WASHINGTON, 6 October 2003 — A month ago Eliot Spitzer, New York’s attorney general and the scourge of Wall Street, announced that his office “has obtained evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars annually.”
Mutual fund houses 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 that bilk small investors in the process), is shocking and, frankly, disgusting.
Worse, Spitzer’s charges were not directed at a few sleazy operators. Instead, wrote Russel Kinnel, director of fund analysis for Morningstar, which collects data on the thousands of mutual funds, they were “leveled at four big fund companies that were fairly well regarded and trusted by millions.”
The question now for investors is what to do in light of the 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 Bank of America Corp.; Strong Capital Management; Janus Capital Group; and Bank One Corp. Then last week, Alliance Capital Management Holding, LP, 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 Malone, who runs the AllianceBernstein Technology Fund, with $3.3 billion in assets, was one of those suspended. In all, Alliance has $37 billion under management in mutual funds; Bank of America has $30 billion. Janus, the largest of the five named, ranks eighth among all fund houses, with $87 billion.
Mutual funds, which are 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 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 won the public’s confidence.
It’s surprising, but the vast majority of mutual funds are not sold directly to investors through 800-numbers and the Internet. Instead, last year, 87 percent of new sales were sold through third-parties, such as brokers, financial planners, money managers, banks, employer-sponsored 401(k) plans, and insurance companies.
This means, first, that “mutual funds don’t know who their shareholders are,” as Barry Barbash, the former SEC 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 to make profits, at the expense of other investors in the fund, through fancy arbitrage.
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 do so. 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).
So what should investors do? I am a fan of mutual funds, but that 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 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.
Here’s My 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. When 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 Standard &Poor’s index typically charges only around 0.2 percent and beats, on average, most funds managed by humans. I haven’t given up on managed funds, but keep the index alternative 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: 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 Robert Carlson, editor of the fine newsletter Retirement Watch, are: Dodge & Cox Income, with an expense ratio of 0.45 percent; Tweedy Browne Global Value, 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, 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 in which your hard-earned cash is being put. It’s your responsibility.
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 the discipline that smart investors apply. Insist on quality, and this industry, which has boomed because it’s 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.
