Is the SEC Coming After High Cost Funds?

Last Updated Sep 24, 2010 3:24 PM EDT

The Securities and Exchange Commission's Head of Enforcement, Robert Khuzami, testified before the Senate Judiciary Committee last Wednesday. His appearance prompted little commentary or coverage, but buried deep within his written testimony was a paragraph that offers mutual fund investors reason for hope.

Earlier this year, the SEC formed a new Asset Management Unit as one of five new groups within the enforcement division that focus on particular areas of the securities industry. According to the SEC, the Asset Management Unit will "focus on investment companies, investment advisers, mutual funds, hedge funds, and private equity funds."
In his testimony, Khuzami said that the new unit has formed a Mutual Fund Fee Initiative, which will allow regulators to examine "the extent to which mutual fund advisers charge retail investors excessive fees."

Mutual fund fee levels have long been a target of reform. The Investment Company Act of 1940 -- which established the standards for regulating mutual fund firms -- states that mutual fund managers "have a fiduciary duty with respect to ... compensation," meaning that fees must be set with an eye on what's in the best interest of mutual fund investors, and not the managers who run them.

Enforcement of that standard was left to the courts. Unfortunately, until last year mutual fund investors had never prevailed in an excessive fee case, failing time and again to convince the courts that the fees they were paying were excessive.

The Supreme Court ultimately weighed in on the issue earlier this year, and I wrote about their ruling in Jones v. Harris Associates here.

While we're still awaiting the first court decision under the standards set by the Jones v. Harris Associates ruling, I'm not holding my breath in anticipation of a sea change in shareholders' success rates in these cases.

There's no denying that fund investors are making modest inroads in these cases. Indeed, I highlighted one such case against Citigroup Asset Management in March of this year. But the simple fact remains that precedence in these sorts of cases is so firmly set in favor of asset managers that even a lawsuit such as the one brought against Citigroup -- which would appear to be a slam-dunk case of managers enriching themselves at the expense of their fund investors -- causes surprise when investors prevail.

Given the reality that a) fund investors are not price-sensitive; and b) there's little market and even less legal/regulatory risk in pushing the fee envelope as far as possible, it should hardly be shocking that there's so little price competition in the mutual fund industry. Indeed, one can easily make the case that fund managers seeking to maximize their own return instead of that of their fund investors are simply responding to the incentives that have dominated the industry for decades.

Which is why the entrance of the SEC into this debate could mark a significant turning point. If the Commission uses it regulatory muscle to help determine just what is and what is not appropriate in terms of mutual fund fees, fund investors could -- for the first time -- find that they're fighting this battle on something approaching a level playing field.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.