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Mutual fund industry : hearings before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, House of Representatives, One Hundred Third Congress, first session, July 22 and August 5, 1993 (Volume Pt. 2) online

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MUTUAL FUND INDUSTRY (Part 2)

1 Y 4. EN 2/3: 103-169

flutual Fund Industry (Part 2)/ 103...

HEARING

BEFORE THE

SUBCOMMITTEE OX
TELECOMMUNICATIONS AND FINANCE

OF THE

COMMITTEE ON

ENERGY AND COMMERCE

HOUSE OP REPRESENTATIVES

ONE HUNDRED THIRD CONGRESS

SECOND SESSION



SEPTEMBER 27, 1994



Serial No. 103-169



Printed for the use of the Committee on Energy and Commerce







U.S. GOVERNMENT PRINTING OFFICE ^FTfc**

86 - »73CC WASHINGTON : 1995 *tyl

For sale by the IS. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington. DC 20402
ISBN 0-16-046871-X



1



MUTUAL FUND INDUSTRY (Part 2)

Y 4. EN 2/3: 103-169



Mutual Fund Industry, (Part 2), 103...

HEARING

BEFORE THE

SUBCOMMITTEE ON
TELECOMMUNICATIONS AND FINANCE

OF THE

COMMITTEE ON

ENERGY AND COMMERCE

HOUSE OP REPRESENTATIVES

ONE HUNDRED THIRD CONGRESS

SECOND SESSION



SEPTEMBER 27, 1994



Serial No. 103-169



Printed for the use of the Committee on Energy and Commerce



'°Sft»




U.S. GOVERNMENT PRINTING OFFICE ^fflTvT^r*

86-473CC WASHINGTON : 1995 ^WWfcl

For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office. Washington, DC 20402
ISBN 0-16-046871-X



COMMITTEE ON ENERGY AND COMMERCE



JOHN D. DINGELL, Michigan, Chairman



HENRY A. WAXMAN, California

PHILIP R. SHARP, Indiana

EDWARD J. MARKEY, Massachusetts

AL SWIFT, Washington

CARDISS COLLINS, Illinois

MIKE SYNAR, Oklahoma

W.J. "BILLY" TAUZIN, Louisiana

RON WYDEN, Oregon

RALPH M. HALL, Texas

BILL RICHARDSON, New Mexico

JIM SLATTERY, Kansas

JOHN BRYANT, Texas

RICK BOUCHER, Virginia

JIM COOPER, Tennessee

J. ROY ROWLAND, Georgia

THOMAS J. MANTON, New York

EDOLPHUS TOWNS, New York

GERRY E. STUDDS, Massachusetts

RICHARD H. LEHMAN, California

FRANK PALLONE, Jr., New Jersey

CRAIG A. WASHINGTON, Texas

LYNN SCHENK, California

SHERROD BROWN, Ohio

MIKE KREIDLER, Washington

MARJORIE MARGOLIES-MEZVINSKY,

Pennsylvania
BLANCHE M. LAMBERT, Arkansas

Alan J. Roth, Staff Director and Chief Counsel

Dennis B. Fitzgibbons, Deputy Staff Director

Margaret A Durbin, Minority Chief Counsel and Staff Director



CARLOS J. MOORHEAD, California

THOMAS J. BLILEY, Jr., Virginia

JACK FIELDS, Texas

MICHAEL G. OXLEY, Ohio

MICHAEL BILIRAKIS, Florida

DAN SCHAEFER, Colorado

JOE BARTON, Texas

ALEX MCMILLAN, North Carolina

J. DENNIS HASTERT, Illinois

FRED UPTON, Michigan

CLIFF STEARNS, Florida

BILL PAXON, New York

PAUL E. GILLMOR, Ohio

SCOTT KLUG, Wisconsin

GARY A. FRANKS, Connecticut

JAMES C. GREENWOOD, Pennsylvania

MICHAEL D. CRAPO, Idaho



Subcommittee on Telecommunications and Finance

EDWARD J. MARKEY, Massachusetts, Chairman



JACK FIELDS, Texas
THOMAS J. BLILEY, Jr., Virginia
MICHAEL G. OXLEY, Ohio
DAN SCHAEFER, Colorado
JOE BARTON, Texas
ALEX MCMILLAN, North Carolina
J. DENNIS HASTERT, Illinois
PAUL E. GILLMOR, Ohio
CARLOS J. MOORHEAD, California
(Ex Officio)



W.J. "BILLY" TAUZIN, Louisiana
RICK BOUCHER, Virginia
THOMAS J. MANTON, New York
RICHARD H. LEHMAN, California
LYNN SCHENK, California
MARJORIE MARGOLIES-MEZVINSKY,

Pennsylvania
MIKE SYNAR, Oklahoma
RON WYDEN, Oregon
RALPH M. HALL, Texas
BILL RICHARDSON, New Mexico
JIM SLATTERY, Kansas
JOHN BRYANT, Texas
JIM COOPER, Tennessee
JOHN D. DINGELL, Michigan

(Ex Officio)

Timothy J. Forde, Staff Director

Gayatri N. Bhalla, Legislative Assistant -Finance

Stephen A. Blumenthal, Minority Counsel

Peter D. Rich, Minority Counsel



(II)



CONTENTS



Page

Testimony of:

Levitt, Hon. Arthur, Chairman, Securities and Exchange Commission 5

Fink, Matthew, President, Investment Company Institute 39

Koppell, G. Oliver, Attorney General, State of New York 34

Phillips, Don, Publisher, Morningstar, Inc 52

Material submitted for the record by:

Levitt, Hon. Arthur, Chairman, Securities and Exchange Commission:
Letter dated September 26, 1994 to Hon. Edward J. Markey, enclos-
ing response for the record 71

(III)



MUTUAL FUND INDUSTRY



TUESDAY, SEPTEMBER 27, 1994

House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Telecommunications and Finance,

Washington, DC.

The subcommittee met, pursuant to notice, at 10 a.m., in room
2123, Rayburn House Office Building, Hon. Edward J. Markey
(chairman) presiding.

Mr. Markey. Good morning.

Today the subcommittee will address a number of issues of im-
portance to more than one out of four American families that have
invested part of their future in one of the Nation's 5,000 mutual
funds. The two reports submitted to the subcommittee today by the
SEC, one addressing mutual fund investments in derivatives, the
other addressing personal trading practices by portfolio managers,
confirm that these are complex and far-reaching issues.

The reports also leave no doubt that questions raised by these is-
sues need to be attended to promptly by the industry, by regulators
at the Securities and Exchange Commission and among the various
States, and in some cases by Congress.

But the significance of these issues and the intensity of the de-
bate about all of these issues is something that is going to com-
mand the ongoing attention of this committee. Also, it is important
for us to understand the relevance of these issues to the ongoing
well-being of the American economy, so there should not be any ob-
scuring of some equally important truths.

First, mutual funds remain the single sector of the financial serv-
ices industry that has escaped major systemic scandal. The indus-
try has its share of problems, but they are problems that have been
confronted openly and constructively.

Second, Chairman Levitt has repeatedly reaffirmed the SEC's
commitment to protecting the Nation's 40 million mutual fund in-
vestors, has made this objective one of the Agency's highest prior-
ities, and has been supported in these efforts by the fund industry
itself. While we are frustrated that we will have to wait for the
next Congress before making the SEC a self-funded Agency, we
should all be aware that in a time of tight budgets, Chairman
Levitt has succeeded in adding nearly 50 new inspectors to his mu-
tual fund team.

Third, the major reasons for investing in mutual funds — a diver-
sified portfolio, professional management, and for the most part,
relatively low costs — continue to make good sense to millions of
middle-income Americans. Although interest rates reversed course

(l)



in February of this year and pushed the stock market into a pro-
longed slump, Americans have continued to add nearly $400 mil-
lion to their annual fund investments every business day. While
this is less than half of the record pace that prevailed through
1993, it is still a staggering amount of money and is evidence of
the continuing trust and faith that investors have in a mode of in-
creasing family wealth that has quite successfully, now for a gen-
eration, gained the trust and confidence of investors within our
country.

The question of how to characterize this enormous industry fairly
and accurately, in light of the problems with derivatives and per-
sonal trading that have been so widely reported, reminds me of a
story about a shoe manufacturer who was searching for new mar-
kets to sell his products. He sent two salesmen to Australia to
evaluate the prospect of developing a market among the many ab-
original tribes of the country's spacious interior. The first salesman
returned home depressed. He said, "Our prospects are hopeless.
These people have never worn shoes." The second salesman re-
turned jubilant. "We must begin shipments immediately," he said.
"These people have never worn shoes."

Perspective is obviously important, and I believe that the wit-
nesses here today are well-positioned to help the subcommittee as-
sess the relevant issues fairly and accurately.

Much of today's hearing will focus on the serious practical prob-
lems that have arisen for those individuals and institutions which
have invested in mutual funds which, in turn, have invested heav-
ily in certain exotic derivatives. The situation is limited to a rel-
atively small number of funds — an important fact that no one
should overlook — but at those funds that do have derivatives, we
are going to have to, on an ongoing basis, now begin to make some
evaluation of whether or not there are safeguards, whether or not
there are problems.

In some instances, the outlook appears rather grim. These funds
are holding a substantial volume of instruments for which there is
no readily available market, a fact which makes the fund less liq-
uid, jeopardizes its ability to establish meaningful and reasonably
accurate daily prices and restricts its ability to respond to other
market developments.

While we attempt to work out the legal and regulatory issues
raised by these investments, others around the country are faced
with working out a different set of problems. Municipalities from
Texas to Ohio, from Charles County in neighboring Maryland to
the Pacific Coast, have lost money from derivatives, and in some
cases as a result of their investments in mutual funds. Colleges,
pension funds and even an Indian tribe have lost money because
of these investments.

For the larger losses, the consequences are painful and dramatic.
Schools and roads are not built, services are arbitrarily slashed,
and teachers are laid off.

Risk is, of course, an essential element of the investment process.
But as Don Phillips wrote in his prepared testimony: a sound regu-
latory regime must enable investors to reasonably identify and as-
sess the risks that they are taking.



Recent reports suggest that some of the descriptions of the risk
associated with mutual fund investments in derivatives are imped-
ing rather than facilitating this process. Three months ago, Con-
gressman Fields and I wrote a detailed letter to Chairman Levitt
raising a broad range of issues that related directly to the use of
derivatives by mutual funds. Among the key subjects addressed in
the letter, and to be discussed here today, were the following ques-
tions:

Does the SEC have adequate knowledge of rapidly changing in-
dustry practices?

Will better disclosure about derivatives and other risks be accom-
plished in a manner that makes a significant difference to average
investors?

Is intense competition in the fund industry leading some portfolio
managers to move risky derivatives into otherwise risk-averse
funds?

Are mutual funds experiencing problems pricing exotic deriva-
tives, and if so, what are the possible consequences for investors?

Today's hearing will also address the possible conflicts of interest
associated with the practice of personal trading by portfolio man-
agers and perhaps a few other questions as well.

The time for an opening statement by the Chair has expired.

I recognize the ranking Republican member, the gentleman from
Texas, Mr. Fields.

Mr. Fields. Thank you, Mr. Chairman.

Mr. Chairman, I commend you on calling this hearing on the use
of derivative instruments by mutual funds. This is the latest, per-
haps the last, hearing on derivatives this Congress, and it is time
to reflect on the testimony that has been presented to this sub-
committee on the issue.

It is clear that derivatives are now an integral part of the finan-
cial landscape. Derivatives have revolutionized financial manage-
ment and have increased the liquidity and efficiency of the mar-
kets.

They have also provided new means of hedging, frequently in
markets for which hedges were previously unavailable. Indeed, it
is arguable that a manager failing to use derivatives may be unnec-
essarily exposing his portfolio to losses that can be avoided.

As SEC Commissioner Carter Beese has noted, in most indus-
tries, management would not even consider a major business trans-
action without using risk-management techniques to hedge against
the danger of unexpected price or interest rate movements. The
same is true of mutual fund managers.

It is also clear that using derivatives is not without danger. And
the regulation of derivatives is evolving, as are the instruments
themselves, in an environment of global integration.

Consequently, it is unlikely that a single scheme of regulation
can be developed, as if in a laboratory, and then imposed on the
waiting industry. A better result will be obtained if financial enti-
ties like mutual funds are examined and what is appropriate regu-
lation of their use of derivatives is established by trial and error
over time. The free enterprise system is at work.



Money market funds, for example, are limited to investing pri-
marily in liquid instruments. Whether they are derivative instru-
ments or not is irrelevant. If full disclosure is made about what de-
rivatives fund managers use and how they use them, investors
should be free to accept or reject the additional risk that accom-
panies the opportunity for higher returns.

Indeed, it appears that some funds are discontinuing their use of
derivatives to satisfy the objections of concerned investors. Other
funds actively market themselves by highlighting their derivatives
expertise. This is as it should be, the free market is the best regu-
lator. And as Federal Reserve Governor Susan Phillips said re-
cently, a flexible regulatory regime is essential if we are to allow
market forces to efficiently allocate these resources.

Any regulatory system going beyond requiring disclosure may
produce an unfortunate side effect. It may create a public percep-
tion that the government is taking steps to guarantee the safety
and soundness of investments. Of course, this cannot be true.

Congress can legislate against fraud and manipulation but as we
cannot pass a law against bad weather, we cannot protect people
from the oscillations of the financial markets.

This subcommittee is familiar with the SEC study that concluded
a substantial percentage of investors in mutual funds believed they
are federally insured. Is it any wonder that investors believe their
principal is safe from loss when they read of an SEC statement
listing derivatives that are inappropriate for money market funds
to use?

When fund sponsors infuse capital into money markets to replen-
ish lost resources and maintain a dollar a share price, is it unrea-
sonable for investors to imply a guarantee against loss?

In these specific instances, I happen to agree with both of the ac-
tions. The SEC and the fund sponsors acted in good faith and
should be complimented on their investor protecting initiatives.

As this subcommittee continues its work on derivatives regula-
tion next year, however, we must address the long-term implica-
tions of overregulation and paternalistic approaches. Our efforts
must underscore the individual responsibilities of all parties to a
transaction. It begins with those who recommend derivatives as so-
lutions to financial problems.

The derivative investments of Odessa College in Texas that
helped fund the university's growing educational program over the
last 3 years by returning 11, 17, and 23 percent annually, did not
become unsuitable this year when they lost money. From press re-
ports it appears that all that changed was the quality of the uni-
versity investment officer's judgement and his decision to ignore a
fundamental precept of finance: "Don't put all your eggs in one bas-
ket." No amount of regulation will ever be a substitute for good
management.

Nor can any amount of regulation remove all the risk to cus-
tomers in these or any other financial transactions. Derivatives are
merely instruments used to shift risk between parties. All legisla-
tive and regulatory initiatives must point towards insuring that
parties to these transactions are given all the information they
need to understand the risk they are being asked to accept. The
only workable system of regulation is one in which the end users



of derivatives, ultimately, accept responsibility for the choice of in-
vestment vehicles used to obtain their financial goals.

Mr. Chairman, I commend you again for calling this series of
hearings. I look forward to the testimony of our distinguished pan-
els today. And yield back the balance of my time.

Mr. Markey. I thank the gentleman.

Do other members seek recognition for the purpose of making an
opening statement.

The Chair sees none.

We will then turn to our first witness, Hon. Arthur Levitt, the
distinguished Chairman of the SEC.

We welcome you back, Mr. Chairman. Whenever you are ready,
please begin.

STATEMENT OF HON. ARTHUR LEVITT, JR., CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION

Mr. Levitt. Chairman Markey and members of the subcommit-
tee, I appreciate the opportunity to testify on behalf of the SEC in
response to your concerns about the mutual fund industry, particu-
larly personal trading by fund portfolio managers as well as the
fund use of derivatives.

Mr. Chairman, I have come before you a number of times to talk
about the importance of investor protection. At the SEC, the inter-
ests of American investors guide our every decision. Safeguarding
these interests is not only our goal, it is the goal of everyone who
understands that investor confidence is what sustains our capital
markets in general and the mutual fund industry in particular. To
preserve that confidence, the industry must maintain the highest
standards of ethical conduct.

A few months ago those ethical standards were called into ques-
tion by reports that fund portfolio managers were actively trading
for their own accounts. Concerns were raised that portfolio man-
agers might be engaging in abusive trading practices such as front-
running — that is, conducting a personal securities transaction be-
fore that of a fund, with the expectation that the fund's transaction
will favorably affect the price of the securities.

We took those concerns seriously, as did the leaders of the mu-
tual fund industry. For our part, the staff of the Division of Invest-
ment Management conducted a special examination of 30 fund
groups. I am pleased today to announce some of their findings.

The staff concluded that, among the fund groups examined, the
vast majority of portfolio managers do not invest extensively for
their personal accounts. More than 40 percent of the managers sub-
ject to the examination engaged in no personal trading, while 75
percent engaged in very little. More than 90 percent of the portfolio
managers refrained from buying or selling securities ahead of their
funds, and almost all of the personal trading that was found took
place at a very, very small number of firms.

As the members of this subcommittee well know, we do not as
a matter of policy discuss specific firms that we are examining.
Nevertheless, I would like to assure you that we are using our in-
spection authority aggressively to make sure that those firms do
not tolerate abusive trading. If we do find abuses, we will not hesi-
tate to bring strong enforcement actions.



The low level of personal investing suggests that the regulatory
system already in place generally works well. Therefore, at this
time, we are advocating neither mandatory investment restrictions
nor a mandatory ban on personal investing. The Investment Com-
pany Institute's Advisory Group on Personal Investing has pro-
posed several voluntary measures that will help minimize the pos-
sibility of abusive trading. We applaud the ICI's efforts and urge
all funds to consider these proposals.

The staff will ask for the industry's response within 6 months,
and we very much hope and expect to see everyone on board by
then. We will work closely with the ICI to see to it that the maxi-
mum number of funds embrace the ICI's standards, which we be-
lieve to be minimal standards.

Although our own study didn't find a major problem, we did find
room for improvement. And with the popularity and importance of
mutual funds at historic levels, we are compelled to see that those
improvements are made. Our recommendations aren't going to sup-
plant those of the ICI Advisory Group but will complement them,
and in some instances, will amplify them.

Let me give you two brief examples: We are going to ask the
funds to disclose publicly their policies on personal trading. We
don't want personal investing to take place behind a shroud of se-
crecy. With disclosure of fund policies, investors can then decide
whether they want their money managed by someone who is also
trading for his or her own account.

We will also ask each fund's board of directors to review the
fund's code of ethics and compliance with that code annually. We
want to make sure the directors are the frontline of defense against
ethical problems. Our proposal would make it plain that they have
an obligation not only to promulgate a code of ethics, but also to
make sure that it is being obeyed. We believe that our proposals,
combined with self-regulation by the industry, are really sufficient
to address this situation.

Just last Friday, I met with several hundred directors of mutual
funds. I was impressed with their determination to protect the in-
dustry's reputation. They know that some 38 million Americans
have now entrusted their hard-earned savings to mutual funds.
They also know that investor confidence must be preserved. We be-
lieve that it will be.

I cannot emphasize strongly enough the role that I believe should
be assigned to independent directors of mutual funds. They must
take a more active interest in what is being done at the funds.
They must understand the policies of the funds in terms of overall
direction and investment strategies. I have asked my fellow Com-
missioners, along with me, to meet with individual groups of direc-
tors, independent directors all over the country, to convey a mes-
sage that we have been conveying to these boards for the past 9
months.

I now turn to mutual fund use of derivatives. I appreciate the
subcommittee's attention to this issue, which has such serious
ramifications for investor protection.

Derivatives have received a great deal of attention in recent
months. But I believe that no issue related to derivatives is more
important than the one we address today. When we talk about de-



rivatives in the context of mutual funds, we are not speaking just
about some abstract financial instrument. We are talking about the
lives of real people who rely on their investments to send their kids
to college, to retire with dignity, in short, to fund both their dreams
and their necessities.

The Commission has, I believe, a special responsibility to protect
these investors who in many instances have taken their funds from
the safety of bank deposits and certificates of deposit and because
of a change in interest rates have moved them into mutual funds.
I think we have a greater universe of relatively unsophisticated in-
vestors today than ever before in the history of our markets.

Mutual funds use derivative products for a wide variety of pur-
poses. Derivatives can increase returns to mutual fund investors
and can also reduce their risks. Like any market instrument, de-
rivatives can also increase risks and lead to significant losses. Un-
fortunately, in recent months we have seen some pretty dramatic
instances of the latter.

I have long believed that the Commission faces two very special
challenges with respect to derivatives: First, I think we have to im-
prove the manner in which mutual funds communicate with their
investors about derivatives, in particular how they convey an un-
derstanding of what risks are entailed. Second, the Commission
must ensure that mutual funds manage their derivative risks as
carefully as possible.

Many derivatives are novel and complex instruments that are
not well-understood even by some so-called experts, not to mention
the average mutual fund investor. The Commission, however, will
not accept novelty and complexity as an excuse for poor commu-
nication with investors. Without exception, mutual funds must
clearly communicate to investors both how they use derivatives and
the effect that derivatives have on fund return and fund risk.

Improving disclosure to investors is one of the Commission's
most fundamental charges, and we take it seriously. We are work-
ing harder than ever to ensure the adequacy of mutual fund deriv-
ative disclosure. The Commission has encouraged funds to enhance
investor understanding of risk. As we review fund prospectuses, we
continually work to improve derivative disclosure. But the Commis-


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Online LibraryUnited States. Congress. House. Committee on EnergMutual fund industry : hearings before the Subcommittee on Telecommunications and Finance of the Committee on Energy and Commerce, House of Representatives, One Hundred Third Congress, first session, July 22 and August 5, 1993 (Volume Pt. 2) → online text (page 1 of 23)