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REPEATING THE SAME MISTAKES, DIFFERENTLY
by Don Christensen

It happened in the early 1930s. It happened again in the early 1970s. And now for the third time in the last 75 years the leaders of the mutual fund concept have created for themselves -- and their hapless shareholders -- an institutional crisis.

As with the scandals that swirled around the mutual fund world following the Roaring Twenties and again following the Go-Go Sixties, the scandals we see unfolding today following what could be called the Noxious Nineties grew out a single human characteristic played continuously throughout financial history: The unbridled greed of important leaders of a financial idea of unquestioned popularity.

Simply put, all the lessons that supposedly were learned during the periods of mutual fund reform in the late 1930s and mid-1970s were forgotten. And, given the chance, the mutual fund industry -- along with the complicity of government watchdogs and the financial media anxious to look the other way when it seemed that everyone was getting rich -- turned to devious and unethical methods to fleece their trusting shareholders.

History repeated itself, with only slight differences.

But the cyclical nature of history is probably not fully played out in this story. There are other possible uncovered land mines ready to surprise those who still refuse to look at the lessons of financial history.

Fund vulnerabilities

While most of the current attention is focused on abuses involving "short term trading," other underlying issues could expand the problems with funds. Three of the most critical vulnerabilities that could plague funds in the weeks and month ahead are:

Pricing of fund shares. At best, the net asset value (NAV) or price per share reported daily for mutual funds (including money market funds) are guesses. It was "pricing inefficiencies" that allowed the short term trading profits enjoyed by fund insiders and a few privileged customers that prompted the first round of the current scandals. Unfortunately, it could be a very short step for insiders to take from exploiting "pricing inefficiencies" to insiders actually manipulating the fund prices in order to be certain of a profitable outcome of short-term trading. After all, one of the joys of insider trading is that there is no risk; you already know in advance how much you'll make and when. The most vulnerable arena for "creative" pricing of mutual fund shares is within a fund's holdings of illiquid securities.

Illiquid securities. One of the scandals of the early 1970s involved the valuations of high concentrations of illiquid securities in fund portfolios. Funds that claimed to be worth one thing were actually worth far less. Reforms of the 1970s put restrictions on illiquid securities. Much of those restrictions were removed in the 1990s. In addition, scandals of the 1970s involving large holdings of new-formed "unseasoned" companies (whose thinly-traded stocks effectively turned out also to be illiquid) prompted part of the reforms of the mid 1970s. These reforms, too, were largely removed during the 1990s. The consequences of high concentrations of illiquid securities could be particularly troubling to funds hit with heavy redemptions because of shareholders fleeing the scene of scandal. As the easily liquidated part of the fund portfolio is sold to satisfy redemptions, the "truth" of the pricing of the illiquid portion of the portfolio eventually will have to be faced. Tragically, the "truth" of the pricing will be borne by the shareholders and not the fund managers.

Financial inter-involvement of funds within fund families. One of the most serious causes of failure of funds in the early 1930s -- then referred to as "investment trusts" -- was the overlapping of funds owning shares of other funds, trading between funds directly outside of exchanges as well as borrowing from one fund to another (for margin buying of securities as well as shares of other funds). When markets were hot in the late 1920s, this direct financial interrelationship of funds with other funds delivered great returns. However, when the markets went into reverse the funds collapsed like a house of cards. Reforms of the late 1930s largely prohibited these relationships of funds within funds within funds. Yet in the 1990s relaxed government regulations and removal of restrictions at many fund families erased much of the lines among funds, allowing borrowing from one fund to another (to raise cash, for example, to satisfy redemptions from anxious shareholders) as well as allowing one fund to purchase shares of other funds and trading of securities (illiquid and liquid) directly among funds. The ultimate question is: Could today's mutual funds collapse like a house of cards as they had in the early 1930s? The most tempered, least alarmist answer: Relaxed regulations and restrictions instituted during the 1990s makes the possibility greater than at any time since the 1930s.

The Great Money Shift

Whether or not we actually experience the worst-possible scenario with the current unfolding mutual fund scandals -- which would push this institutional crisis into a financial crisis -- it is clear that the glory days of the mutual fund mania of the 1990s is over. Actually, the bloom of mania started to wane a few years ago when fund managers were proving to be untrustworthy and inconsistent with their investment practices -- which was euphemistically called "style drift."

The ending of this mania should not have been surprising to students of financial history. It is a simple fact that all financial manias come to an end.

The next step in this final stage of mania -- which, incidentally, almost always ends with revelation of fraud among leaders of the financial idea that was the focus of the mania -- is a drift away from that idea to another idea. The people who were caught up in the mania will never admit they made a mistake. Instead, they will find something else that will look better. Invariably it will be a "new" idea. And we have already seen them begin to emerge. Namely, exchange-traded funds, newly created bank products that promise to deliver guaranteed returns should interest rates go up and new insurance products that could satisfy small investors recently burnt by speculative markets through mutual funds who are now looking for a sense of security in "guaranteed" financial products.

Of course, all of this sets us up for another round of unquestioned popularity focused on a financial idea -- leading ultimately to the another round of abuse of trust and institutional crisis.

In the meantime, there's no need to weep for mutual fund companies or take up a collection for their managers. It might take 20 years or more for the mutual fund concept to regain the popularity it enjoyed during the 1990s. But as a new, future generation will forget the abuses of this round of mutual fund crisis -- just as the current generation chose to ignore the lessons of the 1930s and 1970s -- they will get to learn for themselves what history seems never to convince.