follow the money in the mutual fund industry. Not only these ratios, which we have probably bored you to tears with, but the total dollars involved. This is an immensely profitable industry. Mutual fund managers get paid not only through their expense ratios, but through their use of brokerage commissions for their own benefit.
    Chairman BAKER. Let me hit that point. I am really way over, but let's just take simple examples. Let's assume it is a $100 million fund; I am the investor; you are the portfolio manager and you are getting instructions from your director to do certain things. Let's assume, based on last year's performance, the fund is down 25 percent from the date on which I signed in. But you also assume we have had our 110 percent turnover rate that has been elicited earlier in the comments, and let's just use the average that they have used, the .99 percent transaction cost. Is there a way for you as a portfolio manager in the current scheme of things, even when the fund is down, to generate a profit for you or the directors from the turnover in those fees?
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    Mr. BOGLE. Can you as the portfolio manager or the management company make a profit on turnover when markets are down?
    Chairman BAKER. Based on the generation of the fees that you are talking about. Where does the fee money go, even in a down market? When you are rolling over my stocks at the rate of 110 percent, and assume the stock valuation has gone down from the time I got in, but there has been a lot of turnover, a lot of transaction costs, and it is not going to research and market data. Where does that money go? You are saying, follow the money, tell me where it is going.
    Mr. BOGLE. Okay. Let me just give you a simple example. Take a $10 billion fund and the market drops—
    Chairman BAKER. I like your definition of ''simple.'' Yes, go ahead.
    Mr. BOGLE. Well, I want to make sure the numbers come out in a decent way. I will start with it simple. Let's assume the market goes down 20 percent. The fund is now $8 billion. Annualizing that number, the total management fee at 1 percent would drop from $100 million to $80 million. The manager at the beginning of the year is making about $50 million. The pre-tax profit margins in this business have been, at least at the high market levels, very close to 50 percent. So his profit is going to go down from $50 million of that $100 million of revenues, to—I have got to make sure I have got my decimal points right—from $50 million to $40 million. He will be making $40 million, assuming his costs, which are the other $50 million of the original $100 million remain unchanged. So he makes less money, but it is still 40 million even though the shareholders have lost $2 billion—
    Chairman BAKER. That is my point. Is that I as the investor have lost equity in my fund because of the market under-performance, but the fellow with whom I am doing business is only going to make $40 million as opposed to $50 million. My heart goes out to him.
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    Mr. BOGLE. Yes, mine does, too, sir.
    Chairman BAKER. I do not think we have focused on that enough this morning. I have got to quit, because I am way over my time.
    Mr. Lucas?
    Mr. LUCAS OF KENTUCKY. Thank you, Mr. Chairman.
    I come at this from a couple of angles—32 years in the financial planning business, so I was a supplier of these services and also a consumer. But I think one of the things, and I think it is healthy to have this hearing, and I think that there can be some good come out of it. I would just hope that we as a committee do not overreact to this, because it has been my experience that people who have stayed in functional allocation and in great diversification in mutual funds have been far better off. I think you need to look at the end result. Would the consumer be better off if he or she were involved in function allocation and spread all around the board? Would they be better off in the end paying these fees? The net bottom line is, in my view, the vast majority of consumers who were involved in functional allocation funds have far more in their 401(k)s and profit-sharing plans and individual portfolios today than some of those people who thought they knew all the answers and were in individual stocks.
    So I do not think we should, although I think it is important, as the Chairman said, to be able to know and understand this, the information is there for those who want to ferret it out. I think that competition works that one fund wants to be more open and more competitive than any other. I think those factors are there as well.
    So I really do not have a question, other than I very much am an advocate of this functional allocation. As I would tell my clients through the years, we may not hit any home runs for you, but we are also not going to strike out. Worst case, maybe we will do some singles and doubles, once in a while a triple maybe, in baseball parlance, but I think we have to look at the performance of the funds as measured against the marketplace. I know as a consumer who has a considerable amount of my net worth in the market, even though it is way down, it is much less down than people who are investing in individual stocks.
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    So I would just say, let's do not throw the baby out with the bath water here, and let's not overreact. I am for more disclosure as well, but there are two sides to this coin.
    Thank you.
    Mr. BOGLE. May I comment, Mr. Chairman?
    Chairman BAKER. Certainly.
    Mr. BOGLE. I would just like to say, we have talked a lot about the return of the average fund in these markets. We have talked very little about the return of the average fund investor. This industry, Mr. Congressman, has moved a long way from being an industry selling diversified stock funds, to selling specialty funds. In the recent bubble, technology funds were very big. Internet funds were very big. Telecommunications funds and aggressive growth funds owning those stocks actually, believe it or not, sir, took in $500 billion in the couple of years going up to the market peak, while fund investors were taking $40 billion out of value funds at just the wrong time. Investors had 75 percent of their money in stock funds at the peak, and in round numbers just 50 percent in stock funds now that the market is down—again too much risk at just the wrong time.
    So if we look at the returns of the average investor, not the average mutual fund, we see something very different. A study in one of my exhibits that is in your report shows that in the last 20 years, one of the great bull markets of all time, even after the decline, the stock market went up at a 13 percent rate. You saw that a little bit earlier. The average mutual fund went up 10 percent, primarily because of that 3 percent are points of costs. But the average fund investor, as far as the data we can find tells, and it is going to be very good data, but not precise, made 2 percent annually in that 20-year bull market. The average investor in equity mutual funds earned 2 percent. That means if you started at the beginning with a dollar and owned the market, you ended up with a profit of $10.70. Starting in the beginning with an equity mutual fund on average, you ended up with $5.70—just about half as much. And if you earned that 2 percent that the average fund investor appears to have received, you ended up with a 50 cent profit. That just is not good enough. That is not one of the great success stories of the 20th century. It may not be a scandal, but I think it is close to one.
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    Chairman BAKER. Let me offer time to the other side here. Mr. Haaga did you want to make a comment?
    Mr. HAAGA. I sure did. I will not refute all those numbers, but I will just say I do not agree with them. I guess if we were giving people 50 cents over 10 years, I do not know how we got to be $6.3 trillion in assets.
    I wanted to thank Mr. Lucas for his comments, and buttress them with some figures from Morningstar that really show the value of diversification. Twenty percent of the stocks in their database—that is 6,500 stocks they cover—20 percent of them lost 60 percent or more in value in the year 2002. One-tenth of 1 percent of all equity mutual funds lost that much. So I think that shows the value of diversification.
    One other thing I would like to just set straight. The 110 percent turnover rate, I do not know where that came from. We would like to check. It may be another one of those statistics that is an average that is not what anybody is doing. Our turnover numbers are way below that, but they are higher than they used to be. When I asked our portfolio counselors how come there is more turnover—our turnover is in the 20 to 30 percent range, but it is up from below 20 percent—their answer is that the market is so much more volatile.
    I was reading in Business Week, that said how two out of every five days on the NASDAQ, the market moves by 2 percent or more, and one out of every five days I think it is the S&P moves by 2 percent or more. Those numbers were unheard of. There is just volatility. There were no 2 percent days in the past. I think that is what is happening. I do not want to defend 110 percent turnover number, because I do not agree with it, and we do not have that kind of turnover, but I think we need to know what the real number is and we need to have it in context.
    Mr. GENSLER. As I do find that Paul and I might differ on policy, we tend to agree on numbers. Turnover in the industry is reported by Morningstar from their database. The median is 76 percent. The average is over 100 percent because there are some funds that I do not even know, have 6,000, 7,000 turnover that skew an average. Large diversified funds are probably closer to 60 percent turnover. That is still selling all their stocks every one and a half years. I do share your view that financial planners have a great service to Americans in asset allocation. All the studies that I have looked at show that about 80 percent of American returns come from how you allocate your assets. Do you buy stocks or bonds, and hopefully if you diversify. If you are, as Mr. Bogle said, picking just a sector fund, a technology fund, well then you are in for a wild ride.
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    Chairman BAKER. Mr. Lucas yields back all of his time.
    Chairman BAKER. Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman. It has been a most enlightening hearing and we appreciate all of your participation.
    Mr. Riepe, you indicated at the end of your statement that in your business what you see is what you get. That would seem to indicate that the average mutual fund participant and owner really understands and has all the information available to him in understandable form. Is that really true? Do you think that your customers really do have all of that information in front of them in understandable form?
    Mr. RIEPE. I think, Congressman Oxley, that you perhaps were not in the room when I answered Chairman Baker's comment before, but those are two quite different things—having all the information one needs, and understanding it. I believe that investors get all the information they need to make an intelligent decision about a fund. The challenge for us is to get those investors to spend the time looking for that information, if you will. Understanding it is the bigger challenge. Finding it is not the big challenge.
    Mr. OXLEY. Do you think the SEC is on the right track, then, with their proposal to take the proverbial $10,000 account and try to put some numbers to it?
    Mr. RIEPE. I will tell you two things on that. One, we as an industry have supported that. Personally, I honestly have some reservations about it because my experience over three decades with investors is that they understand things they can compare. Returns on mutual funds, returns on investments are expressed in percentages. That is why the expense ratio has always been the most simple and easily understood way to express a cost. So if I am going to earn 10 percent in this fund and it is going to cost me 1 percent, I can understand that. If you tell me every quarter that it cost me $322 last quarter, and this quarter it is $275, I do not know how to compare that. I do not know whether I put more money in, I did not put more money in, my asset value went up, my asset value went down. I cannot compare it to another fund as easily as I can in simple percentages. So I hope we will not lose the percentages.
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    Mr. OXLEY. If that is the case, let me ask you then, the GAO study indicated an 11 percent increase in that ratio. Those are relatively easy numbers to understand. Mr. Bogle, do you have any comments on that? You heard Mr. Riepe say that the more accurate definition would be the expense ratio, and yet—
    Mr. RIEPE. I did not say accurate. They are both accurate.
    Mr. OXLEY. They are both accurate?
    Mr. RIEPE. They are both accurate. The question is understandable; which will be more useful to an investor?
    Mr. OXLEY. All right. Is it useful to an investor, Mr. Bogle, to understand based on the GAO report that expense ratio has gone up 11 percent?
    Mr. BOGLE. Yes, it is useful, and we ought to show investors the dollar amount of their costs. I do not think we should ever think of these things as mutually exclusive. In my testimony, I recommend that each mutual fund shareholder statement at year end, an annual statement, include a footnote, printed in the statement, showing that the annual expense ratio of this fund is 1.4 percent, say, and where he says the year-end value is $11,000, just let that little computer multiply 1.4 percent times $11,000, and say on that basis your cost would be $154 or whatever it comes out to. I do not see any harm in that. You still have the expense ratio, and at least the person can look at his direct mutual fund costs, previously hidden, and compare them with his electric bill or his rent or anything else he wants to compare them. He has the right to ignore it.
    Mr. OXLEY. Or with other mutual funds, too, in terms of cost.
    Mr. BOGLE. Absolutely.
    Mr. OXLEY. Mr. Haaga, is that a good idea?
    Mr. HAAGA. No, that is just the problem. He cannot compare it with other mutual funds. He can only compare it with his rent, if it is a non-standardized number. That is what we are talking about. We are all interested in including all the costs, reducing them both to a percentage and to a dollar amount. The argument is only whether you should use a standardized dollar amount or the actual dollar amount that the person paid. The comparison you were looking for at the end of your remarks, which is with other funds, can only be made if you use a standardized amount, not the actual amount that Jack Bogle is talking about.
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    You can translate that. If you really want to know that, you could translate that yourself, but you would have to remember if you have made purchases during the period, you have to adjust for that. So we think it is much better to look at standardized amounts, not actual individual amounts. It is all about comparison.
    Mr. BOGLE. It does not take a mathematical genius to apply the standardized expense ratio to the amount the investor has in the fund and show the dollar amount of costs he would expect. I do not see how that can even be controversial.
    Mr. OXLEY. Mr. Haaga, when you sent out the investor account balance, that is net after fees, right?
    Mr. HAAGA. Yes, it is.
    Mr. OXLEY. You are able to calculate how much to take out of my account at that point, to determine the fees and the net, but can it also tell me how much in dollars it took out of my account?
    Mr. HAAGA. We actually do not take it out of the account. The fees are paid by the fund itself, rather than by the shareholder. So we are not calculating that at the shareholder level, nor are we deducting them from shareholder accounts. So when the shareholder gets a statement, that is the net amount they own, which is the net amount the fund earned after the fund paid fees.
    Chairman BAKER. Would the gentleman yield?
    Mr. OXLEY. Yes.
    Chairman BAKER. I just wanted to ask, if somebody else is paying the fee, where do they get the money from in the first place?
    Mr. OXLEY. Yes. Those fees are obviously coming out of somewhere.
    Mr. GENSLER. It really is a wonderful system they have, is it not? It really is. It works well.
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    Mr. HAAGA. The fund is paying the fee, and the investor's account, the investor's earnings, the value of the investor's shares are net of that. But the fund does pay the fee.
    Chairman BAKER. Mr. Chairman, if I may interrupt again, let me understand. I put money up. You manage it for me. In the course of managing that account, you are going to tell me I have this percent of fees that deduct from my net check. Before you get to that check, you have operating expenses that the fund assumes on my behalf. But that offset of operating expenses comes off the top of the distribution that comes back to the investor. Even though it is not allocable to me individually, it is allocable to the fund.
    Mr. HAAGA. That is precisely what we are disclosing.
    Chairman BAKER. Okay. I have got it. I yield back.
    Mr. OXLEY. Mr. Montgomery, do you have any comments in that regard?
    Mr. MONTGOMERY. I guess I am in favor of some kind of disclosure. I do agree with Mr. Haaga that the timing of purchases and sales of a fund complicate it, unless you have this footnote that Mr. Bogle refers to at the bottom of the statement that says, assuming you held your fund for the entire quarter, let's say, without any purchases and sales, it would be this. If you made that assumption, then it is very easy to calculate and I do not see why we cannot do it. If, however, you want to be accurate, if you are telling shareholders that this is the actual fee that you paid from your fund ownership, then you do have to account for purchases and sales. It gets very complicated. Bridgeway actually used to do this level of account disclosure for returns. One of the criticisms of our industry is that, yes, this is the return of the fund, but how has my investment since I made it actually performed? That is what I want to know.
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    So when we created our first account statement eight and a half years ago, we actually told investors what that was. It is a much more complicated calculation if you include the effects of redemptions and purchases. So I am somewhere in between what you have heard today. But if you make the simplifying assumptions, it is a dollar amount, then people can compare it with the ATM fees that Mr. Gensler talks about.
    Mr. OXLEY. Let Mr. Gensler respond. He looks a little skeptical to me.
    Mr. GENSLER. The nature of the mutual fund industry is to promote profits for mutual fund companies. Many of them are public companies. The nature of Las Vegas is to promote profits for the casino. I would make a note, and I find myself probably agreeing with Mr. Riepe, who by the way is my twin brother's boss.
    Mr. OXLEY. He brought the wrong twin.
    Mr. GENSLER. But I would note that if there is some genetic flaw, then he must have it, too.
    Mr. GENSLER. Somewhat like Vegas, we Americans do not really pick our funds on cost. So if we put more disclosure out there, there is probably still going to be 85 or 90 percent of Americans investing in actively traded mutual funds. It is relying on experts. It is a sense of the buzz. It is a sense of in my work-a-day life, maybe I, too, can get an excess return. There are a lot of good things mutual funds do as well—the service, the diversification that has been referred to. So I am a little skeptical that added disclosures will help a lot. I think there are some areas that disclosure should be considered. I think, to comment on Chairman Baker's point earlier, just like with analysts and Wall Street firms, it would be helpful to know what the whole fund family has done, even including all those dead funds. As Mr. Riepe has said, many people pick by the fund family—by Fidelity or T. Rowe Price. It would be helpful to see how that whole fund does, and just put it on the Web site. Let the financial planners know that information is on a Web site. It does not have to go out in some thick owner's manual.
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    I do think at the core there is an issue about governance in the mutual fund business, and all of these fund directors sort of passively going along with the status quo. In many funds, that is all right—probably the funds represented at this table. But we all know with 7,000 or 8,000 funds out there, there are a lot of really poor performers and high churn, high turnover and high fee funds, and if none of them ever change their managers—well now somebody in the press or somebody will find one that did—but so few do. It seems something is out of balance to me in that regard.
    Mr. OXLEY. Well, let me just complete this. That really gets at the core of the whole issue. Why in the world would an investor stay with an under-performing fund that you just described, unless they had no idea what was going on? Why would they do that time after time, when they have the ability to take their money and run, or to vote with their feet and go with somebody else?
    Mr. GENSLER. At the core, I think it is human nature. I think I could quote various studies, and in this case not financial studies, but the psychology of finance, that often we Americans hang with our losers. We sell our winners and hang with our losers, and all sorts of studies have shown this. It is a little like the deer caught in the headlights.
    Mr. OXLEY. I could understand that with individual stocks. It is hard for me to believe in a mutual fund concept, which is just the opposite of individual stocks. You are buying a marketplace of stocks. It is almost like staying in a bad marriage, I guess.
    Mr. GENSLER. It is. Fortunately, I have a good marriage. But it is like picking stocks. A lot of Americans will stay with a bad mutual fund, hopefully not represented at this table, and just stay and not open the monthly or quarterly statements.
    Mr. HAAGA. Mr. Oxley, I have a good marriage, too, by the way.
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    Mr. OXLEY. This was not meant to be a quiz. This is not Phil Donohue or even Jerry Springer, for that matter.
    Mr. HAAGA. Since he said it, my wife is on the Web cast and I thought I'd better say it.
    The truth is, the shareholders do move. We have talked about the lowest cost funds getting the most assets. There is kind of a circle of causality there. And we have also talked about the lowest cost funds performing the best. Those are all related consequences because the funds that do perform better get more people, and then as the GAO and SEC said, they reduce their fees. So they all cycle together. I do not want to leave it on the record that shareholders do not move when their funds do poorly. They move and they move quickly.
    I also do not want to leave it on the record that they do not go for the lower expense funds. I think as our slides show, there has been a million man march in the direction of the low cost funds. I think one of the reasons for that is because they perform better. Another reason for that is because they are lower cost and the people understand it. So I just wanted to add that. Thanks.
    Mr. RIEPE. I would also add a specific example. We have a growth fund that under-performed both the market index as well as its competitive group in 1997, 1998, and 1999. It then out-performed those same benchmarks in 2000, 2001 and 2002, and for the six-year period it is in the top decile of all other funds, and beat the market index as well as the competitors. So it is in the top 10 percent. But that tells you that people are not always confident they know when they should move, and too often they move at the wrong time. Human nature is such that people tend to give up at the bottom, and they tend not to have the courage to go into something at the bottom. I think that is the reason that we, and it was alluded to earlier, went out of our way both as an industry and individually to try and highlight during that bubble to investors the risks of moving into the top performing stocks. But you cannot overcome human nature and greed. They are powerful influences on people's behavior.
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    Mr. OXLEY. My time has expired. I yield back.
    Chairman BAKER. Just barely, Mr. Chairman.
    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    The comment was made that some have bad marriages. My question is, should the government be involved in selecting spouses?
    Is not that what we are talking about here? I guess I am interested in, one, I think the mutual fund industry represents risk. It invests in risk. By definition, there are going to be successes and there are going to be failures. I am more interested to know from the panel, maybe particularly Mr. Bogle and Mr. Gensler, is there any fraud or abuse that you see in the mutual fund industry that we should be attending to? Or are we just talking about poor judgment and boards of director that are not necessarily actively involved in what someone thinks is a standard of selecting new managers or new advisers? I am curious whether you see actual fraud or abuse out here, to the extent that it warrants government intrusion.
    Mr. BOGLE. Well, I am not sure we need additional government intrusion, but let me answer categorically yes, there is fraud, and yes there is abuse. Let me give you a couple of examples of fraud by large managers with a great deal of power in the IPO market because they are clients of the brokers. They take those initial public offerings that they get because they pay large brokerage commissions to those firms. They direct all those IPOs into a new small fund, and the fund goes up, say, 100 percent in a year, or even 100 percent in a month, and they advertise that and put it out to the public. That is what I would call fraud. I am not sure anybody else would call it that, but I would call it categorically fraud.
    Mr. KANJORSKI. You mean they get the advantage of the IPO because they are handling a larger fund, and then that is sort of a backward payoff?
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    Mr. BOGLE. They put the IPO's in the smaller fund where it has a huge impact, and they do it over and over again.
    Mr. KANJORSKI. Should not it go into the same fund that created the incentive?
    Mr. BOGLE. It is a curious thing. Of course, it is the large fund's buying power that gets this free ride—a term that will probably vanish after this great bubble—but of course it should go there from the economic standpoint. But I am sure that the manager argues that the big fund is a very conservative blue chip fund, and I have this little speculative fund over here, so I will put it there. That is a specious argument, because the real idea is to pump up that return to the fund, and then sell it to the unsuspecting public. We have two documented cases where the SEC has taken them to conclusion. Without the SEC having criminal powers, the managers were fined. So this is right there in the record.
    We have something else very close to that kind of fraud or over reaching. If you open up the March, 2000 issue of Money magazine, right at the market high, there were 44 mutual funds that advertised their past returns. The public did not know about these funds, so we advertised them and sold them to investors. We created the funds. The average return for the previous year of those 44 funds that were advertised in Money magazine, the average annual return was 85.6 percent. Our ads are saying, come and get your 85.6 percent. Oh, sure, there is a hedge clause saying past performance may not be repeated in the future. They should have said ''will not'' in this case, but it is in tiny type, barely readable. We know that high returns are what attract the public. Those ads, as it happens, produced business, and that is fraud or abuse.
    Other abuses is this pandering to the public taste by fund managers, bringing out 496 new Internet funds, technology funds, and aggressive growth funds in the midst of the bubble. I do not know that anybody in the investment departments of the fund firms wanted to do that, but I know the people in the marketing departments did. I have been in this business for a long time. I know what causes what. The great firm of Merrill Lynch brought out two such funds at the peak of the market. They sold $2.2 billion of these funds to their customers. One was an Internet strategies fund. One was a Focus-20 fund. Both funds went down about 95 percent in the market decline, and so did customers' money. One fund has been put out of business so its record will no longer be visible. Is that an abuse? Yes, sir. I would argue that is a serious abuse.
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    Mr. KANJORSKI. Of course, the NASDAQ itself went down 75 percent, Mr. Bogle. Is 20 percent a greater loss than that?
    Mr. BOGLE. You know, if you had started—it is a very good question—if you had started, out of your marketing opportunism, a NASDAQ fund when the index was at 5,048, and you said, well of course the index went down 75 percent, and so did the index fund. But, if you want to do that, and people did, the reason you are doing it is not to help people invest better. It is to bring money into the business. This business, as everybody has observed, has become an asset-gathering business, more than an investment management business. Just read what people that are doing all these mergers of management companies and acquisitions of management companies are saying. The first thing they say is, here is the asset-gathering capacity of the firm. I have never seen a word in one of those investment banker's reports that say anything about mutual fund performance.
    Mr. KANJORSKI. Should the government then get into the business of maybe regulating how they advertise?
    Mr. GENSLER. Mr. Kanjorski, the government is in the business. Sixty-three years ago Congress addressed itself to the inherent conflict in the Investment Company Act of 1940. Subsequently, the SEC has promulgated numerous rules and Congress has come back. I think this hearing is just part of the ever-going sort of finding the appropriate balance.
    On the issue that Mr. Bogle raised, yes those very things occurred, where large fund companies start up with what is called incubator funds and by the roulette wheel some of them will do well and some of them will do poorly. The one's that do well, you advertise. Sometimes they try to help the roulette wheel by putting in hot IPOs. Now, the SEC has addressed that with some final rules on IPOs. We could debate whether it has worked, but they have addressed that.
    To your question, I grappled with it. I wrote a book for investors. I did not write a book for Congress. I did not even envision that there would be such hearings. But when I was asked to testify, I sort of thought, Congress has grappled with this for 60 years and the SEC has grappled with it. By and large, I think there should be individual choice, freedom of American choice. This industry, like other industries, has the right to advertise its products. But I think on the margin, some additional disclosures could be helpful and warranted, and on the margin some addressing to governance, particularly around these soft dollars where I do not think that is fraud. I think it is well known. It has been going on for 10 or 15 years, but it seems out of kilter with what the funds really ought to be doing.
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    Mr. KANJORSKI. Can that be handled by the present regulations in the SEC, or do we need additional statutory authority?
    Mr. GENSLER. That is a very thoughtful question, one that I have not thoroughly researched. It may well be that the SEC has authority to address that, and if they did, I would hope that they would, but it may well be the Congress giving them a little added nudge along the way would help as well.
    Mr. BRADLEY. Can I speak to that one?
    Mr. KANJORSKI. Yes.
    Mr. BRADLEY. As I understand, if 28(e) was originally interpreted by the SEC in a far more limited fashion. Managers could not pay for services otherwise and customarily available for cash to the public. The SEC has broadened that through interpretive releases over time. There has been no rulemaking. My concern would be, maybe it is time for rulemaking to say what exactly constitutes paying up, and what exactly is the value of those goods and services to investors.
    Mr. KANJORSKI. Tighten it up.
    Mr. BOGLE. I would like to add one other thing, sir, if I may. I think the government is going to have to look into, number one, a more express statutory standard of fiduciary duty for fund directors. Number two, is building up even further the independent majority of the board, for the present independent director structure clearly have let investors down. And number three, as I mentioned in my testimony, is to have the chairman of the board, not the same person as the chairman of the management company. The Investment Company Act of 1940 was right when it said that investment companies are affected by a national public interest, and all this talk about what buyers do and what buyers choose is fine, but our law says, more is required. It says, in effect, that mutual funds are not toothpaste and mutual funds are not soap, and mutual funds are not beer. They are people's retirement savings, children's college education savings. It is not just a consumer issue, it is a legal and governance issue that requires the boards of directors of mutual funds to see that funds are operated primarily in the interest of shareholders, and not in the interest of managers. I believe that balance has been badly distorted. The system that the law established isn't working.
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    Mr. KANJORSKI. So that is something statutorily that we could do.
    Mr. BOGLE. Yes, sir.
    Mr. KANJORSKI. The other thing that I am worried about in terms of the evidence is no manager has been fired among 7,000 or 8,000 funds—that does raise a question. But it is sort of our shining example of independence. I am just worried about how many people we are going to put in charge of watching over the board of directors, and then who is going to watch over the watcher of the board of directors and how far can we go. Is not this structure sort of the same structure, and there are independent board members. Their job is to have a fiduciary relationship. If they violate that fiduciary relationship, are not they subject to class action lawsuits?
    Mr. BOGLE. We have had class action lawsuits and they have been notoriously a failure for reasons that I think are in many respects too bad, because the courts have judged the level of one funds' fees by the level of other funds' fees. So if you look at a management company with, say, a 1.5 percent fee, and the range of fees is 1 to 2 percent, the court says, in effect, '' we are not going to interfere with that.'' As far as it goes, that is okay, but it is almost the same issue as executive compensation that has gotten so out of hand in this country. If everybody is doing it, then I can do it too. But that is a new standard, and not the standard established by the 1940 Act. The standard of the 1940 Act is fairness to shareholders. Yet even as fees go up, plaintiffs have not been successful.
    Mr. KANJORSKI. Mr. Bogle, I tend to agree with that, but then does not it go contrary to our system? I mean, if we are going to have the SEC approving salaries and activities, where does it end? I mean, if I needed brain surgery, I would not advertise as to who can give me the cheapest brain surgery. I would want to hire the best brain surgeon in the country. I assume that these funds are interested in growing and attracting more investment money. So is not the natural market incentive there to have the best managers and the best advisers in the country?
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    Mr. BOGLE. Yes, sir, and that is a wonderful question. There are, say, 500 different management firms and 10,000 mutual funds, each of which is trying to be the best. But, it is inevitable, given the mathematics of the marketplace, that before costs are deducted, they are all average. When they trade stocks, they trade with one another. I will use the entire institutional community, not just the mutual fund industry because most firms are doing both. So they are all average before costs, but after cost, they are all losers to the market itself. Beating the market, is, must be, and always will be, a loser's game.
    So what happens in this industry? Well, we will have managers who look very good in the short term. The top 20 managers in the two years coming up to the boom, the peak of the boom, were the bottom 20 managers in the two years that followed, metaphorically speaking. Actually, they were not exactly the bottom 20, but they were in the bottom 50 out of 5,000 funds. They looked like good managers, but they were just speculators. So we have a system that is shaped the wrong way—an opportunistic system.
    Mr. KANJORSKI. How do we correct that?
    Mr. BOGLE. Yes, that is a very good question. We need education. Investors should know that the first rule of investing is uncertainty. That the second rule of investing is gross return minus cost equals net return. The third rule of investing is, for God's sake, do not put all your money in the stock market unless you are 20 years old and it is your first $100 in a 401(k) plan, in which case it is fine. We need more education like that. But above all, we need a structure in which the people govern the fund, the directors, the fiduciaries, the stewards of the fund—are called to task to live up to their responsibilities.
    Mr. KANJORSKI. The funds that you show in your chart—the Wellington Fund—you own your adviser group, so that is part of the fund itself?
    Mr. BOGLE. No, let me explain that for a moment. Vanguard is a mutual company owned by our shareholders. It is a unique structure in the industry. We manage about 75 percent of our money inside Vanguard. The index funds and our bond and money market funds are pretty much all managed at Vanguard on an at-cost basis. That was the main example. For the remaining approximately 25 percent of our assets, we use external investment advisers. We use Wellington Management, for one. Actually, I think we use about 18 different outside advisers. We go out and negotiate fees with those advisers. Believe me, if you are legitimately negotiating, you can get a fee of four basis points if the fund is large enough—and admittedly Wellington Fund is large enough—just four one-hundredths of one percent. Our Ginnie Mae fund, which I did not comment on earlier, pays a fee on that is only nine-tenths of a basis point. It is fractional, while other Ginnie Mae funds pay 50 basis points, 100 basis points—sometimes 100 times as much or more. In the Ginne Mae case, it is very much of a commodity fund, so we were of course the best performing Ginnie Mae fund over time. We cannot do it otherwise. We cannot beat the Ginnie Mae index, but we can beat almost everybody else just because of one low cost. There is where our extra return comes from. We have got to educate investors about the importance of cost in shaping what they earn.
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    Mr. KANJORSKI. Why is it that through either the mutual funds themselves or the association or a cooperative formed under that group, why can't you buy seats and trade yourself and set your own cost? Would not that save a great deal, rather than going through the established brokerage business?
    Mr. BOGLE. Well, we do not. I am not sure I fully understand the question, but at Vanguard we do not do any business with affiliated.
    Mr. KANJORSKI. How do you make your purchases on the exchange?
    Mr. BOGLE. First of all, index funds do very little transaction activity, but most is done on the New York Stock Exchange. Counting all index funds together, they account for maybe one-third of one percent of all exchange transactions. Our 18 outside advisers do business largely with brokers. We like advisers with low turnover, but they pretty much have to do business with brokers.
    Mr. KANJORSKI. You have a significantly lower cost. What do you attribute that to?
    Mr. BOGLE. I attribute that cost to—
    Mr. KANJORSKI. Other than your brains.
    Mr. BOGLE. Well, it is thriftiness, but it begins with having a mutual company. Think about it this way. If the mutual fund has a 1 percent fee and the pre-tax profit margin has been about 50 percent, that means if we eliminate that pre-tax profit margin by being mutual in nature and operate at cost, we are already down from 1 percent to one-half of one percent. The second thing is, we negotiate fees. We do not say to the adviser, these fees are just fine. I have done a lot of these negotiations and they are not entirely fun, but sooner or later, you get a better fee, and we've done them five or six times over 20 years for each fund. It pays off for the shareholder and then we are cheap in how we spend our shareholders money. That is the third part of the advantage we provide.
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    Mr. KANJORSKI. Do you think we should separate the investment houses from starting the fund, and that may be an internal conflict that has to be broken?
    Mr. BOGLE. I would love to do that, but I do not see how it is practicable, honestly.
    Mr. KANJORSKI. I see I am shaking up a lot of folks here.
    Mr. GENSLER. I do not see how one would do that, but I would mention your brain surgery analogy is a very good one. Where it falls down, if I might say, is if you take the best brain surgeons, next year you presume they are still going to be very good brain surgeons. If you take the top 50 percent of performers, next year 45 percent of them are in the bottom half—close to what you would say is random chance. It is a little better than random chance.
    In terms of negotiating fees, just to give a little sense, the best academic study in the last year done on fees showed that pension plans, the big state pension plans, whether it is Pennsylvania's or Louisiana's and so forth—the state pension plans go out and negotiate fees. Their fees for advisory services are one level, and mutual fund fees are 2.5 times that level before considering all the administrative costs. So it is not the servicing or the envelopes that there are plenty of. Why is that? Many of the companies at this table and in the industry actually provide both services. I would imagine that many of them—if $1 billion from the Pennsylvania state pension plan came in would probably manage that in the equity market for 25 or 30 basis points, or if they had a good day, 40 basis points. But the standard in the industry might even go down to 20 basis points. The mutual funds, if you take the standard $1 billion large diversified fund is 2 to 2.5 times that. There just is not the competition. There is not the tension in our commercial environment.
    Mr. KANJORSKI. How would we get it there?
    Mr. GENSLER. I think it is the hardest challenge—much harder than disclosure. It may well be in fund governance. It may well be. I do not have a specific recommendation that this Congress and the SEC put more pressure on the deciders of these fees; that the fund directors act in their fiduciary responsibility that was first embedded in the Investment Company Act of 1940.
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    Mr. KANJORSKI. But is not that going to mean that it would force them to a level of mediocrity for safety purposes?
    Mr. GENSLER. No, I do not think so. I do not think that the public pension plans in America—by the way, if you take all state pension plans in America, 57 percent of their U.S. equity dollars are indexed. That is still 43 percent that are not.
    Mr. HAAGA. Maybe that is why their fees are lower.
    Mr. GENSLER. No, I am not talking about the index side, because indexing for $1 billion you can get on a single-digit basis points.
    Mr. KANJORSKI. Do you think out of the seven witnesses here, we could come up with recommendations that the seven witnesses could agree upon?
    Mr. GENSLER. I suspect not, sir, because I think the industry group, as many industry groups in many industries, will be more likely not to wish to embrace reform and change. I would hope that they would, but it is not the customary way of America.
    Mr. BRADLEY. Could I speak to that quickly?
    Mr. KANJORSKI. Yes.
    Mr. BRADLEY. I have a concern about the framing. Behavioral finance teaches us a lot about how people frame the problem and it actually frames the answers. When you think about the purpose of markets, it is not to make investment companies rich. It is to fund new ideas in America. It is to underwrite small ideas that Bill Gates had in a garage out in California; fund it with an investor's risk capital because the bank will not do it; grow the company up so it becomes a mid-cap company or middle-size company; then it gets large and then it gets in the S&P 500. Even the S&P 500 in 1999 and 2000 added major high-tech volatile companies at the top. So the idea that capital formation is only about investor returns is too narrow a perspective; it is a risk-return equation. I would argue that mutual funds are a way for little people to help fund capital formation in businesses in America and, in return be rewarded over time.
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    Mr. WAGNER. I would like to add to that. Sitting here listening to this, I hear ''governance'' coming up all the time over here. Most mutual fund boards that I have ever encountered are toothless tigers. They are selected by the investment manager and they do not report independently to the fund holders, I believe in most situations. We have independent directors for corporations that are really independent and do represent the shareholders—
    Mr. KANJORSKI. At Enron.
    Mr. WAGNER. and I do not see a similar thing in the mutual fund industry.
    Mr. KANJORSKI. But how far do you want the government to get involved in what is a private decision, it seems to me, of selecting or classifying or categorizing board members? I mean, people have a right to be stupid. Is not that a principle—caveat emptor?
    Mr. GENSLER. There is most certainly that in a free market, and I very much believe in free markets. That is the burden of all of us and the benefit of our system. But I think as Congress saw 60-some years ago, there is an inherent conflict, and at times it may be worthwhile addressing that balance and just saying on the margin whether there are things to help the system out.
    Mr. HAAGA. If I can jump in here, a couple of things—one is my colleague Mr. Gensler says that it is not the American way to reform yourself. I would say it is the mutual fund way. You can just look back at history and look at our participation in regulatory initiatives. I might also add that although the 1940 Act requires for most funds only 50 percent independent directors, our best practices, which have been adopted by virtually every mutual fund, call for two-thirds. So we are almost at the point that Jack Bogle would have us go.
    Lastly, I just cannot leave un-commented upon the suggestion that has been made that the only way that you can measure the independence and effectiveness of a board is by counting how many times they fired the management organization. That is a very unusual step. A few years back, we merged with, actually bought, a management company and took over management of its funds. Their board had told them that they needed to go find a good home for the funds. They were tired of their management. That shows up not as a firing that everybody is looking for, but it shows up in the merger statistics that for some reason Jack Bogle finds objections to. Let me tell you, that was a firing and I think a lot of the other mergers that have taken place are prodded if not ordered by directors.
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    Furthermore, we have talked about not firing advisory organizations. Advisory organizations do not manage the individual funds, but portfolio counselors manage the individual funds, and plenty of those have been fired. Finally, even without firing, as someone who has spent a lot of time in boardrooms with a lot of boards, we get a lot of pressure to fix things that are not going right. The boards, do it the right way, they say—give us a special meeting about this fund; we want to discuss its results and what you are doing about it. And they listen to our answers. If they do not like them, and sometimes they do not, we have another meeting and we come up with different answers, until they are satisfied and until things have turned around. Those will not show up in your firing statistics, but they were a case of an active board taking responsibility and putting pressure on the management to make things better on behalf of the shareholders. It goes on all the time in our industry.
    Chairman BAKER. Thank you, Mr. Kanjorski.
    Mr. Fossella?
    Mr. GENSLER. I would just say that I stand corrected. I am delighted that the head of the Investment Company Institute has that constructive approach to reform. So I stand corrected.
    Chairman BAKER. Mr. Fossella?
    Mr. FOSSELLA. Thank you, Mr. Chairman. Thank you, all of you for this healthy dialogue.
    It seems to me in looking at more than 200 years of experience in the industry, I would believe that all of you have an interest to see the future of this industry and a future of getting more Americans to become investors, you have an interest in seeing that it flourishes. It also seems to me that you are all looking at the same situation with varying degrees of criticisms and applause. Some have written books about it; others have made a lot of money in it.
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    It was alluded to before as to what can you all agree on. I am not suggesting that you all have to agree on everything. But is it not in everybody's interest that you establish a common platform for just the industry, and then allow each of you to compete—in my opinion, the American way more so—but on an honest basis, with a sense of providing integrity and truth to your owners? Mr. Bogle has been among, it seems, the most vocal in his, I do not want to say criticisms, but what he thinks would be a healthier future, where others feel that some of those criticisms are unwarranted.
    So I am curious to hear from the rest of the panel. For example, Mr. Bogle just alluded to some possible, I am not saying it is the right thing or the wrong thing, but some possible statutory provisions regarding fund directors or independent directors on the board, and the issue of whether the chairman should be, or the title of the chairman, should he be the head of the fund as well. I am curious as to what you all think about that suggestion.
    Mr. WAGNER. Sounds like a good one to me.
    Mr. MONTGOMERY. I guess I could support that one, too. I am, by the way, both president of the advisory firm and chairman of the board of our board of directors of our fund.
    Mr. FOSSELLA. Mr. Bradley?
    Mr. BRADLEY. I will yield to my colleagues.
    Mr. FOSSELLA. Okay. You mean you do not have an opinion?
    Mr. HAAGA. I am the chairman of our fixed income funds. If they asked me to step aside, I would. I think that specifically separating the role, making the chairman an outside director, would not do much and I think it would be a problem in some organizations, so I will not embrace that. But as I said about the 80 percent thing, we are almost there, and we got there on our own. So I think some things are best left to best practices and industry developments, rather than legislated.
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    Mr. FOSSELLA. Okay.
    Mr. GENSLER. Specifically to having the chair of the fund be independent, I think on the margin that could be helpful. I think at the core, it is questionable. At these funds, it is not just whether they hire or fire, but also how they look at fees and why they customarily would pay 2.5 times for advice what the same service providers, the same T. Rowe Price's or American Century's provide to institutional pension money. So the same advice going to the state of Pennsylvania somehow, if I am the Magellan Fund or I am T. Rowe Price's big, large diversified fund has a higher fee—to ask those questions and find some way to ask those questions and get satisfactory answers.
    Mr. RIEPE. Let me just say that when I worked with Mr. Bogle and he was chairman of the funds, he never held that attitude.
    Mr. BOGLE. That is quite correct, by the way.
    Mr. RIEPE. Clearly, he has had a revelation.
    Mr. FOSSELLA. When did this revelation take place, Mr. Bogle?
    Mr. BOGLE. May I just say that just because you have been mistaken for most of your life does not mean you have to be mistaken all of your life.
    Mr. RIEPE. Can I make my comment? If he starts again—
    Mr. FOSSELLA. I have been mistaken most of my life, or one has been mistaken?
    Mr. BOGLE. Many—
    Mr. RIEPE. Let me just say that I think I would agree with what both Mr. Gensler and Mr. Haaga said in the sense that it could do something, but it is certainly not a silver bullet in any way, shape or form. If we learned anything in this latest corporate abuse experience that we have gone through, it is that just putting independent directors in a room does not guarantee that you are going to have a clean shop. Independent directors can be duped; independent directors can fall asleep and not do a good job. Either way, it simply is not an assurance. I think it makes us all feel better and it seems to make intuitive sense to have a majority of independent directors overlooking management, but it certainly does not protect one by itself.
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    I think in the case of investment companies, the job is easier in the sense that one does not have to worry about accounting frauds and things like that because they do not happen in investment companies. So I think that the role of the independent director is more narrow and can be more forceful. I think this stuff about toothless tigers is a lot of malarkey, when you are talking about the middle 75 percent of the bell curve. I think as Mr. Gensler suggested, there are I am sure smaller groups where a couple of directors are luncheon buddies or something of the chairman. I do not know how one legislates that. I think the SEC has to do it through rules.
    Let me just comment very quickly on the pension question that Mr. Gensler brought up, because we manage money for institutions as well. I do not know where his statistic came from, but I can only hope that our mutual funds were 2.5 times what they are. Our experience is that they are higher than the pension fees that we charge, but I will also tell you that we could operate our company with about 80 percent fewer employees if all we were in was the pension business. Although everybody does not have 35 percent margins, as Mr. Bogle suggested, I will tell you the pension managers have the highest margins because they do not have all the other service requirements and all the other people requirements that are associated with taking care of an investment company. So there is a reason there is a spread between those fees. If someone is getting 2.5 times in their mutual fund what they are managing their private accounts for, then I think they have a very tough explanation to make to their directors. I might add, that fee information goes to our independent directors; and I think most every year it is required as part of the annual contract review.
    Mr. GENSLER. Just to answer the question that was had, the study, since it is not my work, it was two professors—one of business and one of law—Stuart Brown and John Friedman. It is called Mutual Fund Advisory Fees: The Cost of Conflicts of Interest, published August, 2001, University of Iowa Journal of Corporate Law. They excluded all of the amounts of money that went to service the account and just looked at advisory fees. I say that just in my conversations with the industry, generally pension funds will shoot for 20 to 25 basis points, often will pay 30, 35 basis points. That is about one-third of a percent of their money for let's say $1 billion or greater large capitalization, diversified, actively managed fund. If you look at the management fees, advisory portion in the mutual fund industry—somebody could check this with Morningstar—it is going to probably be roughly in the 60, 70 basis points. But again, if I am wrong, statistics will prove out what the real situation is.
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    Mr. BOGLE. Mr. Chairman, could I just respond to the Congressman's question about when my conversion took place?
    Chairman BAKER. Certainly.
    Mr. BOGLE. My conversion actually took place in 1974 when I was fired by Wellington Management Company, and started Vanguard as a mutual company. As such, I was chairman of the funds, and the chairman of the board of the adviser had no role in the firm whatsoever. You saw the chart that showed in 1974, our costs are down 60 percent and the industry's costs are up 60 percent, so maybe that is not such a bad idea to have that separation. It has been a conversion that's lasted 28 years, and I feel real good about the new Bogle as compared to the old one.
    Chairman BAKER. Okay. Anything further, Mr. Fossella?
    Mr. FOSSELLA. If I may, and I know you have other speakers, but I am just curious as to maybe not the focus of this, but to what extent in all of these numbers and statistics does our current tax system affect all of these numbers about movement in and out of funds, or the decisions? I heard different theories—behavioral, market analysis, all this other wonderful stuff. But to what extent do you think the tax code and our policies today affect individual decision making?
    Mr. BOGLE. I would like to just say one very interesting thing which should be brought up at this point, and that is the mutual fund is from an income standpoint the most tax-efficient investment ever devised by the mind of man, because mutual funds that happen to earn dividend income of about 1.8 percent on their portfolios. Taxes take away about 1.5 percent, and leave only 0.3 percent for the Federal Government to get its hands on. From that standpoint, tax policy, even the elimination of so-called double taxation, simply does not matter to the average mutual fund investor. Half of the shareholders pay no tax on their 401(k)s and so on, and the other half are paying taxes on a dividend yield of over three-tenths of one percent.
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    On that point, I want to add another comment about our ability to look so favorably on fees when someone says, well, it is only 1.5 percent of assets. That is the lowest number you can possibly get when you look at mutual fund costs. You say, what percentage is it of the market return? The 1.5 percent cost is 15 percent of a 10 percent stock market return. What percent is it of the mutual fund's income? While capital gains come and capital gains go, income and expenses go on and on.
    I want to give you an interesting example. It is in one of my exhibits here. I got involved in this industry in 1949 when I read an article in Fortune magazine called ''Big Money in Boston.'' The industry was a $2 billion industry then. The article was about a firm called Massachusetts Investors Trust—the oldest, the largest, and the lowest cost of all mutual funds. That article reported that the independent trustees of that fund had just reduced the management fee from 5 percent of income to 3.2 percent of income. They did not calculate it on the basis of assets. They calculated on the basis of income—5 percent to 3.2 percent. Last year, that same old Massachusetts Investment Trust took not 3.2 percent of income and not 5 percent of the fund's income, but 87.5 percent of that fund's income—87.5 percent of income was consumed by management fees.
    One of the big concerns this industry has about putting the dollar amount of fees in the shareholders' statement is that shareholders can see that my fund's income last year was $40, or was in effect $240 gross; the manager took $200 and only left me with $40. That will be easily calculable in that statement when you look at income.
    Chairman BAKER. Mr. Fossella, are you done? I want to recognize Mr. Sherman for a couple of hours.
    Mr. SHERMAN. Thank you, Mr. Chairman. I have so many questions and so many ideas, I will try to get them in within the two hours allotted.
    One idea that has come out of these hearings, and I think it is a good one, is that in addition to whatever basic prospectus you mail out, there ought to be a required supplementary prospectus posted on a Web page. Does anyone disagree with that, knowing that we have to argue what would be in the supplementary prospectus?
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    Mr. RIEPE. No, sir. We put a great deal of information out on the Web.
    Mr. SHERMAN. It would just be good to standardize that, and then of course you would have your non-standardized information—the glossy thing with your picture on the cover, which would attract a lot of investors.
    Mr. RIEPE. Our pictures are not in the prospectuses.
    Mr. SHERMAN. Oh.
    One thing I would like to focus on, because I think I have been affected by it a bit, is what I call the lock-in effect or the bait and switch. It goes something like this. You start an index fund or a bond fund, with, say, a management fee of around 20 basis points. You go out and market it effectively. You get $100 billion. And then you raise the fee to 50 or 60 basis points. Now, with a certain amount of inertia, you can be collecting the 50 or 60 basis points on the $100 billion of assets because people thought it was a good idea when they originally invested, and they do not bother to check that the fees are doubled or tripled. But there is another lock-in effect, and that is, if this is a bond fund or an index fund and the value has gone up, then no sane investor, unless they view themselves as immortal, is going to recognize a huge amount of capital gain income just so that they can invest in one of the fine funds represented here, and get out of this bait-and-switch fund. That is because you are going to be paying a huge fund just to avoid paying an extra 20 or 30 basis points a year until that great step up in basis that occurs at the termination of all of us.
    So is there anything that—and I have oversimplified what I think has happened to a small part of my personal portfolio—is there anything that prevents this ruse from happening—marketing a fund at 20 basis points, and then after you have got a whole lot of cash in the fund, doubling or tripling the fee?
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    Mr. HAAGA. I think what you are referring to—well, the truth is, there are two ways the fees could go up. One is, as I discussed in my oral testimony—
    Mr. SHERMAN. Let me add one more element to this. The way they marketed the fund is they said, because the manager is currently waiving so much of the fee, the fund in its first year only paid a fee of 20 basis points.
    Mr. HAAGA. And they had to tell you what the return would have been had they not waived the fee.
    Mr. SHERMAN. Right. That is a bit of a warning to anyone who has been through this process at least once.
    Mr. HAAGA. Right. And as I told you, if you bought our tax exempt fund of California, it would not have happened.
    Mr. SHERMAN. But is there any rule that says you cannot wake up one day, having marketed a fund as the low-cost California tax exempt bond fund, and change it to the 70 basis point a year California tax exempt bond fund.
    Mr. BOGLE. There is no such law. It is cast in the light of the marketing spirit of this great business, and that is, we are going to do a nice thing; we have a 1 percent fee, and we are going to waive three-quarters of it for you. Money market funds have done this. I think over half of the money market funds will move to wave fees when their yields go down. They do not tell you when they do it. They do not tell you when they put the fee back on. It is just wrong.
    Mr. SHERMAN. What if you did not even do the fee waiver. What if the official fee for 2003 is 20 basis points, and then in 2005, the official fee goes up to 50 basis points?
    Mr. HAAGA. That would require a vote of the board and a vote of shareholders, so you would have gotten a proxy saying, do you want to do this or not, and some fee increases have been turned down by shareholders and many by boards.
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    Mr. SHERMAN. So an increase in the management fee requires a vote of the shareholders.
    Mr. HAAGA. Correct.
    Mr. SHERMAN. So this fee being waived, that is a bit of a warning that that fee may not be waived in the future.
    Mr. HAAGA. Correct.
    Mr. RIEPE. There is a table right in the front of the prospectus that the SEC requires. If you have waived a portion of the fees, and usually what gets waived first is the advisory fee, there is a cap on expenses. Over one-third of the mutual funds now tracked by Lipper have expense caps on them in one way or another. This speaks really to the competitiveness of costs.
    Mr. SHERMAN. I would like to go on to the next question. The other thing that you folks have brought up is the idea of the roulette wheel and the incubator fund. It would go something like this. Let's say you were going to start a low cap fund. You do not start one small low cap fund; you start three. One invests exclusively in corporations whose name begins with A. Another one invests exclusively in companies named with B; the third exclusively in companies with names starting with C. You do not even have to identify it. You just have that as a policy. Then at the end of a year, the A fund is in the tank; the B fund is under-performing; and the C fund tripled its money—not because of any brilliant idea; it just happened that low cap companies with the C beginning their name did very well. And then of course you advertise the hell out of the C fund.
    Would we benefit from a rule that said that when you go out and advertise that C fund and its 300 percent rate of return, that you also have to disclose the rate of return on a weighted average basis of all funds in the same category managed by the same company and its affiliates, so that you would disclose not only the 300 percent rate of return of the Hasbro C fund, but you would disclose the negative 2 percent rate of return of all low cap funds administered by Hasbro.
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    Mr. GENSLER. Mr. Sherman, you hit upon a very interesting problem, not only incubator funds, which are legal and will continue to be legal—that is the roulette wheel.
    Mr. SHERMAN. And as you pointed out, you could enhance the C fund by getting a good IPO into it.
    Mr. GENSLER. That may be a little bit beyond what is good, healthy competition. But I think it does come back—your suggestion is a variation, maybe it is a stronger one—of my suggestion. It is just simply so that fund families can be seen in their full glory. Some will do better than others, but that they do not ignore the closed-down fund or that so many funds, about 5 percent a year go out of business. They aggregate all that performance data and at least have it on their Web sites so financial planners can get that information.
    Mr. SHERMAN. But if I want to invest in a low cap fund, I do not care that Paul has done very well with bonds. I want to know how well his company has done with low cap funds. It does not do me any good to find out that all of the funds he has managed have a rate of return of 6.2 percent. I mean, he could be a euro-bond fund for which he is responsible.
    Mr. GENSLER. You raise a very good observation, and it may well be helpful to have it broken down by major categories. I do not know.
    Mr. SHERMAN. Because otherwise this works perfectly well. If I start 10 incubator funds, I guarantee one will do very well.
    Mr. HAAGA. It works perfectly well, but the one you described involving the IPOs that I think Jack Bogle said was a fraud was the subject of an SEC enforcement action. That is why we know about it. So I think the egregious case is taken care of.
    There is a great deal of analysis and information out there in the Lipper and Morningstar and other things about fund families investment results. So there is a lot to know, plus of course the results of all our other funds are fully disclosed and fully advertised. So I think there is a lot to know there that even if it is, you know, you are hypothesizing that these funds could get buried, they are out there in the fund family data and they are out there in the historical data.
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    Mr. SHERMAN. I think it might be helpful, though, to have—I mean, it is nice to say that if you just know where to go in some Lipper chart somewhere on the Web, that the investor is protected. We need to explore what things should be in the prospectus, and perhaps the rate of return of all funds in the same sector administered by the same management team ought to be disclosed. Otherwise, the system I just—I realize enhancing the system I just described by throwing in IPOs, that gets you investigated by the SEC. But just starting three incubator funds and then advertising the one that does well, while the other two do poorly, it is not enough to just say ''aha, '' but those who look at the Lipper report are going to be saved from being misled.
    Mr. HAAGA. You also ought to remember that funds close for a number of reasons. We started our first global investing fund and the interest equalization tax came in and we closed it. So there are changes.
    Mr. SHERMAN. I think my first hour has expired.
    Chairman BAKER. I just learned that we may be having some votes here in a bit, and there are other members who have been here for a while. If we can, I will come back for a second round.
    Mr. SHERMAN. I just want to bring up one other thing, and that is I think it is important to disclose this whole soft dollar thing, but I am not sure that those advocating such a disclosure have been able to tell us how to do it in a way that is not avoided. What I have seen in another arena trying to prevent or quash or disclose soft dollars is sometimes you just drive things underground. One of the things—maybe you can reply in writing to this, because we do need to go on to other members—is the fact that you are dealing not with brokers, but with broker-dealers. Thus, if we say you have to disclose commissions, what about markups? I would hope that the advocates for the disclosure of either what you are paying in brokerage fees or what you are getting in free services beyond execution, that those advocates would tell us exactly not only how we are going to disclose this, but how does it get disclosed if firms react to the disclosure rules, and for example, instead of buying bonds on the market that have already been out there with a brokerage fee, simply buy new issues and can report a zero brokerage fee. There is a spread for some, a brokerage fee for others, and I look forward to seeing in writing your response to that.
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    I yield back.
    Chairman BAKER. Thank you, Mr. Sherman.
    Mr. Tiberi?
    Mr. TIBERI. Thank you, Mr. Baker.
    Over the weekend, Mr. Haaga, I received a couple of things that you might be familiar with. I got this little lovely piece in the mail. I do not know if you can see it or not. You probably can see this one a little bit better. You might recognize that.
    Mr. HAAGA. Yes.
    Mr. TIBERI. It is an Investment Company of America, but this weekend I did. My question to you is this—congratulations, by the way, on your election to the board. I think I voted for you.
    Mr. HAAGA. Thank you.
    Mrs. KELLY. Would the gentleman yield?
    Mr. TIBERI. Yes.
    Mrs. KELLY. What is going on here between the two of you? Is he a constituent of yours, sir?
    Mr. TIBERI. No. The chairman of the board issue came up earlier, and the chairman of the board for Investment Company of America is a gentleman by the name of Michael Shanahan, who is also the chairman of the management company. As a shareholder, can you tell me why that is an okay thing or a good thing?
    Mr. HAAGA. I think if you look at the rest of the list, you will see that we have over two-thirds of the directors are outside directors. The act of chairing the board involves putting together the agenda; it involves putting together the materials, et cetera. I do not think, in fact I know in his case, and it is certainly not in my case, it does not involve dominating the meeting.
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    I would also add, and I did not get to add it before, so I would like to add it now, that we have separate meetings of only the independent directors in connection with reviewing our performance and our contracts. We even have executive sessions there. In those cases, the chair of the contracts committee chairs those meetings. So we do have a chairing role and a chairing function being performed by the outside directors.
    Mr. TIBERI. So you would argue that we would not—as a shareholder I should not be concerned about that potential.
    Mr. HAAGA. I would argue that the specific designation of Mr. Shanahan as chairman of the board does not impede in any way the independent activity and operation of our outside directors.
    Mr. TIBERI. Just following up on the question Mr. Sherman had with respect to broker-dealers, there is something called revenue payments that are sometimes paid to broker-dealers. Do you believe that fund managers like yourselves should disclose to investors what those payments are?
    Mr. HAAGA. The short answer is yes. The longer answer is, where and how much and to whom. I do not call them revenue sharing. I call them expense sharing.
    Mr. TIBERI. Okay.
    Mr. HAAGA. Because that is a lot of what is going on. For example, we have computers on the desks of broker-dealers that they use to forward trades to us. They have information systems that we put out information to them, and educational sessions, and we split the cost with them. I do not know whether that is revenue. It looks a lot like expense to me. So the question is disclose what and to whom. We have worked hard at the ICI, and when I chaired the NASD investment companies committee, on finding ways to do that.
    I think the issue would arise with what is called revenue sharing if a substantial amount of the payments actually made it to the selling broker, the one who was making the recommendation to choose one fund versus the other. They generally do not. They do not get out to the selling broker. They are made to the management company.
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    I also think it is important to note that a lot of them are not based on assets or sales. They are actually fixed-dollar amounts, where we are paying for some service or the cost of some facility that in effect both of us share. So I would like to find a way to disclose it. The devil is in the details of figuring out how to do it. I think if there were concerns, the fraud would be if there were huge amounts of money paid to sellers, either the firms or the individuals, to favor one fund over another, and that was how they were selecting the funds to be included in their group of sales. What happens is that they request fees at a certain level for all funds, and then all funds participate in paying them, so there is no skewing of the recommendations based on the amounts that are being paid.
    Mr. TIBERI. One of the devils in the detail is also directed commissions that a lot of these revenue sharing agreements have, that the brokerage has. It says that we will give you good shelf space in our supermarket if you also have the funds direct commissions—20, 25 percent of your total commission dollars back to our trading floors. Those arrangements I think are one of the devils in the detail that hopefully could be added to this.
    Mr. HAAGA. What he described is prohibited by an NASD rule, in plain English.
    Mr. WAGNER. I would like to point out the AIMR has approached this four or five years ago and come up with soft dollar standards that probably need to be updated, but at least form a starting point.
    Mr. TIBERI. Thank you, Mr. Chairman.
    Chairman BAKER. The gentleman yields back.
    Mr. Bachus?
    Mr. BACHUS. Thank you, Mr. Chairman.
    First of all, I want to commend you for holding this hearing. Ninety-five million Americans hold mutual funds, and I think it is important that these retirees or investors do not pay excessive mutual fees, and that if they pay hidden costs associated—well, that they really should not pay hidden costs associated with those mutual funds without knowing it.
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    As you know, U.S. fund fees appear to be lower than the vast majority of the funds in other nations, and there is strong evidence recently that there has been more fee-based competition. This being said, unfortunately academic studies have shown that many funds have experienced an economy of scale, and that they are not passing those savings on to the shareholders. In addition, these same studies have noted that shareholder insensitivity to costs may rest with widespread investor ignorance about the various shareholder charges. In other words, they are not opposed to them because they do not know about them, and that is despite a request by the Securities Exchange Commission to get the mutual fund industry to properly disclose their fees.
    With that background, I would like to start with Mr. Gensler, and I would like to pose this question to you. Mr. Montgomery states that the practice of soft dollar commissions is one of the worst examples of undisclosed conflicts of interest in the mutual fund industry. What is the conflict and how does it affect fund shareholders?
    Mr. GENSLER. There is a conflict, and I think it is a good question. Think of three parties—the investor, for this case it could be me; the fund company, if that is all right, if that is the chairman, just for a moment; and if you, sir, could be the brokerage house. What happens in soft dollars is that I pay you a commission—five cents a share, as Mr. Montgomery showed earlier—and part of that is a barter transaction. Part of it is that you are going to provide some services for Mr. Baker's fund company. In providing those services, it could be real estate; it could be data services; it could be a host of those—was it 1,200 services that was on that list. Barter is fine and it goes on in America. It is part of our commercial world.
    But here in this situation, there are three parties. I am paying you, the investor or fund company is paying you, the broker, five cents a share and you are picking up Chairman Baker's real estate or some other expenditures. That is where the conflict is, because it is not either disclosed to me in my fees. I do not see it in that management fee, so the shortest thing would be just add it to management fees. You could say that barter arrangement should be added to management fees, or go further and actually ban it because there is this inherent conflict that Chairman Baker is going to make more profits, and I am going to make less due to our barter arrangement.
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    Mr. BACHUS. All right. Let me go to Mr. Montgomery and ask you the same question. We are talking about soft dollar commissions. What is the conflict and how does it affect fund shareholders?
    Mr. MONTGOMERY. The conflict is that I have a choice as a participant in the mutual fund industry or in the larger investment community, when I have clients who do pay commissions and all people working through a brokerage house are going to pay commissions, so that is fine. But I have a choice when I go to pay for my Bloomberg terminal for the services of Mr. Wagner here, for many things, of paying out of our own advisory fee and profit—and by the way, research is one of the biggest ones of those—so I can pay for it out of our own profits, which you could say come from the management fee. Or I can pay for it with soft dollar commissions, which means it is a cost borne by the fund, but does not affect my own advisory fee expense structure.
    So which am I going to do? One flows directly through to my bottom line, and a dollar of expense there comes directly out of my profit. Or I can pay for it with commissions, which does affect our overall performance of the fund, but does not—
    Mr. BACHUS. And not even reveal that you had to spend that.
    Mr. MONTGOMERY. And that is key, and not even have to reveal it. Nobody is going to see it; nobody is going to ask about it. There are rules. The SEC in their examination when they come in are going to be all over it. So it is not like no one is looking. I promise you, during the examination the SEC is all over this issue.
    However, what are the incentives on my part to control those costs? They are not good. The incentive is very clearly—even if I have a 25 percent profit margin, I have four times the incentive to push it off on my shareholders as opposed to eat it myself. The only reason we do not do it at Bridgeway is it is a conflict of interest you cannot take care of, and we argue even by disclosure. It is too great a conflict of interest. Just do away with it.
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    Mr. BACHUS. Let me ask Mr. Bogle.
    Mr. BOGLE. The same question?
    Mr. BACHUS. Same question.
    Mr. BOGLE. I could not give an answer any better than John Montgomery's. There is a definite conflict there, and I am not sure disclosure vitiates it, but an awful lot of research is paid for, and particular research is paid for through these soft dollars. It is interesting that mutual funds themselves, out of this $75 billion of revenues that I estimate that they got last year—it is very fair estimate—probably spend about $4 billion on their own research. All the rest of it is paid for by the soft dollars with which they could otherwise improve the returns of their clients. So it is a definite conflict.
    Mr. BACHUS. Okay. Let me move to a second question, and this is for the whole panel. Should soft dollar commissions be banned in the mutual fund industry? Or short of banning the practice, what should regulators do to better protect the interest of fund investors? We will just start with Mr. Bogle.
    Mr. BOGLE. I would say soft dollars create great problems, but I would suggest that we should do away with them in the entire system, and not just with respect to the mutual fund industry. The abuse, believe it or not, may be worse outside of the mutual fund industry than it is within it. We should be when we execute a transaction, we should pay for the execution. As one of the charts you saw earlier, we are paying for three or four times that with other people's money.
    Mr. BACHUS. So you say prohibit it.
    Mr. BOGLE. Prohibit it.
    Mr. BACHUS. Okay.
    Mr. WAGNER. The miner's commission in the UK actually recommended this, and that is certainly being experimented with over there, so we will have some evidence on that fairly quickly here. I think that, yes, they could go underground, as Mr. Sherman suggested earlier, that they could go into unbilled category of services that are available from the brokerage firms. So it may not solve the problem. I would opt for disclosure—what is being spent, to whom and what is being received for that payment.
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    Mr. BACHUS. Mr. Montgomery?
    Mr. MONTGOMERY. I am in the banning category, and I think it is just an awful lot more efficient just to kill it. The costs that go into, as a mutual fund company, whether it is the adviser or the fund itself, of the regulators coming into look over the shoulders of it. It is kind of like the worst part of the tax system, with layer upon layer upon layer of loophole and exceptions. We spend a tremendous amount of money just trying to measure it and make sure that it is fair. Even if we were absolutely honorable, have integrity and want to do a good job, and maybe even disclose it—maybe somebody voluntarily discloses it—it is still a tremendous effort and cost that somebody has to pay to measure it, and I think that is inappropriate.
    Mr. BACHUS. Mr. Bradley?
    Mr. BRADLEY. I have a couple of comments that I would like to frame. One would be that it is already underground. So the fear that this would go underground, it is there. The reason it is there is that in 1997, the SEC did a soft dollar sweep and investigation of broker-dealers and looked at these bills they pay, because that is the only audit trial. Two-thirds of the documents at that time were unreported, undocumented. In my earlier testimony, I stated that what we heard from our accountants is, if they were documented it would create an income and expense item on a fund management company's income statement, potentially.
    I think that I would be more in favor though, and I answered a similar question earlier, that we should really go back and revisit your law, section 28(e), and through rulemaking define specifically what ''paying up'' means; gather the execution-only rate from firms so that we can quantify what they pay above that execution-only rate; and then put the burden on fund companies to show their management company through quantifiable results, the value returned to investors.
    Mr. BACHUS. Mr. Bogle?
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    Mr. BOGLE. I apologize, Mr. Bachus, for interrupting you. I was trying to make the following point. We are talking about abuses. I think it is important to note that when the SEC did their sweep a couple of years ago and found abuses, the only people that they found doing that were investment advisers, not the mutual funds. No mutual fund managers were caught up in that. We are throwing the term around back and forth about investment advisers doing that. Those were investment advisers to individuals who were being caught with the abuses.
    I guess in terms of what to do about—you asked the specific question of should we ban soft dollars—and some people answered we should ban it. I think you need to define it first. I will not get into it here, but soft dollars includes a lot of things that may not be wrong. The kinds of abuses that Harold is talking about should be curtailed either through SEC regulation or legislation—probably SEC regulation.
    Mr. BACHUS. And what are some of the areas that you think are particularly abusive?
    Mr. BOGLE. In Harold's case, I think that the ones he mentioned—that long list of things you could pay for. When I was in private practice before 1985, I used to advise some companies about interpretations of section 28(e). I once had a portfolio manager assert to me that if a light bulb shined on a guy doing research, that light bulb should be paid for out of soft dollars because it was research. You can imagine where that extends. There is just no stop to it.
    Mr. BACHUS. So research is an area of abuse?
    Mr. BOGLE. Research ought to have some intellectual content. That is what is permitted under 28(e), and the abuse is that people have taken research—you and I know what research is; it has an intellectual content to it; it is a study—and they extended it out to the light bulbs and the club membership for the guys who do the research because they need to relax after they have studied their prospectuses and things like that. That is where the abuses are. I would not mind getting rid of those abuses, but simply calling it soft dollars or simply repealing 28(e) would not do it. There is something going on that should not be going on, I will agree with that.
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    Mr. BACHUS. And Mr. Gensler, I think you made—
    Mr. GENSLER. Even if that is at the risk of Chairman Baker losing the soft dollars in my earlier example, I would probably be on the side of banning it, or short of that, significantly curtailing it and disclosing the remaining portion.
    Mr. BACHUS. Okay.
    Mr. RIEPE. Let me just say three things. One, I want to be on the record as agreeing with Mr. Bogle on something. Specifically, as Chairman Baker pointed out at the beginning in his opening remarks, mutual funds represent only about 20 percent of the equity market. As Jack pointed out, the soft dollar issue is not unique to funds. Some of the major pension plans in the country use commissions that are generated from their business, and direct advisers like us to pay certain expenses that those pension plan sponsors have incurred, presumably for the benefits of the participants in those plans. So this is not a mutual fund-specific problem.
    Secondly, I think, as Paul Haaga noted, the fund industry and the SEC have been doing a good job of managing it by examination and disclosure; but I do not think that is adequate, obviously, in terms of some of the abuses.
    And thirdly, a specific recommendation is that I think the SEC could be asked to go back and answer that question and have the time and the resources to delve into some of the nuances of it that Mr. Haaga was referring to, and come back with a recommendation on it. I will tell you that we can live with whatever that recommendation is, and if it is a complete ban of directed commissions, then fine. If it is something else, then that is fine as well.
    Chairman BAKER. Mr. Bachus, it is my intent, based on what has preceded us here today, to have a letter to the SEC probably next week, outlining a series of issues for resolution, one of which would include the soft money question. I just make the announcement for members' interest. If they want to sign onto that letter, just let us know. But I have spoken to Mr. Kanjorski and he wishes to participate in the letter as well. So it is bipartisan and it is merely to get some factual determinations and also some definition in the case of soft money, and in a recommendation with regard to that definition. So we will do that.
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    Mr. BACHUS. Can you note, as several gentlemen have said, this is not confined to the mutual fund industry.
    Chairman BAKER. It is larger. Yes, sir.
    If I may, let me recognize Mr. Castle. If we go to Mr. Castle, we can get everybody done before we have to leave for this vote.
    Mr. CASTLE. Thank you, Mr. Chairman. I appreciate being recognized and I apologize for being out of the room during the question-answer, but I heard each of your testimony before I left. Let me just say, I am an admirer of almost all of you, and I agree with virtually everything that you said. I think you are the cream of the crop. We went down about two or three more panels and start to get into some of the more dubious areas of mutual funds and what has happened.
    I am just going to put together one question, and again I apologize if some of this has been asked before, and then ask a couple of you to answer, and then open it up to all of you. I believe in consumer knowledge, and I believe the American public is a heck of a lot smarter than often given credit for, and the American consumer is, too, if they know what they are looking at. I think it is very hard, frankly, when you look at mutual funds to know what you are looking at. With all due respect to Vanguard's ads about lower costs and saving more money and everything else, I just think it is very hard to figure this out.
    So I have a couple of thoughts, and I do not know if this has been asked before or not, but on the whole regulatory board question, should there be a separate regulatory board for mutual funds? It is a huge industry at this point. Or is that not a good idea, because it becomes a captive board, as so many others do, and perhaps it is better to be left in the SEC.
    Another question I have is, what else could Congress do? Talking about it here is great, and there are a couple of TV cameras, but I have a hunch it is not going to lead the news tonight and people are not going to know a heck of a lot more after today. Perhaps we do, but a lot of other people will not. I think we need to get that information out. So what else could the government do in terms of regulations, laws, whatever it may be? What do you think about the SEC? Any ideas you have of getting the word out? I agree with the problems you stated. What is our strategy to try to correct these things?
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    I would like to start with Mr. Gensler because he has some experience in that. And I would like Mr. Bogle to answer this just because he is Mr. Bogle, and I think he does have the temerity of Warren Buffett. I disagree with what he said earlier. And I would then open it up to anybody else who wants to take a step at it.
    Mr. GENSLER. Congressman, it is very good to see you again, by the way.
    I think that the SEC has put forth what is called a concept release on a possible new regulatory structure in this area. With that, they raise some very thoughtful questions, particularly internal compliance officers and how to address compliance issues at mutual funds.
    In terms of regulatory structure, I find myself torn. The SEC, as best I can tell, has the authority to do that which they need to do. So it may well be a funding issue that they want to devolve this to what they call a self-regulatory organization, with the hopes of assessing fees so that they do not have to go through the annual appropriations dance that every agency must and under our constitution ought to go through. So I find myself feeling there are a lot of tough issues here; a lot of issues that could hopefully be dealt with around fund governance, and maybe some marginal additional disclosure. But in terms of the regulatory structure, I think at the core what the SEC is grappling with is probably more a funding issue, and to devolve it to something just to assess fees does not seem like their case has yet been made.
    Mr. CASTLE. Mr. Bogle?
    Mr. BOGLE. Yes, sir. Thank you, Congressman Castle.
    I would like to put this in a little broader context. It is very clear that in corporate America we have moved from an era of owners' capitalism to managers' capitalism, where companies are run in the interests of their managers, rather than their owners. We have to get back to our roots. That is a long and complicated job.
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    The mutual fund industry really never has had an era of owners' capitalism. In its first 25 or 30 years it had a fiduciary-type orientation. That is why fees were so much lower. The average equity fund fee back in, say, 1951, was less than half of what it is today. Then, the fiduciaries took the place of the fund owners, who are large and disorganized, small investors and so on. But just like corporate America, we have moved into an era of managers capitalism in the mutual fund business.
    Managers make a lot of money in this business. I am reminded of Upton Sinclair's comment that it is amazing how difficult it is for a man to understand something if he is paid a huge salary not to understand it. That is really true. It is a universal rule of life. How do we get back to our industry's fiduciary roots? Well, we start off, I would say, by much better disclosure—in shareholders' statements, yes, the amount they pay; in annual reports with a dedicated page on the first or second page showing the fund's returns relative to its costs, turnover costs, turnover, dollar amount of fees—things like that, every fund has to show on one of the first two pages; and other disclosure issues that we have talked about today.
    Next, I think there is something we can do to improve the structural imbalance between the rights of fund shareholders as manifested through their fiduciary boards of directors and the rights of the managers. That is, strengthen the board. The 1940 Act calls for that implicitly. One thing you can do, and should do, is have an independent chairman of the board, just like we are calling for in corporate America, because in both cases the manager as chief executive has too much power. Another improvement would be a larger number of independent directors. Finally, I think, and I am not a lawyer here, which may make this better or worse, is a federal standard of fiduciary duty for mutual fund directors. That would open up a lot of opportunities to have the fund owners served properly and fairly.
    Mr. CASTLE. Thank you, Mr. Bogle. Unfortunately, we are going to have to cut it off. I am interested in the question. If any of you have a written answer you would like to submit on that—the whole issue of what can the government be doing to help resolve some of the problems which we have discussed here today.
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    With that, I yield back to the Chairman.
    Chairman BAKER. Thank you, Mr. Castle.
    There is one further question I had. Mr. Haaga, does the ICI have a formal position with regard to the SEC proposal now pending with regard to disclosure of proxy voting?
    Mr. HAAGA. The proposal has been adopted. Our position was—and I am glad you asked that, because we get characterized as being against it. There were a number of parts of that proposal, and we agreed with most of them—all but one of them. We even suggested a more rigorous alternative to another one of them, which is to include the independent directors to oversee potential conflicts. The only part with which we disagreed was that of sharing the individual proxy votes with, in the original proposal it was anybody who asked in paper. Now, we are gratified that we can put it up on our Web site or the SEC's Web site.
    Chairman BAKER. And with that modification, does that—
    Mr. HAAGA. It has been adopted and we will live with it.
    Chairman BAKER. I know the SEC has adopted it, but the OMB is in the process of promulgation, I believe, so it is not effective.
    Mr. HAAGA. Right.
    Chairman BAKER. I just wanted to clarify the industry position.
    Mr. HAAGA. Well, the industry, of course, we will live with it. We want to make sure that the OMB and the SEC properly take into account, costs. This was adopted in a great hurry, and I think there was not, frankly, an adequate analysis of the potential costs. If they do an analysis of the potential costs and they adopt it, we will comply with it, as always.
    Chairman BAKER. Let me express to you and all the panelists today my appreciation for your longstanding patience. This was a lengthy hearing, but I think it provided members with a much better insight into the areas that are performing properly; into those areas where perhaps we need to make some enhancements. To that end, I have conferred with Mr. Kanjorski and Members, as I said repeatedly, we will get a letter out to the SEC to try to get professional resolution of making that statement. So all parties who are interested can make appropriate comment. And then we would, at some future time, return to this subject to try to bring some closure.
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    I think the most important asset of the hearing, as Mr. Haaga indicated in his opening statement this morning, was that we want to bring about consumer confidence that capital markets are efficient, transparent, and most importantly, responsive to shareholders. That is our goal, and we will work diligently toward that end, and I appreciate your courtesies in helping the committee get there. Thank you.
    Our meeting is adjourned.
    [Whereupon, at 1:34 p.m., the subcommittee was adjourned.]