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Illinois Senator Goes to Bat for Investors

Sen. Peter Fitzgerald has two wishes this year.

One is that Congress passes sweeping legislation to reform the $7.5 trillion mutual fund business, an industry that hasn't seen new legislation since the FDR administration. The other wish is for the Chicago Cubs to finally win another World Series title, a feat that has eluded them since 1908. In both cases, the odds seem stacked against him. But following a year in which bulldog Attorney General Eliot Spitzer knocked the cover off a widespread trading scandal and the Florida Marlins shocked the mighty New York Yankees in the October classic, surely anything can happen.

During the last nine months, a wave of inappropriate market timing and illegal late trading has opened a Pandora's box of problems for the fund industry. Spouting from it has been the misuse of 12b-1 fees and soft dollars, broker kickbacks, lax corporate governance, hidden or excessive fees and an overall dereliction of fiduciary duty.

Fitzgerald, a former attorney and lifelong Cubbies fan armed with extensive knowledge of the banking industry, has been going to bat for the small investor. He believes that despite a good-faith effort and expert advice, investors still remain in the dark about where their hard-earned dollars are being put to work. After hearing testimony at a series of hearings on Capitol Hill in recent months, Fitzgerald drew up the Mutual Fund Reform Act of 2004, a bi-partisan bill designed to curb fund abuses and fix its flawed fee structure.

Money Management Executive Associate Editor Kevin Burke caught up with the Republican senator from Illinois in his Washington office to discuss his proposed reforms and what he hopes to accomplish before his retirement at the end of the year.

MME: You have called the mutual fund industry, quite famously, "the world's largest skimming operation." Explain why you believe this to be true and why you think legislative reform is necessary.

Fitzgerald: The mutual fund industry has enjoyed incredible growth in the last 24 years, rising from $115 billion in assets in 1980 to $7.5 trillion today. A lot of that growth has been promoted by the government by virtue of its promotion of tax-sheltered accounts such as 401(k)s and IRAs. Really, the only way to offer those accounts is through a mutual fund. But I'm afraid that fee disclosure is inadequate and that free market forces need to be liberated so they work better in the mutual fund industry to allow more cost-comparison shopping for investors. By not having full disclosure of fees and a poor understanding of their impact on investors over time, we have made the mutual fund market less cost-sensitive than it should be.

Approximately $400 billion in fees is being collected each year, according to Vanguard Group founder John Bogle. If free market forces were more liberated by greater disclosure, the fees would be squeezed down quite a bit and investors would have much more available to them at return. One percentage point of fees over 40 years of investment will cut somebody's retirement nest egg by 45%. That's a lot of money. The government has created tax-sheltered accounts, but a lot of the benefits of tax sheltering have been captured by the brokers, advisers and other industry insiders and not by the clients. I'm concerned about that. So I think there's a role for government here.

MME: In the hearings on mutual fund practices in the past few months, what testimony has surprised you most?

Fitzgerald: The enormous amount of fees that are paid, how high fees have a more corrosive effect on people's retirement savings over time than even the market timing and late trading.

MME: What about directed brokerage and revenue-sharing arrangements?

Fitzgerald: Certainly, I find objectionable a lot of the shadow transactions that take place in the industry. I'm encouraged, though, that even the Investment Company Institute seems to be headed in the direction that they, too, would like to end revenue sharing and directed brokerage. The SEC has already moved on that front with its point-of-sale disclosure rule.

Mutual funds are almost being shaken down by the brokers, who tell funds, "We won't distribute your shares unless you give us payola." That's what we would call in Chicago a "shakedown." The brokers seem to be extorting, for the lack of a better word, what in Chicago politics they call a "kickback."

Brokers should be giving investment advice based on what's best for the customer, instead of thinking of their own revenue. It may have been commonplace for a long time, but it sounds to me like an unsavory practice that has gone on far too long. I doubt many customers whose broker tells them to go into a particular fund realize that their broker is being paid by the fund advisor to steer them into that fund.