December 05, 2003, 9:06 a.m.
The Real Fund Scandal
Performance-chasing parasites are worse than chiselers.

The financial community is in an uproar over a few crooks in a multi-trillion dollar mutual fund industry. The SEC and New York state attorney general Eliot Spitzer, among others, are going out of their way to catch these thieves and strengthen the regulation of the mutual fund industry. The crime? Mutual fund executives and portfolio managers allowed favored clients to make a few bucks by illegally trading mutual fund shares. Some foolish executives supposedly traded stocks ahead of trades that were being placed by in-house mutual funds.

While these decisions had an impact on the prices of mutual funds, the crooks acted more like chiselers rather than bank robbers. A “chiseler” in today’s world is also a “cheater,” but the derivation of the word explains this type of thief: He files down the edges of coins so that he can take minuscule shavings, so small that their removal goes unnoticed. After a while the chiseler accumulates sufficient filings to melt down and sell for a profit. In the meantime, nobody can really tell that each coin has gotten ever-so-slightly lighter. In effect, that’s what happened to select mutual funds: The shareholders got “chiseled.”

The recent bout of financial chiseling pales in comparison to the real thieves in the mutual fund business: the parasites who live off of fictitious performance data to lure unsuspecting individual investors.

First of all, the performance ratings of mutual funds are based on the concept of time-weighted rates of return. So mutual fund companies, using past performance, roll out their best-performing funds and take major ads in newspapers, magazines, and other publications to tout these “beauty queens.” The ads imply that these nymph funds have found the fountain of youth, but unfortunately, most of them grow whiskers a lot sooner than most investors think.

And therein lies the problem. The use of traditional mutual fund performance calculations doesn’t take into account performance after individual investors respond to marketing gimmicks by purchasing fund shares after the performance has been achieved. Since studies have shown that fund performance is not predictable, the new shareholders are unlikely to achieve the same good performance as past winners. However, there is one way to accurately measure the effect of performance on all fund investors: The solution is to shift to a dollar-weighted rate-of-return measurement.

To quantify the degree to which traditional performance standards are misleading, and then to measure the effects of false promotion on the unsuspecting public, I turned to Warren Bitters, a professional evaluator of mutual funds. Warren spends his waking hours evaluating the deeds and misdeeds of mutual fund companies and one of their key promoters, Morningstar, Inc. This research is not an avocation for Warren; it has a direct impact on his development of asset-allocation models for lifecycle investments. By weeding out some of the problem mutual funds, he adds value to the design of his models.

In a recent study, Warren discouraged investors from adopting Morningstar fund ratings as the basis for investing in mutual funds. He measured mutual fund performance over the period March 2000 to March 2003, and found that “Morningstar ratings were very poor predictors of future performance, at least at this key market turning point.” To support his results, Warren examined the investment performance of all actively managed (non-index), non-sector, unique (eliminated instances of multiple share classes), domestic equity funds with assets greater than $100 million that were rated by Morningstar as of March 31, 2000. This screen produced 810 funds.

His results were astonishing: Over this period, the five-star-rated funds experienced an average mean investment return of –59.95 percent. The one-star-rated funds — the lowest Morningstar rating — experienced an average mean investment return of –10.91 percent. In other words, the one-star funds outperformed the five-star funds by 49 percent! Yikes.

When Warren looked at the 200 largest funds in this screen, 183 received three or more stars from Morningstar. This in itself indicates the importance of past performance and high Morningstar ratings in producing these super-large funds. The Oakmark Fund was the lonely one-star fund. Subjecting these funds to this study, he found that the five-star-rated funds declined 60.76 percent on average while the one-star fund rose 19.24 percent! Yes, it was the Oakmark fund — the one-star fund — that beat the average five-star fund by over 80 percent and beat the best performing of 56 five-star funds (Fidelity Contrafund) by 50 percent. By the way, according to Morningstar, Oakmark had risen to a five-star rating by the end of this three-year period.

Finally, he found that out of the 56 funds originally rated five stars, only three still maintained a five-star rating after the three years; 24 of them fell to either one or two stars.

Until more effective performance standards are adopted, the mutual fund industry will continue to lead unsuspecting investors by the nose. Unfortunately, fund performance-chasing costs investors much more than the chiselers do, and very little is being done about it.

— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc. and an investment consultant for Wealth Management Services of South Carolina.