WASHINGTON - A bipartisan chorus of senators called yesterday for sweeping reforms of the $7 trillion mutual fund industry, accusing fund directors of rampant conflicts of interest and taking federal regulators to task for failing to detect management abuses that cost small investors billions of dollars in profits.
In a packed hearing room, a Senate Governmental Affairs subcommittee heard more than three hours of testimony from industry officials and federal and state regulators, who described an industry that has routinely allowed big investors to profit from preferential trading schemes and fund advisers to cash in on unchecked management fees.
"The mutual fund industry is now the world's largest skimming operation - a $7 trillion trough from which fund managers, brokers and other insiders are steadily siphoning off an excessive slice of the nation's household, college and retirement savings," said Sen. Peter Fitzgerald, an Illinois Republican, at yesterday's hearing.
As the scandal enveloping the industry grows, Fitzgerald and other lawmakers have proposed legislation that would call for more accountability of mutual fund directors, require greater disclosure of fees and put a stop to questionable trading practices that have tarnished the industry's image as a safe haven for everyday investors.
John Bogle, founder of the Vanguard Group, a giant Pennsylvania mutual fund company, called the trading scandals "just a small tip of an enormous iceberg." A longtime industry critic, Bogle has only recently found an audience for his concerns about industry abuses.
"We have opened up a window into a morass of conflict of interest," said New York Attorney General Eliot Spitzer, whose investigation of the industry prompted lawmakers to launch their own probe.
Two months ago, Spitzer, who attended yesterday's hearing, accused several large mutual fund companies of giving a large hedge fund preferential treatment by allowing it to make after-hours trades and use in-and-out trading techniques to gain advantage over other investors.
Late trading allows an investor to place trades after the 4 p.m. closing bell, giving them an unfair advantage over other investors because they can act on late corporate news while others can't. Market timing, which is not illegal, is an attempt by investors to trade in and out of funds rapidly, a practice that can raise fund costs and hurt a fund's performance over time.
Yesterday, Spitzer railed against the industry, saying it has been charging investors excessive fees while mutual fund directors look the other way. He said mutual funds often pay a quarter of a percentage point more in advisory fees than pension funds, even though both types of funds are managed by the same companies. A reduction of that amount would result in a $10 billion annual savings to investors, he said.
Similarly, the management fees charged to investors keeps climbing even as the industry's assets have exploded in size. "Where are the economies of scale that have been promised year after year by this industry?" he asked.
Spitzer joined federal regulators in criticizing mutual fund directors, saying there is an inherent conflict of interest in the way the boards are structured because many directors are affiliated with the advisory firms they are charged with overseeing. The result is that directors often allow fund management firms to pump up fees at the expense of investors.
He hinted that more allegations are likely to come out of his expanding investigation, and that companies caught engaging in questionable activity must be forced to repay investors for fees they received while abuses occurred. "This number will be big, it will impose pain, and it should," he said.
After the hearing, Spitzer said the "entire governing structure of the mutual fund industry needs to be considered and revised."
"You have every possible permutation of wrongdoing," he said. "It is a cesspool, and it is an industry that has for too long said, `We are pure. How dare you attack the virtues that we bring to the table.' They are going to get the comeuppance they deserve based upon on their years of failing to police themselves."
Industry officials acknowledged the need for reform and pledged cooperation. "I am outraged at the shocking betrayal of trust," said Matthew Fink, president of the Investment Company Institute, which represents the mutual fund industry. "We want to rebuild trust, renew public confidence. Every type of reform is ... on the table."
Fink said the trade group backs a Securities and Exchange Commission proposal to curb late trading by setting a 4 p.m. deadline for all mutual fund trades. Any trades placed by an investor or an intermediary after that time would be based on the next day's price. The group also urged the SEC to require a minimum 2 percent redemption fee on the sale of all mutual funds for a minimum of five days after their purchase. Such fees would discourage market timing.