FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted November 1, 2003) [Archive Table of Contents]
Scandal Fires Continue to Ravage
Fund Landscape

As we get ready to post this issue of FundAlarm, terrible wildfires continue to burn throughout Southern California. Real fires destroy homes and lives, while mutual funds are, ultimately, only about money. Without minimizing a real-world tragedy, the current fund scandal has many elements of a firestorm:

Complacent citizens (the fund companies) turned a blind eye to potentially dangerous conditions and, in some cases, set the fires themselves.
Firefighters (the SEC) were powerless to prevent the first flames, and still seem overwhelmed and understaffed.
Fires that we thought were dying out (Strong) suddenly flare up, and new fires (Putnam) erupt without warning.
People in the path of the fires (investors) feel helpless, frightened and confused.
At some point, if the fires don't stop, there won't be anything left that is worth saving.

As you've probably guessed by now, October brought more news on the scandal front, including accusations against Putnam and Strong that would have seemed impossibly outrageous just a couple of months ago. Herewith, a summary of the latest developments from the front lines. (If you're new to the fund scandals, you might want to check our archive first).

The Boston Blaze

This fire was set by Putnam, and it has erupted on two fronts, both having to do with market-timing trades.....On the one hand, Putnam appears to have allowed participants in certain large 401(k) plans to make hundreds, even thousands of market-timing trades, while Putnam's own rules would have barred individual investors from making even a handful of similar trades (ten members of Local 5 of the Boilermakers Union in New York reportedly made profits of more than $2 million by making 5,340 market-timing trades in Putnam funds,* and one Putnam office referred to the last hour of market trading as "boilermaker hour").....For this kind of conduct -- which Putnam obviously thought would keep an important client happy -- the State of Massachusetts (behind William Galvin) has charged Putnam with civil fraud.....So, you think the boilermaker deal is bad?.....It turns out that at least four Putnam fund managers were market-timing Putnam funds for personal gain, including two managers (Omid Kamshad and Justin Scott) who were market-timing their own funds.....Kamshad and Scott had been actively market-timing since at least 1998, Putnam knew (and warned them multiple times) about their timing activities, yet Kamshad and Scott (1) continued to manage their funds, (2) kept their profits (several hundred thousand dollars) and (3) market-timed to their hearts' content until 2003 (mid-2000 in the case of Scott).....It was only last month, more than three years after Putnam first became aware of their market timing activities, and with regulators breathing down its neck, that Putnam finally disciplined Kamshad and Scott (they were fired).....For this astonishing lapse of fiduciary responsibility, Putnam finds itself facing civil fraud charges from both Massachusetts and the SEC.....Kamshad and Scott separately face both state and federal fraud charges.
* "The fund industry is broken," Jim Jubak, moneycentral.msn.com, October 30, 2003
Over the past five years, Larry Lasser has been paid $133.5 million in cash, bonuses, and stock options to run the Putnam fund company, and you might wonder what Lasser was doing while his managers so diligently stole from Putnam investors (above).....Well, nothing.....But, as FundAlarm has discovered, Lasser had a number of good reasons to do nothing, until he finally canned these guys late last month:

The Wild Man Blaze

A fire set by Dick Strong, of the Strong funds, threatens to become the biggest conflagration of all..... According to Eliot Spitzer's office, Dick Strong earned at least $600,000 profit for himself, family, and friends (and perhaps his hedge funds) via market-timing trades in his company's funds..... (Think of the bank president stealing a nickel from every savings account, every month, and you're in the ballpark for understanding these allegations).....Strong, who has a history of multiple ethical lapses, said nothing about his personal trades during the first round of the current scandal, when he had a chance to come clean, so we might add cover-up to the other charges being considered by Spitzer, which include breach of fiduciary duty and insider trading.....What kind of man are we dealing with?.....According to USAToday.com, Strong is known for his "provocative" sayings, among them "If I can get away with it, why not" and "This is a business, not a church"*.....Strong also seems to be a man of high standards (for everyone but himself) , who pays close attention to detail (except when those details involve the law).....For example, Strong reportedly terminated a real estate development deal after he noticed that one of the developer's business associates had missed a belt loop*..... When he arrives for breakfast at his favorite restaurant, Strong wants the window shade in a certain position, and he once interrupted a meeting at company headquarters to call the janitor about a screw in a light plate that wasn't vertically aligned.**
* "Strong founder may bow out amid fund scandal," Elliot Blair Smith, USAToday.com, October 30, 2003;
** "Strong wants firm to be a big player," Kathleen Gallagher, journalsentinel.com, October 4, 2003

Other flare-ups

The Alger funds lost 35 employees in the September 11 terrorist attack on the World Trade Center, and there were serious doubts that the firm would even survive.....Yet, somehow, clients held fast, ex-employees rejoined and rebuilt their former firm, and even competitors helped out wherever they could.....You'd think that a company so dependent on the kindness of strangers would have developed a special sense of public responsibility, but apparently not.....Starting in the mid-1990s, and peaking in 2003, Alger allowed its funds to be market-timed by more than a dozen hedge funds.....This year, Alger also appears to have been complicit in late-trading -- that's the illegal stuff, which robs investors just as surely as a street criminal does.....James Connelly, head of fund sales for Alger, has been slammed the hardest....Connelly has pleaded guilty to a criminal charge of tampering with evidence -- trying to destroy e-mails -- during Spitzer's investigation of the firm....Connelly was also fined $400,000 by the SEC, an astronomical penalty by their standards, and barred (but unfortunately not for life) from any "association" with the mutual fund or securities industry.
Speaking of Alger, President and Chief Investment Officer (CIO) Dan Chung has suddenly seen the light, or maybe he's just trying to deflect the heat.....Chung is now calling on securities regulators and fund industry leaders to come up with new standards on market timing......Chung has only been President since September 2003 but, prior to that, he was CIO, and he knew that Alger funds were infested with market timers.....If the market timers really bothered him, it seems that Chung would (or should) have been able to push through his own standards.....For example, consider the following market-timing policy

Prohibited. Not allowed. Can't do it. Don't even try.
See, that wasn't difficult at all.
Gerald Malone, manager of AllianceBernstein Technology fund, was suspended for "conflicts of interest in connection with certain market timing transactions".....(The fund's new manager is Janet Walsh, who currently runs the mediocre AllianceBernstein Select Investor Series Technology).....An Alliance hedge fund sales executive (Charles Schaffran) was suspended along with Malone, so it doesn't tax our mental powers to figure out what was probably going on: Malone allowed major investors to market-time his fund and, in exchange, those investors agreed to park money in the company's hedge funds.....What was in this arrangement for Malone?.....That's an important question, and we trust that Alliance will eventually share the answer.....It's possible that Malone was just doing a favor for Schaffran, and Malone had no financial motivation to allow market timing.....(It's also possible that your bank will put $1,000 in your checking account, just because you look cute on the security camera).....More likely, Malone had some kind of financial incentive to do what he did, which could be anything from an under-the-table cash payment, to some kind of financial interest in Alliance's hedge fund operation (and, we're guessing, the tip of another fund scandal).
Hedge-fund leech Steven Markovitz, a trader for Millennium Partners LP, pleaded guilty to criminal charges of late-trading mutual funds (he also made market-timing trades).....The Markovitz case is the first time we've seen a dollar amount associated with a late-trading/market-timing allegation.....According to The Wall Street Journal, Markovitz made "at least $200 million" trading mutual funds in the past three years, on a capital base that was never more than about a billion dollars*.....Not a bad return for what is, over time, essentially a risk-free strategy....The hours were pretty good, too: Markovitz typically rolled into his office about 2 p.m. and left by 4:30 p.m. if there were no trading opportunities.....On days when fund shareholders were ripe to be robbed, Markovitz would stay past 9 p.m.**
* "Top Hedge-Fund Trader Admits to 'Late' Trades, Gregory Zuckerman, The Wall Street Journal, October 3, 2002
** "'Timing' Probe Puts a Focus on Millennium," The Wall Street Journal, October 2, 2003

Continuing hot spots

Janus has acknowledged that it had trading relationships with 12 market timers, but it claims that only four of those relationships were active.....Janus also identified the seven funds that market timers were allowed to exploit: Mercury, Worldwide, Enterprise, High-Yield, Overseas, Adviser Worldwide, and Adviser International Growth.....Janus claims that the current managers of the affected funds didn't approve any market-timing relationships, which raises the obvious question, "What about the former managers of the affected funds?".....Janus has gone out of its way to clear one former manager of these market-timed funds (Helen Young Hayes), so that leaves the other two former managers as potential fall guys: Warren Lammert (who recently left Janus Mercury) and Sandy Rufenacht (who recently left Janus High-Yield).....Lammert has said nothing publicly in his own defense, but Rufenacht refuses to be a scapegoat.....Rufenacht says, flat out, that he was unaware of market-timing trades in his funds.....He also notes that such trades would have been contrary to his own financial interest, since he had the vast majority of his personal assets invested in his fund**.....Rufenacht's defense makes some sense, but we don't understand how he could have been totally oblivious to market-timing cash flows, especially if he reviewed the frequent cash reports that fund managers almost always receive.....It's also possible, given Rufenacht's compensation structure (of which we know nothing), that he had the potential to earn more money by allowing market timing in his fund than he might lose as a investor in that fund.....There's an interesting story here, and it hasn't been made public yet.
* "Janus details fund trading abuses," Jonathan Burton, cbs.marketwatch.com, September 30, 2003
** "Janus Ex-Manager Says Timing Was News To Him," Ian McDonald, The Wall Street Journal, October 3, 2003
Mark Whiston, Janus CEO, has posted a scandal-related "Shareholder Q&A" on the Janus Web site, but there's one "Q" that seems to have been omitted:

Question for Whiston: "Were you personally aware of market timing at the Janus funds?"

If the answer is "No," how difficult can it be for Whiston to say so, and reassure his investors?.....And if the answer is "Yes," how quickly can he clear out his office?
In the grand finale to his "Shareholder Q&A" (above), Janus CEO Mark Whiston intones that "Janus has developed a reputation for integrity and it is a heritage we take very seriously".....This is pure public relations fluff.....Before the Spitzer investigation, there was nothing in Janus' history that specifically reflected on its integrity, and to the extent that Janus had any reputation for integrity, it was because Janus (and dozens of other fund firms) tagged along with a spotless industry reputation.....The fund scandal didn't reflect a lapse in Janus' good reputation.....The fund scandal defined the firm's reputation, which can now briefly be summarized as cynical, greedy, and pathetically easy to corrupt.
Early in October, the volunteer Chairman of the Investment Company Institute (ICI), the mutual fund trade association, boldly proclaimed that "everything is on the table" to protect mutual fund shareholders.....Unfortunately, no one can find the table.....The ICI announced the formation of two task forces to study market-timing and late-trading abuses, but the million-dollar-a-year president of the ICI, Matthew Fink, admitted to a reporter that the committees are essentially shams.....For example, Fink couldn't tell the reporter who was invited to join the task forces, or who attended a recent meeting of the late-trading group.....Fink, who's retiring this year, "bristles at suggestions that the ICI has reneged on its promise to look out for the nation's" mutual fund shareholders, but refuses to disclose any of the "20 or 30 things" the ICI is supposedly looking at related to the fund industry.....Allow us to guess one item on the ICI agenda: Hiring someone to replace Fink who doesn't actually hurt the industry every time he opens his mouth.
"ICI task forces spark skepticism," Frederick P. Gabriel Jr., InvestmentNews, October 20, 2003

Test Your Fund Director IQ

Alger MidCap A started 2002 with about $154 million in assets. During the year, the fund took in $3.18 billion in sales of new fund shares, and the fund paid out $3.17 billion in share redemptions. As a fund director, what is your reaction to this astonishing pattern of cash flows?

	(b) "When's lunch?"
	(a) "Wow, three billion is a lot of money!"
	(c) "What an amazing coinkydink! The same amount went in and out!"
	(d) "Someone is moving huge sums of money in and out of our fund. Since that's the classic pattern of market timers, and we're paid fiduciaries, we'd better take a closer look."

The answer, of course, is (d), but chances are the Alger directors never even spotted this issue.....The redemption rate for this fund (i.e., redemptions for the year divided by beginning assets) works out to 2,053%.....That number would be difficult for any fund to top, but several funds -- all victims or suspected victims of market-timing -- had recent redemption rates that should have raised immediate red flags for their respective directors: Putnam Asia Pacific Growth R (1,287%), Putnam International New Opportunity (1,092%), Dreyfus Premier Worldwide Growth A (760%), Alliance Bernstein Technology (649%), MFS Emerging Growth A (400%), and Evergreen International Equity A (about 400%).....If any director did spot anything amiss, it appears that nothing was done.
Data source: "Three Alger Funds Showed Signs of Short-Term Trading," "Funds With High Redemption Rates Say Market Timing Occurred," John Shipman (both), October 16 and October 21, 2003, Dow Jones Newswires; "Are There More Red Flags at Putnam?", Stephen Schurr, October 24, 2003, TheStreet.com

Eliot Spitzer Quote of the Month:

"Where have the SEC and Congress been? They have permitted the mutual fund industry to get away with its claim of purity. We have simply tapped the window and the whole thing shattered."

From the FundAlarm catalog of mutual fund merchandise:

			Fund Manager Confessional. We recently received a shipment of 50 surplus confessionals, and the timing couldn't have been better! If you run a fund that's involved in the current mutual fund scandals, here's the perfect opportunity to simulate contrition. Simply step into one of these booths and play the messages that have been specially pre-recorded for use by fund executives. Express shock and surprise at being caught. Mumble a few platitudes about your commitment to clients. Offer restitution. Promise to do better in the future. Whatever approach you take (or try them all!), you're instantly off the hook. At one point, these confessionals served a serious purpose, and people took them seriously, but that was before they became available to the fund industry. Get yours today! Absolution guaranteed, or your money back.
Item #4BS $2,599

As far as we know, Ryan Jacob (manager of the Jacob Internet fund) isn't significantly smarter this month than last month.....So why is the 12-month performance of his fund this month (+198%) so much better than the performance (+146.7%) that you saw on FundAlarm just 30 days ago?.....It's all a matter of arithmetic and an inflating tech fund bubble.....Last month's 146.7% return covered the period from September 2002 through August 2003, while this month's 198% return spans the period from October 2002 through September 2003.....September 2003, which has now rolled into the 12-month performance calculation, was a pretty anemic month for Jacob Internet but, more important, the horrible month of September 2002 has now rolled out of the calculation, and that makes a big difference.....The chart below shows the ten funds with the biggest percentage increase in 12-month performance, and the accompanying page shows an additional 20 funds:

Fund	12 mo. return in this month's database	12 mo. return in last month's database	% diff in return, this month vs. last month
Jacob Internet (JAMFX)	198	146.67	51.33
ProFunds Ultra Technology Inv (TEPIX)	89.71	43	46.71
ProFunds Ultra Technology Svc (TEPSX)	89.39	42.75	46.64
ProFunds Ultra Semiconductor Inv (SMPIX)	122.24	76.22	46.02
ProFunds Ultra Semiconductor Svc (SMPSX)	120.02	74.37	45.65
Black Oak Emerging Tech (BOGSX)	89.32	48.55	40.77
ProFunds UltraOTC Inv (UOPIX)	115.87	75.61	40.26
ProFunds UltraOTC Svc (UOPSX)	114.34	74.48	39.86
American Heritage (AHERX)	14.29	-25	39.29
Rydex Velocity 100 (RYVYX)	113.8	75.08	38.72

When you see a chart like this, with large (and accelerating) returns, you just know that the next wave of short-term performance-chasing is about to begin in earnest, to be followed by the next wave of disappointment and regret.
"Equity fund returns don't tell the whole story," David Hoffman, InvestmentNews, September 22, 2003

David Snowball is one of the knowledgeable regulars on the FundAlarm Discussion Board.....Back in early August, David posted an item on the Board that he called "On regression to the mean," and we made a mental note to save David's comments for one of our year-end issues.....Herewith, some of David's sage observations:

"...in the long term, the performance of the various equity sub-groups (small value, large growth, developed international markets and so on) is really strikingly similar. In the short-term, however, one group can generate a lead over others - 50 percentage points in a single year is common.

The question becomes, what do you do with a big winner? If the answer is "let it ride," then there's a pretty good chance that you'll see your jackpot slowly evaporate until you've more or less performed about the way the general market has (it's called 'regressing to the mean')."

Better than "let it ride," says David, is periodic rebalancing of your winners and losers.....We've heard this advice many times before -- you probably have too, which is why you're yawning right now, and planning to skip the rest of this item -- but hang on just a minute.....If you're like us, you've never really seen the numbers for a rebalancing example run with real, live funds, so we've created an example to see how the numbers pencil out.....To get started, we looked for a decent fund that's solidly in the large-cap growth camp, and we also looked for a decent fund that's essentially its opposite (i.e., a large-cap value offering).....Without knowing how the example would ultimately work out (honest), we selected Marsico Growth as our growth representative, and Dodge and Cox Stock as our standard-bearer on the value side.....We assumed that someone invested $10,000 in each of these funds on January 1, 1998, and then we ran two different scenarios through September 30, 2003: (1) Buy-and-hold (or, in David's words, "let it ride"), and (2) strict 50/50 rebalancing every January 1, come hell, high water, or bear market.....With a buy-and-hold strategy, our hypothetical investor was able to grow her $20,000 to $31,520 at the end of the example period, as follows:

"Buy-and-hold"

	------------------------------Market value at: -------------------------------
	1/1/98	12/31/98	12/31/99	12/31/00	12/31/01	12/31/02	9/30/03
Marsico Growth	$ 10,000	$ 14,340	$ 21,985	$ 18,500	$ 14,739	$ 12,264	$ 14,770
Dodge&Cox Stock	10,000	10,540	12,670	14,737	16,112	14,413	16,750
Year-end totals		$ 24,880	$ 34,655	$ 33,237	$ 30,851	$ 26,678	$ 31,520

With strict 50/50 rebalancing at the beginning of every year -- in other words, assuming that both funds start each year with the exact same market value -- our hypothetical investor does even better, growing her stake to $32,901:

50/50 rebalancing

	------------------------------Market value at: -------------------------------
	1/1/98	12/31/98	12/31/99	12/31/00	12/31/01	12/31/02	9/30/03
Marsico Growth	$ 10,000	$ 14,340	$ 19,072	$ 14,316	$ 13,586	$ 13,409	$ 16,148
Dodge&Cox Stock	10,000	10,540	14,954	19,788	18,643	14,416	16,753
Year-end totals		$ 24,880	$ 34,026	$ 34,104	$ 32,229	$ 27,825	$ 32,901

In the buy-and-hold example, our investor earned a total return of 57.6%, while she earned 64.5% in the rebalancing example, so rebalancing was good for about an extra 7% -- not bad for a strategy that requires absolutely no skill.....We didn't do any volatility calculations but, based solely on eyeballing, the rebalancing example also seems to result in a smoother ride.....We also didn't attempt to calculate after-tax rates of return and, in general, active rebalancing probably makes the most sense in a retirement account.....Of course, rebalancing won't work with every pair of funds.....But if you want any chance of success, you'll probably want to fill each slot in your asset allocation (for example, large-cap, small-cap, foreign) with funds from the opposite ends of the investment spectrum.....If you don't have any obvious opposites to use for rebalancing, you might want to think about acquiring some opposites as you build your portfolio.

Janus has been in the news a lot, so Linkster Ted, of the FundAlarm Discussion Board, thought this might be a good time for a Janus Retrospective.....Ted dug out all of the items in the FundAlarm archive that refer to Janus, and we've tried to string them together in a way that traces Janus' arc as a firm over the past five years or so.....Before you go to the Janus Retrospective, we've sketched a visual representation of what awaits you:

Briefly noted:

Last April, Vontobel entered into an agreement to rebrand two of its funds under the Janus name -- basically, Janus would distribute the funds and hold the management contracts, while Vontobel would be the subadvisor, with day-to-day stock picking responsibilities.....Now, with Janus taking Eliot Spitzer's fire, Vontobel must feel like the guy who has the long-term contract to supply Saddam Hussein's hair dye: Happy about the business opportunity, but uncertain of the future.....In any event, Vontobel has gone through with the deal, and two Vontobel funds -- US Value and International Equity -- have taken on the Janus name.....Publicly, of course, Vontobel is thrilled: "We have faith in the Janus management and organization, and we think this [problem] is temporary and the future's very, very bright".....Sure, and Saddam might need skin moisturizer, too.

Terry Milberger, of Security Equity, is the rare fund manager who will acknowledge his fallibility on the record.....For this, perhaps, we should praise him, and at some point we may.....But now, it's time for pity.....When confronted with the fact that he has trailed the S&P 500 index for the past 20 years, on a cumulative basis, here's what Milberger had to say:

"When I was successful, I focused more on my growth-at-a-reasonable-price discipline...[After 1996] I took my tech weighting up at the wrong time. Eventually the job became inordinately stressful. The fear of getting too far away from the S&P 500 has haunted many people, myself included. I used to be more of an investor, but now I'm more focused on the short-term indices."

If you own this fund, you can't say that the manager himself hasn't warned you.
"Lake Woebgon in reverse," Andrew Feinberg, Kiplinger's, November 2003

Jack Bogle, esteemed founder of Vanguard, please avert your gaze:

"Ed" posted this item on the FundAlarm Discussion Board, October 29, 2003
Frank Quattrone, the discredited high-tech financier, recently got off with a mistrial....According to evidence presented at Quattrone's trial, hundreds of Friends of Frank received favorable allocations of IPO stock, including Amerindo Investment Advisers, the firm that runs the Amerindo mutual funds.....In an e-mail to Quattrone, who worked for Credit Suisse First Boston (CSFB), Amerindo indicated that it might recommend the use of CSFB as a banker more often to start-up companies if Amerindo could get shares of an IPO.....One of Quattrone's colleagues asked if Amerindo should get "special consideration," and Quattrone replied that he would like to "get closer" to Amerindo.....In still another example of the supremely un-level playing field, Amerindo subsequently received 200,000 shares of the hot Corvis IPO.*
"In Landmark Quattrone Trial, New Momentum for Prosecution," Randall Smith and Kara Scannell, The Wall Street Journal, October 13, 2003
In an item last month, we noted that MBNA Corp., the big credit card issuer, will soon have the ability to funnel credit card rebates into customers' mutual fund accounts.....But at a couple of financial firms, the future is already here.....An astute FundAlarm reader informs us that Fidelity currently offers a credit card that's linked to its 529 college investment plans, with a 2% rebate on purchases.....CitiBank also has a card with a rebate (1%) which is linked to the UPromise 529 program (upromise.com).
Uncle Lenny, we hardly knew ye: Ryan Jacob's Uncle Lenny, who had been classified (according to SEC rules) as an "independent" director of the Jacob Internet fund, has been reclassified as an "interested" (i.e., non-independent) director".....The fund says that it made the change to conform to a new mutual fund "best practice" recommendation by the Investment Company Institute, which suggests that close family members shouldn't be considered "independent" (duh!).....Sorry, Aunt Shirley, you're out of luck, too, and tell Cousin Eppie that she'll have to find a real job.
If shareholders approve, all Lindner funds (except the money market fund) will be acquired by the Hennessy fund family, and the Lindner funds will be merged out of existence.....(As "Joe Btfsplk" asked on the FundAlarm Discussion Board, "There are actually assets still left in the Lindner funds?".....Yes, Joe, there's apparently $300 million of money that nobody cares much about).....Also, the Managers Funds family plans to acquire the Conseco funds.....No changes are planned in day-to-day fund management, at least for now.
As usual, this year's meeting of the Baron funds featured some top-name entertainment: Jewel and Paul Simon.....Ron Baron, who's had some ethical lapses himself, wants to be on the right side of the current mutual fund investigation, so Baron apparently persuaded Simon to alter several of his famous song titles.....Among Simon's surprising, but timely, offerings: Spitzer over Troubled Waters, Sounds of Spitzer, and Me and Eliot Down by the Schoolyard.