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Wednesday, June 18, 2003
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 10:05 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [chairman of the subcommittee] presiding.
    Present: Representatives Baker, Gillmor, Royce, Oxley (ex officio), Kelly, Ryun, Green, Miller of California, Toomey, Capito, Kennedy, Tiberi, Brown-Waite, Harris, Kanjorski, Inslee, Gonzalez, Capuano, Ford, Lucas of Kentucky, Clay, Baca, Matheson, Lynch, Miller of North Carolina, Emanuel and Scott.
    Chairman BAKER. [Presiding.] I would like to call this meeting of the Capital Markets Subcommittee to order. Our purpose here today is to receive testimony with regard to H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003.
    The committee has engaged in market review of the various sectors of market performance, beginning almost 2 years ago, preceding many of the unfortunate events in corporate governance. The committee has acted in a significant way, the Financial Services Committee particularly, with the passage of Sarbanes-0xley and other reform measures to enhance disclosure and transparency in market performance to investors.
    It is exceedingly clear to me that the world has changed dramatically over the past 20 years, where historically the managed funds, institutional investors, and sophisticated investors constituted the bulk of investment of significance in our capital markets. Today, working families through pension funds, 401(k)s or direct investment are significant participants in providing capital for the continued expansion of economic activity and job creation.
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    In recent months, with concerns about the ability of the average investor's capability to get access to information on a timely and unbiased basis, many have chosen not to further participate in the markets and have in fact taken the money and put it on the sidelines for fear that they do not understand the risks that they may be taking. To that end, the committee is engaging today in better understanding the function of and the need for, if necessary, any potential reform in the way in which an investor may analyze the performance of individual mutual funds, and to determine if there is comparability in the data provided at year end.
    I bring to this debate some personal observation. Last year, my son came to me, who is doing far better in life than I, and has several mutual fund investments. He came to me and said, ''Dad, you are the smart guy; sit down and explain this to me,'' and I could not do it, to provide him with some measure of comparable information about which fund was actually performing to the highest level of professionalism. It made clear to me that at least a review of our disclosure regime was not only appropriate, but needed. The bill before us makes several recommendations. However, there are some areas which have yet to be resolved. In response to some who have indicated we have dodged the issue of soft-dollar arrangements, I merely point out that we have not reached some final determination, awaiting the SEC's professional review and recommendation. It is clear that disclosure would be highly warranted.
    Some would go to the issue of banning those relationships, which is the issue, at least in my mind, before the committee, and we hope to get further insights into the benefits of those arrangements and how the expenditures made can actually work to the investor's best interest. On the other hand, if the funds are spent for a weekend in the south of France, that raises an entirely new consideration.
    I am certain there are other issues within the legislation that will generate comment, but we appreciate all the witnesses's participation this morning in the committee's ongoing interest to provide a marketplace which is transparent and treats all stakeholders equitably. We look forward to hearing from you.
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    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    I look forward to this hearing in regard to the Mutual Funds Integrity and Fee Transparency Act. The dynamic mutual fund industry constitutes a major part of our equities market and it has without question worked to democratize investing for millions of Americans.
    Despite this tremendous success, securities experts have continued to regularly examine how we can improve the performance of the mutual fund industry in order to advance the interests of investors. As you know, Mr. Chairman, I have made investors's protection one of my top priorities in my work on this committee. I consequently share your concerns that our committee must conduct vigorous oversight to examine whether our regulatory system is working as intended, and to determine how we can make it stronger.
    During our last hearing on mutual funds, several individuals raised concerns that some practices within the mutual fund industry, because we identified no consensus for addressing these matters, I joined with my colleague, Congressman Bob Ney, in writing to the SEC after the hearing. In replying to our letter, the Commission staff suggested several areas for reform and for further study. In order to ensure that today's hearing record is complete, I request unanimous consent to enter into the record the response that Congressman Ney and I received from the Commission.
    Chairman BAKER. Without objection.
    [The following information can be found on page 165 in the appendix.]
    Mr. KANJORSKI. In addition, Mr. Chairman, you also contacted the Commission after the last hearing to request their observations and recommendations regarding mutual funds. H.R. 2420 attempts to codify several reforms proposed by the Commission in its response to you. In general, H.R. 2420 seeks to enhance the disclosure of mutual fund fees and costs to investors, improve corporate governance for mutual funds, and heighten the awareness of boards about mutual fund activities.
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    While many of these reforms may be good ideas, we should explore whether they can instead be achieved without a legislative mandate, either through the adoption of industry best practices or the promulgation of regulations by the Securities and Exchange Commission. As you know, Mr. Chairman, I generally favor industry solving its owns problems through the use of self-regulation or the adoption of best practices whenever possible.
    Nevertheless, if we decide to mark up H.R. 2420 in the weeks ahead, we should ensure that each provision of the bill is properly designed to help individual investors to make better decisions. We should also examine the effects of the changes on smaller mutual funds and whether those reforms will create barriers to entering the mutual fund marketplace. We should further determine whether the benefits of imposing a reform will outweigh its costs.
    Moreover, H.R. 2420 contains provisions not included in the Commission's report. In my view, we must carefully examine these additional legislative mandates to ensure that they will not produce unintended consequences. For example, H.R. 2420 would prohibit an interested person from serving as Chairman of the Board of a mutual fund. While recognizing that there may be benefits to an independent Board Chairman, the Commission's report questions whether there is a need to mandate such a change if a majority of the mutual fund board is already independent.
    In closing, Mr. Chairman, I look forward to hearing from our distinguished witnesses on this important legislation. 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 hope that we will not rush into a markup on H.R. 2420 before we can work together on these matters.
    I yield back the balance of my time.
    [The prepared statement of Hon Paul E. Kanjorski can be found on page 58 in the appendix.]
    Chairman BAKER. I thank the gentleman for his statement.
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    Mr. Scott?
    Mr. SCOTT. Thank you very much, Chairman Baker and Ranking Member Kanjorski. I want to thank you for holding this hearing today regarding the mutual fund industry.
    Arthur Leavitt, former Chairman of the SEC, calls the high cost of owning some mutual funds the deadliest sin of owning mutual funds. Some funds are able to get away with overly high fees because investors do not understand how fees can reduce their returns. I firmly believe that the individual investor is empowered when given the tools to compare varying investment funds. I want to thank you, Chairman Baker, for introducing H.R. 2420 as an important step to providing transparency for investors. Given that more than half of all U.S. households now hold shares in mutual funds, any step towards transparency will have an impact on millions of investors throughout this country.
    As Ms. Mellody Hobson, the CEO of Ariel Mutual Fund Group will testify later today, we must ensure that any additional regulations do not put small funds at a disadvantage. I certainly look forward to working with Ariel on financial education and literacy and investor education initiatives. I look forward to hearing from today's distinguished panels about the best way to arm investors with strong information on mutual funds.
    Thank you very much, Mr. Chairman.
    Mr. GREEN. [Presiding.] Mr. Miller is recognized for a brief opening statement. No opening statement? Then we will turn to our panel.
    Our first witness will be Mr. Paul Roye, the Director, Division of Investment Management at the U.S. Securities and Exchange Commission. Mr. Roye, welcome.
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    Mr. ROYE. Thank you.
    Chairman Baker, Ranking Member Kanjorski and members of the subcommittee, on behalf of the Securities and Exchange Commission, I am pleased to discuss H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003, which recently was introduced by Chairman Baker and cosponsored by several members of the subcommittee. It is a pleasure and honor to be here.
    This bill would provide investors with useful information regarding their investments in mutual funds, as well as strengthen the corporate governance standards for mutual funds. In addition to providing mutual fund investors with disclosure about estimated operating expenses, soft-dollar arrangements, portfolio transaction costs, sales load breakpoints, directed brokerage and revenue sharing arrangements, the bill would also require disclosure of information on how fund portfolio managers are compensated and require fund advisers to submit annual reports to fund Directors on directed brokerage and soft-dollar arrangements, as well as revenue sharing.
    It also would recognize fiduciary obligations of fund Directors to supervise these activities and assure that they are in the best interests of the funds and their shareholders. In addition, the bill would require the Commission to conduct a study of soft-dollar arrangements to assess conflicts of interest raised by these arrangements and examine whether or not the statutory safe harbor in section 28(e) of the Securities Exchange Act of 1934 should be reconsidered or modified.
    As outlined in our written testimony, the Commission supports the goals of the bill and commends Chairman Baker and the cosponsors of this legislation for their initiative and support of a regulatory regime that best serves the interests of mutual fund investors. We particularly support the goals of enhancing disclosure and the expanded authority the bill would provide the Commission to define which Directors can be considered independent. Overall, the bill has the potential to assist in maintaining investor confidence in the fairness of the operations of mutual funds, which is clearly the investment choice for millions of Americans today.
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    Specifically, the Commission supports the goal of section 2(a) of the bill, which would increase the transparency of mutual fund expenses, including a mutual fund's portfolio transaction costs, as well as require improved disclosure of the use of a fund's brokerage Commissions and revenue sharing payments by fund advisers. The Commission has long been committed to full disclosure of mutual fund costs, as well as other key information so that investors may make informed investment decisions.
    The bill also would require improved disclosure of the structure and method of compensation of individuals employed to manage the fund portfolios. This disclosure is one way to provide fund investors with information that will be helpful in assessing the incentives of the individuals who are responsible for managing their assets. We are concerned about the growth of soft-dollar arrangements and the conflicts they may present to money managers. The bill would require improved disclosure of information concerning a mutual fund's policies and practices with respect to soft-dollar arrangements, whereby brokerage Commissions are paid to a broker who provides research and other transaction services. We agree that fund Directors and investors should be provided with better information about these arrangements. We further support the required report of section 28(e) that is included in the legislative package.
    Once the reforms called for in the bill that relate to soft dollars are implemented, the Commission and the Congress will need to consider whether further revisions are needed. To accomplish this, policymakers will need current information on soft-dollar practices, their impact on fiduciary obligations of advisers, competition between broker-dealers, the impact on the securities markets and the clients and investment advisers, including mutual funds.
    The bill would require improved disclosure of information concerning available discounts on front-end sales loads, including minimum purchase amounts required for such disclosures. Again, we believe that this improved disclosure could be helpful to investors in determining the sales load discount that they are entitled to when they buy front-end load mutual funds.
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    Section 3 of the bill would amend section 15 of the Investment Company Act to require each adviser to an investment company to submit to a fund's board of Directors on a regular basis a report on revenue sharing, directed brokerage, and soft-dollar arrangements. Again, the Commission supports these amendments. They acknowledge the important role that fund boards play in the supervision of fund brokerage arrangements by recognizing a federal duty to supervise these arrangements, and by requiring advisers to provide boards with the information so that they can fulfill their obligations and safeguard the interest of fund shareholders.
    We strongly support the bill's grant of rulemaking authority, which would permit the Commission to close gaps in the Investment Company Act that have permitted persons to serve as independent Directors who do not appear to be sufficiently independent of fund management. Section 5 would extend to mutual funds certain audit committee requirements, similar to those for listed companies required by section 301 of the Sarbanes-Oxley Act of 2002. Extending these audit committee requirements to mutual funds, again, is one way to further benefit and protect mutual fund investors.
    In conclusion, the Commission supports efforts to improve transparency in mutual fund disclosures, to provide fund investors with information they need to make informed investment decisions, and to enhance the mutual fund governance framework. We look forward to working with this subcommittee to further these important goals.
    Chairman Donaldson asked me on behalf of the entire Securities and Exchange Commission to thank Chairman Baker and Ranking Member Kanjorski and this entire subcommittee for the strong leadership you provided in sponsoring and supporting H.R. 658, the Accountant Compliance and Enforcement Staffing Act of 2003. Its unanimous passage yesterday by the House of Representatives was welcome news at the Commission and will go a very long way to ensure that we can rapidly hire the significant numbers of accounts, examiners and economists the SEC needs to serve America's investors.
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    With that, I would be glad to answer any questions.
    [The prepared statement of Paul F. Roye can be found on page 140 in the appendix.]
    Mr. GREEN. Mr. Roye, thank you for your testimony.
    Our next witness is Mr. Richard Hillman, Director, Financial Markets and Community Investment for the U.S. GAO. Mr. Hillman, welcome, we look forward to your testimony.
    Mr. HILLMAN. Thank you very much. I am pleased to be here today to discuss GAO's work on the disclosure of mutual fund fees and the need for other related mutual fund disclosures to investors. The fees and other costs that mutual fund investors pay as part of owning fund shares can significantly affect their investment returns. As a result, it is appropriate to debate whether the disclosures of mutual fund fees and fund marketing practices are sufficiently transparent and fair to investors.
    Today, I will summarize the results of our recently issued report entitled Mutual Funds: Great Transparency Needed in Disclosures to Investors, and describe how the results of this work relates to certain provisions of the proposed Mutual Fund Integrity and Fee Transparency Act of 2003 or H.R. 2420.
    Specifically, I will discuss, one, opportunities for improving mutual fund fee disclosures; two, the extent to which various corporate governance reforms are in place in the mutual fund industry; three, the potential conflicts that arise when mutual fund advisers pay broker-dealers to sell fund shares; and four, the benefits and concerns over fund advisers's use of soft dollars.
    Regarding our first objective on mutual fund fee disclosures, we found that mutual funds disclose considerable information about their costs to investors, but unlike many other financial products and services, they do not disclose to each investor the specific dollar amount of fees that are paid on their fund shares.
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    Consistent with H.R. 2420, our report recommends that the SEC consider requiring mutual funds to make additional disclosures to investors, including considering requiring funds to specifically disclose fees in dollars to each investor in quarterly account statements. SEC and industry participants have indicated that the total cost of providing such dollar disclosures could be significant. However, on a per-investor basis, we found that the costs might not represent a large outlay.
    In addition, our report also discusses other less-costly alternatives that could increase investor awareness of fees they pay on mutual funds, including requiring quarterly statements to include the same information that SEC is now proposing to include in the funds's semiannual reports, which would show the actual dollar amount of fees paid on a $10,000 investment. Doing so would place this additional fee disclosure in the document generally considered to be of the most interest to investors. An even less costly alternative could be required to have quarterly statements include a notice that reminds investors that they pay fees and to check their prospectus and with their financial adviser for more information. These or other possible disclosures would provide investors with more information about fees in the document that they regularly use to check their account value.
    Regarding our second objective on mutual fund corporate governance practices, we found that the popularity of mutual fund investing and the increasing importance of such investments to investors's financial well-being and ability to retire securely increases the need for regulators and industry participants to continually seek to ensure that mutual funds's corporate governance practices are strong. Recent corporate scandals have resulted in various reforms being proposed to improve the oversight of public companies by their boards of Directors. We have supported regulatory and industry efforts to strengthen corporate governance of public companies.
    Although many of the reforms being sought for public companies are already either embodied in regulatory requirements or recommended as best practices by the Investment Company Institute, additional improvements to mutual fund governance such as mandating super-majorities of independent Directors as proposed in H.R. 2420 would further strengthen corporate governance practices and ensure that all funds implement these practices.
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    Regarding our third objective, we found that mutual fund advisers have been increasingly engaged in a practice known as revenue sharing under which they make additional payments to the broker-dealers that sell their fund shares. Although we found that the impact of these payments on the expenses of the fund investors was uncertain, these payments can create conflicts between the interests of broker-dealers and their customers that could limit the choices of funds that broker-dealers offer investors.
    For example, some brokers require fund companies to make revenue sharing payments to become one of six or seven fund companies on the preferred list of funds of their sales representatives. However, under current disclosure requirements, investors may not always be explicitly informed that their broker-dealer, who is also obligated to recommend only suitable investments based upon the investor's financial condition, is also receiving payments to sell particular funds. Consistent with H.R. 2420, our report also recommends that more disclosure be made to investors about any revenue sharing payments that broker-dealers are receiving.
    Finally, as part of our final objective, we also reviewed a practice known as soft dollars, in which a mutual fund adviser uses fund assets to pay Commissions to broker-dealers for executing trades in securities for the mutual fund's portfolio, but also receives research or other brokerage services as part of the transaction. These soft-dollar arrangements can result in mutual fund advisers obtaining research or other services, including from third party independent research firms, that can benefit the investor in these funds. However, these arrangements also create conflicts of interest that could result in increased expenses to fund shareholders if a fund adviser trades excessively to obtain soft-dollar research or chooses broker-dealers more on the basis of their soft-dollar offerings than their ability to execute trades efficiently.
    SEC has addressed soft-dollar practices in the past and recommended actions could provide additional information to fund Directors and investors, but SEC has not yet acted on some of its own recommendations. Consistent with H.R. 2420, our report recommends that more disclosure be made to mutual fund Directors and investors to allow them to better evaluate the benefits and potential disadvantages of their fund adviser's use of soft dollars.
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    In conclusion, the work that GAO has conducted at the request of this committee addresses several of the areas in the recently introduced Mutual Funds Integrity and Fee Transparency Act of 2003. Passage of the Act's provisions in these areas would help to ensure management integrity of mutual fund companies and help to ensure that investors have the facts they need to make informed investment decisions.
    Mr. Chairman, this concludes my prepared remarks and I would be pleased to answer any questions that you or other members of the subcommittee may have at an appropriate time.
    [The prepared statement of Richard J. Hillman can be found on page 117 in the appendix.]
    Mr. GREEN. Thank you, Mr. Hillman, and thank you, Mr. Roye, for your testimony.
    Mr. Hillman, as you referenced in your testimony, some industry representatives have criticized the GAO recommendations that funds provide specific dollar disclosures in the shareholder account statements on the basis that it will be unduly expensive. I don't know if your report makes this estimation or others do, but they believe it will amount to approximately $266 million. Do you have any estimate as to what this additional cost increase would mean for the average mutual fund fee, on an average basis what it would cost?
    Mr. HILLMAN. Yes. If mutual fund companies charge the entire $266 million, which includes estimates prepared by the Investment Company Institute, who surveyed about 77 percent of the assets in the mutual fund industry to ask them what the costs might be to include specific dollar disclosures, they found for that portion of the industry that they surveyed, that if the $266 million in the first year were charged, that the mutual fund fee would increase. Basically, we have determined that the mutual fund increase would be about .000038 percent, or really about one-third of a basis point.
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    Mr. GREEN. The report in its discussion of the merits of enhanced disclosure of portfolio transaction costs cited a number of commentators who said that having mutual funds disclose information such as the report as suggested and you have testified to, would increase competition amongst funds on the basis of those costs and lead to lower expended costs for investors. Can you elaborate on that? Do you believe that would spur cost-based competition among investors and funds?
    Mr. HILLMAN. We surveyed a number of individuals as part of the study requested by this committee. In particular, we talked to a number of financial planners who indicated the disclosing transaction costs would benefit investors. The overall view was suggested that with more information, investors would be able to compare costs across funds, which would likely result in more competition based upon those costs. It was also suggested that more disclosure of such transaction costs perhaps might help reduce turnover of funds, unnecessary trading that mutual fund complexes may engage in.
    Mr. GREEN. If you could elaborate on that point. I am not sure I follow.
    Mr. HILLMAN. With the increased disclosure based upon the costs of trading, including Commissions associated with trading, if fund investors were aware of those costs it might have interest on the part of fund advisers and others to ensure that those costs remain as low as they can possibly be, and therefore potentially reducing unnecessary trading for other Commissions.
    Mr. GREEN. Is there a danger that the information provided under this legislation and pursuant to your report will be information that investors are unable to use or to process? Can it be misleading? Is there a risk that disclosure will not lead to providing more useful information to the average investor?
    Mr. HILLMAN. I think there is always a risk that information in disclosures may not be interpreted correctly. Therefore, I think it is essential that as part of producing any additional disclosures, that sufficient work be done to consult with investors and others to make sure that the disclosures that are provided are clear and understandable and useful to investors. However, I do believe that such additional disclosures are necessary, and if implemented properly should have the desired results.
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    Mr. GREEN. Mr. Roye, do you believe that the increased disclosures will be a practical answer to the problem of regulating soft-dollar practices? Do you believe disclosure will be a sufficient approach to that?
    Mr. ROYE. Historically, the Commission's approach on soft dollars is to encourage transparency of those arrangements. I think the bill would call for additional disclosure in that area and we view that as a positive. In the fund area, we look to fund Directors principally to oversee these arrangements and to make sure that they are in the best interest of the fund and the shareholders. So through our examination program and through other means, we have encouraged Directors to focus on this issue. Again, disclosure would be beneficial.
    Whether or not it is the complete answer to issues regarding soft dollars I think in our responses to Chairman Baker and Ranking Member Kanjorski, we indicated that we had some questions about disclosure and the limitations of disclosure. That has been the traditional approach, and indeed our federal securities law scheme is based on disclosure.
    But in looking at some of the conflicts that soft dollars create, and as alluded to in the GAO report and in our response to the congressional inquiries, we do think it may be time to go back and reassess how the soft-dollar arrangements are working, what kind of impacts they are having, what do these conflicts lead to, and maybe a broader reexamination of soft-dollar arrangements.
    Mr. GREEN. So disclosure may not be enough, is that what you are saying?
    Mr. ROYE. Yes, sir.
    Mr. GREEN. Okay. Thank you.
    Mr. Kanjorski?
    Mr. KANJORSKI. Thank you, Mr. Chairman.
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    Mr. Roye, to put some perspective here for myself and maybe for the record, there are a little over 7,000 equity mutual funds and a little more than 1,000 money market funds, is that correct?
    Mr. ROYE. It depends on how you count them. There are probably 7,000 entities, but each of them oftentimes have separate portfolios so there are probably more like 30,000.
    Mr. KANJORSKI. Okay, let me get a handle around this. How many of these are guilty of abuses that you have clearly seen or have come to your attention, say, in the last year?
    Mr. ROYE. In the mutual fund area, we find problems that merit enforcement actions from time to time, but it is not extensive.
    Mr. KANJORSKI. Give me some numbers. In the last year, how many enforcement actions have been taken against mutual funds?
    Mr. ROYE. In the last year, you could probably count them on one hand.
    Mr. KANJORSKI. So potentially out of 30,000 mutual funds, only five enforcement actions. What did these enforcement actions emanate from? A failure to disclose soft money problems? What was the genesis of the actions?
    Mr. ROYE. We have had some situations where we have had some valuation issues, mis-pricing of securities.
    Mr. KANJORSKI. Mistakenly mis-pricing or intentional?
    Mr. ROYE. It is really sort of negligence overseeing the process. I am trying to think of what some of the other actions have been. We have brought actions related to mutual funds, but they tend to be sales practice type of abuses.
    Mr. KANJORSKI. What would you say of these five areas of abuse in the last year, how much did that cost the investors that were invested in those funds?
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    Mr. ROYE. It is difficult to estimate.
    Mr. KANJORSKI. Billions?
    Mr. ROYE. It has not been that substantial, given the $6 trillion.
    Mr. KANJORSKI. Billions of dollars?
    Mr. ROYE. Not billions of dollars.
    Mr. KANJORSKI. Hundreds of millions of dollars?
    Mr. ROYE. Probably in the millions of dollars.
    Mr. KANJORSKI. Millions of dollars, something under $100 million. It seems to me that if we are going to establish a new army of regulators here, 30,000 funds, we are going to have to build you a much larger office building and hire you an awful lot of people and pay a lot of salaries. Has there been a cost analysis made here of what we are talking about, the increased cost of regulation as opposed to what we would be preventing or what we would be saving? What is the cost-benefit analysis that you have come up with?
    Mr. ROYE. Yes, we have not done a cost-benefit analysis.
    Mr. KANJORSKI. Don't you think we ought to do that?
    Mr. ROYE. Certainly, the Commission in its process of considering regulations, we consider the costs and benefits in doing that. The bill would call for the Commission to take regulatory action in various areas and obviously that is an exercise.
    Mr. KANJORSKI. I listened to Mr. Bogle's testimony last time, and I was impressed that he is very seriously worried about some abuses in the mutual fund industry. I am just wondering whether or not we shouldn't concentrate more on those abuses than trying to do the mathematical calculations of telling an individual mutual fund holder what the cost of their fund is. That could be extraordinarily expensive. It would seem to me before we do that, I would prefer the IRS to calculate my tax requirements so that I don't have to spend a week going to an accountant to do that. Where is the role of government here?
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    Mr. ROYE. I would make this observation. The bill essentially calls for improved disclosure in a number of areas. At the Commission, we agree that in these areas we can improve the disclosure. We think investors ought to understand.
    Mr. KANJORSKI. I know you can improve the disclosure, but the question is the cost of improving that disclosure, is it worthwhile to the investor and to the marketplace? We can all write regulations. You can send me a 300-page prospectus, but it all depends on whether it is really worth it.
    Mr. ROYE. Yes. I think when you look at some of the disclosures that are called for from a cost standpoint, I don't think they really incur a lot of costs.
    Mr. KANJORSKI. They are negligible.
    Mr. ROYE. It is information that is within the fund organization that would be surfaced to fund investors.
    Mr. KANJORSKI. In this regard, though, several members of Congress requested from the SEC reports lately, and those reports came in last week. Does this bill contain anything beyond what the SEC recommended?
    Mr. ROYE. The congressional inquiries asked specific questions. Your letter asked specific questions. We did our best to provide you with comprehensive and complete answers to those questions.
    Mr. KANJORSKI. But my question is, I am not trying to put you on the hook here for anything, I am just asking does this bill go beyond the recommendations made by the SEC to the members of Congress in those two reports?
    Mr. ROYE. I think there are areas that clearly tie in and flow from the recommendations. I think there may be some areas where we clearly did not address in our response, but are reflected in the bill.
    Mr. KANJORSKI. Right. I just have one additional observation to make.
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    Mrs. KELLY. [Presiding.] Go right ahead.
    Mr. KANJORSKI. I will tell you what I am worried about. I am worried about the expenditure of money and additional regulation. I see now, because we have had this downturn in the stock market and Enron and all these problems, that all of us are rushing around as part of the bucket brigade to put out sometimes phantom fires. I make the other observation that every day we are eating food with an awful lot of chemicals and a lot of dyes and everything else, and the argument is made across the board, we don't have to tell the consumer; it can only kill him.
    We are taking an awful lot of time and effort to try and save some dollars. And I am not against that, but quite frankly if somebody is an investor and they have extra capital, at some point there should be a stimulus there for them to make and live by the judgments they make in financial matters, rather than being spoon-fed by the government or so over-protected by the government as to make it ludicrous. Do you feel that we are going close to that edge?
    Mr. ROYE. I think you make an important point. I think with some of this, the devil is in the details in terms of how you implement some of these approaches to enhancing the fee disclosure, for example. The General Accounting Office has made some recommendations. The Commission has an existing proposal outstanding on those issues. We try to balance the cost and benefits of enhancing the disclosure. So I think in a lot of these areas, you are right. We have to be sensitive to overkill. We have to make sure that the benefits outweigh the costs. We try to accomplish the goal and objective, but we do it in a cost-effective way.
    Mr. KANJORSKI. You are causing me a little bit of schizophrenia here. On this side of the aisle, we are supposed to be for regulation. That side of the House is supposed to be against regulation.
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    Something has happened here in the last several months, so you have to give us some guidance down there.
    Thank you very much.
    Mrs. KELLY. Thank you.
    Mr. Tiberi?
    Mr. TIBERI. Thank you, Madam Chair.
    Mr. Roye, could you comment, give us your thoughts on the issue of fund Directors's role in this entire process, and if you believe that it is important or not important to have two-thirds of the Directors be independent?
    Mr. ROYE. Clearly in the mutual fund framework, where you have funds that are separate entities organized by a management company, sponsored by a management company, there are inherent conflicts of interest in those arrangements. The statutory framework contemplates a certain percentage of independent Directors who are there as watchdogs to protect the interests of fund investors and to monitor and oversee these conflicts.
    We view the role of independent Directors as essential in this framework. Indeed, we think the reason for the mutual fund industry being relatively free of scandal is the fact that independent Directors are present in the framework. The Commission several years ago proposed and adopted some rules that would effectively encourage most funds to have at least a majority of independent Directors. We see that as a positive benefit, and independent Directors playing a positive role in this framework.
    Mr. TIBERI. Does the Commission have an opinion on whether the Chairman of the Board should be independent or not affiliated with the company?
    Mr. ROYE. We recognize that there may be benefits to having an independent Chairman in terms of controlling the agenda to make sure that the appropriate issues are raised in the board meetings for consideration by the board. We pointed out in our testimony that once you get to a majority or two-thirds, effectively the independent Directors have the ability to dictate who the Chairman of the Board is.
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    Mr. TIBERI. So the SEC's opinion would be if there is a majority of independent Directors on the board that it would not be necessary to regulate either from a congressional standpoint or from a regulatory standpoint that the Chairman be independent.
    Mr. ROYE. Quite frankly, within the building the Commissioners had some interesting discussions about that issue. I think that while the Commissioners saw benefits, they also recognized that effectively independent Directors have the power to dictate this now if they want it. Indeed, there are funds that have independent board chairmen who operate and those who don't. So I guess at best we were sort of maybe neutral on that point.
    Mr. TIBERI. Mr. Hillman, can you comment on both issues?
    Mr. HILLMAN. GAO has in the past as part of the Sarbanes-Oxley Act come out in favor of a super-majority of independent Directors on boards. The real idea there is giving increased voice to independent Directors, as well as investors in the decisionmaking that takes place on the board.
    Regarding the notion of having an independent chair, we have come out in the past supporting separation from the CEO and the Chairman's position. We have not really discussed specifically the notion of an independent chair. I agree with SEC and Mr. Roye that it includes some positive aspects as well as potentially reducing the flexibility that a board may have in nominating its members. I also agree with a super-majority, which would be more than a simple majority, that independent Directors would have an ability to nominate potentially who they chose to be chair.
    Mr. TIBERI. So your thought is that if we regulate the fact that a super-majority would be independent, that we would not need to regulate the independence of the Chairman.
    Mr. HILLMAN. It may be less important to do so, yes.
    Mr. TIBERI. Less important to do so. Can you comment a little bit about the relationship between the fund and the management company, and if you see there being conflicts in the way that the structure is often set up between the fund and the management company?
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    Mr. HILLMAN. Perhaps that might be a question best addressed to the SEC.
    Mr. TIBERI. It will be.
    Mr. HILLMAN. The fund and the investment company have very close relationships. That is why you really want to have strong representation of independent Directors to help ensure that the interests of investors are heard.
    Mr. TIBERI. Mr. Roye, can you comment on that?
    Mr. ROYE. Sure. Again, the typical structure is you have an external investment management company that is sponsoring and organizing the fund which technically is a separate entity. You typically have management company personnel who serve as officers of the fund. You have them typically represented also as Directors, but the typical framework is that you have a majority of independent Directors.
    The management company is interested in making a profit and receives management fees for managing the fund. Obviously, the more money they make from managing the fund, the more profitable the enterprise. From the standpoint of the fund and the fund's investors, the lower those fees the higher their return. So there is an inherent conflict there and again, the Directors are there to scrutinize the reasonableness of those fees and the relationship between the fund and the management company.
    Mr. TIBERI. So having the super-majority of independent Directors helps solve that potential conflict that you talked about?
    Mr. ROYE. It certainly enhances the independence of the Board.
    Mr. TIBERI. Thank you.
    Thank you, Mr. Chairman.
    Chairman BAKER. Mr. Miller?
    Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
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    Mr. Roye, I understand that the proposed legislation that is before us does not really provide any specific changes in what will constitute an independent Director. Most of the criticism about independent Directors has not just been that there are not enough of them, but that they are not independent enough. They tend to be recent employees, recent retirees from the fund management. They may in fact serve on the boards of several related funds. They may be making $200,000 a year serving as supposedly independent Directors for the same family of funds.
    Why is it we cannot decide now on some of the restrictions that we might impose upon what constitutes an independent Director, to include in the legislation? And what kinds of requirements or restrictions would you look at by way of regulation?
    Mr. ROYE. What the bill does is actually give the SEC the authority to expand the definition of independent Directors really in two areas, because of business or professional relationships or because of family relationships. Indeed, we have seen some family relationships that are outside the current definition that give us some concern, as well as some business relationships that we would have to actually commence a proceeding to have the Director to be deemed interested, and then they would only be deemed interested on a prospective basis.
    So we welcome the authority to be able to respond to situations that we see as problematic. You mentioned the retired executive from the management company of being an area of concern. Quite frankly, we do not see a lot of that, but we have seen it and it concerns us. We would like the ability to deal with it. Technically, we responded to what was in the legislation and we welcome that authority. I suppose you could give some thought to trying to specifically deal with the definition and close those gaps.
    I think what the rulemaking authority does is give the Commission the opportunity to propose rules, to get comments, to react to circumstances, change circumstances, relationships that maybe we could not identify and think of today, but 10 years from now may be problematic. It would give the Commission the ability to respond and assure the independence of the Board.
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    Mr. MILLER OF NORTH CAROLINA. Mr. Hillman, do you think there are certain restrictions we could decide upon now, that we know enough now to include in the legislation, and then have the SEC have the authority to promulgate other regulations to deal with circumstances we have not considered or had not considered sufficiently?
    Mr. HILLMAN. This is not a subject that we specifically covered in our report. However, we are aware of concerns associated with retirement issues and individuals coming back in serving as independent Directors, and also close family relationships as being potential problems. It seems that there ought to be an opportunity to quickly close those gaps in the corporate governance structure. You could do that either through legislation or through the SEC.
    On an interesting parallel, the major exchanges, the New York Stock Exchange and the NASD, also as part of the Sarbanes-Oxley Act and in response to recent corporate failures, are also reconsidering their listing standards for issuers on their exchanges.
    The NASD, for example, is looking at perhaps a 3-year cooling-off period before an individual would be allowed back on a board. The New York Stock Exchange is looking at a 5-year period of time. So there is a lot of debate and a lot of interest about trying to find just what the right gauge is, and it is certainly something worthy of debate.
    Mr. MILLER OF NORTH CAROLINA. Okay. How about simply a restriction on the sheer number of related boards that a board member could serve on? Would that help?
    Mr. ROYE. On that issue, you do have situations where you have Directors serving on multiple fund boards. There can be benefits to that. When you have a fund complex, there are common issues, common areas of concern. Having that consistency with the Directors there overseeing the group of funds can be beneficial. We see it working well in a number of circumstances.
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    Quite frankly, maybe at some point you get to a level where you ask questions whether or not a board can effectively oversee the number of boards that they may be asked to serve on. But I think that the industry has put out best practices in this area, recommended self-evaluation on the parts of board to go through as to whether or not they can be effective given the number of boards they serve on.
    So it is an area that we have not, quite frankly, we do not have the authority to dictate the limits in terms of numbers of boards, but we do see fund groups with different arrangements. Some have cluster boards where they have a group of Directors that may be responsible for all the equity funds; another group responsible for bond funds; another group responsible for funds that are sold as variable annuities and variable life insurance, where there are different issues. So we see funds with all different sorts of arrangements. It can work.
    Chairman BAKER. The gentleman's time has expired.
    Ms. Kelly?
    Mrs. KELLY. Thank you, Mr. Chairman.
    One of the things that I am concerned about is the fact that we have a need to help people feel comfortable in trading. In reading some of the information that we have here, I am interested in the fact that we talk about the fact that revenue sharing is not clearly disclosed. This is one of the areas I believe of discomfort for people who are currently looking at mutual funds. When we talk about the different ways that people do revenue sharing, I think this is part of the confusion.
    Is there any way for us to see a more standardized effort out there with regard to revenue sharing, so people can get their arms around what exactly is being talked about?
    Mr. Roye, do you want to answer that?
    Mr. ROYE. Yes. You point up a very serious issue and a serious concern. We have strived in the disclosure area in the fund area to try to standardize the presentations with regard to fees. In the fund prospectuses, there is a standardized fee table that has the transactional expenses, the ongoing expenses that the funds pay. But revenue sharing is one of these areas where the payments are growing, the distribution channels through which funds are sold, they are demanding more in the way of compensation.
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    This compensation is coming from the advisers out of their so-called profits. It is an area where we think the disclosure can clearly be improved. We think it is an area where there are probably limitations in terms of what you can put in the fund prospectus to describe these arrangements.
    It is really maybe the broker-dealer who is selling the shares, who is getting the payment, and the investor ought to understand the incentives and the compensation that broker has in promoting the fund or trying to sell the fund to you. So that is an area where the Commission has been focused, directed the staff to formulate some recommendations in this area, and certainly we want to frame it in a way that investors can understand it as clearly as possible.
    Mrs. KELLY. Are you currently engaged in any kind of an educational effort for the general public? My concern is that anyone could get numbers on a statement. Unless they understand the numbers, the numbers do not mean anything. Is there any way to help the general public understand those statements they are getting, and what the cut of the revenue sharing is when they get the statement?
    Mr. ROYE. Again, this is a real challenge for us. I think for example if you go to our Web site and look at our investor education materials, you will find a fair amount of information there that is designed to help mutual fund investors. We have something called a mutual fund cost calculator on our Web site, which allows you to take the information out of the disclosure documents and facilitates comparison of one fund to another.
    We have the investor education materials that talk about the importance of fees and how they can reduce your return. We have a whole office dedicated to trying to educate investors in this area. We are open to ideas about how we can enhance investor understanding. This is the ultimate challenge for us.
    Mrs. KELLY. In your testimony, you talk about portfolio transaction costs and you mention that they are substantial in the mutual funds for many of the funds. Do you think that investors really would benefit from the enhanced information about the costs? Can you talk about what that impact might be on their choices, then, of the mutual funds that they use?
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    Mr. ROYE. We pointed out in our responses to Chairman Baker and Ranking Member Kanjorski in their inquiries that trying to get your arms around transaction costs is really very difficult and complicated. The Commissions are easily determinable. The funds know what they pay in terms of Commissions, but spreads are not readily apparent. How do you measure market impact of trades, opportunity costs?
    With all that being said, we think that we ought to work toward trying to improve the disclosure in that area and having investors come away with a better understanding that these additional costs are something that they are bearing. The return numbers that you see reflect those costs, but you ought to have a better understanding of those costs. We think there may be some ways to do that, although it is a very complicated area, as we pointed out.
    Again, we are back to your question of how do you get investors information in a way that they can understand and make use of it. So we view it as a challenge, but something that we think that we have to continue to work toward.
    Mrs. KELLY. I just want to ask one more question, and that is, how frequently would you see this kind of information getting to an investor? Would it be better to have it there monthly, semi-annually? What would you at the SEC feel would be a valid response time for giving information to the investor?
    Mr. ROYE. That is a good question. I think it is something that we would have to analyze and think about. There are various vehicles now that potentially could be used. There is the fund prospectus that investors get when they buy fund shares. Typically as a fund investor, you get the updated prospectus every year because the funds are continuously selling shares. So that is a possible vehicle. They get shareholder reports twice a year, and we are trying to improve the presentations there. This information could be presented there. Then typically they get quarterly account statements, which is another possibility. And then we could create some additional document.
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    But I think we have to be sensitive, again going back to Representative Kanjorski's question, in terms of overload and trying to make sure we tailor this information in a way that is effective and useful. I think that is the benefit of rulemaking and disclosure proposals, and getting comment and having investors react in trying to figure out what is most effective.
    Chairman BAKER. The gentlelady's time has expired.
    Mr. Matheson?
    Mr. MATHESON. Thank you, Mr. Chairman.
    The first question I would like to ask is, it seems to me that our desired goal here is that we would like to move in a direction of having real price competition in the mutual fund industry. First of all, will you give me your opinion on if you think we have any, or to what extent we have price competition today in that industry? Mr. Roye?
    Mr. ROYE. I think that there is evidence that there is competition. If you look at where the assets are in the mutual fund industry, about a quarter of the assets are in the three low-cost providers in the industry. So that, I think, tells you that there are investors who are paying attention to costs, sensitive to costs, and a huge chunk of the industry's assets are in those three fund groups.
    If you look at the cost of comparable funds outside the U.S., in Europe for example, you will see that the cost of comparable funds are probably one-third to one-half as great as they are in the U.S. So I think there is some evidence, and there is a fair amount of information out there about costs. Certainly, we can improve it, but I think you can point to certain factors that say, look, something is working here. Our whole regime is essentially based on trying to make those costs as transparent as we can so investors can make those kinds of judgments.
    Mr. MATHESON. So you are saying that there is evidence that assets have moved to the lower-cost funds, but the fact that we are here, the fact that we are talking about this tells us that probably collectively we think there is not enough price competition in this industry, or we could do better. I guess that leads to the fundamental question of as you look at this legislation, is this going to get us where we want to be? Do you think we do not go far enough? Do you think it goes too far? Is this going to really affect true price competition in a better way?
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    Mr. ROYE. I think that the legislation goes a long way toward making a lot of these costs more transparent. There are certain costs that we view as not transparent enough. To the extent that we can surface those and enhance investor understanding of those, then I think we can have an impact on cost competition in the industry. So we view this as a positive.
    Mr. MATHESON. One specific item in terms of disclosure that we talk about is portfolio manager compensation. Do you think that this legislation is adequate in setting up a system where there will be actual compensation reported to investors for portfolio managers?
    Mr. ROYE. I think technically what the legislation calls for is the method of compensation, structure of compensation. I guess what I would say is that maybe it is not so important that you know the actual dollar amount. You know what the management company is being paid. That amount of dollars is being disclosed. You know what the company is being paid to manage the fund.
    But perhaps the more important information is, what are the incentives that the portfolio manager has in managing the fund? Is the portfolio manager compensated for short-term performance, long-term performance? Is the portfolio manager compensated on a pre-tax, after-tax basis? If you are a tax exempt account, you could care less about taxes, and if you have some information about how the portfolio manager is compensated, you know something about the incentives there. Maybe that will give you some insights into how they run the fund.
    Mr. MATHESON. I would endorse having that information out there about the incentives and how they are compensated. I am trying to understand, and I know you did not draft the legislation, but I am trying to understand if there is some hesitancy to put in actual compensation for a portfolio manager. What are the arguments not to do that?
    Mr. ROYE. I guess it would be privacy, issues like that. Again, you know what the management company is being paid. If they are getting paid millions of dollars to manage the fund, you can make an assessment about their performance and whether or not you are getting value for what the management company is being paid. Do you need to know what they are paying every employee in the management company to kind of make that assessment, probably not, at least in my view.
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    Mr. MATHESON. Thank you, Mr. Chairman. I yield back.
    Chairman BAKER. Thank you, Mr. Matheson.
    My turn.
    Mr. Roye, there are some industry critics of this approach who have stated in press reports, at least, that the cost of conforming and implementing the bill as proposed would outweigh any benefit potentially to investors. Can you comment as to whether you think from the agency perspective, the bill is constituted, even though there may be a point or two over which there would be a differing method to achieve goals, the transparency provided, the reporting provided, the competitive environment which results coming from the flow of information. Isn't that more beneficial to the investor than the potential cost, even as the bill is currently constituted?
    Mr. ROYE. I guess I would answer by saying that what the bill attempts to achieve in terms of goals are certainly worth it from a benefit standpoint. I think where we have to certainly spend some time thinking about is the implementation, the details of how we carry through on some of the directions from the legislation. I think that is what the Commission would have to be sensitive to and the direction from the Congress.
    Chairman BAKER. To that end, there is discussion in your testimony concerning dollar disclosure versus a formula for a model $10,000 investment. You also stipulate in your testimony that the Commission has some significant concern about the level of understanding investors have about the real fees that are assessed, and their ability, even a sophisticated investor, to get to the bottom end conclusion of comparability.
    Is their concern that the dollar disclosure will cost more to fund managers and the investment world than it is worth to the investor side? I am a cost-benefit kind of guy. I don't mind spending money if the end results generates a net gain for us. Can you speak to that balance?
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    Mr. ROYE. Sure. We clearly share your concern, and your example in the opening statement about your son's statement and trying to figure out just what it means and what you are paying in terms of expenses is a real concern and a real problem. We want to address that. The ultimate question is, how do you get there? How do you do it? What makes sense from a cost-benefit standpoint?
    The Commission has an outstanding proposal that would use fund shareholder reports to enhance this fee disclosure. It would be dollar disclosure. I think one of the problems that we sense in the fund area is that when you look at how the fees are communicated, they are largely translated in terms of a percentage of assets, expense ratios.
    Actually, if you took that information and used it, you could make some good judgments about low-cost funds and high-cost funds, but investors have difficulty understanding the concept. So can we turn it into a dollars and cents analysis so investors can make sense of it?
    So you want to enhance competition. You want investors to understand fees. In between, you have to have what you alluded to, which is some means to compare one fund to another. What we tried to do in the proposal with the $10,000 example was using the fund's actual expenses, using the fund's actual return on a $10,000 investment, translating that into dollars. So you could estimate what it costs you to be invested in the fund over, say, a six-month period.
    We proposed a second number which would use the actual expenses of the fund and an assumed rate of return, so you could take that number and compare it to another fund. So if you got your semi-annual report and you looked at the number there, and it showed that it cost you $98 to be invested in that fund, you could take the number, get a report from another fund, and figure out whether your fund was comparable to that from a fee standpoint high or low.
    So we were trying to do that in a way that minimized the burden and the cost, and do it in a way that we thought investors could understand. I think the GAO has recommended we use account statements to do that, and some of the other folks who are testifying have recommended different ways to accomplish that. This is a proposal we want to obviously step back and look at what the GAO has recommended and what others have recommended.
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    Chairman BAKER. Let me bring Mr. Hillman in at that point. Mr. Hillman, what is your view with regard to real-dollar versus a formula disclosure? What is the take that you have?
    Mr. HILLMAN. We have endorsed what the SEC is proposing by placing additional information in specific dollar amounts on a $10,000 investment. We think it will provide additional information to investors and it will also help ensure comparability looking across funds of what these expenses are. The main issue that we seem to have, as Mr. Roye alluded to, is really the placement of some of this information, Mr. Chairman. Our view is in order for these disclosures to be of real benefit, they have to be read by the investor.
    Studies conducted by the ICI and others suggest that the information of most interest to investors is disclosed in the account statement. That is where investors go regularly to determine what their account value is. If disclosures on fees were placed in that statement, we feel it would have the maximum benefit.
    Putting disclosures in a prospectus or putting them in a semi-annual or annual report, or putting them in a statement of additional information which can be requested by the investor to look at, are also important measures, but they are probably not going to give you the same benefit as coming from an account statement.
    Chairman BAKER. Thank you very much. My time has expired.
    Mr. Capuano?
    Mr. CAPUANO. Thank you, Mr. Chairman.
    I just have a few basic questions. I have not heard anyone anywhere ever tell me that they opposed enhanced disclosure. I would just like to hear from Mr. Roye and Mr. Hillman, have you heard from anyone in a professional manner that they would oppose some form of enhanced disclosure?
    Mr. ROYE. In the context of this bill?
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    Mr. CAPUANO. Yes.
    Mr. ROYE. Not yet.
    Mr. CAPUANO. Okay. Mr. Hillman?
    Mr. HILLMAN. Disclosure is one of the less-costly options to ensure that investors have a good understanding of the fees and costs associated with their funds.
    Mr. CAPUANO. So you have not heard anybody oppose the concept of enhanced disclosure?
    Mr. HILLMAN. No.
    Mr. CAPUANO. Because I haven't either, and I was kind of wondering why we are doing this so quickly if no one opposes it. We are all for it. It strikes me that I have two very professional gentlemen in front of me and I have 60-odd professional people here with me, and we are not 100 percent sure yet exactly what is the best way to go and how to get this done in a manner that is not going to overburden the industry, not going to do anything other than help the consumers. Personally from my end of it, I say, well, this is a great idea, let's do it, but let's talk this out. Let's get this right so that we don't have to go back and forth like a ping-pong ball.
    Even as I sit here today, I hear two very valid different viewpoints on an important issue. My expectation is that nobody at the GAO and nobody at the SEC is trying to find ways to say they are for disclosure, but yet really not be. I assume that you are being honest about it, on a personal basis and on a professional basis, for your agency.
    I would also like to know, as I understand it, under current law the SEC theoretically has the ability to do this if they wanted to do it just willy-nilly. Am I wrong in my understanding, Mr. Roye?
    Mr. ROYE. We clearly have the ability to effect a lot of disclosure changes. In some of these areas, we are already working toward that. There are other aspects of the bill that we would not have authority to achieve on our own.
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    Mr. CAPUANO. Then I just want to close by expressing my appreciation for the fact that you are not just knee-jerking, coming up with something that though you have your opinions, you have been willing to listen to other people and to take all that into consideration before rushing to judgment. I would hope and I would assume that the Congress will do the same.
    Thank you.
    Chairman BAKER. I thank the gentleman.
    Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman, and welcome to our witnesses.
    Mr. Roye, in your prepared remarks you state that the bill's disclosure requirements, quote, ''should help to address ongoing concerns that fund investors do not understand the nature and long-term effect of recurring mutual fund fees.'' Would you discuss that a little bit further and indicate how the SEC has cited the lack of investor understanding of fund fees? In that context, how would this legislation and subsequent regulation help in that regard?
    Mr. ROYE. Sure. There are really two categories of fund fees. There are transactional-type fees; sales loads that investors pay. They see those, they feel those. Then there are ongoing expenses and fees that are coming out of fund assets. These are typically again expressed in terms of percentages of net assets and disclosed in that way.
    I think to some extent it is hard for investors to understand what that means in terms of dollars and cents. One of the goals here of the bill is to translate a lot of these ongoing expenses and expenses that are not readily apparent to the investor, to surface those and make them more transparent, again with the goal of enhancing their understanding and hopefully leading to greater competition.
    Mr. OXLEY. Mr. Hillman, do you have any comments in that regard?
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    Mr. HILLMAN. Yes, I would agree that right now, given the fact that investors receive fund performance data net of fees, that is a problem in having investors better understand the fact that their mutual funds incur fees. The legislation requiring more specific dollar disclosure of fees would eliminate this ambiguity over how much an investor is actually paying, and we hope then potentially spur increased competition to ensure that fees are kept to a minimum.
    Mr. OXLEY. In both of your works, did you actually take a look at some of these statements and fee schedules and compare and contrast some of those?
    Mr. HILLMAN. A lot of that fee information that you are alluding to currently is done on a net basis of performance. Therefore, the investor really does not have an opportunity to evaluate how much the fee is and what implications that has across funds.
    Mr. OXLEY. But were you able to discern that by your work that you did in background in preparation for the hearing? Obviously, you are not the average investor. I am just wondering how you came to that conclusion, and indeed how you were able to perhaps break through some of that information.
    Mr. HILLMAN. As part of our study, we did for you and this committee and subcommittee, we did compare the types of disclosures required by mutual funds compared to other types of specific financial products, where they do disclose actual dollar amounts and fees, and where it becomes much more clear to the consumer what those costs are. Those same types of disclosures currently are not available to the same extent in the mutual fund environment.
    Mr. OXLEY. Would you have any other comments, Mr. Roye?
    Mr. ROYE. Yes, what I would add to that is, of course, we write the disclosure documents. We are in charge of the rules so we know what they require, and we know what is in the reports and we know what is in the statements. Again, I think that we look at the existing regime and believe it can be made better.
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    If some of the additional practices have grown, like revenue sharing, we think that the disclosures clearly should be surfaced and made clear to investors so they understand some of the incentives and conflicts associated with some of these payments. So clearly there is work to be done here, and the bill addresses those concerns.
    Mr. OXLEY. Mr. Hillman, as you know and I am sure Mr. Roye obviously knows, the SEC currently has pending a rule proposal that would require mutual funds to disclose in annual and semi-annual reports new disclosure regarding mutual fund fees. Mr. Bullard, who will testify in the next panel, states that the SEC's rule proposal would require disclosure not in a document that less price-sensitive shareholders are likely to review, but in a semi-annual report. Why would the quarterly statement be more useful than the semi-annual report in a prospectus?
    Mr. HILLMAN. In a survey performed by ICI about how investors obtain information about their funds, the Investment Company Institute found that account statements is probably the most important communication to investors. Nearly all shareholders use such statements to monitor their funds. The point here is, for disclosures to be beneficial, you want them to be read. The document that is most read is the quarterly account statement.
    Mr. OXLEY. Thank you.
    Mr. Chairman, thank you very much.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. Emanuel?
    Mr. EMANUEL. I apologize for missing the earlier parts. I was at another hearing at the Budget Committee on waste, fraud and abuse.
    On the two approaches that SEC is studying and GAO is studying, my question is a general question on this approach. I am trying to get relevant information and not confuse the words between ''relevant'' versus ''more.'' They are not the same, and for investors to get relevant information that allows them to compare fund to fund, what is your sense of how we should approach that and how we make the distinction between ''relevant'' versus just ''more'' information?
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    I think everybody has a sense that they are overloaded with information. Really, what we are trying to get at, and root kind of problem is, how do we get the individual investor information that is important to them so they can compare fund to fund as it relates to cost?
    Mr. ROYE. That is a question that we struggle with continually at the Commission. Where we have a disclosure regime, obviously we want the disclosure to be effective. We want it to be the information that investors need to make that investment decision, and how can we present that information so they can make use out of it, and make intelligent investment decisions.
    I think the debate here is how to get really fee information to investors in a way that they can understand it. We think the notion of dollars and cents disclosure is very sensible and that will demystify expense ratios and percentages of assets. If we can communicate to investors expenses in a dollars and cents common sense way, that will go a long way toward making sure they understand mutual fund fees and expenses.
    The question is, what vehicle, what document would be most effective in getting that information and the cost of doing that. We have a proposal outstanding. It is not final. Obviously, we want to step back and look at what our colleagues at GAO have recommended and suggested and others have suggested.
    We are digesting the comments in this area. But the Commission's initial thought on this was again to be able to take a $10,000 investment, use the actual expenses of the fund, and use the actual return of the fund and translate that into a dollar number. So you can understand what it costs you to be invested in that fund.
    Mr. EMANUEL. Can I interrupt for one second? From the GAO's perspective, if we were to adopt what the SEC has recommended, would you see that as an improvement over the present situation?
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    Mr. HILLMAN. Absolutely.
    Mr. EMANUEL. A marked improvement? Significant?
    Mr. HILLMAN. It would be a significant improvement. It would provide investors with increased information to compare fees across funds. It goes the added step of providing the specific dollar disclosure that you are looking for to reduce the ambiguity; to demystify the net assets. Our concern would be more about the placement of that information than the recommendations that SEC is making.
    Mr. EMANUEL. And what would you do, then, if you were just to tweak it, just to get it over the goal line, then?
    Mr. HILLMAN. One possible alternative would be to use exactly the same information that the SEC is proposing, but to put that in addition to semi-annual reports, to put that within the account statement, so that investors have a greater opportunity of actually reading it.
    Mr. EMANUEL. Okay.
    Mr. Chairman, no further questions. Thank you.
    Chairman BAKER. Thank you, Mr. Emanuel.
    We have no further members for questions at this time, am I correct? Okay, I am correct.
    Mr. Roye, I would like to just make a request for the benefit of the committee. It was the hope that we could move toward subcommittee consideration of the proposal sometime in mid-July as a goal. Given the comments of the agencies this morning, we would very much request some closure on opinions perhaps on our return after the July Fourth recess for the members to have time to adequately assess any modifications that may be suggested, so that we can move as much as is practicable to a mid-month consideration of this proposal. If the agency does not find that an unreasonable request, we would certainly appreciate it.
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    Mr. ROYE. We will try to accommodate you.
    Chairman BAKER. We thank both of you for your participation. It has been most helpful to the committee, and thank you for your help.
    At this time, I will call up our next panel.
    I want to welcome our panelists to the hearing this morning. As is the usual custom, we will request that if possible make your statement within a 5-minute constrain. Of course, your official testimony will be made part of the record. I am advised that we will have a series of votes interrupt our consideration at some time within the next 15 or 20 minutes, but we will proceed to receive as much testimony as we can, and then recess the committee briefly for members to make those votes.
    I would like to welcome back to the committee, certainly no stranger here, Mr. John C. Bogle, who is the founder of the Vanguard Group. Welcome, Mr. Bogle.
    Mr. BOGLE. Thank you Chairman Baker and Ranking Member Kanjorski and members of the committee. I am delighted to be back with you again to talk about your proposed amendments on the Integrity and Fee Transparency Act of 2003.
    And particularly on disclosure, I compliment you on the disclosure and the call for reporting of costs, the annual operating expenses borne by each shareholder, I will come back to that in a moment, and especially the requirement which has profound consequences, to have an independent Director serve as Chairman of the funds.
    I want to say right at the outset, however, that I hope the final legislation you draft will go further, because I do not believe that this industry has adequately measured up to its responsibilities to mutual fund investors. The express language of the preamble to the Investment Company Act of 1940, which the Investment Company Institute in its testimony correctly called ''our common legacy,'' calls for mutual funds to ''be organized, operated and managed'' in the interests of shareholders, rather than the interests of ''Directors, officers, investment advisers and underwriters.'' I believe it is impossible to argue that that has been the case in this industry.
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    Consider, for example, how fund expenses have soared over the past quarter-century. I am in a little bit of trouble here with the industry for saying that expenses rose 120-fold, from $523 million in 1979 to $64 billion in 2001. Even in 2002, with our equity fund shareholders having lost 34 percent of their money from the markets deck, the total fund expenses amounted to $62 billion. That 120-fold increase is far higher than the increase in fund assets during that period, which went from $70 billion to $6.5 trillion, or about 90-times over. The net result, the expense ratio of the average mutual fund rose from about nine-tenths of 1 percent to 1.36 percent. So to be fair, the unit expenses are up only, if that is a word one can apply to such an increase, 51 percent.
    In my direct personal hands-on experience in being in this business and running a company for more than 2 decades, the economies of scale in this industry are staggering, and they simply are not being shared with mutual fund investors. Specifically, Vanguard expense ratios, and I don't mean to plug Vanguard here, but we operate at-cost so we know what the costs are, are down 60 percent in that period, compared to the industry rise of 51 percent.
    Expense disclosure will help. Further strengthening the board of Directors will help. But I also think we need an express standard of fiduciary duty playing off the language in the preamble to the 1940 Act, specifically a fiduciary duty that Directors place the interests of fund shareholders ahead of the interests of fund managers and distributors.
    I want to emphasize how crucially important costs are in shaping investment returns. The impact is enormous. For example, if we assume a future market return of 8 percent and assume, on the low side, for costs are actually higher, 2.5 percent cost of mutual funds, the compound return of the stock market at 8 percent would produce a $58,000 profit on that $10,000 investment over 25 years. The return on the same investment after costs of 2.5 percent would produce a $28,000 profit, less than half as much as the profit on the market's return. More than half is confiscated by expenses. 2.5 percent is a huge, huge cost to the long-term investor, staggering in its dimension.
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    Disclosing the dollar amount of costs invest incur would be very helpful to investors, and it would be virtually cost-free. I want to put that to rest. We do not need to make any estimates. All we need to do is take the fund's expense ratio during the prior 12 months, apply it to the dollar value of the assets that the investor has at the end of the period, and say these are your annualized expenses, period. It would cost so far from $265 million, the absurd estimate I have read, that you would not be able to see it. The cost would be virtually zero.
    I want to emphasize something we have not talked about in these hearings. Think of the impact of that disclosure not on equity fund shareholders, but on money market shareholders. Consider a shareholder with $10,000 in a money market fund. The money market fund would yield about 1.25 percent and the investor received net income of $25, a quarter of 1 percent, after fees of perhaps $100; $100 to the manager out of $125 and $25 to the investor. If that would not open an investor's eyes, I do not know what would.
    I am going to skip a couple of things over here, but I do want to get to my final point and do not want to run over my time too badly. I want to comment on the conventional industry allegation that the industry must be good because it has never had a major scandal. If a scandal is described as a ''grossly discreditable condition of things,'' it is not clear that this statement is accurate.
    Consider the returns of mutual fund shareholders versus the stock market. For the last 20 years, the U.S. stock market has averaged a return of 13 percent. The average mutual fund investor, believe this or not, has averaged a return of a little bit over 2 percent a year. An investor in the stock market, $105,000 profit on $10,000; the average mutual fund investor, $5,000. Is that a scandal or is it not?
    That lag is important to the responsibility of this business. During the years leading up to the peak of the stock market bubble, we offered the public. 494 new technology, telecom, Internet and aggressive growth funds favoring those sectors. It is not conceivable that those funds were organized, operated and managed in the interests of investors, rather than the interests of fund managers. Is that a scandal or not?
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    These new funds, these high-risk funds, believe this or not, took in $500 billion in that period, as the investor greed of that era drew the money into funds. But we helped them. We advertised in Money magazine in March, 2000, right at the peak, an average return of 85.6 percent in the previous year. We lured the sheep into this terrible market. Is that a scandal or not? You can decide.
    I have been in this business for 52 years and I think we are suffering from a severe case of the emperor's clothes syndrome. What is all too obvious to anyone who opens their eyes, from Warren Buffett to the respected Morningstar Advisory Service, seems invisible to the industry. I want to emphasize, that every person I have ever met in this industry over my long career has not been other than a good, capable, honest human being. But I believe the powerful financial interests of investment executives and the companies that manage the funds blind them to the realities of today's investments and the terrible penalty of cost.
    That is why I am here today. I believe that this industry can only survive if investors are given a fair shake, with managers focusing not on salesmanship, but on stewardship. Progress is being made, but I think we have got to go further if we are going to live up to the promise of the 1940 Act, which is to serve the national public interest and the interest of investors.
    Thank you, Mr. Chairman.
    [The prepared statement of John C. Bogle can be found on page 60 in the appendix.]
    Chairman BAKER. Thank you, Mr. Bogle.
    Our next participant is the founder and President of the Fund Democracy, Mr. Mercer Bullard. Welcome, Mr. Bullard.
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    Mr. BULLARD. Thank you, Chairman Baker, Ranking Member Kanjorski, members of the subcommittee. Thank you for the opportunity to appear before you today to discuss H.R. 2420, the Mutual Funds Integrity and Fee Transparency Act of 2003. It is an honor and a privilege to appear before the subcommittee today.
    I am the founder of Fund Democracy, a nonprofit advocacy group for mutual fund shareholders and an assistant professor of law at the University of Mississippi. I founded Fund Democracy in January 2000 to provide a voice and information source for mutual fund shareholders on operational regulatory issues that affect their fund investments. I have previously counseled mutual funds and investment advisers in private practice, served as an assistant chief counsel in the Division of Management at the SEC, published an industry newsletter for mutual fund lawyers, and published and written a column on mutual fund operational issues for Thestreet.com.
    More than 95 million Americans are shareholders in mutual funds, making mutual funds America's investment vehicle of choice. These shareholders, I believe, have made the right decision. For the overwhelming majority of Americans, mutual funds offer the best available investment alternative. This will continue to be true, however, only as long as mutual fund rules keep pace with changes in the fund industry. In significant respects, fund rules have not kept pace with developments in the fund industry. H.R. 2420 is necessary to update rules to ensure that mutual funds remain the best possible alternative for investors.
    The fund industry owes much of its success to the requirements of the Investment Company Act of 1940 and the body of law that has grown up around it. The Act provides liquidity by requiring that mutual funds be redeemable on demand at a price based on their net assets. Fund rules provide safety by prohibiting transactions between funds and their affiliates, and by limiting the amount of leverage that funds can use. Transparency and standardization are assured by rules regarding the use of standardized investment performance and fee disclosure. These rules are buttressed by the presence of an independent board of Directors that oversees fund operations to ensure that funds are operated in the best interests of their shareholders, and not fund affiliates.
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    Mutual funds offer liquidity, safety, transparency and standardization at a reasonable price, again partly as a result of effective regulation. The fee information provided in the prospectus provides investors with standardized costs that can be used to compare different funds. This information can also be easily disseminated through the information channels that investors use when making investment decisions. The transparency of fund fees promotes price competition and has resulted in the availability of a wide variety of low-cost fund options.
    Fund regulation has also been successful in adapting to changing business practices. Many of the fundamental characteristics of mutual funds owe their existence to regulatory reforms, including the fee table, standardized investment performance, 12b-1 plans, and multi-class funds. As Mr. Bogle can attest, The Vanguard Group itself, America's second-largest fund complex, exists and operates only by reason of the series of exemptions that Mr. Bogle obtained from the SEC in the 1970s.
    In some respects, however, fund regulation has failed to adapt to changing business practices. Fund distribution and brokerage practices have changed dramatically over the last 20 years. The rules governing fund disclosure and fund Directors's responsibilities have not kept pace. The true cost of investing in mutual funds has become obscured by fee disclosures that fail to reflect accurately how and how much shareholders pay for fund-related services. Fund governance rules need to be improved to give independent Directors the authority and tools they need to oversee funds' increasingly complex distribution and brokerage practices.
    H.R. 2420 takes an important first step in modernizing fund rules to reflect the way that funds operate today. H.R. 2420 will update fund disclosure rules to provide investors with needed information about fund costs. It will provide investors with a clearer understanding of the impact of fees by requiring that they be disclosed in dollar amounts. Fee disclosure will be required to incorporate all fees, including portfolio transaction costs, and to identify all distribution expenses, including those paid outside of 12b-1 plans. Improved disclosure of compensation to portfolio managers and to retail brokers will enable shareholders to evaluate the extent to which these persons' economic interests are aligned with their own.
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    In addition, H.R. 2420 will strengthen the role of independent Directors and further focus their energies where conflicts of interest between the fund adviser and fund shareholders are greatest. Recent scandals have reminded us of the importance of proactive leadership in the boardroom. H.R. 2420's requirement that a fund board's Chairman be an independent Director will ensure that the leadership of America's funds is independent.
    That concludes my statement.
    [The prepared statement of Mercer Bullard can be found on page 66 in the appendix.]
    Chairman BAKER. Thank you, Mr. Bullard.
    For the introduction of our next witness, I would like to turn to Mr. Ford for a comment.
    Mr. FORD. Thank you, Mr. Chairman.
    In the interests of keeping the next witness in good standing with her own congressman, I would defer to her own congressman first and I would love to say a few words once he finishes. So I defer to Mr. Emanuel, Ms. Hobson's congressman.
    Mr. EMANUEL. We have been having this fight for six months on who likes Mellody more.
    I understand, but we have 15 minutes before votes, so I am letting Mellody go. She is an impressive person who, if you do not have an opportunity to hear her today, you can always watch her on Good Morning America giving advice. So we are very fortunate to have her here.
    Chairman BAKER. Welcome, Ms. Hobson.
    Mr. FORD. She also raised some important points about the size of fund that she manages, in a lot of ways ensuring some of the things that the University of Mississippi law professor just raised, ensuring that those kind of things do not impact small funds disproportionately. So it is a delight to see her and I am glad to welcome her to Washington again.
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    Chairman BAKER. Just for the sake of our process here, we have had votes announced. We would like to proceed to receive Ms. Hobson's testimony. In order to give you time where you will not be rushed, I would suggest at that point we then recess for votes and come back to hear Mr. Haaga's testimony at that time.
    Ms. Hobson?
    Ms. HOBSON. Okay. Thank you very much, Chairman Baker, Ranking Member Kanjorski, and members of the subcommittee.
    Testifying about investor confidence when the issue is more important to our economy and a more relevant event to the destinies of average Americans than ever before is a great honor and even greater responsibility. I am President of Ariel Mutual Funds. Ariel is a small investment firm and a small business. We offer four mutual funds. More than 100,000 individuals have given $3.7 billion to us to invest. Ariel is based in Chicago and we have 67 employees.
    In addition to my work at our firm, I also contribute a weekly segment on personal finance and investment issues for a network television program. My colleague John Rogers founded Ariel 20 years ago. At the time, we were the first minority-owned money management firm in the nation. He was 24 years old. John discovered the stock market at the age of 12 when instead of toys, his father bought him stocks every birthday and every Christmas. That childhood interest evolved into his life's work and ultimately created the passion that led to the creation of Ariel.
    This story tells you about the heart and soul of one small mutual fund company in America. Some have suggested to the subcommittee that the mutual fund industry is dominated by firms who have forgotten their fiduciary obligations, lost their connection to individual shareholders, abandoned the basic principles of sound investment management, and repudiated the industry's proud history. Nothing could be further from the truth. As a mutual fund executive, my future, my credibility and my integrity are inextricably linked to Ariel's shareholders's success.
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    Moreover, Ariel takes enormous pride in being part of a great industry. We work hard to reach out to those who have not seen first-hand the wonders of long-term investing, compounded growth, and the creation of enduring wealth. One important aspect of our work is the unique mission to make the stock market a subject of dinner table conservation in the black community.
    It is therefore heartening to come to Washington and see policymakers who care so much about investors. We applaud your efforts. When you find effective ways to reinforce investor protections and support the integrity of our markets, you help our business and you help our shareholders.
    I am aware that four major government reports on mutual funds have been published in the last 36 months, two by the SEC and two by the GAO. Taken as a whole, the reports reaffirm the health of the fund industry and the continued effectiveness of the regulatory regime that governs it. It would be logical to think that the SEC had put other fund initiatives on hold while these studies were completed, but that has not been the case. Since 1998, the SEC appears to have adopted at least 20 new mutual fund regulatory initiatives, averaging one every 12 weeks. This appears to be the fastest rate in SEC history.
    Of course, each initiative can include multiple forms, rules, requirements and mandatory filings. I will attach a more extensive list for the record, but recent SEC mutual fund regulations have included new requirements in areas ranging from consumer privacy to proxy voting to after-tax return performance. In addition, at least four new major initiatives are now pending.
    The sheer number and range of these regulations demonstrates the vitality of the SEC's efforts to help 95 million fund investors. I also think it bears noting that the ICI has worked constructively with the SEC on virtually all of these matters, and has endorsed the overwhelming majority of them.
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    We should, however, remember that these new regulations invariably lead to significant costs. The SEC deserves credit for several efforts that reduced fund regulatory costs, but those initiatives are dwarfed by regulations that have added far larger cost burdens. Reviewing the SEC's own cost estimates for these rules is striking. The net impact of SEC mutual fund rulemakings since 1998 appears to have increased the fund industry's regulatory costs by at least several hundred million dollars annually.
    I am worried that the impact of all of this on small mutual fund companies could ultimately contribute to making the fund industry less hospitable to innovative startups and perhaps even less competitive. I am not certain that in good faith I would advise a 24-year-old today to take on the costs and burdens of starting a mutual fund family, as John Rogers did when Ariel was started.
    Let me turn to some general observations about the bill. Section 2 of H.R. 2420 directs the SEC to initiate expedited rulemaking on six broad new mutual fund disclosure mandates. As the subcommittee considers whether to support this directive, as I have stated, I am hopeful that the inevitable impact on smaller fund companies will be carefully thought out. It would be deeply regrettable if attempts to heighten shareholder disclosure eroded the competitive position of the most dynamic and entrepreneurial parts of the fund business. For that reason, I urge you to provide sufficient time so that a consensus approach to these issues can be embraced.
    Fed Chairman Alan Greenspan recently observed that in our laudable efforts to improve public disclosure, we too often appear to be mistaking more extensive disclosure for greater transparency. He said that improved transparency is more important, but harder to achieve than improved disclosure. Former SEC Chairman Leavitt once expressed a similar concern, stating that the law of unintended results has come into play. Our passion for full disclosure has created fact-full reports and prospectuses that are more redundant than revealing.
    The possibility that disclosures might impede, rather than enhance, decisionmaking is a real concern. For that reason, it is worth noting that the SEC, when they made changes to their own prospectus reform five years ago, they mentioned that learning too much information discourages investors from further reading or obscures essential information about the funds.
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    After reading the SEC and GAO reports and reviewing the transcript of the subcommittee's March hearing, it is obvious that a substantial effort has been undertaken to explore the ways to bolster mutual fund investors' understanding of fund fees and expenses. Fortunately, recent ICI data about investors's actual behavior supports the message that fund fees has broken through.
    The ICI looked at all equity fund sales over a 5-year period ending in 2001 and found that, first, 83 percent of all equity funds bought by investors had expense ratios below the 1.62 percent average charged by the average fund; and secondly, that the average investor holds equity funds with a total operating expense of .99 percent, about 39 percent lower than the fee level charged by the average fund.
    These findings indicate convincingly that very large majorities of fund shareholders own funds with lower than average costs. I hope the subcommittee will bear this data in mind as it further considers these issues.
    Lastly, I mentioned earlier that I conduct personal finance features on a television network news program and author a bi-monthly column. I have received literally thousands of questions and requests for guidance in this role, and hear one refrain more than any other: people feel overwhelmed by information. Young, old, married, single, black, white, working, retired, investors want insight in ways to cut through the noise so they can get to the most important information that will help them make the best investment decisions. I never hear complaints about having too little information. It is always the opposite.
    Interestingly, I have received many fairly sophisticated inquiries, but never have I received one single question about soft dollars, directed brokerage, rule 12b-1, or many of the other mutual fund issues that we have discussed today. Perhaps there can be a small insight gleaned from that.
    Again, many thanks for the privilege of testifying. I look forward to your questions.
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    [The prepared statement of Mellody Hobson can be found on page 135 in the appendix.]
    Chairman BAKER. Thank you, Ms. Hobson.
    We are now down to 5 minutes on votes. We will stand in recess for approximately 20 minutes. Thank you.
    Chairman BAKER. Just to proceed, certainly within the time frame allocated for Mr. Haaga's testimony, we should have a member return. I am advised they are on their way.
    The Chairman of the Investment Company Institute, Mr. Paul Haaga, please proceed, sir.
    Mr. HAAGA. Great. Thank you very much, Chairman Baker and members of the subcommittee. It is actually not a problem that they will miss a lot of my testimony, because we are in very substantial agreement with the SEC and the GAO. So if they were here this morning, this may be largely a replay.
    I am very pleased to be appearing before you today, as I did in March, and again I am doing so as Chairman of the Investment Company Institute's Board of Governors. H.R. 2420 was introduced shortly after the release of a detailed report by the staff of the Securities and Exchange Commission. The SEC report, we are happy to say, found no significant shortcomings in mutual fund regulation. However, the report does recommend a series of policy changes and also identifies areas warranting further study.
    In large part, the industry agrees with the SEC staff's recommendations and we are committed to working with the Commission on these issues. Since then, we have also, of course, received the GAO report and we are in very substantial agreement with the GAO recommendations.
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    I will discuss the provisions of H.R. 2420 in three parts. The first part consists of those provisions that we believe would be beneficial to mutual fund investors and could be implemented through SEC regulation. We call upon the SEC to proceed expeditiously in these areas and we pledge our full cooperation.
    The second are those which would also be beneficial to fund investors and in which voluntary industry practices could be initiated. As Chairman of the ICI, I pledge to move forward in these areas. The third are several provisions that we respectfully submit would not be advisable.
    To begin with we believe the SEC should take action in four areas. First, we call upon the SEC to adopt as soon as practicable the rules it has already proposed that would require fund shareholder reports to disclose the cost in dollars of a $10,000 investment in the fund, based on the fund's actual expenses and the return for the period of the report. We believe this proposal is superior to alternatives that have been suggested, as it will enhance investors' understanding of fees and most importantly, will permit them to compare the expenses of different funds.
    Second, we recommend that the SEC address the other areas of disclosure identified in H.R. 2420, including portfolio transaction costs, revenue sharing arrangements, fund brokerage practices, and the structure of portfolio manager compensation. The SEC report makes several suggestions in these areas, each of which is worthy of serious consideration.
    Third, we recommend that the SEC clarify the roles of fund advisers and fund Directors in connection with soft-dollar and directed brokerage arrangements as the legislation proposes. This is a good idea and the SEC does not need to wait for legislation to take this step. In fact, I would point out this has been a very important part of the SEC's regulatory agenda for a long time now. Back in 1998, they did a sweep of advisers and found a number of problems, but none of those were with respect to advisers managing mutual funds.
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    Fourth, the legislation requires the SEC to undertake a thorough review of soft-dollar practices. We believe this is one of the most important issues addressed by the bill. We recognize the SEC has been actively reviewing soft-dollar practices for some time, especially through its inspection program. We believe it is time now for a review of the rules governing soft dollars.
    There are also areas in which the mutual fund industry can and should take voluntary steps to enhance investor confidence in our own system of corporate governance. First, we support applying the standards for audit committees established in the Sarbanes-Oxley Act to mutual funds. The audit committee standards are one of the few provisions of the Sarbanes-Oxley Act not applicable to mutual funds. H.R. 2420 would require mutual funds to adopt these standards. However, we do not need to wait for legislation, and I will recommend to the ICI board of governors that the standards proposed in H.R. 2420 be adopted as a best practice.
    Second, we agree with the SEC report and H.R. 2420 that it is inappropriate for certain relatives and persons with material business or professional relationships with management to serve as independent Directors of a mutual fund. I will also recommend to the ICI board of governors that it adopt a best practice under which these individuals would not serve as mutual fund independent Directors, as the industry has already done with respect to former employees of fund management companies.
    Third, I wish to point out that the ICI has adopted corporate governance best practices relevant to many of the issues addressed in the legislation. These include having independent Directors constitute at least two-thirds of fund boards, having a lead independent Director, and having independent Directors regularly meet in executive session. Because independent Directors meet and vote separately on the most important governance matters, annual renewal of the management, and distribution contracts, the latter two accomplish the objectives behind the proposal that funds have an independent chair.
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    Our understanding is that the vast majority of fund groups follow all of these best practices. However, in order to ensure that their adoption is as close to universal as possible, I will also recommend to the ICI board that it take further steps to urge each individual member of the ICI to adopt them. I believe that the above SEC and industry actions will accomplish the primary objectives of H.R. 2420, and will send a message to investors that we, Congress, the SEC, the GAO and the industry, intend that their interests come first.
    There are also some parts of the legislation that we just do not think would be a good idea. I would like to briefly mention three of them. First, as I stated, we believe that existing practices in the fund industry, such as lead Directors and regular meetings of independent Directors in executive session, make it unnecessary to require mutual funds to have an independent Chairman of the Board.
    I might add to that the requirement that two-thirds of the Directors be independent. Not only is it unnecessary, but having an independent Chairman could actually result in a less effective board. Most matters that come before a fund board do not involve conflicts of interest, but are matters on which board oversight is facilitated by having a chair be intimately familiar with the operations of the fund. A management representative is usually in the best position to do this. As I stated, for those matters that do involve potential conflicts or would benefit from a separate discussion among independent Directors, the existing practice of an executive session chaired by a lead independent Director would suffice. We note that none of the self-regulatory organizations have proposed that operating companies be required to have an independent chair as part of their recommended corporate governance standard. We think that mutual funds are not any different in this regard and should not be singled out for this requirement.
    Second, we believe it would be a mistake for the legislation to dictate the specifics of how certain items should be disclosed and in which document they should appear. The SEC is the agency charged with administering the securities laws and it has the experience and expertise to make these determinations. Moreover, the regulatory process allows input from the public and a careful weighing of costs and benefits. It also provides maximum flexibility to adjust thereafter to changing circumstances. We are particularly concerned with the legislation's presupposition that prospectus disclosure is not sufficient for any of the items covered. Under the securities laws, the prospectus is the legal document required to include all of the important information that is necessary to assist an investor in making an investment decision. Congress should not inadvertently discourage investors from viewing the prospectus as the most important disclosure document.
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    Third, to the extent H.R. 2420 would require disclosure of individualized operating expenses, we believe this would not be the most effective way of providing disclosure of fund expenses to investors. Unlike the SEC's proposal, this approach would not provide investors with cost information that permits comparisons because costs would not be based on a standardized amount.
    In addition, as the SEC report notes, this type of disclosure would impose enormous costs and burdens on funds and intermediaries. Funds in my group are sold through independent dealers and because of this, my fund company does not send out account statements to most investors. Instead, most investors receive those from brokers or 401(k) plans, so it would be others who would have to implement that.
    For these and other reasons, we recommend that once the SEC adopts its new rules on expense disclosure, which we hope will be soon, Congress study their effectiveness before mandating another costly and in our view far less effective form of disclosure.
    I would also note that the GAO's report which was released this week discussed several different ways in which fee disclosure could be included in account statements. I was pleased to hear the discussion this morning that seemed to offer some flexibility there to include it in another document and to include it on a standardized basis. We would be happy to work with both agencies in that regard.
    I will close by noting that beyond any of the specific matters I have touched upon, the mutual fund industry is committed to working with this subcommittee and others to continue to pursue reforms that will meaningfully benefit mutual fund investors.
    Thank you very much.
    [The prepared statement of Paul Haaga can be found on page 90 in the appendix.]
    Chairman BAKER. Thank you, Mr. Haaga.
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    I think it is important just to reflect a bit on how we came to where we are this morning with the Capital Market Subcommittee review. This really is another component of our market-sector-by-market-sector analysis of arms length oversight which is frankly appropriate in light of the significant time that has passed since the committee has had a mutual fund discussion, and coupled with the enormity of growth we have seen, not only in notional dollar amount, but in numbers of investors. This is no longer an activity that is relegated to sophisticated financial individuals. Working families in everybody's community have some stake or interest in the performance and understanding of their mutual fund investments.
    Secondly, we are really here to help, we hope, with restoration of investor confidence. It had a measurable economic effect when working families made a conscious decision to withdraw their money from the capital markets and park it on the sideline for whatever the reason, whether a corporate misgovernance issue, whether disappointment in the performance of a particular fund. To ensure individuals that there is a third party looking at this matters, I think ultimately is helpful.
    Ms. Hobson, you indicated specifically with regard to concern of a smaller-managed fund, the impact that disclosure may have on the viability of the fund and on net return to individuals who are investors. I share those concerns. But in your further explanation, you indicated that very few investors talk to you about soft-dollar arrangements or 12b-1.
    Frankly, if I went back home to Baton Rouge and talked about 12b-1, most of my constituents would think I was talking about a nutritional program. They don't know about these things. They don't have enough information to propound the question.
    Are there provisions that are now applicable to the operation of your fund that you feel do not provide any significant measure of benefit to the consumer that we could repeal? This is not about just adding on pages, but in your statement, you indicated the number of regulatory steps that had been taken that now require the pronouncement of any number of forms. Help us out. We ought to be able to do both. We ought to be able to facilitate better disclosure, which in my opinion is not adequate, while at the same time helping the industry from the burden of unwarranted reporting. Do you wish to respond?
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    Ms. HOBSON. That is a very good question. I would have to think about the specifics of some of the regulatory issues that we confront on a daily, monthly, weekly basis at our board meetings, et cetera, that have become onerous, and bring those back to you. What I can tell you is that there is a lot of lawyering going on in our board meetings. There is a lot of discussion in every meeting that I am in now, from everything from the investment process to the marketing of the mutual funds around what the rules, laws and legal issues are, and often legal obstacles are to certain things that we would like to get done.
    So I will make sure to think about that and come back to you. But it is everything from the amount of hedge that we put on the bottom of an ad or reprint is so dense that I would argue that very few people actually read that hedge copy with all the disclosure. It obviously goes through lots of forms of review before it is approved to be able to go out. That is just one of many, many examples that we have. I can come back with specifics.
    Chairman BAKER. Terrific. If you could do so for, say, early in July, just take a couple of weeks or so and get us something back, it would be helpful because the goal is not to just throw more stuff inside the door and say ''figure it out.'' It is to get something that is useful, while getting rid of that which is not helpful.
    Mr. Haaga, the same point. I note in your statement you indicate that disclosure of these matters is best left to the prospectus. I turn to Ms. Hobson's comments where she acknowledges even as a critic of the bill that a lot of this stuff does not get read. I would have to say to you that most investors when you get to that little bottom line where it says ''I have read and understand the conditions outlined in the prospectus'' before you make your investment decision, don't put people on the stand and ask them to answer that under oath. Not many people read the entire prospectus and truly understand either the risk or the fee structure in association with it.
    Is there a way for us, not without burdensome obligation, to come to some point? I mean, that is what people care about. When you go make a loan, a lot of people don't ask interest rate; they don't ask terms; what the points are. What I want to have is something that says what the note is. Can you help me there?
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    Mr. HAAGA. Yes. I think it is a great question. I did not mean to say that these things should only go in the prospectus. What I argued against was precluding them from going into the prospectus. So let the prospectus be one of the options is really our position. I didn't mean to misstate that.
    When I look at these things, I am kind of reminded of when I go to church on Sunday and I come out afterwards, there are a number of elderly people who know what business I am in or are friends of ours, and they come up to me and ask me about investing. Actually for them, it is not investing. It is taking money out. They are not putting any more money in. So all these discussions of shelf-space and distribution channels do not apply to them. It is how much can I take out. And most of them, all of them I try to get together with an investment adviser because they need to do scenario analysis and find out how much they are going to move.
    I guess with them, when I talk to them about what kinds of funds they ought to be looking at, I am always aware of the fact that they are sitting down with an adviser, and that the adviser is interpreting a lot of this stuff. So the burden on us to get all of the information directly in the hands of the investor maybe in the directly sold funds may be important, but where there is an adviser or a 401(k) plan trustee, whose is reading this and selecting the funds that are going to be in the 401(k) plan, that is about 80 percent of our investors in the entire group. That is important.
    I am straying a little bit from your question, but when you come back to it, I talk to them about looking at the investment objectives of the fund, the investment record of the fund, particularly volatility, not just the total return over a period. When I talk to them, it is a two-way conversation because you have to talk to them about their investment needs, and sometimes we look at these things as though investors are all the same person with the same time horizon and the same risk-reward structure, and they are not.
    I do tell them that expenses are important, but it is also important to measure expenses against what you receive. The cheaper funds generally don't pay for you to have an investment adviser, so you want to think about whether you need an adviser or not. If you get an adviser, that person needs to be paid and how they are paid needs to be disclosed. That is kind of the discussion. Translating that into a document, I think frankly that the first few pages of the prospectus, which were at one time adopted as the profile prospectus, do a pretty good job of that. If we could get the profiles out there with people, it had a bar chart that showed the annual returns over the last 10 years, which gives you a good idea of the volatility, as well as the rewards. It summarized the fees and it did it in a way that was exactly comparable with other funds. Morningstar makes a lot of money doing one-page profiles about funds. It is basically the same thing. So I would put it on that.
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    Chairman BAKER. Thank you, Mr. Haaga.
    I am reminded, since you gave us the church analogy, there was a Sunday School class during the summer and they had a little day-school thing. The kid gets in line in front of the tray where the fruit is, the preacher put up a sign that says, ''Take one apple, God is watching.'' He gets to the end of the line where the desserts are, and another kid has scribbled out a note that says in front of the cookies, ''Take all you want; God is watching the apples.''
    I think that is my problem. We have got to watch both ends of the line here.
    Mr. Bogle, did you want to comment?
    Mr. BOGLE. Yes. I think first of all it seems to me critically important that we have much more disclosure than the bill asks for. It is not a matter of disclosing, I don't think, just the methodology about how portfolio managers are paid. I think that is the Investment Company Institute's argument. But what is important is not only the amount of compensation the portfolio manager is paid, but how much the management company gets and where the management company spends its money. Does it spend it mostly on marketing? Does it spend it on administration? And how much is profit to the management company? All of that needs to be disclosed.
    We need to pierce this sort of corporate veil that keeps the fund shareholders from knowing what the management company is doing, even though the fund is the only client that management company has. So we need to put that in shareholder reports, at least the annual report, rather than the prospectus. Visualize a situation where a fund has a million investors and no new buyers for whatever reason. Well, it is in a prospectus that nobody uses and you are depriving a million investors of the information.
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    So it seems to me absolute that the shareholders of the fund, the ongoing owners who maybe got a prospectus 10 years ago must be informed of that. So that is, I think, an extremely important thing to show.
    Mr. HAAGA. May I add something to my answer, sir? I was worried that we read the intermediaries out of the equation. I am also worried that we may be reading the Directors out of the equation here. The Directors do know about profitability. They know about all of these things that we are saying ought to go to the shareholders.
    The difference between them and the shareholders is that the Directors can sit down and discuss it with us. They have a fiduciary duty and they can ask us follow-up questions. So I worry that we are saying that everything that ought to go to a Director needs to go right through to a shareholder because that is transparency. That example is just one of them.
    Mr. BOGLE. If I could add to that direct point, if I may. Vanguard reports all those costs to our investors, fund by fund, item by item, how much goes to investment management, how much to distribution, how much to operations and administration, how much to the custodian, to every fund, every investor and the aggregate if anybody wants to add them up. It is not troublesome. It is not burdensome. It is out there for everybody to see.
    I am not arguing that the cost matters so much to the investor, because they clearly do not pay a lot of attention to that. I am arguing that the simple act of disclosure puts something out in the public limelight and changes the behavior of those who are disclosing.
    Chairman BAKER. Ms. Hobson?
    Ms. HOBSON. Yes, if I could add one point to that, respectfully disagreeing with Mr. Bogle. This would be the only industry where your profitability would be mandated to be disclosed. So for example, the way that I have thought about this when I heard this argument was that it would be as if you went to buy a jar of peanut butter; you get your Skippy off the shelf. And every item of that peanut butter is detailed for you. Peanuts cost this much; the oil cost this much; the jar cost this much. That is not material to the person picking the peanut butter off the shelf who wants to know, is it $1.29 or $1.19?
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    The idea of having to then disclose on top of that, we have built up this much profit into the peanuts after we shipped them and paid for all the labor et cetera. There is no other example in business of that kind of disclosure.
    Chairman BAKER. Let me make the observation, though. If it is a peanut butter company that is publicly traded, I can find out all that information.
    Ms. HOBSON. You can find out information about cost of labor; you can find out certain information about components of the business, but all the profitability numbers you can back out of a financial document for a public company, but they are not explicitly stated to you because of competitive considerations.
    Chairman BAKER. I don't want to be argumentative, because I have gone way over my allotted time, but I just think there are some parallels between publicly traded reporting standards and what you can find out about a company's operations.
    Mr. HAAGA. I think Mellody's point is that you can find that out, but you don't find it out when you decide whether to buy a jar of peanut butter.
    Chairman BAKER. Right, not when you are picking up the peanut butter. Right.
    Mr. BOGLE. I like to think that mutual funds are more important to the investor's financial future than peanut butter is.
    Chairman BAKER. Even in that case, you have a bunch of jars and you can pick the lowest price or the crunchiest, whatever you want, but you have a choice.
    Mr. Kanjorski?
    Mr. KANJORSKI. We don't have peanuts in Pennsylvania, Mr. Chairman.
    It is interesting listening to the four viewpoints given. It seems we almost have a philosophical difference. Mr. Bogle, you are equating mutual funds with almost the credit union-type movement in banking. You want to see the least expenditure on experts on investment, on management, and the most advantage to go to the investor. That is a very good concept. I tend to agree with it.
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    I think Ms. Hobson addresses another problem, though, allowing the field to be open to new competition, small mutual funds. And then an overall prevailing issue is, if you take your argument and you show such a small portion of expense for the operation of your fund, that is all well and good. But suppose Ms. Hobson's fund shows 10 times as much expense but 30 times as much profit? I mean, that is significant, too.
    So I don't think we here in the Congress or the regulator or the marketplace is asking us to set up some measurement of certainty of success of investment. That is not our role. There used to be a principle in the law, caveat emptor, but we seem to have forgotten that altogether.
    What I am most interested in is the question I asked Mr. Roye earlier. Has anybody done a cost analysis of this? I just did a back of the envelope with 30,000 funds, obviously every one of them if we pass a new statute has to have legal advice. I have nothing against lawyers. In another life, I was one. But if the minimum fee or the average fee were $10,000 per fund, we are talking about an expenditure here of $300 million to come up with some numbers.
    We all probably agree, and I will confess to it, anyway, when I make a bank loan, the omnipotence of the Congress determines that they have to give us disclosure sheets that you end up signing and never reading. Quite frankly, my eyesight is not worthwhile with the small print anymore to read it. I just know I would not enjoy it, and I don't think 95 percent or 99 percent of borrowers do read those disclosure documents. I tend to agree, it is where it is placed, how it is placed and the simplicity.
    I am not arguing against some simple, easy formula that sets out to give some basis of comparison. But hopefully, it is only a recognized basis. It is not the holy grail that we are putting out here. Much more thought, analysis and insight by the investor is necessary to participate in equity capital markets, whether they use a private broker or whether they use a mutual fund.
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    Quite frankly, I am not one of these people that believe 100 percent of the American people are eventually capable of becoming equity investors. I think we make a mistake, as sometimes my thoughts on real estate and ever pushing for higher ownership just can't be handled by some people.
    But if we are going to spend $300 million here, somebody should convince us that that expenditure is going to save more than that. And yet, I heard the SEC said there are only five problems that they have had this last year, and the losses incurred to the investors in their estimation were under $100 million. So we are talking about a regulation here that is going to cost us three times as much in legal fees as the total money saved to the investors. If that is the case, let's take $100 million and put it in a fund and pay the losses to those five groups that lost. Now, quite frankly, I am going to run out and make an investment in a plane company and a paper company, because I think the stock is about to go up if we do this.
    Chairman BAKER. That would be insider trading. Be careful.
    Mr. KANJORSKI. You know, I think I have listened to everybody's argument here correctly. I think I come up with the sense that we would like to have a more open capital market. We would like to have less potential for abuse and not necessarily any proved abuse. We would like to have some standard of comparison. I think all those elements are good. I tend to favor if it can be done reasonably, that to happen.
    But if we get very burdened down with passing some law empowering another regulator when they have nothing else to do, to go out and get involved in this, when I think there are many other things. I mean, if we are going to spend a lot of time in regulation, I could give a list of another 10 or 20 corporations that probably should be looked into that are probably in very serious condition, and yet haven't even been disclosed.
    That all being said, why don't we look at investor education? Why wouldn't the mutual fund industry be the ideal industry to get together? We require brokers to be licensed, to have a measure of ability and capacity. Maybe we ought to license investors.
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    I don't agree with that. I am being facetious when I say that, but in reality, that is what we are talking about. We are saying there are a lot of people who are probably subject to being hoodwinked or scammed or taken advantage of, even in the mutual fund market, because they lack the financial capacity to make comparisons, involve themselves in the profit-loss statements of the fund, and to understand what is to their best advantage.
    I am convinced that rather than the government thinking about ensuring and anticipating the inadequacies or incapacities of every investor in America, I think that is impossible. Maybe what we ought to do is invest the $300 million in some way with the SEC or NASD or somebody, to more highly educate investors as to how to compare or how to look and how to read, and then encourage a simple disclosure in the statement that people can look at and make a comparison.
    But I am not sure that we should be in the make work posture of putting a federal regulator empowered with a lot more power than they would have now, to get involved in what I consider a relatively successful fund market. Now, you can make the argument, Mr. Bogle, that a lot more money is taken out than should be, and I agree with you. But at least they are allowing people to get into the equity markets. I don't think you are arguing that all advice is of the same value. If I get a brain surgeon, he is going to be high priced. I am not going to price him and bid it. I think with investment advice, you just don't bid the market and get the cheapest price. If you are smart, you pick the best expertise you can and generally it costs a little bit more.
    Sometimes there is fluffing of the price. Sometimes there are add-ons that should not be there. We should find some way to have the transparency to see that simplistically, not with horrendous expense. I am just worried about what we are on a roll here is to start down that road.
    May I make a suggestion? Assuming we want to get to transparency and the capacity to compare, I think Ms. Hobson came up with a very good idea, and I analogize it to the CRAs. When I first came to Congress when we have the Community Reinvestment Act, the major difficulty with the Act was that all banks were treated the same, and they had to comply with the rules and regulations of CRA.
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    A big bank like Citicorp, they spent maybe $100,000 to fill out their report to comply. But a little bank like Ajax National Bank in Paducah had to spend $55,000, $60,000, $65,000 to fill out the same report to show compliance. It was an unusually heavy burden on banks under $100 million, $200 million, $300 million.
    We struggled here. We thought of a three-tier system and having different requirements for disclosure. We thought about taking the lawyers out and shooting them, but that didn't work. A few district attorneys and others did not like that idea.
    Finally, it was resolved. A good friend of mine, Gene Ludwig, became Comptroller of the Currency. He sat down and wrote out a computer program and offered it to every bank in America, that if you file in accordance with and use this computer program, you comply. Rather than $55,000 for lawyers, suddenly they did not have to hire a lawyer because they merely took the comptroller's program, complied with it, and filed.
    Now, why can't we do that with the mutual fund industry? Have the regulator take the responsibility of coming up with whatever that disclosure figure is, where it should appear, and how it should appear; get everybody agree to do it; then put a program together; send it out so everybody can comply without going through $300,000 in legal fees. And we have accomplished something. We have given transparency. We have given a standard of comparison. And we have not shamed an industry or assaulted an industry at a very weak moment in the American economy.
    If we keep questioning the integrity of every financial market and company in this country, we may improve some, and there are some losers, but some bad ones are always going to be out there. But one thing we will have a tremendous impact on, we are going to drive people out of the trust and faith of the capitalistic system. Again, I say on my side of the aisle to be arguing for that probably is a shame to some of my colleagues. But the fact of the matter is, let's not hammer it into the ground, so either the Congress or the regulators can look good and be able to say to our constituents, we did something; we put a new rule in; and we made the mutual fund industry comply, even though it cost $300 million to save $100 million.
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    Let's be practical and respond to all the questions raised and all the testimony given, that if the regulator takes it upon themselves, working with the associations, comes up with a simple formula or simple computer program that will be made available free of charge to the mutual fund industry, this affords the opportunity to protect everybody, to get the transparency, but most of all not to shut off the opportunity that Ms. Hobson testifies about.
    We are not here as the protectors of the giants and the big ones. They are going to take care of themselves. They are going to survive. What we want to do is encourage a real egalitarian capitalist market. It is only through the successes of organizations that Ms. Hobson represents that that is going to happen. We can, in our haste to look good, in our haste to work responsive, can poison the well of the future opportunity of those types of organizations. I think that would be the worst of all.
    Chairman BAKER. Can the gentleman conclude?
    Mr. KANJORSKI. Mr. Chairman, I conclude. I have given you all the best thoughts I have had this morning.
    Chairman BAKER. Thank you, Mr. Kanjorski.
    Is there comment from the panel?
    Mr. BOGLE. Could I respond to that? At least on the cost side. The way I suggest that we estimate the investor's expenses is just take the current expense ratio, it is easily ascertainable, and multiply it by the shareholder's asset value. It has a cost very close to zero. The $300 million cost is simply not relevant. It is a simple thing. Whether smaller companies should be relieved of other regulatory burdens is I think a separate issue and a reasonable one.
    Now let me talk about the impact of costs on mutual funds.
    Mr. KANJORSKI. Just one second. On that, you mean if you managed a fund and this new regulation came down, you would not feel compelled to call your attorney and get an opinion as to what you should do to comply with the law, and whether in fact when you decided what to do you were complying with the law?
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    Mr. BOGLE. I would just do it. I would comply with the law. The attorneys would probably get in there somewhere, but I think we can spend too much time with them. There is such a thing as just doing what is right.
    I would rather tackle the bigger issue, if I may, of how much expenses cost investors? This is a truism, it ought to be stated before this committee, that all mutual funds investors, stock investors, bond investors, money market investors, get essentially the total return generated by those markets, less the cost of operating and trading the securities and mutual funds. That number is approximately $100 billion a year; about $65 billion of mutual fund expenses, dollar expenses, multiply the weighted expense ratios of the funds times the assets. It is not a complicated calculation. The other $35 billion more or less, probably more, can be made up of portfolio turnover costs, sales charges, and out-of-pocket costs. So every year American investors as a group lose to the returns of the stock market by $100 billion a year. That is a staggering cost, a huge cost over time.
    So the way to get them aware of that is to give them their expenses and also to have somebody stand up and look at those expenses, in this case the board of Directors, and say, whoa, this has gotten out of hand; we should not be costing investors; all the fund Directors together, $100 billion a year, it is too much. We could run this industry on half that. That is why Vanguard's expense ratio is so much lower than everybody else, because so many of those items are minimized.
    So it is a staggeringly large number and gives some idea of the dimension of what we have to get across to the investors relative to the tiny cost of some of these improvements.
    Chairman BAKER. Any response to that?
    Mr. HAAGA. I would just say, supporting Mr. Kanjorski's argument, we did not make a big deal about the cost of the individualized expense disclosure because it also happens that the cheaper solution is the better solution; the thing that costs a lot of money is the thing that destroys comparability, and we think comparability is very important. So that is why we did not argue. But I absolutely support that we need to have a very thorough cost-benefit analysis of any regulation that the SEC should pursue.
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    Chairman BAKER. Mr. Tiberi?
    Mr. TIBERI. Thank you, Mr. Chairman.
    Let me pursue this in a little bit different tack. As a former realtor, when I negotiated with a client for their services, I negotiated and disclosed a percentage that I would charge them. And then when I was successful in selling their house, I would then be forced to disclose to the client, to the world, how much I charged for my services.
    Ms. Hobson, you made a passionate case that was very coherent on peanut butter. Can you tell me why or what would be the reason that you would oppose, if you would oppose, maybe you would support, some sort of simplified fee disclosure in actual dollars to me as your client, the cost of me investing with your fund?
    Ms. HOBSON. I can answer that question in two ways. I in no way oppose people knowing what they are paying. It is like that saying with the commercial on TV, it is all in there, the one with the spaghetti sauce. In this situation, the fees are stated very prominently in the first pages of the prospectus.
    Mr. TIBERI. In actual dollars?
    Ms. HOBSON. They are actually stated. They say, if it is a fund, Ariel Fund, that this fund costs 1.25 percent a year. If you invested $1,000, you will pay $12.50, and then it states what that will be for three years, and it will state what that estimate will be for five years. That information is there. I am for anything that helps educate the investor, because long term, that means they will understand what they have bought and stick with it, and I want our customers to stick with us. So anything that helps educate them, I am absolutely for.
    Mr. TIBERI. I have not seen very nice prospectuses. I have seen wonderful annual reports. Would you be opposed to putting that in an annual report or putting that in quarterly or semi-annual statements?
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    Ms. HOBSON. We have said we are not opposed to moving that information to another document. The question is how personalized that information gets, where it becomes onerous for mutual fund companies, particularly smaller companies like ourselves, to be able to provide that information.
    Ultimately for me, the question that I am asking myself, when mom and pop are sitting at the kitchen table making their fund choice investment decisions, either for their 401(k) plan, their retirement, or Susie's college education, is this information materially helping them to make a better investment decisions? That is the critical issue for me.
    Mr. TIBERI. I agree. The interesting thing is, and I would like Mr. Haaga to maybe talk about this, I got into a discussion at church, maybe that is why you should answer this, on Sunday with a group of individuals who are discussing with me the fact that mutual fund fees only came out of profit. I tried to tell them that was not the case. They argued with me that it was the case.
    I think it goes to the point of disclosure, again, that these mutual fund investors happen to believe because of maybe a lack of information or a lack of detail, that on their monthly statements there wasn't anything like that. Can you expand on that?
    Mr. HAAGA. Actually, that is a really good point. I would like to comment a little bit if I could first on the realtor example, because the GAO also had some examples. We are using the terms ''fees and expenses'' interchangeably here. Mutual funds charge both. If it is a fee, it is paid by the shareholder. So when we charge you a sales charge, you get the exact dollars, you get it on the confirm, you know exactly what you paid, and you paid it, so we can tell you that. That is the one that is analogous to a realtor and that is the one where we disclose exactly the same as you do, just as quickly and just as accurately.
    What we are arguing about here is how to disclose operating expenses of the fund that fluctuates and are really borne indirectly by the shareholder because they are taken out of, as you said, returns, if there are returns, and assets if there aren't returns, but they are basically taken out of the returns. They end up affecting the value of the account, even though they are not paid directly. That is the thing that is hard to disclose and hard to be exact about because they are indirect.
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    Mr. TIBERI. Mr. Bogle, do you have a view on that at all?
    Mr. BOGLE. Help me out with the original question.
    Mr. TIBERI. Do you have a view on the cost of personalizing expenses?
    Mr. BOGLE. Yes, I think it is something that should absolutely be done, and I think the cost is trivial.
    Mr. TIBERI. The cost to the fund?
    Mr. BOGLE. The cost to the funds would be trivial if you do it the simple way. There is a complicated way of doing it, you know, trying to go back and show how many shares he owned each day when he goes in and out of the fund. But all you have to do is take the year-end value and multiply it by the expense ratio of the previous year, and it is a simple one extra line or two extra lines in the statement.
    Mr. TIBERI. And you don't believe it will be onerous to a small mom-and-pop shop like Ms. Hobson's?
    Mr. BOGLE. It is a simple shareholder statement. It is a line on the shareholder statement. It is not complicated. I don't know why it gets portrayed as being complicated. I think we ask the wrong question to give a simple answer. I think it would be very helpful, particularly to the investor, particularly in the money market example I gave where the cost in money markets are today consuming something like 80 percent of the return on money market funds.
    Mr. HAAGA. Jack, you say it would be free. When we did the cost study, the cost of doing the estimate that you describe was 90 percent of the cost of doing the exact thing. What you are saying is ''free,'' just is not free. It is 90 percent of the original cost.
    Mr. BOGLE. And how do you define that original cost?
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    Mr. HAAGA. It is the cost of programming at brokers and all the intermediaries to provide information and then following through on it to provide information. We will show you the study.
    Mr. BOGLE. I am very dubious that the simple thing and the way I am talking about doing it would cost that much, but we will take a look at it.
    Mr. TIBERI. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Tiberi.
    Mr. Royce?
    Mr. ROYCE. Thank you, Mr. Chairman.
    Just to allow you each to recap in terms of how you feel about the SEC proposal and why their proposal to disclose fees in a shareholder report is better than or worse than disclosing these costs on an individualized basis, I would like to ask you that. In terms of disclosing the operating expenses, getting back to Mellody's example of the peanut butter, I just wanted to make the observation that probably the government should impose how much of the cost of that peanut butter is a component of our policy of not allowing anybody to grow peanuts unless you had a farm in 1933.
    In other words, there are government-imposed costs in all of this, too. Mr. Kanjorski's point, you know, do we mandate the government-imposed costs on some of these. There are consequences, but we also have evidence here that in this case the government-imposed cost would be very minimal. So maybe we can just kind of sum up with your views. Which approach, the SEC or the Chairman of the committee's bill, and why?
    Mr. BOGLE. I opt for the individual cost disclosure, the number of dollars the investor pays, because it brings home costs relative to the value of his account.
    Mr. ROYCE. But you say this is yearly. As I understand the SEC proposal and the Chairman's bill, wouldn't it presume that it was semi-annual?
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    Mr. BOGLE. Honestly, I don't have a strong opinion between semi-annual, quarterly and annual. I think any one of those is pretty much the same thing.
    Mr. ROYCE. Yes.
    Mr. BOGLE. I think it will bring home the cost to the shareholder in a way that he can compare it to the income the fund has earned. He can compare to the profits he got from the fund. He can compare it with the electric utility bill. He has got to understand it is costing him money. Anytime someone compares dealing with people's financial futures with peanut butter or toothpaste or beer or anything else, the financial service that we provide investors is basically a sacred trust to the investors. It is not a consumer product.
    As in the $100 billion that I mentioned, cost means everything in terms of those returns and we have to make people aware of it. We have to make boards stand up and defend fund shareholders against the interests of the management company which conflict with that. So we need to do this whole program of greater independence.
    I believe an independent Chairman is crucial. And much better cost disclosure, and I would add cost disclosure not only in the shareholder statement, but cost disclosure of all the items that the management company spends its money on, including its profits, are the right of a shareholder to know. Mr. Haaga said that his Directors already know that. Well, his Directors are there to represent the shareholders, so I don't see that it is but one small step.
    Mr. ROYCE. And you are going to take a look, you said, at Mr. Haaga's study if he offers that, to see if that $300 million cost is in your estimate a wild estimation.
    Mr. BOGLE. We work directly with investors. We do not have broker-dealers out there selling our funds. We are a no-load fund group and people come to us. We don't take it through the broker level, so it is probably a little bit easier for us.
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    Mr. ROYCE. That is one of the concerns here. You have a certain methodology that you have developed and they do have a different means, a different way of providing products that are more individualized. As a consequence, I guess you would grant that there might be additional costs in that.
    Mr. BOGLE. Somebody testified that the cost was .000038 or something. I may have gotten a zero wrong.
    Mr. ROYCE. Yes.
    Mr. BOGLE. But fairly trivial in light of the assets of the industry, although I don't think we should be throwing money away on costs. When you realize the profitability of the management company and the management company's net profits in this business after they take the net fees, they take the advisory fees they get, and subtract their expenses and make a net profit that I estimate to be something like $25 billion, I don't think it is a serious cost relative to that profit.
    Mr. ROYCE. One of the comments that I think I heard Fed Chairman Greenspan once make is that there is a tremendous benefit in terms of where someone has specific expertise and can engineer above-average returns. In terms of the results for the overall economy, this is one of the reasons the United States presumably does so well. But you essentially debunk that thesis. Your argument is that over the long haul, no matter how good the expertise, these funds don't necessarily out-perform the market.
    Go ahead. I will let you state your position.
    Mr. BOGLE. I would agree with something even more profound than that.
    Mr. ROYCE. Yes?
    Mr. BOGLE. I would argue it is not just over the long haul, it is every single day, absolutely. That is to say, investors fall behind the return of the market by the amount of the cost of our system of financial intermediation. This is not an arguable proposition. So investors lose to the market, investors as a group, not just fund investors, by roughly $1 billion a day. That is a simple fact. So it is daily. It does not always show up, and we look at returns of funds that are unweighed and all that kind of thing, but for every good adviser who is buying all the right stocks, there is a bad advisor who is selling the stocks to him.
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    It is a closed system. One investor's gain is another investor's loss. It has nothing to do with the expertise of a brain surgeon. I have an expert over here; he is going to be good for a while, someone else is going to be bad. But within the system, it is gross return on the market, the amount of financial intermediation costs taken out is the net return investors get. For that, there is no argument.
    Mr. ROYCE. Can we have a response? Paul or Mellody?
    Mr. HAAGA. Let me start. I would like to point out the irony of Jack waving off three-tenths of a basis point as irrelevant. If we had proposed to raise our fees by three-tenths of a basis point, I am sure he would have strung it out 25 years, present valued it, and made it into a big number.
    Mr. BOGLE. I think the number was three one-hundredths of a basis point.
    Mr. HAAGA. Well, even three one-hundredths.
    Mr. BOGLE. Maybe it was three one-thousandth.
    Mr. HAAGA. First of all, the question was posed as a preference for the SEC approach or the Chairman's bill. It is a matter of interpretation, but I think the Chairman's bill accommodates the SEC's approach. It depends on how you read the words ''each shareholder.'' So they may not be incompatible, and therefore it may not be something you have to decide between the two.
    Mr. ROYCE. The Chairman's bill would also ostensibly allow Jack's interpretation.
    Mr. HAAGA. It could. We just have to clarify that. I just wanted to point out that they are not necessarily inconsistent.
    I think what we have here is a trade-off. The more specific you get with the exact dollar amount of the shareholder's fees or expenses, the less comparability you have and the more it costs. I think what we need to do is look for a compromise here. We think the happy medium here is the SEC's approach that does use the standardized amount. People can interpolate from that what their exact cost is; saving them from the interpolation costs the industry and ultimately shareholders a lot of money, and worse than that destroys comparability. That is really our position. There are two problems. If it were only three one-hundredths of a basis point and it were better, we would be in favor of it. It happens to be three one-hundredths or some number of basis points and it is worse. That is why we are arguing against it because we think it goes too far in the direction of exactitude and gives up on the other two considerations.
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    Ms. HOBSON. The other thing to note is just to underscore Mr. Bogle noted that in the Vanguard situation specifically, they do not have the intermediary concern that perhaps lots of other fund companies have who distribute their funds through others. In the situation of Ariel where we have $3.7 billion under management and about 100,000 shareholders, we have over 2,000 selling agreements with different distributors around the country.
    So this isn't us just flicking a switch to change how we send out a statement. There is a lot of interface that would have to occur, not only at the individual levels of those distributors, but also in our own organization, which is where these costs are meaningful.
    And then the one other point that I don't want us to forget is that I strongly believe our interests, contrary to what others might think, are squarely aligned with those of our shareholders, because every single day our performance is in the newspaper. Every single day the expenses of our fund get deducted out of our performance and therefore affect our competitive standing.
    Portfolio managers in this business are very competitive and they understand to the extent that they out-perform, more investors will come, so we will grow. So to the extent that we do well for our investors, we will grow. So it does put us at odds with them. When any fee discussion comes up in our board room, I can tell you the first person who is the most concerned is the portfolio manager who knows he has to give up performance for that.
    Mr. ROYCE. Thank you.
    Mr. BULLARD. May I add something to that? I am concerned about the disclosure of actual dollar amounts, but to some extent this discussion is making me more concerned that the bill will be viewed as being about that, when at least in my mind there are more significant aspects of the bill that will have a much greater, more positive impact. One of those that is being overlooked is the fact that the simple number, the expense ratio, that if any investor looks at anything other than performance, will be what they look at, does not include all the expenses of funds.
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    In fact, the SEC report shows us that portfolio transaction costs can be a substantial part of fund expenses. It varies across different funds. It depends on their strategies, and that is not being shown to investors. They are prevented effectively from consuming that information. It dampens price competition. The day you include commissions, for example, in expense ratios, I believe you would see a substantial reduction in the amount of turnover in funds portfolios.
    Mr. ROYCE. Thank you.
    Mr. Chairman, thank you for this hearing and for your leadership on so many issues in this Congress.
    Chairman BAKER. I thank the gentleman for his kind remarks.
    I want to express my appreciation to each of you. Our goal here is not to bring about unwarranted, unneeded regulatory burdens. That helps no one. It is adding simply to the expense bottom line. We do, however, want to examine the way in which information is delivered to investors. Ultimately, an enhanced disclosure regime will bring investors back to the market in greater number and both perspectives can win.
    We don't yet have a perfect remedy, but in our business we have timelines and we will have to act at some point. So I encourage each of you in further written comments if you so choose to get it to the committee's attention within the next couple of weeks. We would be most appreciative.
    If there are no further comments, then we stand adjourned.
    Thank you very much.
    [Whereupon, at 1:15 p.m., the subcommittee was adjourned.]