| Highlights and Commentary |
| By Roy Weitz |
 |  More than three years after a couple of Heartland muni funds suffered massive devaluations, the SEC finally filed civil fraud charges against the firm .....And even after several months of scandal fatigue, at least two of the Heartland allegations are stunning: A trio of the firm's senior executives, including CEO William Nasgovitz, sold their own holdings in the failing funds before the news was made public.....Also, late in the crisis, Heartland's legal counsel sent an e-mail to her colleagues, advising them to purge their files of any materials related to "portfolio securities, underlying credits and valuation issues".....Several other allegations in the Heartland case are serious, but almost anticlimactic:
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Speaking of Heartland (above), one of the firm's independent directors was A. Gary Shilling, a well-known economic consultant and Forbes magazine columnist.....Here's what we had to say, exactly three years ago, about Shilling's role in the Heartland debacle: | [From Highlights and Commentary, January 2001] | ||
| Mutual fund directors are supposed to protect the interests of mutual fund shareholders, so it's a fair question to ask "Where were the directors of the Heartland funds?".....Heartland's troubled bond funds employed a total of 11[!] directors, and you'd think that at least one of these worthy souls might have awakened long enough to sense that something was amiss.....Alas, seven of the 11 directors receive their full-time paychecks from Heartland, two of the directors are public relations professionals, and one of the directors is Jon Hammes, who owns the half-empty building that Heartland occupies in downtown Milwaukee, and stands to lose a major tenant if Heartland goes belly-up.....The remaining "independent" director is A. Gary Shilling, a well-known economic consultant and a regular Forbes columnist.....Shilling's silence, above all, is inexplicable -- as one commentator recently noted, Shilling "knows how to figure out what happened and he knows how to communicate it".....Perhaps, even as you read this, Shilling is working on a dynamite, tell-all column about the Heartland disaster.....Or, perhaps not. | ||
 | A water salesman thou art, and unto a water salesman shalt thou return: Years ago, Richard Sapio was a water-cooler salesman, then he started 1-800-MUTUALS, which designed and managed bizarre mutual fund portfolios for mom-and-pop investors, and then he launched a line of gimmick mutual funds (Generation Wave and the Vice Fund)......Somewhere along the way, Sapio also started a couple of brokerage firms, and that's where his current legal problems originate: In a civil action, the SEC alleges that Sapio and other top executives of his company (mutuals.com) used these brokerage firms to make thousands of questionable mutual fund trades for hedge-funds and other institutional clients.....Mutuals.com was blacklisted for making market-timing trades at almost 300 mutual funds, but the company kept trading via a number of subterfuges, including multiple account numbers and multiple, disguised identities.....According to the SEC, mutuals.com also ran a thriving business that facilitated late trading in mutual funds, which is out-and-out illegal....The company's mutual funds aren't directly involved in this mess, but the SEC was obviously uneasy, so the fed appointed a "special monitor" to make sure that the Vice Fund and the Generation Wave funds weren't also screwing around.....Here's our prediction: The principals of mutuals.com will also face criminal charges, and this firm will be out of business before the end of 2004.....The firm's mutual funds will probably be liquidated so, if you're an investor, why not get out now?.....As for Sapio, well, if he can still lift a water bottle, it looks like he's got the potential for a good, honest, post-prison career.
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 | In the early days of the fund scandal, way back in September, firms suspected of malfeasance were at least contrite (or managed to simulate contrition ).....Invesco, which was sued by the SEC and Eliot Spitzer in early December, has decided to stonewall, and that sets up an interesting scenario.....When a firm like Putnam prostrates itself with mea culpas, and tries to make amends, it can be tough to remain angry, even if you don't believe that anything has fundamentally changed.....But when a firm like Invesco refuses to acknowledge that anything was wrong, and refuses to accept responsibility for its actions, the regulators need to show no mercy.....The documents implicating Invesco are, by far, the most inflammatory of any that have surfaced in the scandals to-date (for example, in several e-mails, Invesco's senior fund manager almost begs his colleagues to cut off market timers, because the timers are "killing" his long-term investors, but the manager is ignored).....Invesco's conduct stinks, from the CEO on down, and the record needs to show that Invesco violated federal securities laws, not some mealy-mouthed settlement that "neither admits nor denies" wrongdoing.....If that means Invesco goes out of business, well, the folks at Invesco should have thought about that when they first decided to engage in the these activities, and especially when they refused to come clean.....Meanwhile, if you own any Invesco funds, we urge you to read some of the documents in this case (there's a nice collection on Spitzer's Web site, at http://www.oag.state.ny.us/press/2003/dec/dec02a_03.html. We especially recommend the complaint, pages 13 through 20)......Then ask yourself: With attitudes and behavior like this, why would you want to have anything to do with these people?
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Alliance folds: Alliance quickly settled its market-timing cases with both the SEC and Eliot Spitzer's office, and it looks like the company couldn't get this monkey off its back soon enough: Alliance agreed to pay a penalty of $100 million, it agreed to disgorge ill-gotten gains of $150 million, and it agreed to 20% reduction in mutual fund fees that will save Alliance fund investors about $70 million during each of the next five years.....The SEC and Spitzer's office jointly negotiated the monetary penalties, but the fee reduction was Spitzer's baby, and the SEC wasn't happy about it.....Since this case wasn't about fees to begin with, the SEC felt that fees shouldn't be part of the settlement, and the feds weren't shy about criticizing Spitzer in public.....Spitzer obviously sensed that there was some fee money on the table, and he went for it.....The SEC calls the fee concession "rate setting," but to us it looks more like an additional penalty, and we think Spitzer's fee deal was entirely appropriate.....As part of the settlement, Spitzer also requires Alliance to hire a "full-time senior officer" to oversee the firm's fee-setting practices, and this is where we think Spitzer dropped the ball.....Here's how Spitzer's office describes the new position:
| "The senior officer will ensure the reasonableness of fees charged to retail [mutual fund] investors either through competitive bidding or an annual independent evaluation that considers factors including: the level of fees charged to institutional
investors; the costs of providing services; and, Alliance's overall profit margins.
The senior officer will also take steps to ensure that information on the calculation of fees is fully disclosed to the public." |
Maybe there was even more money on the table: Alliance currently charges a management fee of 75 basis points (0.75%) for one of its garden-variety large-cap U.S. growth funds (AllianceBernstein Growth).....Alliance also subadvises a large-cap U.S. growth fund for Vanguard (Vanguard U.S. Growth), for which Alliance charges a management fee of about 16 basis points.....If Alliance is willing to cut its management fee for Vanguard by 79% -- when it's not under any kind of legal pressure -- maybe Spitzer's 20% reduction isn't such a big deal after all. And speaking of Vanguard U.S. Growth: What is Vanguard waiting for, anyway?.....Alliance has been in charge of this fund since June 2001, and it remains a miserable performer.....With the Alliance scandal, Vanguard had the perfect opportunity (perhaps even responsibility) to fire Alliance, yet Vanguard preferred to sit on its corporate duff.....Maybe Vanguard is simply too embarrassed by this fund, and would rather not draw attention to its failures once again.
| Early in December, Dick Strong relinquished all day-to-day involvement with the Strong funds, although he did keep ownership of the fund management company (which is where the money is).....There's some thought that Dick Strong is planning to wait out the current storm, and then reclaim control of his company, which might explain the large spider hole reportedly being dug behind the company headquarters.....There were also indications that Strong was looking for a quick sale of his company.....Whatever Strong decides to do, we're willing to bet that there will be bumps along the way.
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How things get done in Washington: 
The One Group Mutual Funds has been in the scandal spotlight as long as anyone....The company has also probably done more than anyone else to make things right, and for that it deserves praise.....Unlike some tainted fund companies, which seem to expect kudos for doing the bare minimum (do we hear Putnam?), the folks at One Group have clearly studied up on progressive fund governance, and they are making some significant, voluntary changes.....Among the noteworthy improvements, One Group says that it will:
The Frontier Equity fund has appeared on this page several times, most recently in April 2002:
| Frontier Equity, based in Pewaukee, Wisconsin, is a tiny mutual fund with a big distinction: At 15.6%, it has the highest expense ratio of any fund in the U.S......Frontier Equity is managed by Jim Fay, who also runs a financial planning firm in the Pewaukee area, and most of the fund's 110 shareholders are Fay clients.....The fund's directors have tried several times to kill the fund -- as they should -- but each time fund investors have rallied to keep the fund open.....Not surprisingly, fund performance has been abysmal, with a five-year annualized return of -24.33%.....And you know what?.....Fund investors don't seem to care. |
Exactly a year ago, there wasn't a single technology fund in our database that had a positive 12-month return.....This month, there's not a single tech fund in our database that doesn't have a positive 12-month return.....2003 has obviously been a good year for technology stocks, but the rising tide hasn't raised all funds -- in fact, the tide seems to have swamped a number of them.....A year ago in FundAlarm, there were just eleven tech funds that were slapped with our 3-ALARM designation.....This month, even after a great year, there are twenty-one 3-ALARM tech funds, or almost double the number from a year ago.....On the other side of the ledger, there were 26 tech funds on our no-alarm Honor Roll last year, while there are only 11 no-alarm tech funds this year:
| # of tech funds one year ago | # of tech funds today | |
|---|---|---|
| 3-ALARM | 11 | 21 |
| NO-ALARM (Honor Roll) | 26 | 11 |
For the record: Only five tech funds made our Honor Roll a year ago and also make the Honor Roll this month, in a very different market:
| Fidelity Adv Technology Inst (FATIX) |
| Fidelity Select Computers (FDCPX) |
| Fidelity Select Technology (FSPTX) |
| PIMCO RCM Global Tech I (DRGTX) |
| RS Information Age (RSIFX) |
| Hancock Technology A (NTTFX) |
| Hancock Technology B (FGTBX) |
| INVESCO Technology Inv (FTCHX) |
| PBHG Technology & Commun (PBTCX) |
Psst! Get out of our fund! The firm that manages the Sequoia fund has reportedly sent letters to about 200 large fund investors, encouraging them to switch to the firm's private accounts.....It's an odd letter for a fund manager to send, and the reason for the letter is an odd provision of the Internal Revenue Code: Once positions of 5% or more of a mutual fund's assets total over 50% of a fund's value, a fund can no longer add to those stakes, or create new 5% positions .....(For example, say 10 different stock positions, worth $5 million each, are held in a $100 million fund. The "50/5 rule" says that the fund can longer add to those 5% positions, or create new ones, since they already represent 50% of the fund's assets.).....Sequoia is a highly concentrated fund, with 72% of its assets in only five stocks (each with a 5%+ position).....The managers of Sequoia bumped up against the 50/5 rule long ago, and for years their new stock purchases have been severely limited.....Private accounts aren't subject to 50/5, so the folks in charge of Sequoia are trying to nudge their large investors in that direction.....Several other concentrated funds are also constrained by the 50/5 rule, including White Oak Growth Stock, Yacktman Focus, and Oakmark Select.
Theoretically, mutual fund performance fees are a good idea: As you earn a higher return on your fund, the manager earns a higher management fee, and vice versa.....But like every good idea, the performance fee can be pushed to its limit, and then it becomes a bad idea.....Want an example?.....Consider the following performance fee schedule for the Birmiwal Oasis Fund:
| Performance difference between Fund and S&P 500 Index | Investment management fee (annual rate) |
|---|---|
| 14% or more | 5.3% |
| 12% | 4.9% |
| 10% | 4.5% |
| 8% | 4.1% |
| 7% | 3.9% |
| 6% | 3.7% |
| 5% | 3.5% |
| 4% | 3.3% |
| 3% | 3.1% |
| 2% | 2.9% |
| 1% | 2.9% |
| 0% | 2.9% |
| -1% | 2.9% |
| -2% | 2.9% |
| -3% | 2.7% |
| -4% | 2.5% |
| -5% | 2.3% |
| -6% | 2.1% |
| -7% | 1.9% |
| -8% | 1.7% |
| -10% | 1.3% |
| -12% | 0.9% |
| -14% | 0.5% |
James Gipson and his team manage the Clipper fund, one of the esteemed names in the fund business.....Gipson et al. also manage PBHG Clipper Focus, which melds one esteemed name (Clipper) with one name that's currently just about worthless (PBHG).....Therein lies an interesting tale, recently told by fund columnist Timothy Middleton (moneycentral.msn.com).....Middleton originally bought Clipper Focus for his own account because he wanted access to an undiluted version of Gipson's best stock picks.....Perhaps because of his respect for Gipson's talent, Middleton didn't pay as much attention as he should have to the differences between the two funds.....Clipper is almost 20 years old, with a board that has served since its inception.....None of the board members serves on any other fund, and each board member personally owns at least $100,000 worth of shares (the maximum size holding that needs to be disclosed).....Gipson himself is a significant shareholder in the fund, which has a relatively modest expense ratio of 1.07%.....PBHG Clipper Focus came into existence in late 1998, just after Gipson sold his management company to UAM.....Except for Gipson's stock-picking services as subadvisor, Clipper Focus has never borne Gipson's unique stamp, and the fund has always been run by another company -- first UAM, then Old Mutual under the PBHG name.....Recently, PBHG Clipper Focus had an expense ratio of 1.45% (about a third more than Clipper), and the fund's independent directors also served on 28 other PBHG fund boards.....Incredibly, only one of the fund's independent directors has invested more than $100,000 in the entire PBHG complex, one has invested between $50,000 and $100,000, and the other director has invested less than $50,000 in all of the PBHG funds he directs.....Now that PBHG is involved in scandal, Middleton has decided to sell Clipper Focus, and he considers it a lesson learned: An expensive fund, with overextended and indifferent directors, is not where he wants his money.....At the time he wrote the article, it sounded like Middleton was going to move his cash to Dodge & Cox Stock.
The world of fixed-income securities is like a big pond, and when yields on U.S. Treasury securities gyrate wildly, there's typically no sector -- corporate, muni, or mortgage-backed -- that's doesn't feel some ripples.....For 10 days last August, yields on U.S. Treasuries with a five-year maturity went from 3.18 percent to 3.40 percent, which is a huge fluctuation in that particular market.....During the same period, however, the net asset value (NAV) of at least two bond mutual funds, Franklin AGE High Income and Quaker Intermediate Municipal), barely budged.....How can that be?.....One possibility is that the funds failed to properly value their underlying bonds, which means that investors buying or selling those funds during that 10-day period may have paid (or received) the wrong amount of cash.....There's no evidence of wrongdoing, and there may be a perfectly innocent explanation for the slothful NAV, but we doubt it.....NAV is a sacred concept at the SEC, and this could be another area for investigation in 2004.