FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

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

Fight! Fight! Fight! There's a nasty legal battle being waged in Northern California between Kevin Landis, of the Firsthand funds, and his former public relations mouthpiece, Steven Witt.....Some of Witt's allegations raise serious questions about Landis' management of his mutual funds, while other allegations offer juicy insights into life at a rapidly-growing (and then rapidly shrinking) money management firm.....Witt's allegations run about six pages, but they can be summarized as follows:

Witt was hired to get press coverage for Firsthand and he did a good job, overseeing an explosion of assets from just over $1 million (in May 1996) to a peak of $8.4 billion (in March 2000).
Witt had an ownership interest in Firsthand, then he was forced to sell his interest back to Landis (more about that later), then Witt got another ownership interest in Firsthand (sort of), then Landis tried to turn some of Witt's income into "loans," then Landis drained all of the cash out of the company via a "callable dividend" (yeah, we've never heard of that one, either).
Landis started to misrepresent the operation of his mutual funds to the public, Witt got nervous, and Witt threatened to blow the whistle on Landis. Landis fired Witt and stopped paying him, hence this lawsuit.

[Insert here: Assume that Landis denies all of Witt's allegations, and looks forward to his day in court]

Here are some of Witt's specific allegations (the quotes come directly from Witt's legal complaint):

"In April 1999...Landis stunned [Witt and Ken Kam, co-founder of Firsthand]...with an ultimatum: they each must accept a forced buy-out of their interests in [Firsthand] or Landis would quit and start his own investment advisory firm, threatening to take all of the [firm's assets] with him. Based on this ultimatum, the [firm's shareholders] executed a "buyback" agreement..." Ever since Kam separated from Firsthand, which was clearly a firm on a roll, people have wondered why. Perhaps Witt has now provided the answer.
"On or about December 31, 2001, Landis launched two Firsthand Growth Funds ("FGF")... Landis repeatedly represented to the public that the FGF were managed by a team of investment advisers. In fact, ...Landis exercised complete control of the [new funds]." Witt's allegation here seems to go beyond just the two new funds; in Witt's complaint, he recounts a conversation with Firsthand's head trader, to the effect that nobody at Firsthand, other than Landis himself, had "ever entered a single trade ticket on any fund."
Witt alleges that he repeatedly warned Landis not to publicly misrepresent the nature of Firsthand fund management, but Landis "continued to make inaccurate statements to journalists." For example, in a September 2, 2002 phone interview with a journalist, Witt says that Landis intentionally inflated the number of analysts employed by Firsthand, in order to hide the severity of the firm's cutbacks. Witt says that he later called the journalist and provided the correct number of analysts, and Witt's number ultimately appeared in the story.
By early 2003, Witt "was becoming increasingly uncomfortable representing Landis and [Firsthand] based on Landis's statements to the public..." Witt says that he continually reminded Landis "to take meaningful action to correct [his] inaccurate statements," but it appears that Landis did little or nothing to remedy the problem. In April 2003, Witt threatened to take his concerns to Firsthand's Board of Directors. At that point Firsthand -- and, by implication, Landis -- launched a series of "reprisals" against Witt, which led to Witt's firing.
In announcing Witt's departure, Landis publicly stated that Witt had left the firm for "personal reasons."

[Insert here: Assume that Landis denies all of Witt's allegations, and looks forward to his day in court]

Witt's legal complaint states 12 causes of action, including breach of contract, wrongful discharge, fraudulent concealment and misrepresentation, negligent infliction of emotional distress, and all-around jerkitude (OK, all except that last one).....A trial-setting conference is scheduled for late September, but beyond that there's no indication where this case is headed, or how quickly.
Steven C. Witt v. Firsthand Capital Management, Inc., et al., California Superior Court (Santa Clara County), Case No 1-03-CV-002601

From the prospectus for Firsthand Aggressive Growth (December 31, 2001):

FUND MANAGEMENT

Firsthand Funds (the "Trust") retains Firsthand Capital Management, Inc., 125 South Market, Suite 1200, San Jose, CA 95113, to manage the investments of the Fund. Kevin M. Landis, who also serves as a Trustee of the Trust, controls the Investment Adviser. Mr. Landis is the Chief Investment Officer of the Investment Adviser, a position he has held since 1994. The day-to-day management of the Fund is provided by members of the Investment Adviser's research team.[bold added by FundAlarm]

Firsthand Aggressive Growth is no longer with us.....But if Witt's allegations (above) are true, and Landis managed this fund entirely by himself, this statement in the prospectus is false.....No matter how Witt's lawsuit turns out, this is something that might be of interest to the SEC.

Fidelity charges 20 basis points (0.2%) to manage a stock portfolio for the Massachusetts state pension fund, and Fidelity charges 50 basis points (0.50%) to manage the Magellan mutual fund.....Well (you might say to yourself), the pension fund must be larger than the mutual fund, so it's entitled to a lower management fee.....Well, you'd be wrong: The pension fund in question holds about $500 million in assets, while Magellan holds 124 times as much ($62 billion), yet Magellan investors pay Fidelity two-and-a-half times more to manage their money.....This fee discrepancy has caught the eye of a Boston law firm, and Fidelity is now being sued for breach of fiduciary duty in setting its Magellan management fee*.....Unfortunately, this lawsuit will fail, and here's why we can say that with such assurance: As far as we know, in the last 25 years or so, no plaintiff has ever won an excessive fee case (several such cases have been settled before trial, although it's not clear that lower management fees were part of the settlement terms).

The problem for fund shareholders began in 1982, when one Irving Gartenberg sued Merrill Lynch for excessive management fees in its money market fund.....Gartenberg not only lost the case, his name forever became associated with the impossible legal standard promulgated by the Federal appeals court that heard his case..... According to the Gartenberg standard, no mutual fund management fee ever will be deemed excessive unless it is:

"...so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining [between the fund's directors and management firm]"

In other words, "abandon all hope ye shareholders who enter here"....As things stand now, there are only two ways shareholders will be able to crawl out from under the Gartenberg standard: Either a federal court must overrule or reinterpret it, or Congress must amend the law which gave rise to it (Section 36 (b) of the Investment Company Act).....Senator Fitzgerald's superb mutual fund reform bill, introduced earlier this year, would have taken a small (but effective) step toward undoing the Gartenberg standard, but that bill is going nowhere.....Since Congress seems disinclined to pass any mutual fund legislation, shareholders will have the same chance as before -- zero -- of winning excessive-fee cases.
* "Lawsuits challenge unequal fund fees," Andrew Caffrey, boston.com, August 18, 2004

If you've never heard of stable-value mutual funds, you probably won't be too concerned that they could be on their way out.....But for some investors, stable-value funds have helped plug the portfolio gap between money market and short-term bond funds, and their absence would be noted.

What are they? The typical stable-value fund seeks to achieve a better-than-money-market rate of current income, while preserving principal and maintaining a stable (i.e., constant) net asset value (NAV) per share. (Note that we're talking here about stable-value funds outside of 401(k) plans.)
How do they work? Most stable-value mutual funds invest in fixed-income investments with relatively short maturities (say, two to five years). But even short-term fixed income investments can fluctuate in value, so managers keep their fund's NAV constant by entering into "wrap contracts". The wrap contract is basically a financial leveling device. If a stable-value fund sells a holding at a loss, in order to meet shareholder redemptions, the party on the other side of the wrap contract (often an insurance company) effectively reimburses the fund for that loss. Conversely, if the fund sells for a gain, the other side of the wrap contract gets the financial benefit.
So let me guess. The problem is the wrap contract. You've got it. The wrap contract is an asset of the fund, just like the fund's fixed-income investments, and therefore the wrap contract must be properly valued for purposes of determining the fund's NAV. Since the fund's underlying fixed income investments fluctuate in value every day, the value of the wrap contract is effectively the plug amount needed to keep the fund's NAV constant (typically, at $10 per share). But it seems to defy economic reason that every wrap contract, every day, is worth just enough -- and not a penny more or less -- to keep every stable-value fund at a constant NAV. And that potential valuation problem has caught the eye of the SEC.

The SEC has been investigating the valuation of wrap contracts for more than a year, and nobody knows how that investigation will shake out.....But a couple of fund companies apparently think the news won't be good, and they don't want to be caught with a stable-value fund that can no longer live up to its name, or one that might have to undergo drastic financial surgery on short notice.....In late July, Principal converted its stable-value fund to a money-market fund, and last month PBHG announced that it was converting its stable-value offering to a conventional, short-term bond fund*.....Also, during the past year, several fund companies held off creating new stable value funds because of the uncertainty over the SEC investigation.....The SEC has an obligation to all stable-value investors (and potential investors) to rule on this matter quickly and decisively.....The SEC should either kill off stable-value mutual funds once and for all, or allow fund companies to make them work.
"Stable-Value Mutual Funds May Die," Christopher Oster, The Wall Street Journal, August 18, 2004

It's been a slow three years at Numeric Investors: These are the most recent "News" stories, from the Numeric Investors Web site:

A couple of years ago in FundAlarm, we ranted about how poorly Evergreen reports manager changes for its mutual funds:

"In the almost-six years that we've been publishing FundAlarm, we've learned to admire the way some fund companies handle the reporting of manager changes (Fidelity, for one, does a very thorough job, even if it does bury the press releases deep within its Web site). We've also learned to despise the way some fund companies report manager changes, and Evergreen falls into that category." [FundAlarm, April 2002]

Evergreen is still one of the laggard fund firms when it comes to reporting manager changes, and recently Evergreen screwed up another one of its important reporting obligations.....Here's the story: By early 2003, Evergreen was aware that its Precious Metals fund had been market-timed by its own manager.....But Evergreen chose to sit on that information for months, and continued to sit on the information even after September 2003, when the mutual fund market-timing scandal broke and everyone else started coming clean.....It wasn't until January 2004, when Evergreen filed the fund's annual report with the SEC, that Evergreen finally "revealed" the manager's market timing -- and even then the disclosure was only an obscure reference, buried deep within a footnote in the fund's financial statements.....Early last month, when Evergreen learned that the SEC was investigating the manager's market timing, Evergreen finally filed a prospectus supplement with a few vague details about the scandal, but it was almost another week before Evergreen would even reveal which fund was involved -- and then (we suspect) only because a Morningstar article had exposed Evergreen's continued stonewalling.**

Back in April 2002, when we complained about Evergreen's abysmal reporting of fund manager changes, we had this to say:

Evergreen shareholders, you should be angry: Your fund company has so little respect for you, it won't even tell you who is running your fund.

Today, we just have to change a few words:

Evergreen shareholders, you should be angry: Your fund company has so little respect for you, it won't even tell you who is market-timing your fund.

It's interesting how some firms really do seem to have a corporate culture, both for better and -- in Evergreen's case -- for worse.
* "Two Evergreen Funds Are Subject of SEC Probe," Christopher Davis and Jeffrey Ptak, morningstar.com, August 4, 2004

The company that runs the Calamos funds has announced that it's going public.....As usual, investors in the Calamos funds stand to gain nothing from this move.....Also as usual, the prospectus for the Calamos stock offering presents a laundry list of potential investment risks, including this one, which we found especially interesting:

"Regulatory developments designed to increase the independence of mutual fund
boards of directors may result in downward pressure on [Calamos management] fees"

Thanks to Calamos for connecting the dots that no other fund company seems willing to connect.....When the fund industry recently opposed the rule requiring independent chairs for mutual fund boards, the industry claimed that it was acting to protect the best interests of investors.....Calamos makes clear what the fund industry was really concerned about: If independent board chairs, and independent directors, truly start acting independently, management fees inevitably will be cut.....We think that's a good thing.....Fund companies like Calamos apparently disagree.

Doug Fabian is a self-proclaimed mutual fund market-timing guru, which means that he's in the business of selling mostly unsupported promises.....But even among people who are accustomed to the shameless self-promotions of market timers, a stunt that Fabian announced in August 2003 still raised some eyebrows: He was going to take $500,000 of his own money and double it in 365 days, using a souped-up version of the investing technique that he sells to mom-and-pop investors.....Well, the results are in and, as expected, Fabian looks like a fool: Instead of $1 million, his $500,000 nut ended the year at $307,936.....On his Web site, Fabian claims that the lessons he "learned from this exercise are worth far more than the $192,000 [he] forfeited," which suggests that Fabian doesn't expect a lot of value for almost $200,000 of his money.....In fact, the investment lessons that Fabian boasts about are so elementary, he could have picked them up from $64 worth of investment books, and donated the rest of his $192,000 loss to charity, where it might actually have done some good.....For the record, here are Fabian's three hard-won investment lessons:

Lesson	Fabian's comments	FundAlarm's comments
#1: "Let price movement dictate investment decisions and leave my ego at the door"	"I didn't want to be wrong [about my decision to short the market]; no one in my position does. Instead, I focused on proving that I was smart and right. Well, I was dead wrong for 6 months. Had I cut my losses early on and monitored the trends more closely, I could have been making money on the long side of the market."	"Had I a large, hairy body, I could pass for a gorilla."
#2: "Always have an exit strategy"	"When I took this [short] position, I never really had a plan for when I'd sell. And when I did set a mental stop (based on the 50-day moving average or a trading range high), I didn't follow through. "	We hear this every day at the investment firm of Coulda, Shoulda, Woulda.
#3: "Treat every market climate as an opportunity to profit"	" I latched onto the tech bubble theme and wouldn't let go. What has now become blatantly obvious to me was I had no strategy for an up market. While I was shorting the Nasdaq 100 for 6 months and losing money, I could have making the same money had I been long the market. "	Yes, but that would have required something called "investment talent."

Several class-action lawsuits against Garrett Van Wagoner and his eponymous mutual funds allege that he overvalued his funds' private securities during the years 2000 and 2001.....Yet according to a recent SEC action, Van Wagoner undervalued the private securities in his funds, starting in November 2000, and continuing for about a year .....So which is it, overvalued or undervalued?.....In fact, it's possible for both versions to be correct -- it just depends on the time period you're looking at.....Throughout the tech crash of early 2000, Van Wagoner's funds had significant holdings in small, private tech companies, and the value of these securities didn't budge a dollar, even as similar, publicly-traded securities went straight into the tank.....Clearly, during that period, the value of Van Wagoner's private tech holdings (and therefore the net asset value of his funds) was overstated.....Beginning in late 2000, Van Wagoner reversed course, and he started taking huge, unsupported writedowns on his funds' private securities.....We can't know for sure what Van Wagoner was thinking, but he was certainly aware of a self-imposed rule that limited his funds to a maximum 15% in the private-asset category.....By intentionally undervaluing his funds' risky and illiquid private securities, Van Wagoner gave himself room to buy additional private securities without bumping into the 15% limitation -- in effect, he was like the losing gambler who doubles up on his next bet.....Van Wagoner still faces his day in court with the class-action lawyers, but the SEC has finished with him, and Van Wagoner can count himself extremely lucky.....For blatantly manipulating his funds' 15% private-securities rule, Van Wagoner was hit with a modest monetary penalty, some governance changes, and he's been barred for seven years from serving as an officer or director of a mutual fund.....But Van Wagoner is still allowed to manage his mutual funds, and he can still share in the profits of his fund company, which makes the rest of the SEC sanctions pretty much meaningless.

Briefly noted:

In mid-August, the SEC voted unanimously to require fund companies to disclose the dollar amount that fund managers have invested in their own funds (the disclosure will be in discrete dollar ranges, with the highest range being "$1 million and over") .....Fund companies also will be required to disclose how fund manager bonuses are determined, and funds will no longer be allowed to use the cop-out term "team-managed" to describe how a fund is run.....Henceforth, funds will be required to designate the managers of each fund by name (and their respective roles within the fund), which means that fund investors should get a much better handle on manager turnover.....Kudos to the SEC, since these are examples of almost perfect government regulations: They provide useful information to the investing public, at virtually no additional cost, and they give mutual fund journalists months and months of new story ideas.
On a roll: As a result of the same mid-August SEC meeting (above), fund companies will now be required to disclose all other investment accounts run by each mutual fund manager, and funds will not be able to "direct" their stock purchases to reward favored brokers.....The new disclosure requirement should help investors figure out if their fund manager has potential conflicts of interest with other accounts (e.g., hedge funds), or if the manager is simply overworked.....The ban on directed brokerage will keep fund companies from overpaying commissions -- in other words, using shareholder money -- to pay off brokers who sell the firm's mutual funds.
Sometime this fall, Pioneer will complete the purchase all Safeco mutual funds.....In the process, one of the great loser funds of all time -- Safeco Core Equity -- will be merged out of existence.....If you own shares of this benighted fund, you could simply allow your money to move over to its new home, which will be the flagship Pioneer fund.....Or, you could do what savvy investors would do in a similar situation: Evaluate the post-merger fund (in this case, Pioneer) as if you were considering an investment for the first time.....They key question is, "Without a merger, would Pioneer still be the best place for my money?".....Unless you totally lack initiative, or good fund-screening tools, we doubt that Pioneer would be at the top of anyone's mutual fund wish list.
"Even a step up may not be the right step," Charles Jaffe, cbs.marketwatch.com, August 6, 2004

Roy's new line of fund- manager apparel, guaranteed to improve fund performance

According to a recent study, your fund might be better off if your manager never touches it.....Over a period of about 4½ years, ending in June 2004, 11 of the 15 largest actively-managed stock funds would have had higher returns if their respective December 1999 portfolios had simply been frozen in place, and their managers hadn't made a single trade.....For example, if both Janus Twenty and the Janus fund had locked in their 1999 portfolios, they would have returned -3.1% and -2.3% over the period in question, a huge improvement over their real-world returns of -14.4% and -10.3%.....Other large funds that would have benefited from do-nothing status include American Century Ultra, Putnam New Opportunities, and two Fidelity funds (Magellan and Growth & Income).
"Professional Help Can Prove to Be A Hindrance," Ian McDonald, The Wall Street Journal, August 5, 2004

Fund manager BlackRock has agreed to buy State Street Research & Management, which means that BlackRock will also take over the State Street mutual funds.....BlackRock is best known for (wait a minute, we're still working on it), while State Street's mutual funds are best known for (just a second, it's on the tip of our tongue).....This promises to be an auspicious union.
Last month, we reported that a major, as-yet unnamed investor was planning to withdraw $5 billion from funds managed by Janus.....That investor turns out to be ING, which is bailing out of several Janus Aspen annuity funds.....An ING spokesperson says that Janus is being fired because of concerns about "investment performance, cash flows, investment talent, and ongoing feedback from [ING] customers," which pretty much covers every reason anyone would ever want to fire a manager, except for "annoying laugh" and "poor personal hygiene."
If your product isn't good enough to sell itself, get someone else to hustle it for you: Janus made its name (such as it is) selling funds directly to investors.....Now, Janus plans to add an "A"-class share to about 15 of its existing funds.....These funds would be hawked by brokers, and would carry front-end loads up to 5.75%
"Janus plans shift in sales strategy," James Paton, rockymountainnews.com, August 6, 2004