Folios

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The following is an unedited version of an article about the legality of folios, an abridged version of which first appeared in Investment Advisor (Jan. 2001):

The state of the mutual fund industry calls to mind a saying on a plaque outside of my local Barnes & Noble: Middle age is when one's broad mind and narrow waist have changed places. The industry's waist is now $7.2 trillion wide, and its attitude toward the regulatory flexibility responsible for much of its growth has narrowed considerably.

Last month, the SEC hosted the 60th Celebration of the Investment Company Act of 1940, the principal statute governing mutual funds. Rather than celebrating the Act and its rules as models of regulatory flexibility, industry representatives accused their host of failing to enforce the Act strictly enough.

The attack was led by John Brennan, the then-Chairman of the Investment Company Institute, the trade group for fund management companies, and the current Chairman of the Vanguard Funds, which under Jack Bogle's leadership was the most outspoken advocate for the other side of the fence: mutual fund shareholders. Brennan's broadside against folios left no doubt whose interests he was representing.

For those who haven't been keeping up, folios recently replaced exchange-traded funds as the newest new thing in the world of diversified investment pools sold to retail investors. A folio is a pre-selected portfolio of stocks that can be bought and sold with a single mouse click. The best-known folio provider, Foliofn, charges $29.95 per month, or $295 per year, for an unlimited number of folio trades. You can customize your folio and manage trades to minimize taxes - two key advantages over mutual funds. But Steve Wallman, Foliofn's founder and CEO and a former SEC Commissioner, agrees that index mutual funds are still a better deal than folios for small accounts, depending on the investor's tax situation and other factors. Wallman advises these investors to buy a Vanguard index fund.

Vanguard's Brennan has a distinctly less charitable view of folios, labeling them "a big threat to investor protection . . . aimed point blank at middle America." Bob Pozen, Fidelity's CEO, has predicted that the legality of folios will be litigated. In July, the ICI sent a letter to the SEC arguing that folios should be subject the same regulations as mutual funds, and accusing Foliofn of selling unregistered mutual funds, a violation that can carry a five-year prison sentence.

But Wallman won't be wearing prison stripes any time soon. Over the last 20 years, the SEC has taken the position that pools of securities, even when commingled, generally are not themselves securities, much less mutual funds, if the investor owns the individual securities, as opposed to an undifferentiated interest in the pool. Under SEC positions, a folio generally is exempt from regulation if its clients can impose reasonable restrictions on their accounts (e.g., by excluding particular companies from their folios), and retain the same rights to their securities as they would if the securities were held outside of the account, including the ability to withdraw and vote the securities, receive confirmations of their individual transactions, and sue the issuer of the securities. Folios meet all of these criteria.

This view apparently is shared by a recent director of the SEC's investment management division, Marianne Smythe, whom Foliofn has retained as counsel. While the current SEC staff has said that it is reviewing the legal status of folios, it remains silent eight months after Foliofn commenced operations, thus suggesting that it agrees that folios are not required to register as mutual funds under the SEC's current positions. This does not, however, foreclose a major overhaul of the SEC's position on securities pools, the efficacy of which has been steadily eroded by technological advances.

Notwithstanding the chorus of complaints by Brennan, Pozen and the ICI, some fund management companies believe that folios are good for investors. Indeed, American Century is a major investor in Foliofn. Diane Mulcahy, Vice President of American Century Ventures, explained that, "through investments like Foliofn, American Century actively supporting the development of products that offer investors control, choice and a personalized investing experience." Oppenheimer Funds has taken a 15% stake in another folio provider, PersonaFunds, with an option to buy another 15%.

These fund companies' lack of concern about folios' legal status suggests that other motives may be at work. The ICI represents only registered funds, so by diverting assets from its members, folios threaten to reduce its membership rolls. And Brennan may fear that Vanguard's reputation as the leading provider of low-cost funds is being eroded. First, exchange-traded funds embarrassed Brennan's group by offering index funds at half the Vanguard price. Just as Vanguard prepares to roll out its own exchange-traded funds, folios are demonstrating again that, when it comes to low fees, Vanguard is no longer at the vanguard of the industry.

There was a time, about 20 years and $7.1 trillion ago, when the mutual fund industry was the lean underdog fighting to loosen legal restrictions to permit better and more competitive products. At the urging of the fund industry, money market funds were made possible by the adoption of Rule 2a-7, a rule so successful than many foreign funds boast compliance with Rule 2a-7 as a major selling point. 12b-1 fees take their name from the rule that permitted funds to use their own assets to pay for distribution. Love them or hate them, 12b-1 fees facilitated the investor awareness of mutual funds to which they owe much of their growth.

Since these reforms, the number of mutual fund shareholder accounts has climbed from 10 million to 228 million, and the percentage of U.S. households owning mutual funds from 6% to 51%. Mutual funds have become Americans' investment vehicle of choice in large part because of the adaptability of the legal regime under which they operate, and the SEC's good judgment in exercising its broad statutory authority to update mutual fund laws.

Indeed, Vanguard's very existence depends on a number of exemptions granted by the SEC decades ago. In the 1970s, the SEC wisely chose to relieve a maverick named Jack Bogle of important legal requirements because it recognized that the benefits to investors of Vanguard's novel structure outweighed the risks. Thus, the irony of Vanguard's Brennan leading the attack on folios is acute.

Nonetheless, the industry's narrow-minded, all-or-nothing position on folios is unfortunate, for it clouds the very real regulatory concerns posed by these products. Brennan correctly charges that folios are targeting the retail mutual fund market and accordingly raise concerns that do not apply for more sophisticated investors. The website for Netfolio boasts, "Goodbye Mutual Funds, Hello Netfolio," and offers "expert advice to help you build and buy your own personal funds." The ads for a related product offered by BuyandHold.com invite you to "make your own mutual fund of any stocks." This in-your-face assault on conventional mutual funds makes the fund industry's anxiety about public confusion between regulated and unregulated funds understandable.

Technological developments have enabled low cost, diversified pools to be offered at the retail level, a situation that did not exist when the SEC decided that products structured like folios should not be subject to mutual fund regulations. Folios pose many of the same risks that mutual fund regulation is designed to address, including self-dealing, deceptive advertising, and misleading disclosure. They also lack many of the investor protections built into mutual fund regulation, such as independent directors, public and SEC reporting requirements, and state corporate and trust strictures.

Folios evidence the continuing need for discriminating innovation by SEC to ensure that Congress's statutory design for diversified securities pools of securities remains relevant. This will entail not only considering what mutual fund regulations may be appropriate for folios, but also what regulations need to be modernized and streamlined - for folios and conventional funds alike.

But the industry's insistence that the entirety of the Investment Company Act apply to folios would make them prohibitively costly and deprive retail investors of the substantial cost and tax savings that folios offer, in direct contradiction of Franklin Roosevelt's hope that the Act would "enable the investment trust industry to fulfill its basic purpose as a vehicle to diversify the small investors' risk."

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