FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted November 1, 2002) [Archive Table of Contents]

Oops: In spite of all their other problems, most mutual fund firms are pretty good at handling back-office details, and it's rare that you hear about a major administrative snafu at a fund company.....But there's always an exception to the rule: The folks who run the FBR funds were recently responsible for a gigantic screwup, which has caused the FBR funds to operate for all of 2002 without a valid investment advisory agreement and without a valid "distribution agreement" (a.k.a., 12b-1 plan).....Nobody's fund investment is in jeopardy, and nobody (except FBR) is likely to lose any money, but you just know that FBR wishes this entire incident would go away.....We'll see what we can do to prevent that.....Here's some quick background, and the details of how FBR went astray.

All mutual funds are required to have a written investment advisory agreement with the manager of the fund, and that agreement initially must be approved by a majority of the fund's directors and shareholders.....An advisory agreement may have an initial term of two years, but thereafter the directors must approve the agreement every year at an in-person meeting.....If the directors fail to approve the agreement on schedule, it automatically lapses, and the fund must obtain both director and shareholder approval for a new agreement.....A 12b-1 plan is subject to similar rules, including the requirement that it be approved annually by a fund's directors.....If a 12b-1 plan lapses, any replacement plan is subject to both director and shareholder approval.

So how did FBR screw up?....The initial advisory agreement between FBR and its funds was effective December 31, 1996, and that agreement had a two-year term.....The advisory agreement was renewed in 1999 and 2000, as required, but the 2001 renewal was botched.....It seems that everyone at FBR forgot about the December 31 renewal deadline, and FBR scheduled the 2001 renewal meeting to coincide with another business meeting that took place on January 24, 2002.....The directors voted to renew the FBR advisory agreement at the January meeting, but by then it was too late: The agreement had automatically expired on December 31.....There was nothing that anyone at FBR could do other than call a special shareholder meeting, send out proxy materials, and solicit retroactive shareholder approval for the agreement that the directors forgot to approve in December, all of which is in process as you read this.....Since the 12b-1 plan also wasn't renewed on time, it also lapsed, and FBR is asking shareholders to retroactively revive that plan as well.

Amazingly enough, FBR says that it didn't discover all of these problems until "early August," so FBR kept taking its management fee out of the FBR funds, just as if it were operating with a valid advisory agreement.....Legally, FBR must ask for shareholder permission to keep those 2002 advisory fees, which it's also doing as part of the same proxy materials discussed above.....And what happens if shareholders withhold permission for FBR to keep the fees? Does that mean shareholders will get a free ride for their funds for most of 2002?.....Not on your life: If shareholders refuse to let FBR keep the advisory fees, FBR has strongly hinted that the firm will sue the funds and try to recover its money that way.....Throughout the year, FBR also has been taking its 12b-1 fee.....The firm is asking for shareholder permission to keep that cash as well, with the same threat of legal action if shareholders refuse.

And now, a word from the Investment Company Institute: The Investment Company Institute is the mutual fund industry trade association and, like many trade associations, the ICI often tries to pass off self-serving "research" as newsworthy consumer information.....Consider, for example, the recent ICI study which purports to show that "total shareholder cost" for all equity mutual funds has actually declined 5 percent since 1998, and 43 percent since 1980.....Even if you don't follow mutual funds very closely, these figures probably seem preposterous, and in fact they are.....The problem with the ICI study lies with the concept of "total shareholder cost," which is purely an ICI invention.....Unlike the "expense ratio," which is used (and understood) by everyone else, "total shareholder cost" includes sales loads, and that's why the ICI conclusions are so misleading .....To understand the problem, take a look at the underlying numbers:

Source: Investment Company Institute,
"Total Shareholder Cost of Mutual Funds: An Update"

Year	(Col. A) Average "traditional" expense ratio*	(Col. B) Average sales load**	(Col. C= Col. A + Col. B) "Total shareholder cost"
1980	.77%	1.49%	2.26%
1998	1.05%	.30%	1.35%
2001	1.08%	.20%	1.28%

* The "traditional" expense ratio includes investment management fees,
fund administration costs, shareholder servicing costs and 12b-1 fees.

** The ICI has converted one-time sales loads into the equivalent of an
annual payment paid by the investor over the life of the investment.

Thus, we see that "total shareholder cost" (Column C) has indeed dropped dramatically over the past 21 years, just as the ICI says, but this drop has come about as the result of two opposing trends: On one hand, the traditional expense ratio (Column A) has increased dramatically since 1980, while the average sales load (Column B) has decreased dramatically, due mainly to the popularity of 401(k) plans and no-load funds.....When the ICI crows that "total shareholder costs" have been decreasing, the ICI cynically ignores the upward trend in the traditional expense ratio, which is the one number than everyone else cares about.

"That fund is a disaster."

	Those are not the words that you want to hear from a top executive of your fund company, but those are exactly the words that William Braman, chief investment officer of the Hancock funds, recently used to describe Hancock Small Cap Equity.
Source: "John Hancock Struggles to Refurbish Its Name in Funds," Tom Lauricella, The Wall Street Journal, October 7, 2002

"I did about as horrible a job as I could have done."

	Those are not the words that you want to hear from the manager of your fund, but those are exactly the words that William Braman, John Hancock CIO (above), recently used to describe his brief and spectacularly unsuccessful tenure as manager of Hancock Large Cap Growth (June 2000 through March 2002, although most of the damage was done by mid-2001).....Take it from Braman: He knows what he's talking about.
Source: The same Wall Street Journal article, above.

Now appearing on the Thurlow Funds Home page:

Most mutual fund Web sites don't contain a link to an "S.E.C order," because most mutual funds haven't screwed up as badly as the Thurlow Funds.....Here's the story: In early 1998, the Securities & Exchange Commission (SEC) conducted a routine examination of the Thurlow Funds, and in June 1998 the SEC found that the Thurlow Web site (thurlowfunds.com) was reporting out-of-date performance information.....Thurlow's attorney promised that, henceforth, all performance data would be updated or removed at the end of each quarter, and that was enough to get Thurlow off the hook.....In December 2000, the SEC conducted a follow-up investigation of the Thurlow Funds, and it found that performance information on the Thurlow Web site was still out-of-date.....In fact, as of December 19, 2000, the Thurlow Web site reported performance information for Thurlow Growth only through March 10, 2000 -- which, not coincidentally, was the exact day that the Nasdaq index, and Thurlow Growth, both hit their high for the year.....Subsequent to March 10, 2000, through September 30 of that year, Thurlow Growth dropped about 40%, but that information was nowhere to be found on the Thurlow Web site.....As a result of its "willful" misconduct, the SEC has censured the Thurlow Funds, fined the company $20,000 and, among other things, required Thurlow to maintain a link to the SEC order on the Thurlow Home page.

Kudos to FundAlarm reader Peter Speyer: Back in August 2000, Peter alerted us to the exact issue that the SEC focused on in its December 2000 investigation of the Thurlow Funds (above).....We ran the following item in the September 2000 edition of FundAlarm, and who knows: It may have helped trigger the SEC investigation.

[From FundAlarm Highlights and Commentary, September 2000]:

Lies, damned lies, and ~~statistics~~ certain mutual fund performance graphs: Performance graphs can serve a valuable function.....But, as Mark Twain said about statistics, they can also mislead.....If you visited the Thurlow Funds Web site on August 25, 2000, you would have seen the following performance graph for the Thurlow Fund:

As FundAlarm reader Peter Speyer points out, there are a couple of big problems with this graph.....For one thing, the information was definitely not "New!" on August 25, since the measurement period ended March 10, 2000.....And just in case you were wondering about that date, it's no accident: On March 10, the share price of the Thurlow Fund hit its high for the year.....From March 10, 2000, through August 24, the Thurlow Fund lost about 46% of its value, but that little nugget of information is nowhere to be found on the Thurlow site.....If Tom Thurlow doesn't have the time or resources to keep his Web site up-to-date, he should shut it down.....And if he's intentionally trying to deceive investors with this graph -- well, at least you know the kind of guy you're dealing with.

From the FundAlarm Spy Photographer:

Fund manager Tom Thurlow,
on his way to an SEC compliance seminar

Metropolitan West AlphaTrak 500 is an enhanced index fund and, like all enhanced index funds, some behind-the-scenes brainiac has come up with a system that's supposed to slightly outperform the underlying index, while exposing shareholders to less risk.....In the case of AlphaTrak, the system is a type of "fixed-income overlay," and the index is the S&P 500.....Specifically, the system works like this: The AlphaTrak manager takes a portion of each investor's dollar and purchases futures on the S&P 500 Index.....Since the futures position essentially replicates the performance of the index, and there's still some leftover cash, the manager is able to buy a short-term fixed income portfolio that's designed to provide a little bit of extra return.....All enhanced index funds have a weak link and, as you might have figured out by now, the weak link is always the very thing that was intended to enhance the fund in the first place.....For AlphaTrak 500, the weak link is the fixed-income portion of the portfolio and, sure enough, that link has snapped.....Earlier this year, AlphaTrak 500 held significant positions in WorldCom and Qwest paper, and when those positions tanked, AlphaTrak 500 took a heavy hit.....Year-to-date, the AlphaTrak "index" fund trails its S&P 500 bogey by an eye-popping 5.65%, and the fund now also trails the S&P from inception.....Will AlphaTrak 500 be able to recover the ground that it has lost?.....Perhaps, but given the nature of the fund, that probably won't happen soon, and there's no guarantee that the fixed-income portfolio won't blow up again along the way.....Meanwhile, shareholders continue to fork out 0.80% in annual expenses for the right to trail the index.

Briefly noted:

The independent directors of the Invesco funds are now receiving monthly performance information for the funds they oversee, instead of the quarterly reports that they used to get.....Invesco directors have also come up with something called a "portfolio review committee" which -- hold onto your hats! -- meets regularly to discuss the performance of each Invesco fund.....While you might have thought that Invesco directors were already reviewing monthly performance information, and already scrutinizing fund portfolios on a regular basis, you would have been mistaken....."In the old days," according to one Invesco fund director, "portfolio managers were able to run funds without much accountability" (in this case, "old days" means "last year").....Here's what we want to know: What were these directors getting paid for? And, if a director is willing to admit this kind of negligence in public, what kind of secrets is he hiding?
"INVESCO Grills Portfolio Managers," institutionalinvestor.com, October 4, 2002; thanks to Aaron Coates, a CFP designee in Elkhart, Indiana, for bringing this item to our attention
The SEC regularly audits the internal operations of mutual funds, and 85% to 90% of those examinations result in a "deficiency letter," which means that the fund has failed to comply with one or more SEC rules (some of the infractions are minor, some are not ).....If you're wondering why you've never seen a deficiency letter, it's because the SEC never releases them.....And if you're wondering why the SEC never releases deficiency letters, a senior SEC compliance official says that secrecy is necessary because funds "might be less willing to cooperate" if they knew that audit findings would be made public*.....Think about this pathetic statement for a minute -- the cop is worried about antagonizing the potential wrongdoer -- and you realize how far the SEC still has to go until it becomes an effective investor advocate.
* "Fund Manager Knows Best," Neil Weinberg, Forbes, October 14, 2002
Take my funds, please: As we reported last month, the Berger fund company is about to be dissolved, and the in-house Berger funds are about to find themselves without managers.....The trustees (directors) of the Berger funds have invited other fund companies to propose terms for taking over the Berger funds, and at first it seemed that only Janus would show any interest.....Recently, American Century, Turner, and Alger have also started sniffing around.
For several years, Fidelity has been losing its mutual fund managers to hedge funds, so someone at Fidelity apparently got hold of an industrial-strength thinking cap and came up with a bright idea: "Let's start a hedge fund of our own".....As a mutual fund investor, why should you care about this development?.....Fidelity's hedge fund managers will almost certainly have the potential to earn more than its mutual fund managers, so there could be an internal brain drain in favor of the hedge funds.....There's also a potential conflict of interest if a hedge fund decides to sell a stock short when that same stock is held long in one or more Fidelity mutual funds, especially if it's a large position.....Probably the best you can hope for at Fidelity is what happened to the hedge fund that Vanguard was trying to start: Dead, for lack of interest.
"Fidelity plans new hedge fund to plump assets," Svea Herbst-Bayliss, CBSMarketWatch.com, October 1, 2002
If you own mutual funds from more than one family, you've probably noticed that the quality of the annual shareholder report varies widely from company to company.....That's partly because the SEC guidelines governing those reports are so broad, requiring only that a fund's annual report "discuss the factors that materially affected the Fund's performance during the most recently completed fiscal year, including the relevant market conditions and the investment strategies and techniques used by the Fund's [manager]".....The SEC is aware that some fund companies use these guidelines as an excuse to BS their customers, and the SEC is reportedly considering a rule that would at least require funds to disclose how their largest holdings performed during the period.....In the meantime, a shareholder's best weapon is still his or her feet: If you look for substance in your fund's annual report, and you never find any, walk away.....There are plenty of funds that respect you enough to communicate properly.
"What's Your Fund Doing? Some Managers Don't Say," Tom Lauricella and Aaron Lucchetti, The Wall Street Journal, October 7, 2002
For the past couple of years, an investment in the Van Wagoner funds has been one of the best ways to lose big money.....Now, Van Wagoner has come up with a way to lift a few extra dollars from its shareholders' pockets.....Beginning December 27, Van Wagoner will charge a quarterly "account servicing fee" of $6 to any investor whose Van Wagoner account falls below $2,500, even if it falls below that amount because of abysmal fund performance (IRAs won't be raided until they reach a minimum of $1000, and a combined balance of at least $15,000 will get you off the hook entirely).....Van Wagoner says that the fee is necessary to offset the "disproportionately high costs of servicing accounts with low balances,"* which is probably true, but that's not the point.....Given all the money that Van Wagoner made off his shareholders in the good years, and all the money he's lost for them since, you'd think that the guy might have enough class to absorb a $24 fee for (at most) a few thousand shareholders.....Guess we're mistaken.
"New fee is salt in wound for Van Wagoner investors," James Paton, Reuters, October 1, 2002
According to a Vanguard spokesman, mutual fund investors definitely have the right to know what their mutual funds own, but that right is somewhat limited....."Twice a year and that should be sufficient," said Brian Mattes, when queried how often fund companies should be required to disclose their holdings*..... Mr. Mattes, who apparently knows your needs better than you do, might also be willing to tell you how much income, how many cars, and how many children "should be sufficient."
*"If Now, Then How? Writing The Rules of Fund Disclosures," Ian McDonald, wsj.com, October 15, 2002
Attention Pioneer investors! You all need to chip in, and buy this book for your fund company:

A recent print ad for the flagship Pioneer fund attempted to highlight eight famous historical events in relation to a graph of the fund's performance.....According to the Pioneer timeline, the Great Stock Market Crash occurred in 1928 (it was actually 1929), Black Monday occurred in 1989 (it was 1987), and the Gulf War occurred in 1992 (it should have been 1991).....A Pioneer spokesman says the errors are being corrected, and Pioneer hopes that next year, 2001, brings an error-free ad program.
Money, November 2002 (Cybelle Weisser)
Steven Oristaglio was the deputy investment chief for Putnam during the boom year of 1999, as well as the disastrous years of 2000 and 2001.....During those years, two of Oristaglio's major responsibilities were reportedly portfolio risk management and portfolio construction.....Two of the main reasons that Putnam funds performed so dismally in 2000 and 2001 were faulty portfolio risk management and faulty portfolio construction, both Oristaglio responsibilities.....Oristaglio recently received some news about his job and, no, he wasn't fired.....He was promoted to head of Putnam's entire investment operation, a post he'll share with a new hire from the Delaware funds.
"Putnam reassigns investment chief," Beth Healy, boston.com, October 9, 2002
The Johnson family runs the Franklin Templeton funds, and one of the Johnsons has gotten himself into a huge legal mess.....Get out your Johnson scorecard: Charles E. Johnson, a director and co-president of the company, and son of CEO Charles B. Johnson, has been charged with felony domestic violence, and other related crimes, that could land him in jail for more than 10 years.....Charles E. has taken a leave of absence as a result of the charges (no word if the absence is with or without pay).....Charles E. had been responsible for spearheading Franklin's overseas operations, as well as its internal technology.....Those duties will be assumed by his fellow co-presidents, Martin Flanagan and brother Gregory Johnson.

The Muhlenkamp fund has always been difficult to pigeonhole (mid-cap? value? growth?) but, whatever it is, performance has held up pretty well over the past five years and three years (+3.18% and +3.40 annualized returns, respectively).....Year-to-date, however, the fund is down over 25%, and surely Ron Muhlenkamp, who runs the fund, could have picked a better time to introduce his "investment slide show," above.....FundAlarm reader Gibbs LaMotte got frosted enough to fire off the following e-mail:

Dear Mr. Muhlenkamp:
Given your track record this year against your peers and almost any index you can name, it takes real chutzpah for you to talk about making money in this climate. Have you no shame, sir? Perhaps you could spend less time pontificating on television, and giving "workshops," and more time on making money for your shareholders.

If there's something about your fund, or fund manager, that annoys you, please let us know, and we'll consider publishing your beef in a future issue of FundAlarm.....We can't promise that anything will change, but a lot of people will read it, and we guarantee that you'll feel better.

Now he's one of us: During his confirmation hearing in August 2001, Harvey Pitt promised that he would divest himself of individual stocks if he became SEC Chairman.....Well, he did and he did.....After selling his stocks, Pitt invested between $800,000 and $1.7 million in five stock and bond mutual funds from the American family.....Pitt and his wife also have between $200,000 and $500,000 in Lord Abbett Affiliated and Fidelity Advisor Equity Growth, and between $50,000 and $100,000 in State Street Mid Cap Value.....Pitt's retirement accounts are invested in various Fidelity funds, as well as several Merrill Lynch funds, including Basic Value, Global Growth, Large Cap Growth, and Small Cap Value.....Since these are mostly broker-sold funds, here's a thought for all of you brokers and financial planners out there: Could there possibly be a scarier client than the Chairman of the SEC?
"Pitt Sold All Individual-Stock Holdings, Moved Into Mutual Funds," Dow Jones Newswires, October 18, 2002
Strong Multi Cap Value, a 17-year old go-anywhere fund, has been managed for about 18 months by Charles Rinaldi, who inherited the fund from David Schafer (under whom the fund was known as Strong Schafer Value)..... Earlier this year, Strong started another go-anywhere value fund, Strong All Cap Value, which is also run by Charles Rinaldi and is essentially the same fund as Multi Cap Value.....Over the past one, three, and five years (and also over the past ten and fifteen years) Strong Multi Cap Value has been one of the worst mid-cap value funds in existence, but somehow this sorry fund has been able to accumulate about $220 million in assets.....Strong All Cap Value has virtually no track record, and it holds only about $2 million in assets.....FundAlarm reader "Eric" believes that Strong is getting set for a merger: He predicts that All Cap Value will absorb its sad-sack sibling, and Strong will get to bury Multi Cap's embarrassing track record.....Eric is probably right, and you heard it here first.
Sic transit Fidelitus managerus: Since the stock market peaked in March 2000, every single Fidelity Select fund (41 in all) has received a new manager.....The most senior Fidelity Select manager has been on the job since April 2000, while 30 managers have a tenure of less than 12 months.
"Once Revolutionary, Sector Funds Swoon," Floyd Norris, The New York Times, October 6, 2002
Sic transit hottus fundus: Nicholas-Applegate plans to merge its Global Technology fund into its Global Select fund.....Global Technology was the best-performing fund of 1999, and perhaps of all time, with a 494% return*.....Since January 1, 2000, the fund has lost about 80% of its value and about 90% of its assets, so this decision isn't exactly a shock.....Also being merged out of existence is Nicholas-Applegate Global Health Care.
* Dow Jones Business News, October 3, 2002
For at least 20 years, banks have been trying to figure out how to make money selling mutual funds, and now it appears that one Midwestern bank has hit upon a unique fund distribution strategy.....According to Brian Reeves, an investment representative at First Indiana Investor Services (an arm of First Indiana Bank): "A lot of times older clients really don't want to drive, so I go out to the house" to sell them funds......On one sales call, Reeves says, he ended up changing the battery in an older client's car (it's not clear if he also sold any funds).
"Mutual funds find a place in the mall," Chris O'Malley, The Indianapolis Star (at usatoday.com), October 3, 2002
A rival of First Indiana Investor Services (above) refuses to be outdone by a fund rep who merely changes car batteries:

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