October 07, 2003,
A month ago, Eliot L. Spitzer, New York's attorney general and the scourge of Wall Street, announced that his office had "obtained evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars annually."
The corporate accounting scandals since 2001 have rocked the confidence of many investors, but, on the surface at least, Spitzer's new revelations sound even more devastating. After all, there are many thousands of listed companies, and the fact that a few of them cheat, while disheartening, is unsurprising. Mutual fund houses, however, are fiduciaries. Their job to manage and safeguard clients' money is practically sacred. To find that they may be taking payoffs to let big investors do things that small investors can't (and bilking small investors in the process) is shocking and, frankly, disgusting.
Worse, Spitzer's charges were not directed at a few sleazy operators. Russel Kinnel, director of fund analysis for Morningstar, which collects data on the thousands of mutual funds, wrote they were "leveled at four big fund companies that were fairly well regarded and trusted by millions."
The question for investors now is what to do in light of the new scandals: ignore the flap, try to find ways to identify good firms from bad, or bail out of funds entirely?
The four fund houses that Spitzer initially cited were Nations Funds, owned by Bank of America; Strong Capital Management; Janus Capital Group; and Bank One's One Fund Group. Then, a week ago, Alliance Capital Management suspended two employees because of "conflicts of interest" that hurt shareholders in Alliance mutual funds while benefiting Alliance's hedge fund operations.
Big funds are involved here. For example, Gerald T. Malone, who runs the AllianceBernstein Technology Fund (ALTFX), with $3.3 billion in assets, was one of those suspended. In all, Alliance has $37 billion under management in mutual funds; Nations has $30 billion. Janus, the largest of the five named, ranks eighth among all fund houses, with $87 billion.
Morningstar, the bible of the industry, has taken a hard line against the alleged miscreants. Kinnel wrote last month: "Given the seriousness of the charges leveled against Bank of America, it's prudent for investors to avoid the firm's in-house Nations Funds."
In a review of Janus Twenty (JAVLX), a fund that was extremely popular during the tech boom (no wonder with its highly concentrated portfolio, it returned 73 percent in 1998 and 65 percent in 1999) and still holds $10 billion in assets, Morningstar analyst Brian Portnoy wrote, "We think the accusations are serious enough and the existing evidence compelling enough to encourage investors to consider other options." Portnoy's advice applies to all Janus funds, even Twenty, which was not "specifically mentioned in the complaint."
I don't agree. I would dearly love to see the miscreants go to jail, but I doubt it's time to toss funds overboard at least, not yet. But first, a little background.
Mutual funds which are technically individual companies that gather cash from shareholders and invest it in stocks or bonds or both have been around for about 80 years, but they began to gain enormous popularity, and in the process democratize American finance, only in the past two decades. The industry was largely scandal-free, and its growth showed it had clearly won the public's confidence.
In 1980, just one U.S. family in 16 owned a mutual fund; today, it's one in two. According to the Investment Company Institute, the mutual fund industry's main trade association, funds held $7 trillion in assets at the end of August, an average of $25,000 for every man, woman, and child in the United States. That's a 50-fold increase since 1980, and up 500-fold since 1960.
This means, first, that "mutual funds don't know who their shareholders are," as Barry Barbash, the former Securities and Exchange Commission official in charge of mutual funds, puts it. Fund assets are held in "street" or "omnibus" accounts by the third parties, or intermediaries. So the fund itself can't tell which individual investors are breaking the rules against, for example, jumping in and out in an attempt to make profits, at the expense of other investors in the fund, through fancy arbitrage. Barbash says: "Intermediaries are at the root of the problem. It seems to me they're a weak link in fund regulation."
The rising domination of intermediaries also indicates that more and more investors are turning over responsibility for making decisions about which funds to pick to someone else. Most investors don't have the time or the inclination to choose stocks and funds themselves, so they pay a trusted adviser to. The issue is whether investors are trusting the advisers too much and whether the advisers, in turn, are trusting the funds too much (especially if the funds are enriching them through high commissions).
Before I get to my conclusions, let me describe the worst of the practices that Spitzer uncovered. It's called "late trading." Mutual funds are required to price their funds that is, total up the fund's net asset value (NAV), using the stock market prices of all the companies it owns (in the case of a stock fund) once a day. Most funds do that when the U.S. markets close at 4 p.m.
For example, when you put in an order to sell your mutual fund anytime during the 24 hours preceding 4 p.m. Tuesday, you get the price, or NAV, as of 4 p.m. Tuesday. Ditto for purchases.
Now, imagine you put in an order to sell your shares at 4:01 p.m. on Tuesday. In that case, you would get the NAV of 4 p.m. on Wednesday, the next trading day. Those are supposed to be the rules for everyone.
But, in the Bank of America case, for example, investigators say that to win banking business officials of Nations Funds allowed a hedge fund called Canary Capital to trade after 4 p.m. Tuesday and still get the 4 p.m. Tuesday price, instead of the 4 p.m. Wednesday price.
Say that news comes out about a company's earnings after 4 p.m. Tuesday that will clearly boost the stock price of the company and other firms in the industry when trading resumes the next day, thus raising the value of a mutual fund that owns such stocks. A hedge fund that buys shares in the appropriate Nations mutual fund in late trading would reap a guaranteed reward. Spitzer, in an apt metaphor, calls this "betting on a horse race after the horses have crossed the finish line."
Other scams "market timing" with funds and "valuation" schemes cited by Spitzer have similar themes. In addition, some funds were showing lists of their holdings to privileged big investors (most funds reveal their holdings only twice a year), perhaps giving those investors a chance to benefit by buying or selling stocks in the portfolio ahead of the fund. To its credit, the Investment Company Institute is moving to make it more difficult to get away with such practices, but the truth is, the temptation to cheat can never be obliterated.
So what should investors do? I am a fan of mutual funds, but I have reservations as well. Mutual funds offer small investors the chance to get professional money management of the sort once enjoyed only by the very rich at relatively low cost. Mutual fund portfolios, averaging about 100 stocks, also provide diversification that is nearly impossible for individual investors to achieve on their own. And funds handle the bookkeeping and the tax records.
Plus, do you really have to pay a fund manager an average of 16 percent of your profits (in addition to that upfront fee) to own a portfolio headed by such obvious choices as Microsoft (MSFT), Dell (DELL), First Data (FDC), Intel (INTC), and Cisco Systems (CSCO)?
The real question is: Who on earth would pay such high fees for such a ho-hum fund? The answer: lots of people, many of whom have been led astray by intermediaries hankering for a nice commission. Which brings me to seven pieces of advice:
1. If you own funds that you like in the five affected houses, don't abandon them just because of the current accusations. There's no proof yet that these scams were directed from the top. If such proof appears, however, ditch the funds quickly. Otherwise, put them on probation.
2. Realize that expenses are not correlated to performance. If you are buying funds through an intermediary, ask what the expenses are. Unless the fund has an exceptional long-term record, you should not be paying more than the average for a stock fund: 1.2 percent. Also, realize that an index fund that owns the 500 stocks of the S&P typically charges only around 0.2 percent and beats, on average, most funds managed by humans. I haven't given up on managed funds (I own both kinds), but keep the index alternative firmly in the front of your mind.
3. A reliable indicator of trustworthiness is a manager's longevity. All fund managers have rough patches, and a fund house that lets a manager ride them is usually a solid institution with a long-term view. The best managers have the confidence to buy good companies and own them for a long time, so look for low turnover ratios (reported by Morningstar at www.morningstar.com).
4. Seek fund houses with reputations for consistent, low-key performance. Three of them are Dodge & Cox of San Francisco, which manages just five funds, with low expense ratios and generally excellent performance; Tweedy, Browne, a venerable New York firm with only two public funds and $5 billion in assets; and the much larger T. Rowe Price Associates of Baltimore. Three specific funds (one from each house) recommended by Bob Carlson, editor of the fine Retirement Watch newsletter, are Dodge & Cox Income (DODIX), with an expense ratio of 0.45 percent; Tweedy, Browne Global Value (TBGVX), which has beaten its international benchmark by an annual average of 9 percentage points over the past five years; and T. Rowe Price Small-Cap (OTCFX), with an average annual return of better than 11 percent since 1998.
5. Don't make the biggest mistake of mutual fund investors: chasing the hot ones. A fund that is doing far better than average may be taking wild risks, which work on the downside as well.
6. Question your investment adviser closely not just about fees but about the strategies, managers, and track records of the funds you're putting hard-earned cash in. It's your responsibility.
7. Finally, don't expect the regulators to protect you. At a hearing last Tuesday, William H. Donaldson, the chairman of the SEC, told a Senate committee that he has undertaken an aggressive new program to keep mutual funds in line in such areas as advertising, proxy voting, disclosure of operating expenses, highlighting broker incentives, director nominations, and on and on. I suppose some of these new rules may have a little merit, but there's also a serious danger here: Most investors will pay no heed to the disclosures because they don't have the time or the knowledge, but, unfortunately, they'll assume that thanks to the new rules, they can relax. They can't.
In the end, you owe it to yourself to buy good funds from houses with good reputations. Three large houses that meet this test and are untainted by scandal are American Funds, Fidelity, and Vanguard. Morningstar also recommends funds whose principals have their own money at stake, such as Davis/Selected; American; Tweedy, Browne; and Longleaf Partners.
The best way to keep mutual funds honest and productive is with the discipline that smart investors apply. Insist on quality, and this industry, which has boomed because it has provided a great service to tens of millions of investors and is now in jeopardy of losing its way, will receive the discipline it needs.
James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned above, Glassman owns Microsoft and Dell. This article originally appeared in the Washington Post.