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Investor Alert: Be On Guard Against Inappropriate Pitches

By Werner Renberg

Your mutual fund portfolio may have been performing about as well as you could have realistically expected -- if not better. It may even have been demonstrating relative stability in this volatile year. 

But this is no time to let your guard down. Not because you -- and other investors -- may be surprised any day by the stock market, the Federal Reserve, the President, Congress, the Organization of Petroleum Exporting Countries, or somebody you never heard of. But because you may be vulnerable to a tempting pitch by some mutual fund sales person or sponsor for a fund that may be inappropriate for you, to an exaggerated performance claim, or to a costly practice that you should be questioning. 

Their likelihood was raised a few days ago by Paul F. Roye, director of the Securities and Exchange Commission’s Division of Investment Management, in a talk at the Mutual Funds and Investment Management Conference, an annual gathering of fund industry lawyers, in Palm Desert, CA. The possibility of inappropriate promotion was also addressed by Matthew P. Fink, president of the Investment Company Institute, the conference’s other keynote speaker, who strongly urged ICI members to refrain from -- and to oppose -- such practices. 

Slower mutual fund industry share sales -- due to “many competitors… aggressively questioning the benefits of mutual fund ownership and…trying to lure fund investors with new products” and to “broker-dealers…offering…accounts with asset-based fees…and developing (competing) products” -- have led to intensified competition among fund companies for slices of the fund market, Roye observed. As a result, he has become concerned by several things, primarily three: 

* New funds: “To stay competitive, mutual fund companies are starting to create and market new types of funds,” he said. “We are seeing an increasing number of Internet funds, tax-managed funds, market-neutral funds, and stable-value funds. We may also be seeing a revival of the fund of funds…our Disclosure office is seeing new funds with some rather creative investment philosophies. “Some funds offer novel benefits to their investors, others merely gimmicks.” They seem to be characterized, he added, more by “clever marketing appeal” than by “sound investment principles (or) real financial benefits and value.” 

* Redemption fees -- Last year’s slow-down in net sales of mutual fund shares (including reinvested distributions) -- they dropped 15 percent from $581 billion in 1998 to a still hefty $493 billion, according to the ICI -- “may be increasing pressure to hold onto fund assets” by the imposition of excessive redemption fees, Roye said. (Total 1999 sales were over $9.0 trillion; total redemptions, over $8.5 trillion.) Inasmuch as the key feature differentiating mutual funds from other investment companies is the right of investors to redeem their shares at any time -- as provided by the Investment Company Act of 1940 -- an excessive redemption fee could raise a question as to whether a fund complies with the law. “The SEC staff has taken the position that a fund may impose a redemption fee of up to 2 percent without raising the redeemability issue, if the fee is reasonably intended to compensate the fund for expenses directly related to the redemption of fund shares,” he explained. “Redemption fees should not be imposed at a level that imposes a penalty on an investor’s ability to redeem out of a fund.” 

* Advertising -- The SEC’s top fund cop expressed a “fear” that fund competition may result in “overly aggressive advertising.” “A number of funds achieved extraordinary triple digit returns in 1999,” Roye said. “Few investment professionals, including the fund managers who achieved these returns, believe that these numbers are sustainable. “Advertisements that lead investors to expect these returns are at best opportunistic; at most, they are misleading.” At the request of SEC Chairman Arthur Levitt, he reported, the SEC staff is conducting a special review of fund marketing, including websites, sales literature, and advertisements to determine whether fund performance and strategies are consistent with website statements, advertising, and prospectus disclosure. “…we will not tolerate the misuse of performance information to mislead investors,” Roye declared. 

In his customary role of reminding industry members to remain “true to the tradition of integrity that each of us is heir to,” ICI President Fink focused on “our continuing effort to do what we can to make sure (investor expectations) reflect time-tested and enduring principles." Taking a position similar to Roye’s, he said, “…our commitment to the spirit of the (1940) act requires that we consider how our marketing efforts can contribute to the future expectations of some investors…We again urge investors to keep recent market performance -- including the triple-digit performance of some mutual funds in 1999 -- in historical perspective.” 

In support of its position, Fink reported, the ICI has “taken the initiative of suggesting to the NASD that they consider providing additional guidance to mutual funds with respect to the use of past performance figures in advertising and sales material.” (The National Association of Securities Dealers, or NASD, is a Congressionally authorized self-regulatory organization, which has principal responsibility for reviewing fund advertising.) “We must be the fiercest critics of our own practices and never hesitate to adopt voluntary best practices that exceed legal requirements whenever needed,” he declared. “…we must put aside individual differences to work for the common good.” 

As you read, watch, and listen to fund advertisements, scan promotional literature, and hear sales pitches in coming weeks, you will be well served by remembering Roye’s and Fink’s admonitions to fund industry lawyers.

Copyright © 2000 Werner Renberg. Reprinted with permission.