Testimony of Edward A.H. Siedle, President, Benchmark Financial Services, Inc.
Before the
Committee on Banking, Housing and Urban Affairs, United States Senate, March 31, 2004
Chairman Shelby, Ranking Member Sarbanes, members of the Committee, thank you for the opportunity to appear before you today to discuss the crisis in confidence in the mutual fund industry. It is an honor and privilege to appear before the Committee today.
I am the founder and President of Benchmark Financial Services, Inc., a firm that investigates money management abuses primarily on behalf of public pension funds. The matters we examine typically involve esoteric breaches of fiduciary duty by brokers, money managers (many of whom manage mutual funds) and pension consultants.
Years ago I was referred to in the Press as the "Sam Spade of money management" and unfortunately the name has stuck in the minds of those in the industry. I have also been called "the nation's most vocal critic of money management abuses."
I began my career as an attorney in the Division of Investment Management of the SEC in 1983 and subsequently served as Associate Counsel and Director of Compliance of Putnam Investments. The difficult investigation I initiated regarding personal trading violations by portfolio managers at Putnam in the late 1980s was the first such investigation publicly reported. That investigation, which has been the subject of numerous articles, forewarned of the problems Putnam is facing today -- some 15 years later.
From 1990 through 1997 I owned brokerage firms that offered "soft dollar" trading services to pensions and money managers. In the mid-90s I suggested the SEC examine the role "soft dollar" brokers played in encouraging "soft dollar" abuses. As a former SEC attorney, I was aware that many of firms were offering to "soft dollar" anything from condos in Colorado to office rent bills. The unprecedented "sweep" of "soft dollar" brokerages the Commission undertook at that time put brokers on notice that they too could be held liable for facilitating "soft dollar" abuses.
Over the past 10 years I have written and spoke about unethical and illegal activity in the mutual fund industry. I have periodically urged the FBI and the SEC to actively pursue those involved in money management and mutual fund wrongdoing. It is a very real pleasure to have endured in the industry long enough to witness the dawn of an era of public scrutiny of mutual fund practices.
I can tell you from experience, that breaches of fiduciary duty by money managers, which may involve esoteric business practices, are difficult to prove, and lack precedent, result in significant, quantifiable harm to investors. For example, we have seen that a multi-billion pension may quietly lose an amount equal to 15% of its value over time when a fiduciary neglects to act in the best interests of the fund and instead engages in self-dealing.
Given the trillions in mutual funds and the unethical and illegal activity in the mutual fund industry I am aware of, I suspect that mutual fund adviser malfeasance has cost the nation's investors in excess of $1 trillion. That is, $1 trillion that might be in investors' savings accounts available for their retirement or other purposes is not.
Time and again I hear their stories: The 70 plus year olds who, in my native state of Florida, are spending their golden years bagging food at the neighborhood supermarket because their Social Security check is not enough to live on and their savings have been depleted. Middle age investors who have seen their IRA or 401k accounts shrink or disappear and have to begin saving for their retirement again. They all trusted the mutual fund industry. It is tragic and it's going to become a national crisis as the baby boom generation reaches retirement age without adequate funds. Who will pay the bill? Who is to blame? Where did the money go?
In 2003, the nation's 95 million mutual fund investors began learning of the pervasiveness of unethical behavior in the mutual fund industry. Twenty years after the mutual fund boom began, fueled by 401(k), IRA, and other legislation, the masses, got their first glimpse of the games money managers have been playing with their money.
It is not surprising that the first generation of Americans to hire professional money managers en masse should eventually learn that there is a dark side to this industry.
Investors have been disappointed with the results their professional managers have delivered over the years and have grown tired of perpetually chasing, yet somehow never obtaining, the stellar returns advertised by funds. Many have asked themselves what were they doing wrong.
In 2003, investors discovered they were not solely to blame for the poor investment results they experienced. Investors gained insight into how the mutual fund industry has been skimming money from their accounts.
The harm to investors related to the mutual fund industry's betrayal of trust is staggering. How big is the price tag?
A. It is clear that well over 50% of the hundreds of billions in mutual fund investment advisory fees investors have paid over the years are excessive.
Our 2003 survey of the investment advisory fees paid by pensions indicates that the pricing of institutional investment advisory services is somewhat irrational. Yes, even some institutions pay excessive money management fees. We have found that some pensions are actually paying as much as four times the fees as others for the same services. "Most favored nation's" clauses inserted into the contracts pensions have with their managers which are designed to assure that pensions receive the lowest fees managers offer, generally result in only illusory protection. Our conclusion was that pensions needed to be more informed regarding fees, negotiate more vigorously and carefully draft "most favored nation's" provisions for inclusion in their contracts with managers.
As bad as the news is about pension investment advisory fees, for mutual fund investors it's exponentially worse. Mutual funds frequently pay ten times what pensions pay for the same services. There is simply no good reason for these excessive fees.
Mutual fund management fees are excessive simply because mutual fund boards have utterly failed to fulfill their fiduciary duties related to negotiating fees with managers. And the nation's mutual fund investors are paying the price.
Use of "most favored nation's" clauses alone could radically reduce the fees funds pay. Yet I am unaware that any of the prestigious boards of the many mutual funds out there has demanded such a protection.
Keep in mind that the excessive investment advisory fees mutual fund managers charge enables them to comfortably enter into "revenue sharing" arrangements involving billions that assist in marketing funds. That is, fat fees serve a marketing purpose-they're "bonus money" that can be shared with brokers who agree to push the fund.
B. Mutual fund brokerage commission rates related to portfolio trading are twice what they should be and are intentionally kept high by managers primarily in order to compensate brokers selling fund shares.
I'll never forget the first meeting at a fund complex I attended where the subject of brokerage commissions for the upcoming year was discussed. I asked, "Shouldn't we negotiate commissions downward slightly each year as trading volume grows," and I was told, "If we push the brokers too hard, they'll stop selling our funds." The goal wasn't to get the best deal for shareholders -- it was to keep the brokers selling the fund happy.
C. In addition to widespread use of commissions for marketing, manager use of commissions to purchase on a "soft dollar" basis investment research they would otherwise have to pay for themselves is unjustified. If managers are already being paid an advisory fee, why should they be permitted to dip into client funds to pay for research they use in connection with managing client portfolios?
Astute pensions may include a provision prohibiting "soft dollars" in the contracts they have with money managers. It's simple enough to do. Yet mutual fund boards have failed to take such simple steps to protect funds against such abuses.
Another approach some pensions employ is to include "soft dollar" amounts in fees when comparing manager fees since "soft dollar" amounts are, in reality, another form of manager compensation.
As a result of using client commissions for marketing and research managers are enriched beyond the hefty advisory fees mutual funds pay. Billions of dollars in client commissions are being used to further the business interests of mutual fund managers.
While "soft dollaring" may sound ugly, use of commissions for marketing involves far greater amounts of shareholder funds. Since use of commissions for marketing is so pervasive, prohibiting such usage will require many mutual fund complexes to development new distribution techniques or lose market share. However, mutual fund investors will benefit far more from such a prohibition than from banning "soft dollars."
D. Another improper use of client assets involves payments from funds to the ICI, the industry lobby group. Contrary to what the ICI would have investors believe, it does not represent the interests of mutual fund investors and investors do not benefit in any way from the ICI receiving their money.
Legislation prohibiting payments to this industry lobby group is long overdue. And I believe the SEC should prohibit the ICI from representing to the public that it represents the nation's mutual fund investors. It's misleading and harmful to those investor who rely upon the ICI for investment advice.
Mutual funds have been treated as "retail sucker pools of money" because they are far less fee and performance sensitive than institutional accounts and far less profitable to managers than hedge funds. "Assets under management" has come to mean "assets used by management" as the mutual fund industry has lost any ethical moorings it may have once had.
The staggering harm mentioned above has been longstanding. While some believe that the transgressions surfacing at this time were desperate measures adopted by the mutual fund industry as assets under management plummeted around 2000, I know from personal experience that illegal and unethical activity has been pervasive for over 20 years.
The effect upon the nation's retirement savers is tragic. The entire investment return attributable to an individual's retirement account over a lifetime may be eaten away by excessive fees and other malfeasance. Many investors will be lucky to even find their principal intact when it comes time to retire. Others appear doomed to join the ranks of the impoverished elderly, bagging groceries to make ends meet.
I believe that skimming by the mutual fund industry is a significant factor in explaining why the nation's retirement savers enter into retirement with lesser assets than they envisioned-far less than necessary to support a quality retirement lifestyle. You can never save enough if unbeknownst to you someone is siphoning money out of your account.
While we can never eliminate the potential for poor decision-making, we must seek to ensure that investors have the information necessary to make good decisions and are treated fairly.
We want investors to succeed. And we want as many investors to succeed as possible. Every success strengthens our society and every time an investor is robbed of his hard-earned savings, our society suffers. It is time to put an end to self-dealing by the mutual fund industry and provide mutual fund investors with the protections they thought they always had.
