Nov. 1–Is your mutual fund safe?
Despite the scandal roiling the $7 trillion mutual fund industry, the answer is probably yes. Or, to put it more precisely, at least as safe it ever was, given the turbulent nature of Wall Street.
But if a contingent of federal prosecutors, regulators and activists gets its way, the clubby nature of mutual-fund management would change radically. And investors would benefit if the changes increased disclosure about fund activities and lowered fees.
The recent scandals have shed unprecedented light on fund practices and are “a blessing in disguise,” said John Bogle, the founder of the Vanguard Group and a longtime industry critic. “It’s an ill wind that blows good.”
The allegations of unethical or illegal trading brought against various mutual fund companies–including Bank One in Chicago and Strong Financial in suburban Milwaukee–should have little effect on the principal of the average mutual fund investor, industry experts say.
The trading activity in question may have siphoned off billions of dollars. But those billions are spread across trillions of dollars managed by the fund industry.
More important for Joe Investor is that the scandals have focused attention on broader concerns about how mutual funds are run and whether fund managers are putting their own financial interests ahead of shareholders’.
The allegations are “just a function of the culture at these companies, and that’s what’s under examination,” said Don Phillips, managing director of Chicago’s Morningstar Inc., a major publisher of mutual fund data.
This week, a host of regulators and industry experts including New York Atty. Gen. Eliot Spitzer, Vanguard’s Bogle and Morningstar’s Phillips are scheduled to testify before congressional committees investigating the industry.
They will advocate wholesale changes in the way mutual funds are governed, how fund managers are compensated and how fees are structured. It is likely to be just the opening chapter in an effort resembling reforms underway in the corporate and financial worlds.
“It can be of little surprise that the mutual fund industry has not escaped the same kinds of scandals that have faced Wall Street and corporate America,” Bogle said in a recent speech.
Until this fall, it seemed that mutual funds had, in fact, skirted the scandals. Besmirched companies such Enron Corp. and WorldCom Inc. might have been held by many funds. But the funds themselves were often seen as victims, too.
Then on Sept. 3, word broke that Spitzer’s office had accused an obscure hedge fund called Canary Investment Management of trading illegally in mutual funds run by bedrock names such as Bank One, Janus Capital Group, Strong Financial and Bank of America. Separate allegations quickly spread to include executives at Putnam Investments, the nation’s fifth-largest fund company, and then took in Richard Strong, founder of the prominent Strong funds in Menomonee Falls, Wis.
Spitzer accused Strong, whose personal fortune is estimated to approach $800 million, of personally profiting from secret trading in his company’s mutual funds. He may have generated $600,000 in profits from the irregular trading, most of which occurred from 1998 to 2001, according to Spitzer’s office.
Strong Financial did not dispute the allegations but said it had hired David Ruder, a former chairman of the SEC, to oversee management and structural reform. Richard Strong also said he would be willing to step down.
Most of these cases focus on one of two issues. The first is allowing insiders or heavy-hitting customers such as Canary to make rapid-fire trades in mutual funds after the market closes and the funds have calculated their “net asset value,” or share price, at the end of the day.
Such late trading lets the investor benefit from news that happened after the markets closed. For instance, if a major technology company announced strong profits after the end of trading, the late trader could increase his position in a tech-heavy fund, figuring its value would rise the next day.
Then there’s market timing, which investors often use to make money based on time-zone differences and the tendency of international markets to react similarly to changes the day before in U.S. markets.
A market timer might decide to buy an international mutual fund on a day when U.S. markets rise. To make a quick profit, he then would turn around and sell it the next day, after foreign markets follow suit.
Unlike late trading, market timing isn’t illegal. But most mutual funds strongly discourage it because heavy trading volume drives up a fund’s transaction costs and can dilute other shareholders by increasing the number of shares outstanding. Some funds charge redemption fees as high as 2 percent when shares are sold within 60 days to 90 days of purchase.
Bogle and the Investment Company Institute, a mutual fund industry group, are advocating a mandatory 2 percent fee for all funds to discourage such short-term trades. They also would like to see an earlier close to the trading day in funds.
Stanford University professor Eric Zitzewitz has estimated that late trading and market timing cost U.S. investors more than $5 billion annually. Some industry observers, including Morningstar’s Phillips, question that number. But even assuming that Zitzewitz is correct, $5 billion means little to U.S. investors who own trillions worth of equity mutual funds. On a per-share basis, it has little measurable effect.
The bigger issue, said both Phillips and Bogle, is trust.
“If managers are willing to circumvent your interests in this area, maybe they are willing to do it in other areas as well,” Phillips said.
Industry critics complain that market timing by fund executives is possible because there is not enough public disclosure about fund company activities. They also argue that mutual funds, like many other types of companies, are overseen by insular boards of directors dominated by insiders. The end result, they say, is that the interests fund managers often hold sway.
This is especially true when it comes to the fees that investors pay fund companies to manage their money.
Spitzer plans to argue in congressional testimony this week that large investors, such as pension funds, often pay much lower fees than individuals do. Bogle says the difference is often as much as 100 percent.
Fees may not seem like such a big deal, but they can be corrosive.
Consider the case of a $300,000 investment in a fund carrying a 1.5 percent annual fee, the industry average. As a percent of the principal, that amounts to $4,500 a year. But it doesn’t end there. The 1.5 percent also comes out of any appreciation the fund might enjoy.
Consequently, if your fund manager earns 5 percent on your money, the fund company’s 1.5 percent reduces that by one-third, leaving you a 3.5 percent return.
“You never have to write a check for that, so it fades into the background,” said Phillips. “But what people don’t realize is that fund fees can be one of your top 10 household expenses each year.”
Phillips, Bogle and others would like to see regulation that clarifies fees and increases the independence of fund-company management, beginning with an independent board chairman charged with watching out for the shareholder’s interests. That could put downward pressure on fees or align them more with managers’ performances.
Fund companies currently take in $123 billion in fees a year, Bogle said. If a truly independent board of directors negotiated those fees on behalf of shareholders the way a pension fund does, “you could easily take out $25 billion a year,” he said.
William Nygren, manager of Chicago’s highly regarded Oakmark and Oakmark Select Funds, has said that concerns over fees are overblown. The key for investors, he said Friday, is whether their funds perform well over the long term and whether they have the type of organization in place to sustain that performance.
He points out that because the majority of his net worth is sunk in his funds, his interests are aligned with those of other shareholder. Oakmark funds also are careful to articulate, and stick to, a long-term value strategy. And they place a 2 percent fee on short-term trades to discourage market timing.
With more than 3,000 funds out there, Nygren said, “there’s no simple solution” to finding one that’s right. “You’ve got to do the work,” he said.
Bogle and other fund critics say they’d like to make the job a little bit easier for investors.
REFORMING THE MUTUAL FUND INDUSTRY
Here are some of the reforms critics of the fund industry seek:
–Appoint independent board chairmen and directors at fund companies.
–Implement practices to discourage short-term trading.
–Fully disclose fund manager compensation.
–Require all fund investors, large and small, to pay the same fees.
–Require fund statements to show fees in dollar amounts, not only percentages.
By Michael Oneal and Susan Chandler
—–
To see more of the Chicago Tribune, or to subscribe to the newspaper, go to http://www.chicago.tribune.com/
(c) 2003, Chicago Tribune. Distributed by Knight Ridder/Tribune Business News.
ONE, ENRNQ, WCOEQ, JNS, BAC, MMC, OAKMX,
