As director of the Securities and Exchange Commission's division of investment management, Barry P. Barbash is the mutual fund industry's chief regulator. So it is not surprising that his keynote address to an industry conference last month in Palm Desert, Calif., was heavily attended and much discussed. The excerpts below are the first installment in a three-part series that will appear in coming weeks.
An article in a major business publication recently put a troubling question to readers: "Is it time to sell your mutual fund?"
After reviewing events in the mutual fund area over the last year or two, the article concluded that the growth of mutual funds has spawned problems of such dimension that the very reasons investors have sought out these vehicles are now being called into question.
There has been no single crystallizing event or scandal to focus investor attention on the deficiencies of funds - just a growing number of mishaps and a slow, steady erosion of the credibility of many of the organizations that operate these vehicles.
To suggest, however, that mutual fund shareholders sell their shares and invest directly in financial instruments seems an impractical answer to the problems experienced by funds recently.
Mutual funds have become an integral part of the average American's savings and investment strategy, whether directly or indirectly through defined contribution employee benefit plans. In 1980, one out of 16 American households owned mutual funds, and today it's one out of four. The current level of aggregate mutual fund assets rivals the deposits of commercial banks.
Changing the fundamental operations of funds through legislation or regulation also does not seem to be the answer to the recent problems of funds. The basic operation of mutual funds has not changed over the years, and it does not seem to be inherently flawed.
To be sure, the types of instruments in which many funds invest today are more complicated and potentially more confusing than the stocks and bonds in which they invested 25 to 30 years ago. But the problems presented by derivatives, for example, are essentially no different for mutual funds than they are for other institutional investors.
So what then is the solution to the recent difficulties of mutual funds? The answer requires a closer focus on the problem.
The problem is not, I submit, that mutual funds can and do invest in sophisticated and volatile instruments, or that funds take too many risks. Nor is the problem how funds are operated or how they invest.
Rather, at the heart of the recent difficulties is how mutual funds are sold to investors.
A report issued last fall by the North American Securities Administrators Association concluded on the basis of a survey of 44 states and the District of Columbia that the greatest area of concern regarding investor protection in the fund area is the oral presentation made by a selling agent to an investor.
While there were very few complaints regarding the completeness or accuracy of prospectus disclosure or printed advertising, nearly one-third of all complaints involved some allegation by the investor of misrepresentation on the part of the agent.
Among the types of misrepresentation cited in the report were misstatements about the safety of principal of government bond funds and promises of specified levels of performance by certain other funds. Investors also complained about being misinformed about sales loads.
A recent commentary by Morningstar Inc. echoed concerns about mutual fund selling practices. The commentary noted that during 1994, taxable fixed-income funds lost all of the assets they had gained in 1993 as well as a good portion of those they had gained in 1992.
Morningstar concluded that this trend was predictable and the result of questionable marketing practices. Rather than providing suitably diversified products and educating investors as to their virtues, fund companies sold highly concentrated sector funds as alternatives.
For a while, Morningstar said, this path proved rewarding. As long as interest rates trended down, savers had every reason to sign up for bond funds. CDs simply couldn't compete on a yield basis, and bond funds didn't demonstrate their dangers.
Unfortunately, by not taking the time to educate their new shareholders, bond funds didn't win these investors over for the long term. Instead, Morningstar concluded, they guaranteed that once CDs offered a competitive yield again and once the bond market fell apart, their clients would head back to their banks.
