Welcome to the strange world of mutual funds. The trading scandal spreading through the $7 trillion industry is revealing more than just trading abuses that enriched insiders and big investors at the small fry's expense. It's also shining a spotlight on fundamental weaknesses in the way mutual funds are governed. In case after case, fund boards were totally in the dark about the extent or even existence of abuses. The boards' failure to protect investors was so complete, says Senator Peter G. Fitzgerald (R-Ill.), that "it's time for a wholesale reorganization. [Fund boards] are a study in institutionalized conflicts that have cost investors dearly."SOME 95 MILLION Americans own mutual funds, but maybe 0.1% of them understand the industry's antiquated set-up. Under a 1940 law, each fund is a separate company -- but it's essentially a shell, with directors but no employees. The fund board contracts out for all key services, from stock-picking to record-keeping. In theory, the board can choose any adviser, but in reality, a fund company usually sets up a fund, appoints a board, and the board then hires the management company that founded the fund: Fidelity Investments, for example, manages all 343 of the Fidelity funds.
In other words, the board is at the adviser's mercy: It has no independent information on operations and little authority. An unhappy board could fire its adviser. But that rarely happens, partly because most directors have ties to the adviser. Plus, shareholders who bought, say, a Fidelity fund would probably balk if T. Rowe Price stock-pickers were suddenly in charge. The upshot: Boards lack the will and clout to watch out for investors' interests.
So far, regulators are discussing reforming the existing structure. Representative Richard H. Baker (R-La.) wants to require that two-thirds of directors and the fund chairman be independent of the adviser. The Securities & Exchange Commission may force funds to have compliance officers report directly to boards. New York Attorney General Eliot Spitzer, whose testimony before Congress on Nov. 3 unveiled a litany of trading abuses, wants to require any fund that settles trading charges to shop around for advisers each year.
But fine-tuning won't turn boards into the guardians investors need. To retool fund governance to fit the reality of what the industry has become, Congress should scrap the fiction that each fund is a separate company. Instead, funds should be folded into the management company -- and funds and advisers should be under the authority of one board. That would give directors authority over managers, with the information, muscle, and responsibility to watch out for investors' interests.THERE'S ALREADY a model for a combined company: Vanguard Group Inc. Vanguard funds share a common board. More importantly, they own the investment manager, which operates at cost. Not only do Vanguard funds run more cheaply than rivals, but their directors are accountable only to shareholders of the funds, which jointly own Vanguard Group. "If regulators could start over today, they'd probably get close to the Vanguard model," says Jonathan F. Zeschin, president of Denver-based Essential Advisors Inc.
Another promising model: treat mutual funds as investment products rather than companies, just as banks sell accounts and insurers sell policies. "It might make sense to permit funds to structure themselves the way people actually think of them -- as services bought based on performance and cost," says Steven M.H. Wallman, a former SEC commissioner who is now CEO of brokerage FOLIOfn Inc. For this to work, funds must be required to reveal more, Wallman says, so that investors could shop based on more accurate fees and returns.
As scandal after scandal reveals the funds' conflicts of interest, the industry faces its biggest shakeup since 1940. But Congress and the SEC shouldn't just patch over current flaws. It's time to go back to the drawing board and design a mutual-fund industry for today's markets and investors. By Amy Borrus and Paula Dwyer