Six Hopes for the Obama Administration

President Barack Obama
1600 Pennsylvania Avenue NW
Washington, D.C. 20500

Dear Mr. President:

Congratulations on today's inauguration.

We know that you've got a lot on your plate fixing fundamental problems in the economy, but citizens will share in the much-needed recovery at least partially through their investments. We have hopes that your newly minted government and Congress will make sure that fund investors are better protected, can fully participate in the next upturn, and won't be hindered by investments that aren't working for them as hard as they should be.

What follows is a list of some of the investment-related regulatory and policymaking initiatives that we'd like to see your team tackle over the next four years.

Increase Oversight of Hedge Funds
The biggest regulatory problem with hedge funds is that there isn't any regulation. The theory has been that allotting hedge funds complete freedom gives them the power of innovation, thus their ability to run circles around more tightly regulated entities. This theory took a battering in 2008, when many prominent hedge funds incurred huge losses and some shut down altogether.

Morningstar does retain a bit of sympathy for the notion of relatively unfettered investment managers. But there are several areas of the hedge fund realm that can and should be regulated; these regulatory initiatives have nothing to do with investment performance and everything to do with investor protection. The Madoff scandal has driven home the fact that even wealthy investors can fall prey to scams in the very lightly regulated hedge fund world. Moreover, hedge funds have increasingly appeared in endowments and other institutional accounts in recent years, thereby affecting more than just ultrawealthy, sophisticated investors. Finally, hedge fund activity has the potential to create big dislocations for smaller investors. We saw that last year, when hedge funds' mass exodus from municipal bonds roiled that market.

For starters, we'd like to see a requirement that hedge funds use an independent, nonaffiliated administrator. And custodian. And pricing service. And auditor. What's more, all four of those entities should be certified by the SEC as being qualified to fulfill those roles with hedge funds--no more faked-up companies operating out of a one-bedroom apartment in Hoboken as fund "auditor."

In addition, performance reporting for hedge funds should be standardized and tightened, and limits set on leverage. (These limits should continue to allow hedge fund managers to make aggressive bets, but there should be limits all the same.)

Finally, the paper trail afforded by portfolio and manager disclosure is necessary. Hedge funds needn't disclose their portfolios as often as with mutual funds--perhaps twice annually, with a 90-day delay. We'd also like to see a requirement that hedge funds of funds disclose their subadvisory relationships. These disclosures would help provide some safeguards that the hedge fund is not operating a Madoff-style Ponzi scheme.

Put the Tax Treatment of Mutual Funds on Par with That of Other Investments
We've been calling for the reform of mutual fund capital gains taxes for years, but we think it's time it gained traction. If you buy shares of  Microsoft (MSFT) and hold them for 10 years, you won't pay taxes on gains from your investment until you decide to sell. Mutual fund investors, however, aren't so fortunate. They could have to pay taxes every year on the gains that their money manager incurs from buying and selling stocks in their portfolio, even if the fund investor didn't sell a single fund share. Even worse, fund investors sometimes pay taxes on gains that their managers generated before becoming shareholders. (If a manager sells a stock for a profit in April and you buy in July, you might be on the hook for gains that you weren't around to enjoy.)

We think that the tax code should treat fund and stock shareholders equally. So, instead of footing a tax bill on gains every year, fund investors would pay capital gains tax on their mutual funds only once, when they sell shares in their fund. (Dividend tax treatment would remain the same.)

With mutual funds being the primary investing vehicle for most Americans, we find it strange that the tax law discriminates against them. Improving the tax treatment of mutual funds could also increase interest in investing at a much-needed time. Moreover, many mutual funds have capital losses on their books that they could use to offset gains for several years to come. As a result, implementing the tax-code change now is apt to have little effect on the government's tax receipts in the near term.

Help Investors Rebuild Their Retirement Nest Eggs
To help retirement savers rebuild their nest eggs--and to encourage a culture of saving and investing at an opportune juncture--we'd like to see the Obama administration and Congress take a few specific steps. First, we'd like to see contribution limits on IRAs, 401(k)s, and other key retirement-savings vehicles increased on a temporary basis, perhaps for three years or so. Additionally, we're fans of allowing those already in retirement to delay mandatory distributions from their retirement accounts. That would help some retirees avoid the unfortunate predicament of having to take distributions from their accounts when their account balances are at a low ebb, thereby reducing their portfolios' ability to benefit from a market recovery.

Continue to Identify Creative Ways to Improve 401(k) Participant Outcomes
With most 401(k) balances suffering steep drops in 2008, there's been a lot of hand-wringing over whether the 401(k) vehicle should be scrapped altogether. However, assuming that individuals are going to be in charge of their own retirement funding, we'd argue that there's nothing fundamentally "broken" about the 401(k) as a savings vehicle. (Given their druthers, many 401(k) participants might prefer to have their retirement costs covered by their employers or the government, but that's a discussion for another day.)

Rather, 401(k) plan participants are often their own worst enemies, not saving enough, not paying sufficient attention to asset allocation, and trading too often. Instead of going back to the drawing board on 401(k)s, policymakers should focus their efforts on improving 401(k) participant behavior. Harnessing research from the growing field of behavioral finance, the Pension Protection Act of 2006 included some worthwhile provisions in this vein, allowing companies to automatically opt their employees into their 401(k) plans and to put them into diversified, age-appropriate vehicles such as target-date vehicles. We hope that policymakers will continue to work to improve 401(k) participant outcomes in creative ways like these over the next four years.

Improve 401(k) Disclosure
That's not to say that 401(k)s can't be improved, however. They can, and disclosure is a good place to start. If a 401(k) plan consists of traditional mutual funds, it's not difficult for investors to research the funds' salient features--expense ratios, management fees, past returns, and so forth. But if a plan invests in separately managed accounts or commingled funds--and many plans increasingly have begun to utilize these options--the plan participant is often flying blind when it comes to evaluating the investment's salient characteristics. Bottom line: For participants' sake, we believe that any investment in a 401(k) plan should be subject to the same disclosure requirements as a '40 Act mutual fund.

Moreover, we'd like to see improved disclosure for all 401(k) plan participants when it comes to fees. Although 401(k) participants will have an easy time locating the expense ratios associated with the mutual funds in their plans, the other costs of the plan--notably the administrative costs--are usually far less accessible. Having to clearly disclose a plan's "all-in" costs would help dissuade employers and investment providers from engaging in practices like revenue sharing, which can reduce the employer's costs and pad the investment provider's bottom line at the expense of plan participants' returns.

Make Fund Boards More Independent
The Obama administration could make its mark on mutual fund governance by making fund boards of directors more independent of the funds they're overseeing. The SEC has a rule on its books that would require that fund boards be led by an independent chairman and that three fourths of a board's directors be independent. Unfortunately, due to litigation and foot-dragging by some big mutual fund companies, the SEC hasn't enforced this sensible regulation.

As we've told the SEC, we think that shareholders are best served by highly independent fund board leadership. Funds led by independent directors get to set an agenda based on their view of what's best for shareholders--not what's best for the fund company. After all, the fund company stands to profit from many of the fund board's directives. For example, some of the fund board's most important duties are negotiating the fund's expense ratio and renewing the advisor's annual management contract. We think that it's more likely that a highly independent board would push for lower fees or fire the fund's advisor for poor management than would a fund board led by a fund-company executive. Not surprisingly, academic research suggests that funds led by highly independent boards are likely to have lower fees.

We acknowledge that there are cheap, well-run funds that are overseen by fund boards that don't yet comply with the independent chairman rule, but it's difficult to argue that such a board structure is a best practice. We're not sure why those well-run funds aren't willing to concede leadership of their fund boards to an outsider. What do they have to lose, exactly, other than the potential for conflicts of interest?

We hope that you'll take our suggestions with the good intentions with which they're offered, and we would also like to extend our best wishes to you and your administration in the next four years.

Sincerely,
The Morningstar Analyst Team

Christine Benz, Christopher Davis, John Rekenthaler, and Laura Lutton all contributed to this article.