- Janus Funds stated that it had allowed large clients to avoid the short-term trading re-strictions mandated in their policies;
- Money magazine reported that Wilshire Associates had engaged in short-term trading of mutual funds;
- Alliance Capital suspended a portfolio manager and an executive for related activities;
- In October, for similar reasons, Prudential, Merrill and Alger funds took action against some of their employees.
- Review the funds prospectus, most recent quarterly and annual reports, and marketing materials;
- With that as background, review the comments of independent observers such as Morningstar; and
- Hire commitment, brains and passion and reject pomposity, simplicity and marketing hype.
- Who makes the decisions on issues relating to research, allocations, purchases and sales?
- How are new investment ideas generated?
- What resources are devoted to research?
- What is the managers trading discipline?
- What is the managers buy and sell discipline?
- Manager letters that address investors as owners;
- Manager letters that address investors as intelligent adults interested in the truth;
- Admission of errors as well as successes;
- Appropriate and timely disclosure of positions and market exposures;
- Honesty regarding details of the individuals responsible for making daily decisions in the management of investors money; and
- A board of directors with significant representation of truly independent directors.
- Trust: Each investor must decide for themselves what they believe to be the truth as related to the issues raised by regulators. My own judgment is that there is adequate public information to conclude that the failure of fiduciary responsibility is endemic to the firms. My firm has monitored the actions and statements of the firms and weve not been impressed (for instance, Richard Strongs quoted comments). Fool me once, shame on you; fool me twice, shame on me.
- Reality: I believe, totally independent of the ethical/moral issues involved, there is the risk of being the one person standing in a game of musical chairs. As I write this, the media reports that Putnam has lost $14 billion in assets and estimates for Strongs losses are more than $1 billion with major institutional investors poised to jump ship. Remaining shareholders are at risk of increased fees as costs are spread over a smaller asset base. They also risk sub-optimal returns as managers are forced to sell to meet liquidation demands regardless of their market expectations and as the firms management is distracted by legal and regulatory issues.
- Ever increasing disclosures of fraudulent actions;
- Class-action suits against fund companies undermining their attention to the management of the funds and potentially threatening the solvency of some firms; and
- Soft dollar scandals.
- More and better regulations, particularly on issues such as market timing, portfolio disclosure, improved board independence and authority, along with board fiduciary responsibility to the shareholders;
- A renewed recognition on the part of fund companies of their fiduciary responsibilities;
- Better disclosure of fund fees;
- Reporting of fund turnover costs; and
- Better disclosure of the names of individuals responsible for the management of the funds and the nature of their compensation.
Scandal! What Should You Do With Your Funds?
by Harold Evensky
Many individual investors remained relatively sanguine after the corporate blowups, such as Enron, because the problems directly affected institutional investors, not individuals.
Its hard to believe, but those scandals seem like the good old days, and a newer set of scandals has beset the mutual fund industry. Since September, there has been an increasing number of news stories concerning some new legal and moral failures by those entrusted with individual investors funds.
What should individual investors do in the face of these unhappy revelations?
The tip of the iceberg was exposed by New York States Attorney General Eliott Spitzer, when he claimed that the Strong Funds allowed a hedge fund manager—Canary Capital Partners—to illegally late trade, meaning that they were allowed to trade fund shares after the legal trading hours. Mr. Spitzer also accused Bank One of allowing Canary to sell funds without paying the short-term redemption fee that supposedly applied to all investors.
Then came these disclosures:
Poster children for the scandals are Putnam Investments, Strong and the Pilgrim Baxter family of funds. A tip from a Putnam call-center employee to regulators in Massachusetts led to Putnam becoming the first fund family to be charged for improper trading. The New York states attorney generals office has indicated that it is seriously considering filing criminal charges against Strong funds founder, Richard Strong.
Gary Pilgrim and Harold Baxter, founders of the PBHG funds, also stepped down as a result of allegations related to their personal timing of their own funds. In addition, in early November, Lawrence J. Lasser was removed by Marsh & McLennan, Putnams parent, as Putnams president, CEO and director. About the same time, Richard Strong resigned as chairman of Strong.
Stanford professor Eric Zitzewitz, an economist who has studied these issues and was referenced by Spitzer in his briefs, estimates that late trading occurs in at least one out of every six fund families and costs investors $400 million a year. He estimated a $5 billion a year loss from short-term traders, or market timers. Note, however, that this estimated loss is not all attributable to scandalous fund management. Some firms allow and others encourage participation by timers. In those cases, the losses may exist but the responsibility of the loss is on the naive buy-and-hold shareholders who may be investing in ethically managed, but inappropriate, funds.
Fund apologists have noted that, in the scope of fund assets and returns, these losses are really quite small.
This is probably true, but the observation completely misses the point. The issue is a massive failure of fiduciary responsibility. A scary example of ethical relativity is Richard Strongs claim that his trading wasnt disruptive to the funds, although he has pledged to repay any investor losses caused by his trading.
What Should You Do?
Investors need to integrate in their investment planning a serious effort of due diligence (i.e., intelligent investigation), a large dose of skepticism (if its too good to be true, it isnt true), and a big measure of common sense. Also, and they need to touch base with reality (mutual funds might now seem like the worst form of investment—except for the alternatives).
In selecting a manager, start by ignoring performance and focus on the three Ps: philosophy, process and people.
Philosophy: Ask yourself why you should give the fund some of your money to manage. You should be able to discern a clearly defined, credible and consistent statement of the managers strategic view of his or her investment markets. To do this, you should:
If you cant get answers to these kinds of questions (or if you get inconsistent answers), remember caveat emptor and run for the nearest exit. Although there is no definitive research, so far the problems have been associated with funds and/or firms that emphasized hot performance associated with high fees. I dont think investors will go very wrong by using hype ads and high fees as quick-and-dirty criteria for eliminating a manager from consideration. Here are some reasonable maximums for mutual fund fees:
|Investment-Grade Bond Funds||0.8%|
|Large-Cap U.S. Stock Funds||1.0%|
|Mid-Cap U.S. Stock Funds||1.0%|
|Small-Cap U.S. Stock Funds||1.5%|
|Foreign Stock Funds||1.5%|
|Emerging Market Funds||2.0%|
Dont just look at the ads, read the ads. Firms that promote hot returns, particularly for the short term, may just be telling you something about their corporate culture: greed often begets greed, and guess who will end up the loser. Consider that one of the most respected of managers, Vanguard, as a matter of policy, does not use performance data in its ads.
Firms that use misleading marketing should cause you to hesitate—for instance, offering funds with names that dont accurately reflect the nature of the funds investments, or having a history of redefining their mandate when their market takes off and they want to keep bringing on investors. A skeptic might believe this is bad news for the investor and bigger fees for the manager.
Look for funds with a history of closing to new investors when too much money starts pouring in.
Also, be on the lookout for managers who tout their funds but invest elsewhere—they may know something you dont. The funds Statement of Additional Information lists anyone who holds at least 5% of the funds shares. Some funds voluntarily provide this information for all senior management and managers. Although no guarantee of ethical behavior, someone who eats his or her own cooking is unlikely to add poison to the recipe.
And look for funds that at least have some controls over market timing. In particular, look for a statement in the prospectus indicating that the fund has a policy regarding the control of market timers. The following is a good example:
Excessive Trading Policy: Frequent trades in your account or accounts controlled by you can disruptportfolio investment strategies and increase Fund expenses for all Fund shareholders. The Fund is not intended for market timing or excessive trading. To deter these activities, the Funds or their agents may temporarily or permanently suspend or terminate exchanges out of a fund in a calendar year and bar future purchases into the Fund by such investor.
Of course, as with all of the previous criteria, this is not a guarantee—the policy above is from a Janus prospectus.
Believe actions, not words. When Money magazine interviewed Richard Strong in 2002 for a profile story, the reporter noted that one of Strongs first comments was The client comes first at all costs.
But those are just words. Credible actions include:
Consider the alternatives. We live in a messy world and may as well make our peace with it—while watching our money like a hawk. Before you give up on a fund or fund family, decide if the problem is endemic to the firms culture, or a disappointing but honest failure of the firms oversight system.
If its the former, get out!
If the problem is a result of poor oversight, how has the firm reacted?
Has management unequivocally acknowledged not only the problem but the responsibility to fix the problem?
Has management taken swift and unambiguous action to resolve the problem and made every effort to ensure no further repetitions?
Or has management cavalierly reported that the financial consequences were minor and, in its benevolence, it will make good the diminimus losses.
Have patience with those making a demonstrable effort, fire the cavalier.
As for alternatives, in addition to a significant number of good guy (I hope) fund companies (including biggies such as Vanguard, T. Rowe Price, American Funds and TIAA-CREF), there is the universe of exchange-traded funds and separate accounts.
Putnam, Strong and PBHG are certainly the biggest names in the current scandal sheets. I believe that investors should give serious consideration to changing to new investment managers. I base this recommendation on two considerations:
Others in the hot seat include Bank of Americas Nations Funds, Bank One Corp. and Prudential. So far, these seem to fall into the category of a failure of the system rather than a failure of the firm. My recommendation for investors in these and other firms that may come under scrutiny: Wait, but watch, and be prepared to move.
Charles Schwab disclosed in mid-November that its own internal investigation, initiated as a result of inquiries from regulators, uncovered evidence of improper trading both in its supermarket of funds and at the fund family of its subsidiary, U.S. Trust.
For me and my firm, this was the news that hit closest to home. Although we do not currently invest in Schwab or U.S. Trust funds, many of our clients have assets custodied at Schwab. Also, as a firm and personally, weve had a long, positive relationship with Schwab and its employees. Based on the information to date and our decade-plus of experience with Schwab (the people), I am convinced that the issue is a system, not people, failure.
In addition, I find the firms current response to the disclosure in keeping with my expectations.
However, even though my experience and gut tell me that the problem is disturbing but manageable (and forgivable), I will not ignore basic skepticism. We will carefully monitor the news regarding the firms and regulatory investigations as well as the firms on-going response.
For those who like to have something new to worry about, you can expect:
In short, keep your eyes open and your antenna alert.
What Is Late Trading?
Late trading refers to the practice of placing orders to buy or sell mutual fund shares after the market close at 4:00 p.m. ET, but at the net asset value (NAV), or price, determined at the market close. Late trading enables the trader to profit from knowledge of market moving events that occur after 4:00 p.m. ET, but are not reflected in that days fund share price. Late trading is illegal.
What Is Market Timing?
Market timing refers to the practice of short-term buying and selling of mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Although market timing is not illegal per se, many mutual funds try to prevent it because it tends to harm long-term mutual fund shareholders.
Harold Evensky, CFP, is chairman of Evensky, Brown & Katz, a fee-based financial planning and investment management firm based in Coral Gables, Florida; 305/448-8882; www.evensky.com. Mr. Evensky is also the author of Wealth Management, published by McGraw/Hill and available through www.amazon.com.