SEC To Review Web-Based 'Basket' Portfolio Products

Mike Godfrey, Tax-news.com, New York

29 September 2000

At this time of year, when the holders of mutual fund units have learnt to expect capital gains tax shocks from fund managers, and unit prices often dip accordingly, so-called 'basket' portfolio products can expect a boost as investors realise that they are less vulnerable to tax shocks, or at least more controllable.

This is because, in a basket product, the investor gets to choose the contents of the portfolio on a customised basis, has direct ownership of the stocks themselves, and can vary the composition of the basket at will, within a set fee, thus timing the capital gains payable on the basket so as to suit his own tax situation, rather than having to accept the mutual fund manager's decisions, which may constitute bad timing for an individual investor. Basket accounts, also referred to as folios, e-baskets or web-based investment portfolios, allow investors to make small monthly investments in their basket account stocks, as they can buy fractional shares.

Greater choice through personalisation and greater tax efficiency are two of the main advantages of basket protfolio products, but they may be more expensive than straight mutual fund holdings. Still, they are rapidly growing in popularity, and this has led the mutual fund industry to complain to the Securities and Exchange Commission that basket products have a regulatory advantage - since their managers are equivalent to brokerages rather than to fund managers they escape the regulatory burdens imposed on mutual fund managers. Currently, basket account providers are registered as broker/dealers and subject to the rules of the National Association of Securities Dealers.

In July, the Investment Company Institute, the mutual fund industry’s main trade group, asked the SEC to regulate basket account companies as mutual funds. That would make basket accounts subject to advertising restrictions and fee limits that the fund industry says puts them at a disadvantage with basket accounts. The Securities and Exchange Commission has begun a review of web-based investment portfolio products: according to Cynthia Fornelli, senior advisor to the director of the SEC’s Division of Investment Management, such a review is a standard procedure when a new product hits the market. “There has to be an understanding of how the products fit into the investor protection framework,” she says.

Although Fornelli says there is no timeframe for the review, the SEC is working quickly given the number of new basket products cropping up. “It’s a delicate balance; we have to be deliberate, but there are already products out there with more on the way,” Fornelli says. Fornelli adds that the review could also include SEC inspections of basket portfolio providers to look at their operations. “It’s not inappropriate to see examination staff involved in the process,” she says.

Considering that the skills of the investment intermediary with a basket product evidently have to include sophisticated order-matching and back office functions, and that the intermediary is not making investment decisions or self-purchases (or at least doesn't need to) it seems correct that they would be regulated as brokers rather than as fund managers.

Nancy Smith, vice president of education and content development at Foliofn, one of the leading 'basket' providers, says that the fund management sector's request to the SEC is simply a defensive reaction to a competitive threat. 'Should we be subject now to both sets of regulation?” she says. “It’s not a fear of regulation. Their arguments just does not make any sense.” She says that Foliofn does not underwrite securities, making self-dealing a non-issue.

Smith also says that the mutual fund managers will themselves launch basket products shortly in order to compete, and indeed, there are fund managers among Foliofn's shareholders.

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