The U.S. mutual fund industry will mark its 80th birthday in March, but no one is much inclined to celebrate as the $7 trillion business slogs through the worst scandal in its history.
Some of the biggest, oldest and proudest names in the industry are facing lawsuits or investigations for so-called market timing, and no one is quite sure when the last muddy shoe will drop.
To those steeped in the traditions of the fund industry, saying the scandal is about late trading and market timing is like saying Enron is about how the books were kept. In each case, they say, the larger sin was that trusted, powerful people betrayed those who trusted them.
And it is the betrayal of the investors that seemed to weigh most heavily on the minds of fund-industry luminaries and former industry regulators who were asked for advice on how regulators, the industry and fund customers should best navigate through this quagmire.
I was outraged, said Charles Schwab, one of the giants of the business. I just couldn’t quite believe that a fund company would be in cahoots with hedge funds to allow them to use portfolio information to game their funds.
A number of experts offered seasoned advice about the practical ways that regulators, industry executives and investors could address the scandal.
But several said the only real cure would be a profound change in the industry’s culture.
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Charles Schwab
Founder, discount brokerage
Charles Schwab, founder of the financial services firm that bears his name, said his reaction to the mutual fund scandal was outrage.
These were infractions that really went over the line, he said.
I just couldn’t quite believe that a fund company would be in cahoots with hedge funds to allow them to use portfolio information to game their funds.
Why? I guess the answer is, there was money to be made and there were no controls. But I just said, ‘Oh my goodness in a $7 trillion industry.’ The good news is, this is not as big or as bad as, say, the savings and loan debacle was.
But it goes to the heart of the reputation and integrity of the industry, and we’ve got to bring those back into line.
I think there ought to be the Modernization Act of 2004 with respect to mutual funds, he added.
We’re operating under the Investment Company Act of 1940, and that was some 64 years ago.
There are lots of piecemeal things going on, putting a finger into the dike here and there.
Schwab also questioned the role of hedge funds.
They have induced mutual funds and brokers to do certain things here that were really outrageous, he said Where did they lose their moral compass on this thing?
Schwab advised investors to diversify among funds. And if they are in a tainted fund?
I would definitely take the opportunity to redeem those shares and find a mutual fund group that I have some trust in, he said.
In fact, I have done that with some mutual funds in some of my IRA accounts.
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Michael Price
Former head, Mutual Shares funds
Michael Price, now a private investor, ran the Mutual Shares fund group, helping it grow from $5 million to $20 billion in assets.
When I got into the business in the mid-1970’s, you couldn’t give mutual funds away, he said. But as the market got better after a terrible bear market, funds did better.
Soon, he added, the professional managers, the marketing types, were running the show, guys who succeed based on the amount of assets under management and the growth in those assets, rather than from the performance of the money which is backwards.
Most funds are very mediocre, Price said. They’re lousy stock pickers who tend to run in a herd and who really got caught with their pants down in 2001 and 2002. But the public has kind of been educated by these marketing and distribution guys in the wrong way. The regulators can help on the advertising side, big-time.
Price urged regulators to eliminate hidden fees but warned against cutting fees so deeply that funds could not reward good stock-pickers.
The operative theme should be, ‘If our funds grow because of good performance, our money managers get paid’ not ‘If our funds grow because of good distribution, our distributors get paid.’ The industry will go broke if they don’t deliver good performance over long periods.
I personally think the number of mutual funds in the country should shrink by at least a third or a half. Funds under $100 million should be merged together to cut overhead. Those with bad performance? Close ’em up!
Investors have to be re-educated, he added. Most money managers are pretty mediocre, but there are good ones out there, and you should find them. These are your life savings.
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David Silver
President, Investment Company Institute
As a young regulator, David Silver helped negotiate the rule that sets the 4 p.m. deadline for mutual funds pricing, a rule that some funds took advantage of and that he says is now obsolete. Silver, the longtime president of the Investment Company Institute, says the scandal has brought to light a change in the industry’s culture.
The companies affected so far roughly fall into two groups, he explained. One is relatively new entrants into the business who simply just never had, or never developed, a fiduciary culture. The second group is old-line fund groups that were acquired by other organizations that were not primarily in the American mutual fund business. As a result, there clearly has been a breakdown in the fiduciary culture traditionally associated with money management. If you’re managing money for your mother, you don’t go around looking for opinions from lawyers about legal ways to skim. That’s what it means to be a fiduciary.
For the industry, Silver added, my message would be transparency, transparency, transparency. There is nothing to lose from even more disclosure on the impact of fees and charges on investors.
For investors, he added, my advice would be to start reading those annual reports you’re getting, but don’t race for the door.
Silver added: When you have an area of ambiguity, and people not thinking in terms of their fiduciary responsibility, you get a recipe for trouble.
This scandal should make investors very angry If you go to a dinner party with some of your best friends and you get home and find your pocket has been picked of $25, you’re going to be angry. But maybe you don’t break off a good relationship with a friend you’ve had since high school on the basis of that one incident.
