Mutual Fund Sins and Penance

11/19/03 – Tom Beilstein, Portfolio Manager

Every day we pick up the business section of our favorite newspaper and find another article discussing improprieties in the mutual fund business. As of this writing, Alger, American Express, Alliance, Bank of America, Bank One, Blackrock, Federated Investors, Janus, Legg Mason, Morgan Stanley, Pilgrim Baxter, Prudential, Putnam, Schwab, Strong and Wachovia have all been tainted with Elliot Spitzer’s brush in one form or another. Elliot Spitzer is the attorney general of New York who brought up allegations of wrongdoing against the mutual fund industry.

There seems to be a number of different “sins” that have been committed. One of these “sins” is market-timing. Market-timing involves frequent short-term trading of mutual fund shares that is designed to exploit inefficiencies in the way mutual fund companies price their shares. Although market timing is not against the law, it tends to add trading costs to a fund, which eventually get passed along to long-term shareholders.

Another “sin” is something known as late-trading. Unlike market-timing, late-trading is against the law. Late-trading is purchasing mutual fund shares after the 4pm cut-off. Some funds have made arrangements to allow special clients to purchase shares after the market is closed. Mutual funds are priced using the net asset value (NAV) of the fund’s holdings as of the close of the market on each business day. A number of mutual funds allowed special customers to wait until after the close to purchase shares, which gave these investors an unfair advantage. This advantage can be especially useful when trading International funds. With the differences in time zones and active market hours, arbitrage situations may occur that can be taken advantage of due to inefficiencies in mutual funds’ pricing practices.

Some companies and brokers have “sinned” by not disclosing important information about the purchase of certain mutual fund shares that could end up costing investors more in fees while increasing the commission paid to the broker. The practice of compensating a broker more for selling any particular mutual fund is discouraged because it can impair a broker’s judgment, which is why brokerage houses are required to disclose any such arrangement before the transaction takes place.

Another “sin” committed by some brokers deals with break points. When buying load funds, or funds that carry a sales charge, a customer earns a reduced sales charge if his assets are above certain preset dollar amounts known as break points. In many cases, a customer has up to a year to achieve these break points. It has been found that some brokers have not disclosed to fund companies when break points have been hit and have not been forthcoming in encouraging customers to reach break points with individual fund families.

The final discouraging thing about this entire scandal is who the individuals are that have committed these “sins.” Dick Strong, founder of Strong Mutual Funds, allegedly profited from market timing in his account and his family’s accounts using Strong funds. Gary Pilgrim, one of the founders of Pilgrim Baxter, allowed a hedge fund to market-time his funds. At Alliance and Putnam, fund managers allowed market-timing in their own funds. A number of high ranking officials have resigned from their posts because, under their supervision, they allowed these questionable activities to occur.

So where do we go from here? Do we get out of mutual funds all together? Do we sell out of all mutual funds connected with the scandal? These are tough questions with which we at Bill Few Associates have been wrestling. We do not feel eliminating mutual funds as an investment tool is the answer. Mutual funds allow us to diversify stock and bond holdings in ways that we would not otherwise be able to do. Clients would have to be multi-millionaires to meet the minimums of a number of private account money managers in order to get the diversification offered by mutual funds.

So what do we do with the scandal-tainted funds? We look at each fund on a case by case situation. We have made the recommendation to sell out of some funds all together, while we have taken a wait and see stance on a number of other funds and fund families. There are three key issues we consider when making the decision to sell or keep one of these funds.

First we ask, is our fund directly affected by market-timing or late-trading? In the case of the Putnam International fund, we believe that this was one of the funds in which the indiscretions occurred. We have been particularly sensitive to issues dealing with our international and global holdings, since they seem to be most vulnerable to questionable behavior. Meanwhile, funds like the Janus Small Cap Value Fund and the PBHG Clipper Focus Fund are far enough removed from the scandal that we are comfortable keeping these funds. Both of these funds are managed by third parties that are not in the fund family’s home office and have impressive long-term track records separate from their parent fund families.

Next we tackle the issue of trust. Do we still trust the fund and the fund family, and will they take their fiduciary duties seriously to put our client’s interests first? This is entirely a judgment call. In analyzing the situations, we have placed an emphasis on who committed the “sin.” In Strong’s case, it was the founder of the company. When it starts at the top, it is hard to imagine that the environment truly places the emphasis on the shareholder’s interests. If the “sin” occurred with a number of brokers not associated with the funds directly, like Prudential, we would be more likely to give the funds some time.

Finally, we are concerned with cash flows coming out of the funds. Large outflows force fund managers to sell some of their holdings. This leads to capital gains, which are paid by the shareholders that are left behind. As of this writing, the Putnam funds had already experienced withdrawals of around $21 billion, which is approximately 8% of their assets. With outflows this large, we do not want our clients to be left holding the tax-bill.

What is the final result of this scandal going to be? Simply put, the mutual fund industry is going to clean up its act. SEC Chairman William Donaldson unveiled a number of reforms he hopes will help restore trust in the mutual fund industry. Donaldson is proposing that funds have specific procedures to keep market timers out of a fund including: 1) mandatory redemption fees for investors who make short-term trades in funds (typically 2%), 2) requiring that brokers disclose the names of new investors to fund families so that market timers can’t hide in omnibus accounts and 3) requiring all fund employees to hold shares for at least 90 days. We should see fund firms stick to the 4pm deadline for mutual fund trades. Finally, funds will be forced to offer more frequent disclosure of their mutual fund portfolios.

In the end, the mutual fund world should be a better place. We will probably have to jump over a few more hurdles to reach it.