FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted May 1, 2004) [Archive Table of Contents]

Jim has informed us that you resigned as Janus CEO on April 20, and we will be sorry to see you go. This memo covers certain logistical details and financial matters related to your separation from Janus, which we would like to wrap up at soon as possible.

Please refer to your Janus Employee Handbook, page 12, for a checklist of items that you must return to this office before your last day of employment. In particular, please be sure to turn in your building key, parking card, and Janus ID card. Please make arrangements to clear out your office by the end of May, and be sure to remove all "Death to FundAlarm" signs.

As a result of your resignation, we understand that you have negotiated a severance package of $17.1 million, which breaks down as follows:

Separation fee and fee for future consulting services: $5.8 million
Deferred compensation: $7.9 million
Vesting of Janus shares: $3.4 million

As you know, shortly after you resigned Janus also settled its recent market-timing difficulties with the SEC, as well as the Attorneys General of New York and Colorado. The cost of that settlement, which will be $225 million, breaks down as follows:

Restitution and disgorgement: $50 million
Civil penalties: $50 million
Mandatory reductions in fund fees: $125 million

As you will note, Janus is in the unusual position of paying you more than $17 million in severance benefits, while at the same time Janus is obligated to pay $225 million in settlement of its market-timing activities, some of which you presided over as CEO. In a spirit of fairness, Jim has asked if you would agree to reimburse the company for a portion of its financial obligation. In round, ballpark numbers, Jim estimates that your actions (or inaction) as CEO were responsible for $50 million of damage to the company. Therefore, we would ask you to forego your $17.1 million severance package, and enter into an agreement whereby you agree to reimburse Janus, on a monthly basis, for the remaining $32.9 million of damage that was attributable to your tenure as CEO. We are flexible on the terms of the repayment sechdule, and we would consider any time frame for repayment (interest-free) up to 30 years. For example, if you select a 25-year term, your reimbursement to Janus would be $109,667 per month.

We believe this is an equitable proposal, and we look forward to hearing from you as soon as possible.

On a more pleasant note, Jim wishes to remind you that FundAlarm has ended its "Whiston Watch."

Columbia Young Investors is one of the funds that sold its soul to market timers, and Columbia recently paid $140 million in fines and resitituion to settle with the SEC and New York regulatory authorties.....During the entire time that Young Investor welcomed market timers, its prospectus contained a strong anti-timing statement:

"The fund is not intended for short-term or frequent trading in its shares. [Market-timing transactions] disrupt portfolio management and increase Fund expenses."

Now, with the market-timing settlement under its belt, the latest Young Investor prospectus seems a bit less certain about the hazards of market timing:

"Purchases and exchanges should be made for investment purposes only. [Market-timing transactions] may disrupt portfolio management and increase Fund expenses."

We've highlighted the word "may," just above, because it's actually quite astonishing.....A few months ago, before its legal troubles began, Columbia was willing to say, without qualification, that market timing was disruptive and increased fund expenses.....Today, a somewhat poorer and supposedly chastened firm can only say that market timing "may disrupt portfolio management and increase Fund expenses".....Looks like we're seeing the hand of a lawyer here, who's creating some wiggle-room just in case there are future market-timing allegations.

Muhlenkamp to Investors: "We're Partially Brain-Dead"

Most fund shareholders don't find out that they've got a brain-dead manager until it's too late, so kudos to the Muhlenkamp fund for setting the record straight from the start.....In fact, it's all spelled out in the current Muhlenkamp prospectus, under the heading "Proxy Voting Procedures".....The manager of the Muhlenkamp fund says that it used to vote proxies based on the "perceived...merits of the individual proposals," which sounds like a pretty good idea to us......But about a year ago, the SEC required fund managers to start making their proxy votes public.....The folks at Muhlenkamp don't like the idea that they'd have to keep records of their proxy votes, and they also don't like the idea that the new SEC rule might require them "to defend those votes at a later date".....Therefore, Muhlenkamp has announced its new proxy policy, which is to turn off its brain and "always [vote] in line with management recommendations."

If you want to know how much it costs to operate your mutual fund, you might take a look at its expense ratio.....But as many investors now know, the expense ratio accounts for only a portion of each fund's true cost of operations.....For example, commissions to buy and sell fund securities aren't included in the expense ratio, even though the dollar amount of commissions can often exceed all other fund expenses combined.....Some funds incur high commission costs because they trade a lot, while other funds knowingly overpay commissions as part of a soft-dollar plan [what are soft dollar payments?].....According to a recent study, commissions as a percentage of fund net assets (in effect, the "commission expense ratio") are most significant at the following 15 funds:

Fund	(A) Reported expense ratio	(B) "Commission expense ratio"	(A)+(B) Combined expense ratio
Van Eck Intl Invest Gold A (INIVX)	1.97%	3.85%	5.82%
ING Sm Cap Oppty A (NSPAX)	1.89	2.24	4.13
Van Wagoner Emerging Growth (VWEGX)	2.00	2.02	4.02
RS Midcap Opptys (RSMOX)	1.67	2.33	4.00
RS Diversified Growth (RSDGX)	1.69	2.24	3.93
Quaker Aggress Growth A (QUAGX)	2.17	1.59	3.76
AXP Global Tech A (AXIAX)	1.91	1.72	3.63
RS Smaller Co Growth (RSSGX)	1.95	1.50	3.45
Strong Mid Cap Discip (SMCDX)	1.49	1.81	3.30
RS Value + Growth R (RSVPX)	1.66	1.61	3.27
AXP Partners Small Cap Growth A (AXSCX)	1.55	1.64	3.19
PBHG Tech & Commun (PBTCX)	1.70	1.46	3.16
Caldwell & Orkin Market Oppty (COAGX)	0.92	2.05	2.97
ING Small Company I (AESGX)	1.13	1.75	2.88
PBHG Large Cap (PLCVX)	1.20	1.56	2.76

If you own one of these funds with an eye-popping combined expense ratio, what should you do?.....The quick and easy answer is "Find a cheaper fund".....Unfortunately, we're not aware of a single mutual fund that currently discloses its "commission expense ratio".....None of the current SEC fund-reform proposals calls for disclosure of the commission expense ratio, although some fund firms, such as Putnam, say that they'll start making this information available on their own.....The best investors can hope for is that other firms will voluntarily follow Putnam's lead and start disclosing their own commission expense ratios.....And what were the chances, six months ago, that we'd be holding out Putnam as a model for the fund industry?
"Deciphering Funds' Hidden Costs," John Hechinger, The Wall Street Journal, March 17, 2004

FundAlarm had its doubts about PBHG way back in November 1997:

PBHG wants to hang with the big boys: With great fanfare, PBHG recently lured away Fidelity's marketing manager, Paul Hondros.....Seems that Hondros and PBHG have ambitious plans to expand, and PBHG now sounds like an unfocused teenager making career plans: It may open (or acquire) several new funds, it may start a line of broker-sold funds, it may establish a discount broker, it may pursue the 401(k) market....Apparently not on the list of PBHG possibilities: Dating Madonna, starting a rock band, or simply doing a better job with what it already has..... And what are the potential benefits of expansion for PBHG shareholders?..... Absolutely, positively, nothing.....This is an ego trip, pure and simple.....OK, we take that back....It's not just an ego trip: It's also an attempt by PBHG management to grab the bucks while the grabbing is good .....If you own a PBHG fund, take note: Your interests are not being served.

As it turns out, we were way too easy on the firm.....According to a recent, devastating article in Fortune magazine, PBHG was pretty much the definition of the corrupt, dysfunctional fund company from the time it first appeared on most investor radar screens in the mid-1990s.....Among the dots that few seem to have connected until now:

In 1995, PBHG principals Gary Pilgrim and Harold Baxter sold their firm to United Asset Management (UAM) for about $135 million, and they also retained a sweet revenue-sharing deal (worth, at its peak, about $20 million a year between them). But Baxter, the super-salesman, suffered a severe case of seller's remorse after the UAM deal. Baxter became especially bitter when PBHG's asset base exploded, and it became clear that he and Pilgrim could have sold out for hundreds of millions more than they got from UAM.
Pilgrim and Baxter quickly turned into money grubbers, obsessed with recouping the cash they felt was left on the table after selling to UAM. The two owners weren't willing to provide meaningful financial incentives for key employees, they weren't willing to spend on building a distribution network (which is why Hondros, above, ultimately failed in his grand expansion plans), and -- most ominously -- they turned to to market-timing hedge funds as a way to squeeze additional cash out of their mutual fund business. Beginning in 1998, Pilgrim and Baxter opened their firm to as many as 100 different market timers, and one estimate puts the market timers' take at $750 million, all of it skimmed from the accounts of legitimate fund investors. Pilgrim nurtured his own, special relationship with a hedge fund called Appalachian Trails, in which he eventually owned a 45% stake. In 2000 and 2001, Appalachian made $13 million from market timing PBHG funds, and Pilgrim allegedly made sure that the Appalachian manager always had up-to-date information about PBHG fund portfolios, so that Appalachian's trades were essentially risk-free.
In keeping with Pilgrim and Baxter's me-first attitude, PBHG became a playground for Baxter's family members. Baxter's daughter Patty became a $100,000-a-year office manager, which at least minimized the damage she could do to investors. But investors weren't so lucky with Baxter's other daughter, Christine, a freshly-minted philosophy major, who became the first co-manager of PBHG Emerging Growth. When Emerging Growth cratered, and Chrissie grew tired of mutual funds, the fund was handed to Erin Piner, an manager with no evident qualifications other than being Patty Baxter's best friend. Oh, and back to Christine: Somewhere along the way, she became friends with one of the firm's assistant traders, who didn't like working under PBHG's well-qualified head trader. To keep her friend from leaving the firm, Chrissie arranged to have the head trader fired, and the assistant was installed in his place.

PBHG currently claims to be rebuilding itself, which seems like a poor choice of words, since the Fortune article makes clear that there was never any substance at PBHG to begin with.....Unlike some scandal-tainted firms, which arguably have some traditions and values to fall back on, PBHG was never much more than a balloon inflated with marketing gas.....PBHG has a recognizable name and some assets, but otherwise it's a firm that is truly starting from scratch.....If you're a PBHG investor, you might ask yourself if this is the kind of learning experience you want to subsidize.
"The House Always Wins," John Helyar, Fortune, March 8, 2004.

And now for something completely misleading:

[From the Website of the Heartland funds]


	Oh, sure, Heartland doesn't profit from 12b-1 fees, just like vultures don't profit when lions make a kill.....The fact is, 12b-1 fees -- taken directly from investors' pockets -- pay for things that Heartland would otherwise have to pay for itself, which is just as good as a profit.....More importantly, 12b-1 fees help Heartland grow the asset base of its funds, and a larger asset base means larger management fees, which translates into just about pure profit.

You can expect a flurry of new fund rules from the SEC over the next few months, almost all in reaction to the ongoing fund scandals.....The first batch of rules, announced in mid-April, provide for the following:

Every fund must now disclose...	...in the following document
...the risks faced by shareholders as a result of market timing	Prospectus
...whether its directors have adopted policies and procedures with respect to market timing and, if not, why not	Prospectus
...its policies and procedures to deter market timing, if any, described "with specificity"	Prospectus
... any market-timing arrangements currently allowed by the fund	SAI*
...the circumstances under which it will use fair-value pricing	Prospectus
...its policies and procedures for disclosing information about its portfolio securities (also, any ongoing arrangements for making such disclosures)	SAI*

* Statement of Additional Information
This is pretty boring stuff, but we suspect these rules will be relatively effective in putting a stop to market timing -- not because every fund shareholder will read the disclosures (few will), but because few funds will want to hang the scarlet "T" (for timer) on themselves.....And speaking of scarlet letters, what about the words, above, that we've highlighted in red?.....Thanks to the SEC, funds will still be able to bury the description of any current market-timing arrangements in the Statement of Additional Information....Since this is by far the most embarrassing disclosure, and also probably the most significant one, you have to wonder if the SEC really has its heart in these new rules after all.

Briefly noted:

On April 1, 2004, Thurlow Growth ranked in the 100^th percentile -- dead last -- for performance over the preceding one day, one week, four weeks, three months, one year, and three years, compared to all mid-cap growth funds.

"Why, that looks like the work of an amateur."

"Bingo."

Source: "This fund can't escape strategy, expense ratio," Chuck Jaffe, cbs.marketwatch.com, April 2, 2004
"It hasn't sucked recently as much as it's sucked before": When that's the best you can say for a mutual fund, it's probably time for a manager change, and Vanguard finally got the message with Vanguard U.S. Growth.....Effective immediately, William Blair & Co. will pry about 25%-30% of this fund's assets from its current (and ineffective) sole manager, Alliance Capital Management.
As a part-time critic of the mutual fund industry, Warren Buffett has been both outspoken and right on-target.....Now, Buffett will get a chance to put his mouth where his money is.....A holding company co-owned by Berkshire Hathaway, Buffett's company, has agreed to buy various assets of Safeco Corporation, including the company that manages the Safeco mutual funds.....Starting this fall, when the deal closes, you can expect Buffett to implement some of this own mutual fund advice.....First, he'll sit down with the directors of the Safeco funds, and encourage them to put all Safeco fund-management contracts up for competitive bidding.....Shortly thereafter, Buffett will announce a voluntary reduction in the management fees charged to all Safeco mutual funds, and he will ask the trustees to abolish all 12b-1 fees.

"So, you really think that's going to happen?"

"No."

Here's a fund reform proposal that would cost next to nothing, could be implemented instantly by the SEC, and would vastly improve the usefulness of every mutual fund prospectus:

"Nearly all fund companies are running through prospectus changes these days, either to eliminate the problems they encountered or to make sure they won't be the next company tagged by authorities.

The average investor would have to know a prospectus by heart to find some of these changes, particularly the subtle ones.

That's why funds should take a page from the folks who print sports rule books and put a page at the front that details the changes being made each year. What's more, all changes should be printed in a special font and should carry an explanation or justification for the change.

In this way, an investor can find any rules changes just by skimming the prospectus, which makes it much more difficult for a fund to bury key maneuvers in the fine print."

Does anyone see a problem with this proposal?.....So, SEC, what about it?
"Better disclosure will aid fund picking," Chuck Jaffe, cbs.marketwatch.com, April 11, 2004

More on "NAV transfers": As we dicussed last month, several fund companies will waive the usual load on purchases of their Class A shares, if the money that you're investing has come from the sale of another family's load fund.....Here's some additional information about NAV transfers, from an article* that came to our attention after last month's Highlights and Commentary was posted:
- In addition to Eaton Vance, which was mentioned in last month's FundAlarm, several other fund families also offer NAV transfers, including Oppenheimer, Calvert Group, Dreyfus Premier, First Pacific Advisors, Hotchkis & Wiley, Hartford, John Hancock, Phoenix and First Eagle.
- In most cases, NAV transfers must be handled by a broker or financial planner. But a handful of companies, including Oppenheimer, Calvert, and Hartford, permit individual investors to execute NAV transfers on their own.
- If you do make an NAV transfer through a broker, pay attention to the share class that the broker exchanges you into. For example, at Dreyfus Premier, the broker is allowed to make an NAV transfer into the "T" class of shares, which will earn the broker a trailing commission of 0.5% per year, and cost you 0.18% more per year than the "A" class shares, which are also eligible for NAV transfers.
* "A no-cost way to leave a troubled fund," Martin Skala, christiansciencemonitor.com, February 5, 2004
As we reported last month, Warren Isabelle's firm, Ironwood Capital Management, was recently fired as outside manager of IDEX Isabelle Small Cap, and the fund's management duties were reassigned to Transamerica Investment Management (the fund was also renamed TA IDEX Transamerica Small/Mid Cap Value, or TAITASMV, for short).....Transamerica owns IDEX so, in effect, IDEX is bringing the management of this fund in-house, and IDEX will be able to keep the entire management fee instead of splitting a portion with its former subadvisor (Ironwood).....This month, we can report a few more details about this management change: Under Isabelle's leadership, IDEX Isabelle Small Cap was the best performer in the IDEX stable for all of 2003.....The fund's new no-name management team, with no public track record in small-cap investing, has agreed to work for a lower fee -- but Isabelle's firm offered to match that fee before it was fired (IDEX says the matching offer came too late).....When all is said and done, investors in this fund get to save a few pennies, but they have also lost a good manager and picked up a bunch of no-names.....Meanwhile IDEX gets to be a dutiful subsidiary of Transamerica, and push more money to the corporate bottom line.
* Forbes, March 29, 2004
There are more than 2,600 directors currently serving on mutual fund boards, and let's assume that half of them are independent.....In a group of 1,300 independent directors, it's reasonable to assume that some number -- maybe 50 a year -- retire, die, or resign, and it's also reasonable to assume that professional search firms would be hired to find qualified replacements for the departing directors.....Reasonable, maybe, but not correct.....According to a top official at a leading executive-search firm, there has been exactly one retained professional search for a mutual fund director in the past 25 years*.....The rest of the independent directors, we can assume, came from the usual pool: Friends of the current directors, friends of the management company, old boys, old girls, washed-up politicians, and arthritic ex-athletes.....If mutual funds are soon required to have 75% independent directors, as seems likely, can we assume that the talent pool will also expand?.....Alas, probably not.
* "Want to Be an Independent Fund Director? Good Luck!," Christopher Oster, The Wall Street Journal, April 5, 2004
Keith Tucker, chairman and CEO of Waddell & Reed Financial, was one of the investors in an abusive tax shelter who had been trying to keep his accounting firm (KPMG) from disclosing his name to the IRS.....According to court and other public documents, Tucker earned almost $2.2 million in salary and bonuses during 2000 (plus millions more in stock options).....Tucker paid $500,000 to KPMG in an attempt to avoid paying tax on some or all of that income, and that's the shelter that has now blown up.....Tucker faces the prospect of back taxes, interest, and penalties.
"Taxpayers Who Fought Release of Names Are Tied to a Mutual Fund," Lynnley Browning, The New York Times, April 16, 2004
Crusader for the little guy reports big-guy income: New York's crusading Attorney General Eliot Spitzer reported almost $756,000 in adjusted gross income for 2003, which includes his state salary of $145,159.....Most of Spitzer's non-salary income, about $526,000, came from his share in a family real estate partnership.....And for some reason, the otherwise savvy and intelligent Spitzer reports that he owns small amounts of several JP Morgan mutual funds, including JP Morgan Capital Growth, JP Morgan Growth and Income, and JP Morgan International.
Bloomberg, April 16, 2004