Highlights and Commentary
By Roy Weitz
(Originally posted January 1, 2005)
[Archive Table of Contents]

Squeaky-clean brokerage firm Edward Jones was dragged through the mud last month and, sadly, the firm deserved every painful, reputation-destroying minute....The problems at Jones arose from the practice of revenue-sharing, which we've talked about in FundAlarm before, but in a slightly different context....Basically, here's what happened: Jones approached a number of mutual fund companies (ultimately, seven in all) and sold those fund companies preferred status in exchange for cash payments and brokerage commissions worth as much as $300 million to Jones (and that's just since January 2000).....And what did the fund companies get for their preferred status?.....A virtual lock on mutual fund sales at every Edward Jones office in the U.S.....While individual Jones brokers could theoretically sell any one of hundreds of other funds, the Jones home office created and promoted financial incentives that virtually assured its brokers would only sell funds from the seven preferred families (American, Federated, Goldman Sachs, Hartford, Lord Abbett, Putnam, and Van Kampen).....Of course, Jones never disclosed any of these preferred arrangements to its customers, many of whom (oh the innocence!) believed that they were getting objective, unbiased fund advice from their Jones advisors.....In addition to this violation of client trust, Edward Jones was sanctioned for sponsoring certain sales contests for preferred fund companies, in violation of NASD rules, and for potentially allowing 8,700 [!] late mutual fund trades between May and November, 2003.....As a token punishment for its misdeeds, Jones has settled up with the SEC, NASD, and the New York Stock Exchange, to the tune of $75 million in penalties.....But California Attorney General Bill Lockyer wants more from Edward Jones, so Lockyer has refused to sign on to the SEC settlement.....It was Lockyer who calculated that Jones earned the aforementioned $300 million by selling preferred status to fund companies, and Lockyer has filed a lawsuit against Jones seeking forfeiture of the entire $300 million.....Lockyer will probably agree to a lesser settlement, just like all the posturing politicians, but think for a moment about what he's proposing: When a financial services company screws its customers, it should actually lose all of its ill-gotten gains.....What a concept!


All the paid-off legislators, and all the ex-military shills on its Advisory Board, couldn't put First Command back together again: We've written about First Command several times, never favorably, and now the chickens have finally come home to roost.....For those of you unfamiliar with this sordid company, here's part of what we had to say about it in August 2004:

There are people in this country who make a ton of money selling garbage financial products to the men and women in America's armed forces.....Even worse, these lower-than-bacteria salespeople (1) have been granted official access to our military personnel, (2) the military brass doesn't have the tools (or the will) to rein them in, and (3) key members of Congress have been bought and paid for by the companies that sell these products.....As we've noted before in FundAlarm (September 2003), First Command is probably this country's biggest purveyor of mutual funds with 50% front-end loads, also called "systematic" or "contractual" plan funds.

In the past, First Command has been able to blow off media criticism of its sales practices and products, or have its lackeys do the dirty work, but this time its luck ran out.....A series of articles in The New York Times last summer led to Congressional investigations, and unfavorable legislation seemed imminent, so First Command waved the white flag and announced that it would no longer sell contractual-plan funds....And just in case anyone is inclined to miss First Command, or think it was the innocent victim of a politically-correct media mugging, the SEC and NASD recently fined the company $12 million for misleading sales pitches.....Among other things, First Command's officially sanctioned sales scripts, for use with military personnel, described no-load funds as suitable only for "speculators" and "short-term traders," and the scripts noted (incorrectly, of course) that only systematic (contractual) plans are designed for dollar-cost averaging.....The scripts also made scary, nonsense statements about the "cash-flow volatility" of non-systematic funds, they misstated the percentage of systematic-plan participants who actually complete their 15-year plan, and they said virtually nothing about the government's inexpensive Thrift Savings Plan, which is an excellent and inexpensive option for most service people.....It's unlikely that First Command will simply slink away forever --- the company could, for example, draw upon its former expertise, and start renting crappy furniture to poor people for an unconscionably high monthly fee.....But for now, chalk this up as a big victory for our service men and women, and a victory for ethical business practices as well.


TIAA-CREF likes to position itself as one of the good guys of the money management business and, for the most part, it is.....But when a good guy screws up, it's still a screw up, as we saw last month at the TIAA-CREF mutual funds:

Ross has since resigned, and an embarrassed TIAA-CREF is scrambling to institute new policies, too late, that will weed out directors who don't need no stinkin' ethics rules.


FundAlarm's spy photographer has sent us an exclusive shot of a shrine to New York Attorney General Eliot Spitzer, which was recently erected by junior attorneys at the law firm of Ropes & Gray:


Boston-based Ropes & Gray represents a number of fund companies that have been targeted by Spitzer and caught up in the fund scandals, including Putnam, MFS, and PIMCO.....Thanks in part to Spitzer, business at the law firm has been great, and bonuses for first-year lawyers have been boosted from $10,000 to $25,000.*
*boston.com, December 22, 2004


If you had the job of buying stocks for the Fidelity mutual funds, a lot of stock brokers would probably like to make your acquaintance.....Some of these stock brokers might even try to curry special favor, by sending expensive gifts your way, and that's exactly the possibility that the SEC is currently investigating.....This isn't the most complex problem in the mutual fund world, but sometimes a crude little graphic can help highlight the issues involved:



On the left side, brokers who sell stocks to Fidelity's mutual funds appear to have showered gifts on Fido's stock traders (not necessarily every gift shown, but you get the idea).....On the other side, we're supposed to believe that Fidelity's stock traders don't favor these gift-giving brokers and, specifically, don't choose to overpay these gift-givers even a penny when it comes to buying stocks for Fido's mutual funds.....Fidelity has internal policies that are supposed to prevent such conflicts of interest, and Fidelity employees appear to be prohibited from accepting gifts worth more than $100 a year in this kind of situation.....But it's clear that Fidelity has been enforcing these policies on the honor system, and we've all seen how effective the honor system was in the case of market timing by fund insiders -- which is to say, not very effective at all.....Fidelity recently disciplined 14 stock traders for gift violations, and two other employees left the firm, apparently just ahead of the official axe.....Fidelity says it has tightened its gift policies, but refuses to provide specifics or dollar amounts, and Fidelity says that it's seeking the "support" of the brokerage community in cracking down on inappropriate gift-giving.....This is all essentially meaningless, and a smoke screen for keeping potentially corrupt practices in place.....Fidelity is a monster presence in the brokerage industry.....If the firm were really serious about putting an end to gift-giving corruption, or even the possibility of corruption, it could adopt a simple, two-part gift policy that would fix the problem overnight:


By settling for a lesser standard, Fidelity continues to wink at corruption.



BlackRock CEO
Laurence Fink
Several months ago, BlackRock announced that it was acquiring State Street Research & Management (including the State Street mutual funds).....Now, the slashing has begun.....BlackRock is allowing State Street's two chief investment officers to leave (including Kim Goodwin, its prize catch from a few years ago).....According to news reports, "most" of State Street's senior portfolio managers also are in the process of being booted, including Tucker Walsh and Andrew Morey (of State Street Research Emerging Growth), Paul Haagensen (of State Street Research Aurora), and John Wilson (of State Street Research Investment Trust)*.....Overall, State Street will lose about 31% of its employees, which suggests that BlackRock was never interested in State Street as a firm, but simply as a collection of assets (State Street does fundamental research, BlackRock uses quantitative investment models, and BlackRock's approach clearly will prevail)**.....If you own a State Street mutual fund, congratulations: You are now part of BlackRock's asset collection.....If that's not exactly where you want to be, you have a chance to tell BlackRock how you feel about your funds being mauled.....It's called "selling."
* "BlackRock slashes SSRM's staff," Douglas Appell, Pensions & Investments, December 13, 2004.
FundAlarm hasn't been able to independently verify these reported departures,
so we haven't included them yet on our page of Recent Manager Changes.
** "Changes dismantling State Street Research," Beth Healy, boston.com, December 16, 2004


It's no surprise that the following two items appear side-by-side on the ING funds Home page:


Principal-protection funds (the right-hand item) are a lousy deal for investors -- so lousy, even the NASD has warned against them -- yet ING continues to crank out principal-protection funds in all their Roman-numeraled glory.....That's strike one for ING.....When it's necessary to close a mutual fund, because it's gotten too large, shareholder-friendly companies will often slam the door with only one or two day's notice, since the last thing they want is a flood of new money.....Companies that value their management fees more their shareholders will, like ING, hype a fund closing for weeks (the left-hand item), and that's strike two for ING*.....Here at FundAlarm, we're often asked how fund investors can identify fund companies that don't pursue shareholder-friendly policies.....Sometimes, as in the case of ING, it's as easy as looking at their Home page.
* "Time for the Lump of Coal Awards," Charles Jaffe, cbs.marketwatch.com, December 12, 2004


And what's the opposite of a fund that closes the wrong way? A fund that opens the wrong way, of course.....Gabelli ABC specializes in M&A (merger & acquisition) arbitrage, and manager Mario Gabelli closed this fund to new investors in late 2002 because he didn't have enough M&A deals to invest in.....In March 2004, when the fund stood at 70 percent cash, Gabelli reopened it.....Obviously, Gabelli had some good, new investment opportunities in mind.....WRONG!.....As of December 2004, the fund's cash stash had actually grown, to 80 percent.....Meanwhile, from March through December, Gabelli earned his one percent annual management fee on every new, idle dollar.
"Lump of Coal" article, above


Last month, we ran an item about the "bank overdrafts" that have recently appeared on the financial statements of several Oppenheimer mutual funds [click to view this item].....Six months earlier, when we ran a similar item, an Oppenheimer representative wouldn't even talk to us about the overdrafts.....This time, a different Oppenheimer representative (Bruce Dunbar, OppenheimerFunds Senior VP, Director of Corporate Communications) sent us an informative e-mail on the subject.....Mr. Dunbar has given us permission to quote from his comments, which appear below in italics.....Dunbar's e-mail should help put the overdraft issue to rest, and his comments also shed some interesting light on day-to-day cash management issues at mutual funds:

"Overdrafts are a common occurrence in the mutual fund industry and occur in mutual funds’ custodial accounts for a variety of reasons. Most typically they result from the effects of failed trades in portfolio securities and from unanticipated cash flows from shareholder activity. [FundAlarm note: However, it appears that few if any other fund companies use the specific term "overdraft" in their financial statements. Other firms use the description "payment due to custodian," or something similar.]

...When overdrafts appear in a fund’s financial statements, it is important to keep in mind that this data is a 'snapshot' of the fund’s finances on a single day. At OppenheimerFunds, overdrafts may actually reflect a proactive cash management decision that is intended to maximize returns for fund shareholders.

We have developed cash management and monitoring practices that are intended to anticipate, to the extent possible, the effects of daily portfolio trading and settlements and shareholder activity (purchases, redemptions and exchanges of fund shares). However, it is not possible to predict exactly what a fund’s cash position will be at the end of each day, net of all these factors. For example, if a trade that is supposed to settle on a particular date does not settle, it can create an unanticipated cash surplus or deficit in the fund’s custodial account.

Several years ago in consultation with the boards of the Oppenheimer funds, we developed a cash management practice to invest cash surpluses in short-term securities. These 'cash equivalent' investments produce a positive return for the fund. However, when a late-settling trade actually settles, the cash may not be available that day to pay the settlement because it is invested in the short-term securities. While this causes a one-day overdraft, the positive earnings from the cash equivalents is expected to more than offset any cost to the funds from the overdraft. We think this is a good cash management practice for fund shareholders. This is specifically what occurred with [Oppenheimer] Strategic Income Fund [almost a $70 million overdraft], where a single purchase of securities for the Fund settled after 13 days instead of the standard three and the cash for settlement of the trade had been invested in cash equivalents.

In our view, it is not practical nor a good fund management practice to keep a large cash balance uninvested in portfolio securities because that can reduce returns for shareholders. Our portfolio managers attempt to keep each fund as fully invested in portfolio securities as possible. We carefully monitor and evaluate overdrafts and their costs. Our review has shown that, over time, our cash management practices with respect to overdrafts have produced neutral or positive effects on returns for shareholders."


Un-Busted? Well, not quite: Shortly after the mutual fund scandals broke, in September 2003, FundAlarm added a feature called Busted!, which is our archive of mutual fund malfeasance (it can be found as a permanent link at the top of this page).....Monetta was one of the inaugural entries in the Busted! archive, and Monetta's early spot on our list of shame arose out of events that occurred more than ten years ago.....Briefly, here's what happened: The Monetta mutual funds were (and still are) run by Monetta Financial Services, with Robert Bacarella as CEO.....According to SEC allegations, Monetta Financial Services ("MFS") got its hands on some hot IPO stock back in 1993, and Bacarella allocated some of that stock to directors of the Monetta mutual funds, who were also clients of Monetta's private money management business.....MFS didn't disclose these allocations to the Monetta fund directors who weren't clients, and the SEC claimed that such failure to disclose constituted "fraud or deceit" by MFS under federal securities law.....The SEC also claimed that Bacarella personally "aided and abetted" this violation of securities law and, in December 2000, an administrative judge agreed with the SEC's case against both MFS and Bacarella.....The case bounced back to the SEC for a final order and, in June 2003, both MFS and Bacarella were censured and fined, and Bacarella was suspended from the securities industry for 90 days......In an unusual move, Bacarella appealed the SEC's sanctions to federal court and, in late November 2004, Bacarella won at least partial vindication: The federal court agreed that MFS committed fraud, for failing to disclose the IPO allocation scheme to the other directors, but the court found that Bacarella (even though he was CEO of the company) didn't "aid and abet" the fraud (think of the court's ruling as the puzzling, legal equivalent of winning the Oscar for best director, but losing the Oscar for best picture).....Now, this eleven year case has been thrown back to the SEC again, to redetermine the appropriate sanctions......In the meantime, we've decided to leave Monetta in the Busted! archive, but we've updated the information consistent with what's discussed above.
"How One Exec Fought the SEC and Won," Alsion Sahoo, ignites.com, December 13, 2004


Forget what you know about international investing: Not too long ago, "negative correlation" was the main rationale for investing in foreign stocks and foreign-stock mutual funds.....(Basically, it used to work like this: When U.S. stocks were in the dumps, foreign stocks tended to perform relatively well, and vice versa).....Recently, most foreign markets (with the notable exception of Japan) have started to move more in synch with the U.S. market (i.e., correlations have become significantly more positive), which means that the key underpinning for foreign investing appears to be on its way out .....What's likely to take the place of negative correlation as a justification for foreign investing?......Simply the recognition that there are many good companies based outside the United States, and a foreign fund can be the best way to get broad exposure to those markets.
"Investors Look Abroad, but Not for the Usual Reason," Jonathan Feuerbringer, The New York Times, December 12, 2004


Forget what you know about share classes: If you've spent time learning about the differences among mutual fund share classes -- "A," "B" and "C" -- some of that knowledge could be on its way to obsolescence [here's a quick primer on A-B-C share classes, for those who need one].....Beginning January 14, 2005, Franklin will become the latest (and largest) fund family to shut down sales of "B"-class mutual fund shares.....B-class shares have been subject to abuse for years.....Apparently believing that brokers can neither be educated, reformed, or properly disciplined in this area, Franklin has decided simply to remove the temptation.....Taking a different tack, the American funds family recently announced that shareholder accounts with combined American Funds assets of $100,000 or more will no longer be eligible for Class B share purchases.....In addition, B-shares of American funds will be available only for individual purchases of $50,000 or less (down from $100,000).....According to American, the goal of these changes is to "help" its shareholders "take advantage of Class A share sales discounts" (in other words, "force" its shareholders, and the brokers who sell American funds, to pay more attention to breakpoints).....As recently as four years ago, B shares outsold A shares by a four-to-one ratio.....Now, B shares are an endangered species.....Sometimes, even without government regulation, the market gets the message.
"American Tweaks B Shares, Others Sure to Follow," Chris Frankie, ignites.com, December 15, 2004


Martin Flanagan and Gregory Johnson are co-CEOs of Franklin Resources, the company that runs the Franklin Templeton mutual funds.....During 2004, Flanagan and Johnson presided over almost $100 million in regulatory settlements, mostly for market-timing and revenue-sharing transgressions that occurred on their watch.....Despite this huge (and unnecessary) money drain, the directors of Franklin Resources still apparently appreciate the role that the two men played in the company's "very strong" 2004 performance (that's the directors' words, not ours).....Accordingly, Flanagan and Johnson will each earn $5.79 million this year, about twice what he earned last year*.....Hey, guys, nice work.....And next time you lecture some employee about taking personal responsibility for his or her actions, try not to crack a smile.
* "Pay for Franklin Chiefs Nearly Doubles, ignites.com, December 23, 2004


Spain's Private Media Group is a publicly-owned, adult entertainment company.....Private Media is looking to expand its presence in the U.S, and it would especially like to find a sponsor for its reality TV show, in which five ordinary guys compete onscreen (in ways you'll have to imagine) to earn a contract as a porn star.....Even as it looks for a TV sponsor, Private Media has strong financial backing from at least one company with U.S. ties.....Fidelity International is Private Media's biggest institutional investor, with almost three million shares (that's about 5.8% of the company, worth about $12.3 million).....Fidelity's U.S. fund arm, Fidelity Management and Research, owns about $1 million worth of shares*.....We're not sure which Fido funds actually own Private Media stock, but we can say for sure that Fidelity's Puritan fund does not.
* Barron's, December 6, 2004


We couldn't have said it better ourselves:

From ConsumerReports.org:
A fund that consistently underperforms its benchmark is a strong candidate for sale.


From FundAlarm.com (Deciding to Sell a Mutual Fund):
A fund that consistently underperforms its benchmark is a strong candidate for sale.


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FundAlarm © Roy Weitz, 2005