FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted December 1, 2003) [Archive Table of Contents]

Your November Scandal Recap

November was another busy scandal month, as fund firms continued to discover both improper trading activity and ethical lapses by their executives. The most newsworthy events, as indicated on the calendar above, were as follows:

November 2: Dick Strong, who has admitted market-timing his own funds, resigned as chairman of the Strong funds' board of directors, but kept his position as chairman of the management company.....(In a move of equal significance, Strong also relinquished his role as organizer of the firm's football pool).....Strong's resignation as top director means essentially nothing, since the real power (and money) reside in the management company, and Strong isn't about to give up his top spot with the management company unless he has to.....The Strong funds seem to have avoided massive redemptions, which is good news for investors, but Strong himself is squarely in Eliot Spitzer's sights, and Dick Strong is almost certainly spending his last December in the fund business.
November 3: Lawrence Lasser was fired as Putnam's CEO (as you may recall, Lasser was asleep in the guardhouse as several Putnam managers turned their funds into market-timing playgrounds).....Despite firing Lasser, and despite settling with the SEC (on November 13, below), Putnam continues to bleed assets, both from its private accounts and its mutual funds.....In fact, there's a good chance that several Putnam funds are in the early stages of a death spiral, which happens when shareholder redemptions cause fund managers to sell favorite holdings and maintain large cash balances, which leads to poor performance, then more redemptions, then more sales, then even worse performance, and so on, all the way down.....If a broker or financial planner helped put you in a Putnam fund, now is the time for that person to earn his or her sales commission.....Your broker should be actively monitoring your Putnam funds for deteriorating performance, both against benchmarks and peer groups, and you should be developing a plan to bail out of Putnam funds if and when that becomes necessary.....Brokers should also be putting pressure on their Putnam contacts, especially fund wholesalers, to provide real-time information about Putnam funds that are bleeding assets, and therefore most likely to spin out of control.....Mutual funds are separate legal entities, and it's virtually impossible that Putnam's troubles will cause any of its funds to go bankrupt.....But there's a good chance that Putnam's troubles will hurt the performance of at least a few funds.....For years, the fund industry has justified load funds, like Putnam, by claiming that investors are paying extra for better service.....Now, brokers and financial planners have a chance to prove it.
November 13: The SEC entered into a settlement with Putnam over its market-timing activities, just a few weeks after the firm was first charged, and in the midst of massive redemptions from Putnam's investment accounts.....How bad was this settlement? Let us count the ways: (1) The settlement was bad public relations, because it looked like the SEC had again caved in to fund industry pressure.....(2) The settlement was bad policy, because it sent a message to other fund companies that the SEC would protect big fund companies from their own greed, stupidity, and negligence (Putnam wasn't required to admit wrongdoing, and even the calculation of Putnam's monetary penalty was deferred until sometime in the future).....(3) The settlement was bad economics, because it didn't allow time for market forces to work, even if the market ultimately would have destroyed Putnam.....No matter what had happened to Putnam, the financial markets weren't going to be disrupted, fund investors weren't going to be bankrupted, and the fund industry wasn't going to shrivel and die.....In fact, this was the perfect case to let a big fund company twist in the wind for a while.....The SEC screwed up by settling with Putnam and, because they did, we're all a little worse off.
November 19: The House passed a bill to reform the fund industry, and it was surprisingly tough legislation, with one glaring exception: Caving in to pressure from the Investment Company Institute (ICI), the House bill doesn't require an independent chair for each fund's board of directors.....Preventing an independent chair has become an obsession for the ICI, the fund industry trade association and lobbyist, and it's pretty clear why: The ICI knows that board chairs wield significant power, and the fund industry won't be able to fight its rearguard action against reform if fund companies lose control of fund boards......Here's our suggestion, which seems to us the very model of reason and compromise: Require the chair of every fund board to be independent, but specifically allow the independent directors to delegate the chairman's spot to a non-independent director (i.e., a fund company representative) if the directors feel it's in the best interest of fund shareholders to do so.....That way, the independent directors have the flexibility to run their fund the way they see fit, and Congress goes on record with a general presumption in favor of an independent chair, which is the way it ought to be.....Next up: The Senate weighs in on fund reform, probably some time in January or February.
November 20: Gary Pilgrim and Harold Baxter, President and CEO of the PBHG fund family, flew to the top of the mutual fund sleazebag list, as the SEC hauled them into federal court on charges of fraud and breach of fiduciary duty (Spitzer filed a similar case in New York).....The SEC says that Pilgrim personally gave permission for an outside hedge fund to market-time PBHG Growth, at the same time that Pilgrim was managing the fund, and, by the way, Pilgrim was also a substantial investor in the hedge fund.....At one point, Pilgrim owned 45% of the hedge fund that was timing his own fund.....During just two years of trading (2000 and 2001, while PBHG Growth investors were losing about 65% of their money) Pilgrim earned $3.9 million from his hedge-fund investment, which appears to be a return of at least +30% on his money.....Meanwhile, Baxter was aware of Pilgrim's hedge fund investment, as well as the market timing arrangement, and did nothing to stop it.....Apparently trying to keep up with his partner in corruption, the SEC says that Baxter also provided a broker friend with non-public information about PBHG fund portfolios, which the broker passed along to select customers.....Then (you guessed it) the broker's customers used that information to market-time PBHG funds, with Baxter's knowledge.....Pilgrim and Baxter have resigned, they have agreed to make restitution, blah, blah, blah, blah.

Here's your chance to get Roy: Just in case anyone is looking for a new independent fund director, I thought I'd let you know that I'm available.....I'm easy to get along with, I don't eat much, and I clean up after myself, which are desirable traits in any boardroom.....I also have some pretty strong views on fund governance, so please be aware of these before you get in touch.....In fact, here's my entire fund director platform:

I'll push to replace underperforming managers through competitive searches
I'll seek to lower management fees, so they are comparable to those paid by pension plans
I'll work to limit soft-dollar payments and 12b-1 plans to their original purposes
I'll use my best efforts to disclose every shareholder cost

As an independent fund director, I would also:

	Sign a pledge to act as a fiduciary, with my only loyalty to fund shareholders Oppose lump-sum directors' fees that bear no relation to services rendered Take my director's fee in fund shares Limit my service as director to no more than 10 funds at a time

Yes, this is a serious proposal -- perhaps even the shape of fund governance to come -- but I won't spend too much time waiting for the phone to ring.

Janus tries a proven marketing strategy: According to Allison Linn, of the Rocky Mountain News, several Janus managers have penned letters, which were recently included with their funds' annual reports, focusing on the fact that "they aren't just responsible for overseeing the funds, they're also major investors in the funds".....It occurred to us that we had seen Janus' approach before, in a slightly different context:

How persuasive are the Janus managers?.....Scott Schoelzel, for example, says he is one of the largest direct individual investors in his fund, Janus Twenty.....He also says that he continues to buy shares of the fund, and has never sold any shares since becoming manager in 1997.....Jonathan Coleman (manager of Janus Enterprise) says that he is one of the five largest investors in his fund (ouch), he continues to buy shares with every paycheck, and he has never sold any shares, while David Decker (Janus Special Equity) says that he has 80% of his liquid assets invested in his fund (sorry to hear that), and he has never sold a share.....All of the letters are well-written, and sincerity oozes from every page.....Ultimately, however, we find them unconvincing.....These letters fail because of what isn't disclosed, and the biggest undisclosed item is each manager's compensation package.....As we've said before, it's easy to imagine a situation where a manager has significant personal assets tied up in a fund, yet the manager still allows market timing (or other shenanigans), simply because the misdeeds generate more in bonuses (or other compensation) than they cost in lost fund return.....Even without managerial misdeeds -- and we're not suggesting any -- large fund holdings by Schoelzel and the gang don't necessarily equate with acting in the best interests of fund investors.....If Janus managers want to prove a common interest with fund investors, let them share the details of their employment contracts.....Then, and only then, will we know that Janus managers and their shareholders are really in this together.

The Mindset That Launched a Dozen Fund Scandals:

	"Mutual fund directors are largely responsible for the success and prosperity of investment companies. Directors play a central role in the management -- and regulation -- of the fund industry. Over the last 55 years, directors have commendably fulfilled their responsibilities and have earned the confidence of the SEC. As my colleague Chairman Arthur Levitt said before this conference last year, the relationship between the SEC and fund directors is a partnership in the public interest. This partnership has been a remarkable success. The mutual fund business has been remarkably free from significant problems or scandals. Thanks in no small part to the role of directors, the SEC has been able to accomplish its mission with very little cost to the public."
--Former SEC Commissioner Steven Wallman, addressing a conference of the Investment Company Institute, September, 1995; thanks to Chris Tobe, CFA, who brought this quote to our attention in an article that he wrote in 1999, and published in 2000, while employed by the Kentucky State Auditor's Office

OK, we admit that we occasionally exaggerate. But this seems a bit harsh:

Back in 1994, Don Christensen wrote a book called Surviving the Coming Mutual Fund Crisis.....Don's book didn't predict the current scandal in detail, but it did review the cyclical history of fund scandals, it suggested that another scandal was coming, and it higlighted some fund abuses (including weak directors) that have clearly contributed to the current mess.....Don has prepared a new essay for FundAlarm, "Repeating the Same Mistakes, Differently," in which he takes a look at three current (and future?) areas of fund vulnerability.....You can find Don's essay on the accompanying page.

Busted! update: A couple of months ago, we introduced Busted!, our archive of mutual fund firms that have been subject to SEC enforcement action.....This month, we've added Parnassus to the archive, as the result of an SEC enforcement action in September 1998 that we previously overlooked.....We've also added the SEC enforcement action against Putnam, arising out of the current fund scandals, although the SEC still hasn't determined Putnam's financial penalty (and some, like FundAlarm, would say that Putnam has barely been "busted" at all).....Finally, although the SEC action against PBHG (discussed above) is just beginning, and isn't ready for inclusion in Busted!, you might be interested in reading the SEC press release (http://www.sec.gov/news/press/2003-161.htm), or viewing the full legal complaint (http://www.sec.gov/litigation/complaints/comp18474.htm).....In fact, if your scandal outrage is starting to wane -- or if you never had any outrage to begin with -- we highly recommend that you read the "Facts" section of the PBHG complaint, which begins on the third page of that document.

Briefly noted:

Charles Schwab, champion of the small-fry investor, admitted that it allowed market timers to prey on the Schwab-owned Excelsior funds.....Schwab CEO David Pottruck also acknowledged that there has been some late trading in the company's mutual fund supermarket, but Pottruck suggested that those late trades were nothing more than after-hours "adjustments" and "substitutions" to pre-existing fund orders ("Would you like fruit instead of fries, or Strong Asia Pacific instead of Driehaus International Discovery?").....Pottruck also noted that none of Schwab's employees earn a commission on the trades they process, and he suggested that employees who facilitated after-hours trades may have done so merely out of a desire to provide good client service.....Thanks for clearing that up, Dave.....We were concerned that some of your employees might have taken a little juice under the table.....Now, can you explain why phone clerks were allowed to change fund orders, without any kind of supervision or approval?
The SEC has fined Morgan Stanley $50 million (about four hours of revenue) for two mutual fund violations: (1) Without disclosure to its clients, Morgan Stanley sold slots on its preferred fund-company list, and Morgan Stanley brokers received extra payments for pushing preferred-list funds; and,(2) Morgan Stanley brokers regularly earned more from pushing Class B shares of Morgan Stanley funds, even when Class A shares would have been significantly cheaper (and better) investments.....In a public statement, Morgan Stanley CEO Philip Purcell expressed his "regret" that some his firm's "sales and disclosure practices have been found inadequate," which is as about as far from an apology, or even a recognition of responsibility, as any CEO is ever likely to attempt after an investigation by federal regulators.....Suggestion for the SEC: In cases like this, where the monetary penalty isn't even petty cash, you might at least insist on approving the CEO's public statement.....Otherwise, guys like Purcell will continue to make your work seem completely meaningless.
For those of you who are keeping a scandal scorecard, you might want to pencil in the Van Eck funds.....Van Eck has apparently been subpoenaed by Eliot Spitzer's office, and it hasn't been charged with anything yet, but the evidence of guilt is compelling: For 2002, Van Eck International Gold A experienced almost $2 billion in matching sales and redemptions, on an asset base of about $170 million -- the surest test yet devised for market-timing activity.....It looks like Van Eck Global Hard Assets A also played host to market timers, along with three annuity funds in the Van Eck Worldwide Insurance series (Emerging Markets, Real Estate, and Hard Assets).
"Van Eck Subpoenaed Amid Canary Link Concerns," Stephen Schurr, TheStreet.com, November 19, 2003
Just over three years ago, a couple of Heartland muni-bond funds were revalued, and fund shareholders lost millions of dollars overnight.....Was it negligence, stupidity, fraud or arrogance?.....Probably a bit of each, but that hasn't stopped Heartland from trying to salvage its reputation.....Starting in December, and running through April (in other words, IRA season), Heartland will sponsor two popular news shows on National Public Radio (Morning Edition and All Things Considered)..... At some point during my lifetime, the SEC will probably take enforcement action against Heartland.....If that action should happen to come during the next few months, both of these NPR shows will have a unique journalistic opportunity: Explaining why they took money from (and lent their good name to) a company that violated federal securities law.
The new Watchdog Fund is designed to hold stock in slacker companies, then goose management into improving operations, with the idea that fund shareholders will eventually profit.....It's a good cause, but it's probably not the right idea for a mutual fund, and the folks who run Watchdog have left themselves wide open to charges of hypocrisy.....For example, Watchdog will almost certainly seek changes to company Boards of Directors, but the fund's own board will be chaired by the same person who runs the management firm -- precisely the kind of conflicted interest that many fund reformers are trying to stop.....Watchdog also makes no commitment to disclose its soft-dollar payments or expenditure of 12b-1 fees, the process for setting its management fee (a steep 1.5%) is as opaque as any run-of-the-mill offering, and its directors are the same ciphers found everywhere else.....In the current environment, some fund has the opportunity to make a huge splash with a truly transparent, consumer-friendly structure.....Unfortunately, it isn't going to be Watchdog.
"Fund Striving For Better Governance, Including Its Own, John Shipman, Dow Jones Newswires, November 18, 2003
You may recall FBR Total Return Bond Fund, which we wrote about shortly after its jaw-dropping summer swoon (down 19% in July).....Even worse than the loss, we noted that the fund's manager wouldn't (or couldn't) explain what had triggered such a steep drop in this supposedly conservative fund.....The fund's directors might have been getting nervous, too, and they've decided to kill this offering.
"Fund Track" column, Karen Damato, The Wall Street Journal, October 30, 2003
Other than your boss, have you ever considered who are the most overpaid workers in the U.S.?.....Reporter Chris Pummer, of CBS.MarketWatch.com, has put together an eclectic list of occupations that earn too much, including (in ascending order) wedding photographers (#10), pilots for major airlines, West Coast longshoreman, airport skycaps, high-end real estate agents, motivational speakers and ex-politicians on the lecture circuit, orthodontists, CEOs of poorly performing companies, and washed-up pro athletes in long-term contracts.....The #1 overpaid profession, according to Pummer, is mutual fund managers.....Pummer says that he's not just kicking managers when they're down....."They've long been overpaid. Stock-fund managers can easily earn $500,000 to $1 million a year including bonuses -- even though only 3 in 10 beat the market in the last 10 years."
From a recent profile of Dick Strong, of the Strong funds, describing his firm's 25th anniversary party:

"All the people Dick had hired and trained and helped and paid big salaries to...there should have been dozens of well-wishers at the party. Not a single person came back. Not one."
From A Christmas Carol, by Charles Dickens, describing the scene at Scrooge's "deathbed":

"He lay, in the dark empty house, with not a man, a woman, or a child, to say that he was kind to me in this or that, and for the memory of one kind word I will be kind to him."
Next time someone tries to convince you that mutual fund reforms don't matter, consider what's happened with proxy voting.....As you may recall, Vanguard was one of the firms that vehemently opposed an SEC proposal that would have required all fund companies to disclose their proxy votes.....The SEC proposal passed, in spite of Vanguard's whining, and we're coming up on the date (August 31, 2004) when Vanguard (and everyone else) must make its first proxy vote disclosure.....In the days before Vanguard was required to disclose its votes, the firm rubber-stamped 90% of full corporate director slates......This year, with disclosure looming, Vanguard has fully agreed with only 29% of the corporate slates -- or, to put it another way, Vanguard has withheld its vote from at least one nominee in an astonishing 71% of the cases (versus 10% under the old rules).....The proxy-vote disclosure rules have had another important effect on corporate governance: Many companies don't even submit issues for a proxy vote, now that fund companies are showing some backbone.....Instead, the companies will work with their large shareholders ahead of time, to create slates (and corporate policies) that have a chance for passage.
"Mutual Funds: Tossing Out The Rubber Stamp," David Henry, businessweek.com, November 17, 2003
Back when the proxy vote rules were being debated (above), Vanguard was joined in its public whining by Fidelity.....Fidelity claimed that disclosing proxy votes would politicize the money-management process, and that quiet, behind-the-scenes negotiation with company management was a more effective way of securing corporate change.....In Europe, however, Fidelity regularly gets involved in loud, public, and high-profile corporate disputes.....Why the difference between Fidelity U.S. and Fidelity Europe?.....Part of the reason is ownership: The Johnson family owns essentially all of Fidelity U.S., so Fidelity's milquetoast U.S. policies reflect the Johnson family preference (the Johnsons own only 40% of Fidelity Europe, so it's possible for them to be outvoted).....The other big difference is cultural: National governments in Europe expect fund companies to be activist shareholders, so of course the fund companies oblige.....In the U.S., where there are no similar pressures, companies like Fidelity can sit on their collective hands and pretend that indifference to corporate governance is good fund-company policy.
"Across Atlantic, Fidelity's Voice is Loud, Public," David Reilly, The Wall Street Journal, October 28, 2003
The Sycuan Band of Kumeyaay Indians is launching the Sycuan U.S. Value Fund (it will be subadvised by Brandes Investment Partners).....The tribe also operates casinos in the San Diego area, so there's some thought that investors may associate the Sycuan name with gambling, and shy away from the fund.....A tribal spokesman, however, dismisses such concerns, and he's got a marketing pitch that even the oldest U.S. fund company can only dream about....."In our case, the Sycuan brand is 12,000 years old. We're not trying to market Sycuan as a gaming enterprise. We're trying to market Sycuan as a tribal enterprise."
"Tribe Bands in New Role: Manager of Mutual Fund," Bruce V. Bigelow, The San Diego Union Tribune, November 14, 2003
What do you do with a disgraced fund family?.....Why, you merge it out of existence and, if you're lucky, investors will quickly forget that you ever had a problem.....Bank of America recently announced a deal to acquire FleetBoston Financial, and the new company comes with two fund families -- Liberty and Columbia.....According to Timothy Middleton, of moneycentral.msn.com, it should be an easy job for B of A to merge its disgraced Nations funds into Fleet's lineup, and get rid of the Nations name.....With that simple maneuver, the Bank will be able avoid years of costly scandal fallout, and retain all of its current fund assets.
Psst! Do you want to end your career in the fund industry? Then you might offer to chair the Investment Company Institute's general membership meeting.....John Carifa, Chief Operating Officer of Alliance Capital, chaired the meeting in 2002, and he was recently booted from Alliance for being too cozy with market timers.....Robert Gordon chaired the meeting in 2003, and Gordon (of the Nations fund group) was one of the first fund executives fired during the current scandals.