Highlights and Commentary

By Roy Weitz

(Originally posted March 1, 2004) [Archive Table of Contents]
After slowing a bit in January, scandal activity picked up nicely in February, and the fund industry continued to check off items on its scandal "to-do" list:



Items #1 through #4 on the industry to-do list were checked off long ago, but some fund companies either didn't get the word, or wanted to make their own contribution to the industry-wide effort:

• The SEC fined MFS $225 million for allowing market timers in eleven funds, and failing to detect late traders, over at least a four-year period. CEO John Ballen, who was actively involved with the market timers, and repeatedly ignored warnings about the damage that timers were causing to his company's funds, received a token suspension from the fund industry, as did Chief Investment Officer Kevin Parke.
  
  
• Franklin admitted that it gave a market timer access to its Small-Mid Cap Growth fund. Greg Johnson, a top company executive (and member of the founding Johnson family), was actively involved in negotiations with the market timer.
  
  
• PIMPCO PIMCO allowed market timing in three of its PEA-brand stock funds (Target, Growth, and Opportunity), and the firm also allowed market timers to park money in PIMCO Total Return, a bond fund run by the ever-present Bill Gross. PIMCO is under investigation by both the SEC and the State of New Jersey, but the firm has invoked the Dumbus Luckus defense, arguing that no investors were actually harmed by its decision to allow market-timing.
  
  
• Item #5 ("Steal money from children") was checked off last month for the first time, when the folks who run Columbia Young Investor fund (and several other funds) admitted that they had allowed market timers to ransack their fund for as long as five years (as you may recall, Young Investor is designed to attract money from kids and teens, and is supposed to teach them the virtues of steady, long-term investing). Not surprisingly, the SEC has charged Columbia with civil fraud. Columbia added to its glory when it fired Bill Garrison, manager of Columbia Small Company Equity, for making market-timing trades in his own fund.

Only Item #6 remains on the fund industry to-do list ("Steal money from Alzheimer's patients"), and the industry still has plenty of time to check that one off, too.....Maybe next month.


Busted! update: We've added two new SEC documents to FundAlarm's Busted! archive: The MFS settlement and the Columbia complaint, both discussed above.....You can view these documents, and the rest of the Busted! archive, by clicking on the permanent link at the top of this page.

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Yes, folks, you are reading these two headlines correctly.....While thousands of honest and law-abiding Americans still look for work, "Boston money-management company" MFS has already announced that it will rehire disgraced executives John Ballen and Kevin Parke upon the expiration of their token suspensions (above).....New MFS CEO Robert Manning can't even say what Ballen and Parke will do when they're rehired, but Manning will apparently find some kind of work for them*.....According to Manning, "this is our way of saying that the recent legal action against MFS was meaningless, and that we have utter contempt for both the SEC and our fund investors".....Oh, sorry, Manning didn't really say that.....I must have misread my notes.
* "Punished Officials to Return to Boston Money-Management Company," Andrew Caffrey, The Boston Globe, February 15, 2004


This should get their attention: As part of its fraud action against Columbia (above), the SEC is asking that Columbia Advisors, the management company for the Columbia funds, be permanently enjoined (prohibited) from "serving or acting with respect to any registered investment company as an...investment adviser".....In other words, if the SEC gets its way, Columbia would be barred from managing its own funds.....And, finally, a proposed penalty that means something.


Last September, we ran an item about shareholder Lionel Amron who was suing the folks who run Morgan Stanley S&P 500 Index.....Amron claimed that they were "grossly overcompensated" by the fees that they earned from the fund, and Amron also claimed that a large percentage of the brokerage commissions of Morgan Stanley S&P 500 Index fund were used as soft-dollar payments to purchase third-party "research" [what are soft dollar payments?].....As we noted at the time:

"Inasmuch as an index fund has no conceivable need for "research," and assuming that Amron's allegation is true, the managers of this fund were almost certainly enriching themselves at the expense of their shareholders.....Whatever the court decides in Amron's case, this seems like an area where the SEC could rule quickly and easily.....The SEC should prohibit index funds from spending soft dollars, period.

Well, maybe the SEC is listening.....The SEC has indicated that it's taking a look at the use of soft dollars by index fund managers......The SEC is also questioning why expense ratios vary so widely for index funds, which are essentially commodity products that should have the same underlying cost structure (a little electricity to power the computers, and perhaps a few bananas to feed the trading desk).....The people who run Sentinel Growth Index C, for example, might want to start brewing some coffee for their SEC visitors, who will probably want an explanation for that fund's 2.68% expense ratio (that's before reimbursements, which bring the expense ratio down to a still-absurd 2.03%).
SEC/Cutler: Sees Potential Conflicts In Fee-Based Accounts," Judith Burns, Dow Jones Newswires, February 3, 2004

Fidelity CEO Edward C. Johnson 3d

In late January, Fidelity hosted a "Conversation on the Economy" with President Bush, unofficially known as the "Greater New England Brown-Nose Competition".....Fidelity provided the facilities for this Presidential campaign stop, and even provided an audience of hand-picked employee shills, who (no surprise) universally expressed their delight with the President's recent tax cuts.....As you may recall, Fidelity was a vocal, public supporter of the tax cuts when they were originally proposed, and Fidelity even trotted out a "survey" of its customers showing that they, too, overwhelmingly favored the legislation.....(As far as we know, Fidelity hasn't followed up with a survey to see how satisfied its customers are after the fact).....In any event, Fidelity CEO Edward C. Johnson 3d (left) was the winner of the brown-nose competition, when the President suddenly stopped short on his way to the auditorium stage.

A year ago, Fidelity CEO Johnson (above) teamed up with Vanguard CEO Brennan to write a futile, poorly-reasoned op-ed piece for The Wall Street Journal.....In last year's piece, Johnson opposed disclosure of mutual fund proxy votes, which happened anyway.....This year, Johnson apparently got the itch to wage his second futile battle, and on February 12 he penned another Journal op-ed column.....This time, Johnson (flying solo) came out against the recent SEC proposal for an independent mutual fund board chair.....Johnson's family owns Fidelity, and Johnson is also chairman of every Fidelity fund board, which seems to suit him just fine.....In his column, Johnson looks to the world of operating companies.....In arguing against independent chairs for fund boards, Johnson notes that corporate boards with independent chairs have had a mixed record of success.....This may be true, but it's a bogus argument, and Johnson knows it.....The director of a mutual fund isn't even remotely comparable to the director of a company that has fixed assets, and inventories, and customers.....Fund directors need to do only three things, but they need to do them with an attitude of complete independence: Negotiate the lowest possible management fee, monitor performance, and make sure that nobody breaks the law.....In general, independent directors have failed miserably at these tasks, especially the first two, but it's safe to say that owner/directors like Johnson have less incentive than anyone to push hard in these areas.....Mutual fund boards need better and more independent-minded directors, but they definitely don't need fund owners in charge......Johnson is going to lose this battle, just like he lost a year ago, and we're already looking forward to his next futile column.


If it looks like a duck and quacks like a duck, it must be someone else's duck:

• On September 30, 2003, five of the ten largest holdings of Putnam Small Cap Growth jumped at least 1 percent in the final 15 minutes of trading;
  
  
• On that same day, six of the top 12 holdings of Oberweis Micro-Cap jumped at least 1 percent in the final 15 minutes of trading;
  
  
• On that same day, three of the top 12 holdings of Bjurman, Barry Small Cap jumped at least 1 percent in the final 15 minutes of trading;
  
  
• On that same day, three of the top six holdings of Nicholas Applegate Growth Discovery jumped at least 1 percent in the final 15 minutes of trading;
  
  
• On that same day, three of the top eight holdings of RS Smaller Company Growth jumped at least 1 percent in the final 15 minutes of trading;

In each case (except for RS, which refused to comment), the fund's manager denied making any trades that could have caused these quarter-end price increases (and therefore led to higher performance rankings).....If you look at last-minute stock price increases for June 30, 2003 (the end of the second quarter), and probably for every quarter in recent history, you'll see a similar pattern, and you'll get similar denials from mutual fund managers.....It's clear that some fund managers, somewhere, must be manipulating the small-cap market, but the SEC continues to be frustrated in bringing this kind of case, because it's so tough to prove intent.....Meanwhile, for investors, this kind of manipulation makes published performance numbers less reliable, and it also makes buying a small-cap fund on the last day of a quarter becomes something to avoid if at all possible.
"The Other Mutual Fund Charade," Bob Drummond, Bloomberg Markets, February, 2004


Welcome back, Porky. What's on your mind?

Porky

Thanks, Roy. You know, over the years I've noticed that humans tend to be an optimistic species, and pigs generally aren't. I think it may have something to do with the different way we're treated in restaurants. Anyhow, humans have recently been optimistic that the mutual fund scandals would result in lasting improvements to the fund industry, and especially lower fees. Oh, you deluded, short-snouted beasts! In a move that every trough-feeder can admire, Evergreen recently announced that it's increasing the 12b-1 fee at 19 of its funds by 25%, even though most of those funds have already grown dramatically over the past year, and several have more than doubled in size. (The official reason for the fee increase: "...to promote the sale of more shares of the Fund to the public.") If you're an optimistic human, you probably think the SEC will swoop down on Evergreen, and slap them around for abusing an already-corrupt 12b-1 system. But take it from me, the other white meat: Evergreen will get away with it, and other fund firms will follow. Where I come from, we call this "business as usual." (Porky's comments were inspired by an article by John Shipman in The Wall Street Journal)

If you want the real inside scoop on your fund company, check out the February 2004 issue of Money magazine (which is also available online)*.....Several months ago, Money put together a terrific questionnaire, which it sent to 108 of the largest mutual fund companies.....The questionnaire was clearly inspired by the recent fund scandals, but it's not merely a scandal survey, and many of the answers provide unique and useful information about fund company practices......Among the answers that we found most interesting:

Four fund companies (Davis Selected, Eaton Vance, Putnam, State Street Research) admitted that they incubate new funds (i.e., start new portfolios that are unavailable to the general public until a good track record is established). Incubated funds can mislead investors, and incubation is one of the sleaziest marketing tricks in the fund industry's bag of sleazy marketing tricks. Only one company (Brandywine) pays its directors entirely in fund shares (the rest of the companies pay in cash, or they give directors the option to receive fund shares). Five fund companies (MFS, Oppenheimer, Putnam, Sun America, Waddell & Reed) provide "pensions or other retirement benefits" for their independent directors. This seems quite generous, considering that many people who have real jobs still don't receive these benefits. Only one fund company (Janus) flat-out prohibits its fund managers from owning individual stocks in their personal accounts, a policy which eliminates a serious conflicts of interest. Two fund companies (Sun America and Wasatch) base fund manager bonuses on "one year" or "calendar year" performance, which can encourage managers to be overly aggressive in their trading. Most other fund companies base their bonuses on some type of multi-year formula (for example, "1,3,5" or "rolling four year periods" in the case of the American funds). Davis Selected bases its bonuses solely on five-year performance, which is a good long-term incentive, while a couple of firms (Oakmark and T. Rowe Price) look at both short- and long-term performance (i.e., one, three, five and 10 years). Relatively few fund companies pay manager bonuses based on a fund's "asset size or net cash flow." However, a few fund companies (ABN AMRO, Baron, Neuberger Berman, PBHG, Sun America, and Thornburg) do admit to this practice, which can encourage managers to emphasize the size of their portfolios instead of the quality of their results. Only two fund companies (Longleaf and Waddell & Reed) have a "written policy requiring portfolio managers to invest in the funds they manage." Portfolio managers for the Baron funds have invested, on average, $72 million in their own company's offerings, which is by far the largest amount of any fund company that responded (and is no doubt helped by Ron Baron's own, substantial investment). Other large investments include an average of $9.2 million by managers of the Royce funds and an average of about $18.5 million by the folks who run the Weitz funds.

Some of the responses to the Money survey, above, don't reflect particularly well on the respective fund companies, but 59 firms at least took the time and trouble to answer the questionnaire (this includes several firms that are already in hot water over the fund scandals and easily could have begged off).....Forty-nine fund companies received the questionnaire but chose not to respond, and the reasons for not responding range from the unconvincing to the totally obnoxious.....For example:

Fund company not responding to the Money questionnaire	Stated reason for not responding	FundAlarm says:
Gabelli	"Mr. Gabelli doesn't have time for a survey"	"Hey, Mario, that's what a staff is for"
Gartmore	"Legal is very concerned"	"Hmm, do they have reason to be?"
JP Morgan	"They don't see what they'll get out of it, they're not under scrutiny"	"They might get better-informed customers. Oh, wait, there's no money in that."
Lord Abbett	"Just given the current environment [we] would rather pass on the opportunity"	"Who wouldn't?"
Nuveen Investments	"Mutual funds not one of our core businesses"	"Bet that's going to be news to some of your mutual fund investors"

The accompanying page contains a list of all fund companies that did and did not respond to the Money survey.

* Accessing the Money survey: The February 2004 print edition of Money contains a summary of the survey results, but the real meat is online.....All AOL users can access the survey via the keyword "money," but only Money magazine subscribers can access the survey at www.money.com.....In both cases, from the Money home page, click on "Mutual Funds" (left side of page), and then click on "Ultimate Mutual Fund Guide 2004".....We suggest that you first view the individual survey responses for each firm that you're interested in.....Once you're familiar with the questionnaire format, you can compare your firm's responses to all of the other firms by viewing the comprehensive spreadsheet that Money has prepared.


Briefly noted:

• Don't look now, but Fidelity Magellan is a pointless fund.....Oh, darn, somebody did look: According to Brooke Southall, of InvestmentNews, Fidelity's flagship fund has fallen into a deep, benchmark-lagging hole.....This behemoth fund has trailed the S&P 500 index for four of the past seven years that Bob Stansky has been in charge, including the past two years in a row, and Stansky is about 100 basis points (1%) behind the S&P 500 on a cumulative basis .....Stansky isn't necessarily a bad manager, but this is pretty much an impossible fund for anyone to run, and -- we'll go out on a limb here -- Magellan will never again beat the S&P 500 over any five-year period unless the fund becomes significantly smaller.....You can help yourself, and your fellow investors, by making sure this fund becomes smaller: Sell it, and find another large-cap blend offering, especially if you can do so in a non-taxable account.
  
  
  
• Mutual fund columnist Scott Burns also took a look at Fidelity Magellan, and also didn't like what he saw.....Starting with FundAlarm data -- good man -- Burns notes that Magellan is a 3-ALARM fund.....Magellan has also trailed the S&P 500 for the past 10 years (twice as far as FundAlarm looks back), and the fund has barely outperformed the S&P over the past 15 years (it's ahead by just 0.24% per year, annualized).....Burns notes that Magellan took in about $516 million in management fees for Fidelity last year (which, we note, generated more profit for Fidelity than T. Rowe Price earned as an entire company).....So, what's the chance that some Fidelity employee will ever propose fixing this fund, and risk screwing up the firm's fattest cash cow?.....You are correct: No chance at all.
  "Fidelity Magellan: 'A Strong Candidate for Sale'," Scott Burns, uexpress.com
  
  
  
• Mary-Kay Bourbulas is the manager of Strong High-Yield Municipal Bond.....In July 2001, Bourbulas told The Wall Street Journal that "the worst is over" for her struggling fund.....Several months later, in October 2001, the default rate on the fund's holdings had crept up to 10.9%, the performance of the fund was still dismal, and Bourbulas told the Journal that her outlook for the high-yield muni market was "positive".....In September 2002, Bourbulas apparently grew tired of feeding BS to The Wall Street Journal, so she turned to Kiplinger's magazine, telling a reporter that she was "slowly purging the fund of its worst bonds".....Last month, Kiplinger's again turned its attention to the Bourbulas basket case, and the news is not good*.....In 2003, for the fourth straight year, Strong High-Yield Muni finished dead last among all tax-exempt bond funds.....The fund's 11% loss for 2003 also marked the fifth straight year of negative returns.....The fund still has about $84 million in assets, which means that a number of its shareholders (1) are dead, (2) have forgotten about their money, or (3) prefer to emphasize hope over bitter experience.....Even Strong's muni-bond chief says that "it would be nice to merge this fund away, but the portfolio is not positioned to do that right now."
  * "A persistent odor of failure," Mark McLaughlin, Kiplinger's, March 2004
  
  
  

  New co-managers Jonathan Art (left) and Mark Bauknight

  Lawrence Auriana and Hans Utsch, the famous suspender-clad duo who manage Federated Kaufmann, have quietly added two co-managers.....FundAlarm reader "Ron" suggests that a changing of the suspender guard may be coming soon, and we have a feeling that Ron may be right.

  
  
  
• Over-caffeinated investors, who have never had a fund specifically designed for them, may be interested in the launch of Trend Trader Growth and Income.....The fund's assets will be allocated among four different rapid-trading models, with each model based on a 60-minute [!] time frame .....According to the fund prospectus, "portfolio turnover rates will generally not exceed 400%," which seems low, but certainly puts Trend Trader out of consideration for taxable accounts.....The quoted expense ratio of 1.05% is also low.....Transaction costs, which are not included in that number, could easily add another percent or two.
  
  
  
• Look for the ads that say WOW! Fidelity has again started advertising the short-term performance of its funds (remember 1999?), and columnist Chuck Jaffe has a great suggestion: Require every fund ad with performance numbers to include the fund's worst 12-month performance as well.....Investors would be able to put each fund's performance claims in context and, not incidentally, fund companies would be less likely to run these irresponsible performance ads in the first place.
  "Show us your worst," Chuck Jaffe, CBS.MarketWatch.com, February 22, 2004
  
  
  
• The SEC has been busy cranking out proposed mutual fund rules, and more are on the way for March.....If you'd like to keep track of these rules, and maybe even comment on them, the SEC maintains a Web page just for that purpose: http://sec.gov/rules/proposedwebforms.shtml.....It usually takes a couple of weeks from the time you read about a proposed rule until it's made available on this page, but they all get here eventually.....And, if you just want to waste some time, it's fun to read the e-mail comments that the SEC has already received from other investors (look under each proposed rule for a link that says "Comments received electronically are available for this proposal").
  
  
  
• He gets it: Senator Peter Fitzgerald (R-IL), who's been conducting hearings on the mutual fund industry for the past several months, has finally produced his fund reform bill, and it's a gem......Fitzgerald understands the key issues for investors, and he's nailed them in this bill which (among other things) calls for the complete abolition of 12b-1 fees.....Unfortunately, Fitzgeralds's bill is likely to go nowhere unless Senator Shelby, of the Senate Banking Committee, also gets on board.....While we await further action, you might want to renew your faith in a small part of government by reading a summary of Fitzgerald's bill, which we've lifted off his Web site.
  
  
  
• If you're not already familiar with The Callan Periodic Table of Investment Returns, you might want to take a look (and thanks to Linkster Ted, of the FundAlarm Discussion Board, for posting a link to this Table).....The Callan Table is an extraordinary chart, now with 20 years of history, that shows the relative annual performance of seven stock-market segments (plus one bond-market segment).....If there's a better case for investment diversification, we've never seen it (http://www.callan.com/resource/periodic_table/pertbl.pdf).
  
  
  
• Inexplicable mutual fund graphic of the month:
  
  

  From the Sentinel funds Web site

  
  
  
• Congrats to the mutual fund industry, which recently earned the #9 spot on a national list of "Top 10 Scams, Schemes, and Scandals"......The list is compiled by the North American Securities Administrators Association, and "mutual fund sales practices" are now recognized along with such long-time scandal regulars as Ponzi schemes, investment fraud on seniors, and affinity fraud.
  
  
  
• The Whiston Watch:
  
  

  	Number of months that Janus CEO, Mark Whiston, still hasn't explained his role in the Janus market-timing scandal, including what he knew and when he knew it.

  
  
  

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