Highlights and Commentary

By Roy Weitz

(Originally posted July 1, 2005) [Archive Table of Contents]
What happens when we add one more alarm?


Each month, we evaluate the performance of every fund in our database over three periods (the preceding 12 months, three years, and five years), and a fund that has underperformed its benchmark for all three periods is classified as 3-ALARM.....From time to time, readers have asked us to look at the funds in our database over an even longer period -- 10 years -- and this month we decided to give it a try, with a particular emphasis on 3-ALARM funds.....Specifically, we wanted to find out how many 3-ALARM funds also have underperformed their respective benchmarks over the past 10 years -- in effect, these would be our 4-ALARM funds.....Here's a summary of the results:

This month's database contains a total of 1,276 3-ALARM funds 732 of these 3-ALARM funds have been in existence at least 10 years (this doesn't include Specialty funds, for which we weren't able to obtain 10-year performance data) Of the 732 3-ALARM funds in existence for at least 10 years, 619 are also 4-ALARM funds (in other words, 85% of the eligible 3-ALARMS are also 4-ALARMS).

Over the years, we've noticed that a sad group of 3-ALARM funds tends to stay 3-ALARM, year-in and year-out, and over many different market cycles.....But even we were surprised at how many of this month's 3-ALARM funds also have underperformed over the past 10 years.....There's a persistence to many loser funds that's difficult to explain, but also hard to ignore.....And that's another good reason to consider selling your chronic 3-ALARM funds.....The vast majority of them just don't seem to get better.

The accompanying page shows the "4-ALARM" status of all 3-ALARM funds in this month's FundAlarm database.

According to a recent article, there are a "surprising number" of parent-offspring teams running mutual funds.....Actually, this doesn't surprise us at all, since money management is a hugely profitable business, the hours are good, and there's no heavy lifting, so why not hand your child a silver platter if you possibly can?.....The word "nepotism" is trying to rear its ugly head here, but we're going to push it back under the plush carpet and try not to spoil the party.....Let's assume, in every case, that the founder's child is the most qualified person to succeed his parent, and let's further assume that even if the parent had conducted a worldwide search for his successor, his child would have come out on top.....Some of the fund families in which investing genes are bountifully distributed include the following (the fund family appears in bold, followed by the father's name, then the son's): Nicholas (Ab and David Nicholas); James Advantage (Frank, Barry, and David James); Alpine (Stephen and Sam Lieber); Hodges (Don and Craig Hodges); Oak Associates (James and Mark Oelschlager); Oberweis (James D. and James W. Oberweis).....As far as we've been able to tell, there aren't any father-daughter teams currently managing mutual funds (Edward Johnson and Abigail at Fidelity are executives rather than money managers, so technically they don't meet our criteria).....Perhaps someone out there knows of a father-daughter management team.
"Surprising number of parent-offspring teams run mutual funds," Associated Press, June 16, 2005

[Update @ 6/1: That was quick. One reader has already pointed out that Roy Papp and his daughter, Rosellen, manage several funds for Pioneer.]

[Update @ 6/4 to Update @6/1: That was quick, too. Another reader has pointed out that Rosellen is Papp's daughter-in-law, so the search for a father-daughter management team continues.]

In addition to the parent-offspring teams, above, FundAlarm has discovered a number of prominent mutual fund managers who have evil twins in the business.....For obvious reasons, these well-known managers would like to suppress even the existence of their siblings, so kudos to the FundAlarm research team for unearthing these murky family connections.....Herewith, four mutual fund managers we're all familiar with, and the twin brother each would just as soon forget about:

	The Manager We Know...		...and his Evil Twin...
John Montgomery	Humble, sets a voluntary limit on his salary, strong advocate of good governance and shareholder protection. Runs the Montgomery funds.	Jiminy Montgomery	Arrogant, grabs for all the bucks he can, allowed his fund to be market-timed. Employed by Janus.
Robert Gensler	Capable tech manager, keeps his head down, avoids the media spotlight. Employed by T. Rowe Price.	Rufus Gensler	Tech fund consistently underperforms, can't stop talking, loves to see himself on TV. Employed by Firsthand.
Bill Miller	Creative, self-confident, has outperformed the S&P 500 index every year for the past 14 years. Runs Legg Mason Value.	Biff Miller	Not a lot of good ideas, starting to get gun-shy, hasn't outperformed the S&P 500 any year in the last 10. Runs the Evergreen fund.
Alberto Vilar	Blowhard, vaporized billions, arrested for stealing client money, confined to his luxury apartment with a bracelet around his ankle. Recently booted as manager of Amerindo Technology.	Alberto Vilar	Same.

Speaking of Alberto Vilar and his evil twin, Alberto Vilar (above): He was arrested just before the Memorial Day weekend, charged with stealing money from a private client, and jailed until he could come up $10 million in bail (we reported all of this last month).....Since the arrest, the independent directors of Amerindo Technology have booted Vilar as manager and hired the dismal Munder firm as interim manager (the directors apparently picked the letter "M" out of a hat, and hired the first "M" manager they could think of, otherwise this choice makes no sense).....Also: Vilar's bail was reduced to $4 million (yet it still took him almost 25 days to raise the money, and then only with big-time help from his friends), and investors pulled millions out of the Amerindo funds (by the time you read this, probably more than half of total fund assets will have been removed).....Needless to say, if you still have money in Amerindo Technology, you should get it out now.....Also needless to say, when all the dust settles, Amerindo Technology will still have a few shareholders who didn't get out, and we'll all wonder (as usual in such circumstances) if these shareholders are dead, comatose, distracted, or just scared of fessing up to the spouse that they lost the kids' college fund.


One father-son team that didn't work out: Robert O'Connell used to run MassMutual Financial Group, until he was recently forced out by his board for his "conduct".....Jared O'Connell, Robert's son, used to work at OppenheimerFunds, which is owned by MassMutual, and Jared reportedly passed along stock-trading tips to his brother-in-law.....When personnel at OppenheimerFunds attempted to discipline Jared, his father reportedly intervened -- one example of the "conduct" that got dad fired
* "Advisors Concerned Over Oppenheimer Scandal," Tom Leswing, ignites.com, June 14, 2005; Reuters.com, June 15, 2005


June was a busy month for news about the SEC: Chairman Donaldson, who turned into a good friend of mutual fund investors, announced that he was leaving office as of June 30.....Within hours, the White House proposed a replacement for Donaldson: He's Republican Rep. Christopher Cox of California, who's variously been described as a "free market proponent," a "libertarian" and a "soulless economic robot" (the latter description, we believe, only by FundAlarm).....At best, Cox is likely to follow the "disclose and let the peons fend for themselves" school of regulation, which means that the recent round of mutual fund reforms has come to an end.....And then there was another hiccup: On June 21, a federal court in Washington, D.C. ordered the SEC to review its new rule, which requires mutual fund boards to have independent chairs.....The U.S. Chamber of Commerce (which is almost certainly fronting for fund companies like Fidelity and T. Rowe Price that are still opposed to the rule) had complained to the court that the SEC didn't properly consider the costs of having independent chairs, or possible alternatives.....The court agreed with the Chamber of Commerce, and ordered the SEC to reconsider these issues.....Almost immediately, SEC Chairman Donaldson scheduled a June 29 review and re-vote on the independent chair rule, which was exactly one day before he was due to step down......(Donaldson obviously believed the rule would be in danger if left to the mercies of incoming Chairman Cox).....The re-vote went as expected -- 3-2 (again) in favor of requiring fund boards to have an independent chair.....(The two Democratic SEC Commissioners again voted to uphold the independent chair rule, the two Republican Commissioners again voted against the rule, and Donaldson, a Republican, again sided with the Democrats)......The Chamber of Commerce has said that it's going to bring another lawsuit to invalidate the independent chair rule which, unfortunately, has now become a partisan political football.....Donaldson deserves credit for his principles and tenacity but, one way or another -- either by court decision, or action by the new SEC Chairman -- we're predicting that the independent chair rule will never be implemented under Cox.


Keeping score: Of the 20 largest mutual fund groups, 12 already have boards with an independent chair: AIM, American, American Century, American Express, Hartford, Janus, JP Morgan, Merrill Lynch, MFS, Oppenheimer, Putnam, and Scudder.....No matter what ultimately happens to the independent chair rule at the SEC, it's unlikely that any of these fund companies will revert to an "inside" board chair, at least in the foreseeable future.....But eight of the largest fund groups still have board chairs who are affiliated with the fund management company: Dodge & Cox, Fidelity, Franklin Templeton, Pimco, Smith Barney, T. Rowe Price, Van Kampen, and Vanguard.....Unless these firms are required to install an independent chair, there's almost no chance that they'll do so on their own.
"SEC's fund rule, revisited," Kathleen Pender, sfgate.com (San Francisco Chronicle), June 23, 2005


Lousy funds, and a scandal, too: This month's FundAlarm database tracks 40 Smith Barney mutual funds: 19 of these funds are on this month's 3-ALARM list, and not a single Smith Barney fund is on the FundAlarm Honor Roll.....Overall, FundAlarm evaluates the 40 Smith Barney funds over a total of 120 measurement periods (i.e., 12 months, three years, and five years), and Smith Barney funds have underperformed their respective benchmarks in 80% of those periods -- a dismal showing even for brokerage-firm funds, which are chronic laggards.....If you're a Smith Barney fund investor, and you're feeling a bit uncomfortable right now, we have more bad news: Smith Barney funds were recently implicated in a scandal that was every bit as corrupt and cynical as any market-timing scandal, yet it received almost no media attention.....The Smith Barney scandal revolved around the relatively obscure transfer agency function, and that's probably one of the reasons for the great, collective yawn.....But if you stay with us, the story is relatively easy to follow:

• Every fund needs a transfer agent, or some entity to perform the functions of a transfer agent, such as processing buy and sell orders for the fund, calculating daily net asset value, operating a customer service call center, distributing fund literature, preparing year-end tax reports, etc. Transfer agency fees are a legitimate fund expense, which are paid out of fund (i.e., shareholder) assets. But, as with all fund expenses, it's the obligation of the fund Board (and, to a lesser extent, the fund manager) to obtain transfer agency services at the lowest possible fee and the highest possible quality.
  
  
• Beginning in 1994, First Data served as transfer agent for the Smith Barney funds, which were managed by Citigroup Asset Management (CAM). In 1998, First Data's transfer agency contract came up for review, and First Data offered to rebate a huge percentage of its transfer agency revenue directly to CAM in order to keep the contract. CAM never informed the directors of the Smith Barney funds about First Data's rebate offer, which potentially could have saved millions of dollars for fund shareholders.
  
  
• CAM was told by its accounting firm that it would be illegal to keep the First Data rebates, because those rebates would belong to the funds. To get around this annoying little technicality, CAM created a shell transfer agent, and the shell transfer agent officially replaced First Data. The shell continued to collect the old transfer agency fee in full; the shell transfer agent then subcontracted with First Data to actually do the work at the previously negotiated, significantly reduced rate. In other words, a fund might pay $1,000 to CAM's shell transfer agent, the shell would pay First Data $500 to do the actual transfer agent work, and CAM would pocket the difference ($500) as pure profit.
  
  
• CAM not only continued to hide the First Data rebates from the fund Board, but CAM actively misled the fund Board in a memo proposing that the shell transfer agent be hired. On the other hand, it doesn't appear as if the independent directors were asking a lot of tough questions, either.
  
  
• Have you guessed by now? The chairman of the Smith Barney fund board was an "inside" director -- an employee of the fund management company, CAM. By misleading the independent directors on the fund Board, and promoting the sham transfer agency structure, the chairman of the Smith Barney funds enriched CAM -- his employer -- at the expense of every shareholder.
  
  
• The SEC has required CAM to pay back its staggering, illicit profits -- about $100 million -- and also pay an $80 million penalty. As usual, CAM has admitted no wrongdoing.

So, Smith Barney fund investors, there you have it: Dismal performance by your fund family, do-nothing independent directors, and blatant thievery by your fund management company, assisted by the chairman of your funds' board of directors.....Not a pretty picture.


Just as we were getting ready to post this issue of FundAlarm, Legg Mason acquired Citigroup's mutual funds, which includes the Smith Barney and Salomon Brothers fund families.....Legg Mason is being a bit vague about its plans for the Smith Barney funds, probably because even Legg Mason doesn't know what to do with this huge, dysfunctional glob of assets.....As of now, it seems likely that the Smith Barney fund family will remain separate from Legg Mason (although probably under another name), the worst Smith Barney funds will be merged out of existence, and Smith Barney's few big-name managers (Rich Freeman, Hersh Cohen and John Goode who run, respectively, Smith Barney Aggressive Growth, Appreciation, and Fundamental Value) will remain in charge of their funds*.....So what should you do if you own Smith Barney funds?.....Before Legg Mason entered the scene, we probably would have recommended that you sell them all, or at least sell all of your Smith Barney funds that aren't run by Freeman, Cohen, or Goode.....With Legg Mason now in the picture, scandal-tainted Citigroup Asset Management (CAM) out of the picture, and only one fund director remaining from the time of the First Data episode, we'd probably hold until we see what Legg Mason has in mind.
* "Legg Mason joins the major leagues," Jonathan Burton, MarketWatch.com, June 27, 2005


As part of the Legg Mason/Citigroup deal (above), the Legg Mason CEO says that Bill Miller's fund, Legg Mason Value, will be "incorporated into the Smith Barney brokerage system," and "the use of Bill Miller's funds should grow dramatically".....Good news for Legg Mason and Bill Miller, not-so-good news for investors in their funds.
MarketWatch article, above


As thousands of investors await restitution from their scandal-tainted mutual funds, let's take a look at another program that was designed to help investors who have been harmed: In April 2003, when regulators settled with investment banks for misleading stock research, $85 million of the settlement was set aside for state and federal investor-education efforts.....The federal investor-education program, led by the SEC, has all but collapsed, and the SEC is seeking court approval to move its share of the investor-education money ($50 million) over to the NASD Foundation.....Meanwhile, the organization that represents the state investor-education efforts is suing in federal court to prevent the transfer to the NASD Foundation, and to get its own hot little hands on the money....Not that this state-backed organization (the Investor Protection Trust, or "IPT") has performed much better than the feds: The IPT has disbursed only about 2% of the state investor-education funds and, in the first three months of this year, the IPT suffered $80,000 of investment losses in its endowment fund (remember, this is the organization that is supposed to teach all of us dimwits how to be better investors).....The IPT would probably like to ascribe its recent problems to start-up pains, but the IPT has actually been in existence since the 1993, when it first received funding from another scandal settlement.....Since 1993, the IPT has mostly helped line the pockets of a private consulting firm, and has produced a financial literacy curriculum, used in schools across the country, that contains inaccurate and out-of-date information.
"What's the Best Way To Invest in Teaching The U.S. to Invest," Deborah Solomon, The Wall Street Journal, May 26, 2005; SEC, States To Square Off In Investor-Education Fund Spat," Judith Burns, Dow Jones Newswires, June 8, 2005


And now for a discussion of spandex, studs, and brokers: Recently, several threads dealing with variable annuities created much heat, and some light, on the FundAlarm Discussion Board.....It all started with a defiant insurance salesman, whose first post helped liven up a quiet Sunday:

The reason most people invest in variable annuities as opposed to mutual funds or stocks is protection. It's not tax-deferral (90% of my VA sales are in IRAs) and it's not outperforming the market (though my clients VAs have outperformed the market). Obviously the public thinks the extra expense (about .6% on average) is worth it [bold added by FundAlarm]

The agitation caused by this declaration -- especially the IRA part -- was roughly equivalent to the agitation caused by the introduction of raw steak into a shark tank.....Claims and accusations flew back and forth, leading to the following exchange between our fools-rush-in insurance salesman and Discussion Board reader "Pidea".....

Insurance salesman:

Hey folks, if you can whip yourselves into shape without a trainer [i.e., financial/insurance advisor] all power to you. But if you want a stud to make sure you stay strong and healthy, you got a pay him. So get over it!

FundAlarm reader ("Pidea"):

Please don't offer me the stud when I can just have the gym membership. And don't recommend going to the gym if I'm working out just fine at home. Its a good comparison, though. Most people who hire the stud pay too much, quit after a month anyways, regret it, and end up even fatter due to the poor experience. The stud takes the money to the bank, and buys tighter spandex to try to appear more studly (it's all in the marketing). The ones who stay with the stud just like his buns (due to the new spandex), not his training *cough* expertise.

After some lively posts, the consensus of the Board was not surprising: Variable annuities bought from (or, should we say, sold by) commissioned salespeople are expensive products, with little transparency, a lot of tax inefficiency, and they come with some unpleasant surprises (for example, the "surrender charge" is a cash penalty that kicks in if you bail out of your annuity in the first seven to 10 years).....If you need the life insurance part of an annuity, buy it separately, and consider term insurance.....Then, get your stock market exposure from a conventional mutual fund.....If you need a guaranteed income stream for a period of years -- the original purpose of an annuity contract -- take a look at no-load annuities, which offer this feature as inexpensively as possible.....Oh: And never, never buy an annuity in an IRA.


Back in January, we wrote about an investigation of excessive gift-giving at Fidelity, as follows:

If you had the job of buying stocks for the Fidelity mutual funds, a lot of stock brokers would probably like to make your acquaintance.....Some of these stock brokers might even try to curry special favor, by sending expensive gifts your way, and that's exactly the possibility that the SEC is currently investigating.....This isn't the most complex problem in the mutual fund world, but sometimes a crude little graphic can help highlight the issues involved: On the left side, brokers who sell stocks to Fidelity's mutual funds appear to have showered gifts on Fido's stock traders (not necessarily every gift shown, but you get the idea).....On the other side, we're supposed to believe that Fidelity's stock traders don't favor these gift-giving brokers and, specifically, don't choose to overpay these gift-givers even a penny when it comes to buying stocks for Fido's mutual funds....

According to The Wall Street Journal, regulators are now looking into the possibility that Edward Johnson III, Fidelity's top dog, may have received hard-to-get Olympic figure-skating tickets from a Wall Street brokerage firm.....This may seem like a trivial item but, as the Journal notes, regulators are "especially interested in the actions of top executives whose behavior sets the tone for the firm".....Regulators are also looking into the role played by Abigail Johnson in securing the tickets (Ms. Johnson, a Fidelity executive, is Edward's daughter and his heir-apparent).....A Fidelity spokesperson says that "any implication that the Johnsons were involved in regular or repeated acceptances of tickets or other gifts is completely false," which pretty much seems to acknowledge that the Johnsons did accept occasional gifts.....To us, the issue is whether the Johnsons followed Fidelity's own rules on business gifts.....In this situation, it appears that Fidelity's internal rule would have limited the Johnsons to a maximum gift value of $100 per year from any single company.....If Edward Johnson accepted a gift worth more than that, he should be disciplined for his actions, and he should offer a public apology.....And we should stop smoking whatever it is that we're smoking, because we've obviously entered a fantasy world.
"SEC Inquiry Reaches Members of Family Controlling Fidelity," Craig/Hechinger/Smith, The Wall Street Journal, June 28, 2005


Briefly noted:

• On May 6, Fidelity filed documents to open a new fund, International Small Cap Opportunities, which will follow an investment strategy identical to that of Fidelity International Small Cap, which Fidelity had closed the day before*.....How nice of Fidelity to wait one full day, before shafting the investors of International Small Cap.
  * FundTimes, Dieter Owen Bardy, morningstar.com, June 10, 2005
  
  
  
• According to a recent research study, men who inhale a nasal spray spiked with oxytocin give more money to partners in a risky investment game than men who sniff a placebo spray.....Oxytocin, which is also used to induce labor in pregnant women, appears to increase an individual's willingness to accept social risks -- including investment risks -- in a face-to-face setting.
  
  
  
• From the FundAlarm catalog of mutual fund merchandise:
  
  

  			Investment Gas Mask. Does your broker or financial planner keep up with the latest medical research studies? If so, he or she could be packing oxytocin at your next office visit, a drug that's been shown to make people take unusual investment risks when inhaled. It's tough enough resisting your broker's sales pitches for mediocre mutual funds with heavy sales loads. Protect yourself from the additional danger of oxytocin-induced fund purchases with this exclusive product!
  Item #PSSSSS $165.00

  
  
  
• Down memory lane, with a really arrogant companion: Six years ago this month (July 1999), we ran a short item about mutual fund performance fees, and we noted that Janus (on a hot streak at the time) didn't like management fees that fluctuated with performance.....A then-spokesperson for Janus said that the firm preferred a simple fee "that doesn't eat into above average gains".....Several months after that quote, Janus began delivering above-average losses, highlighting an aspect of the performance fee debate that apparently hadn't occurred to our Janus spokesperson in that earlier, invincible time.
  
  
  
• In July 1999, we also ran a surprisingly prescient "pop quiz," which accompanied the item (above) about Janus and performance fees:
  
  

  	According to Proverbs 16:18, what goeth before a fall?
  	(a) A slippery floor (b) Summer (c) The Janus funds (d) A haughty spirit

  
  We noted that the correct answer was (d), but we awarded partial credit for (c).
  
  
  
• Sad, but almost certainly true:
  
  

  	"My wife is a biochemist trying to find a cure for cancer. I'm a lawyer trying to end securities fraud. She's going to succeed before I do...It is human nature at some point in commercial dealings to go too far, to try to take advantage."
  	-- Joseph Grundfest, former SEC Commissioner and now Stanford law professor

  
  
  
• Something for every free-market proponent/libertarian/soulless economic robot/incoming SEC Chairman to pay attention to:
  
  

  	"My wife is a biochemist trying to find a cure for cancer. I'm a lawyer trying to end securities fraud. She's going to succeed before I do...It is human nature at some point in commercial dealings to go too far, to try to take advantage."
  	-- Joseph Grundfest, former SEC Commissioner and now Stanford law professor

  
  [Thanks to Ken Kivenko, Canadian investor advocate, for sending us the Grundfest quote, above.
  It originally appeared in the June 27, 2005 issue of Fortune.]
  
  
• Schwab is a newcomer to the market for targeted-maturity funds and, as a newcomer, you might expect Schwab to compete on price with the big, established players (Vanguard, T. Rowe Price, Fidelity) [what is a targeted maturity fund?].....Or, given its other financial problems, you might expect Schwab to grab for every penny it can.....If you chose "grab for every penny," you would be correct: The other major players offer their targeted funds without adding any extra expenses, and investors pay only the expenses of the underlying funds.....But Schwab is tacking onto each targeted fund an extra layer of expenses, equal to 22 basis points (0.22%).....A portion of this charge will be absorbed by Schwab, at least through February 2007, but until then Schwab's target fund investors will be nicked for anywhere from one to ten basis points.
  "Schwab Jumps Into Target-Date Fray," Marc Hogan, ignites.com, June 1, 2005
  
  
  
• American Funds Growth Fund of America, a behemoth with $102 billion in assets, is not only the biggest large-cap growth fund, it's bigger than the next three large-cap growth funds combined (the runners-up are all Fidelity funds: Contrafund, Growth Company, and Blue Chip Growth).....As we suggested last month, there will come a time when even American's decentralized "counselor system" won't be able to effectively manage a fund this large.....We're guessing that time is near, if not already here.
  Fund Spy, Kunal Kapoor, morningstar.com, June 23, 2005
  
  
  
• Good advice: Write down the following five words:
  
  

  Now Must Best Next Top

  
  Whenever you see a mutual fund (or other investment) article with any of these words in the headline, ignore it.
  "Five words every investor should ignore," Chuck Jaffe, MarketWatch.com, June 22, 2005

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