Mutual Funds
Recent articles:
• He runs the fund -- but does he invest in it?, 9/23/2003
• The real Wall Street rip-off? Fat fund fees, 9/16/2003
• Don't let crooks manage your money, 9/9/2003
More...
| | Mutual Funds
Fed-up fund investors shut their wallets
The amount of money flowing into funds dropped 70% in the weeks after major players were accused of cheating investors. It's no coincidence.
By Timothy Middleton
The New York attorney generals bombshell assault on mutual fund fraud may well have turned off the spigot on flows of funds to the industry. The stock market weakened immediately after Eliot Spitzer alleged that key industry players had taken unfair profits, choking off a rally that had seen major benchmarks rise in double digits this year.
In the aftermath of Spitzers filed complaint, scores of lawsuits have been filed or threatened against the accused fund complexes. But the scandals damage could be far worse -- a spreading lack of confidence in funds, which could translate into shriveling demand for common stocks.
The Spitzer lawsuit -- alleging after-hours trading arrangements that created unfair profits for several hedge fund and mutual fund companies -- was announced Sept. 3. In the seven days ending on that date, equity funds had attracted $4.2 billion in net inflows, according to AMG Data Services. Funds had been attracting rising flows for months: $17.4 billion in July and $18.1 billion in August.
But flows in the three following weeks, ended Sept. 24, together did not equal that first week, says Robert Adler, AMGs president. The average was $1.2 billion in each of those three weeks -- a plunge of more than 70% in the industrys new assets.
In the aftermath of news of the worst scandal in the history of funds, Adler says, Its safe to say equity flows are diminishing.
Sure, the sudden slowdown in fund flows could be a coincidence, due more to the markets pause than fear (and loathing) of the scandal. September has been a bad month for four consecutive years: Last year the S&P 500 Index ($INX) tumbled 10.9% in September -- that index's biggest one-month decline all year.
But Adler says he has seen no seasonality in September flows, and he doesnt think thats a factor now. Badly burned by three years of bear market, investors have been cautious about getting back into equities. But until Sept. 3, that caution resulted in the purchase of more-conservative funds rather than the withholding of money altogether.
Regulators response is lacking
Whatever the ultimate effect of the mutual fund scandals, the industry and its regulators have reacted to the scandal like neglectful parents protecting an errant child. The Securities & Exchange Commission's timorous response: a mailing to fund companies asking for information. The industry's leading trade association, the Investment Company Institute, fired off a flurry of Oh, my goodness! press releases, including one on Sept. 25 with the headline, Mutual Fund Leaders Pledge to Fulfill Obligations.
I beg your pardon? Hedge fund manager and MSN Money contributor James Cramer hit the nail on the head in an apoplectic essay in New York magazine. That headline: Send those mutual-fund crooks to jail!
Left to themselves, investors are voting on the scandal with their feet and their wallets. What had been a strong rally in the stock market in the third quarter was strangled in September as buying dried up.
On the day Spitzer made his charges public, the S&P 500 Index ($INX) was up 4% from the close of the second quarter. In the succeeding days, through Sept. 25, the index slid 1.8%. That brought the markets year-to-date gains to 10.4%, from 12.4% on Sept. 3.
Will it be a loaded future?
Perversely, two of the fund companies implicated in the probe reported no interruption in flows from their customers, adding assets throughout the month in line with the industry average, AMG says. They are Bank of Americas Nations Funds and Bank Ones One Group.
Both are broker-sold. At the two no-load complexes used by self-directed investors, Strong and Janus, the opposite occurred. At Janus, equity outflows accelerated to $1.6 billion after Spitzers action, which is the largest three-week total of the year, Adler says.
Strong does not report flows weekly to AMG, but a Strong spokesman told me equity flows to the complex were flat in September, defying the industrys gains.
My conclusion? Commission-driven brokers successfully twisted the arms of investors in Nations and One Group to keep their money flowing in. Lacking a sales force, Strong and Janus had no such protection from investor sentiment.
Troublingly, the industry may draw exactly the wrong conclusion from these divergent trends. If load funds prove themselves able to squeeze more money from shareholders even in the face of disastrous news, and no-loads cannot, the pressure on no-load companies to convert to commissions will increase.
Both Janus and Strong, traditionally no-load houses, now sell relatively small amounts of funds through brokers. Since the entire scandal is about greed, seeing greed newly rewarded sends shivers down the spine.
An important caveat: the nations three largest fund complexes, Fidelity, Vanguard and American Funds, do not report weekly to AMG, and together they have accounted for between 45% and 60% of total equity fund inflows this year. So Septembers AMD numbers are preliminary, but Adler says the direction in which they point isnt likely to be reversed when the big three report monthly data in October.
Be careful who you heed
For those delayed by hurricanes and tornadoes from keeping up with the fund news, Spitzer has reached an agreement with one accused hedge fund, Canary Partners. Canary more or less admitted colluding with four fund families to skim profits from other shareholders through unethical and sometimes illegal trades, with the fund management companies being enriched by fees.
In securities cases, defendants routinely pay up without formally admitting or denying guilt. Canary, controlled by the Hartz Mountain family, coughed up $40 million, and its managers agreed to get out of the securities business.
When the scandal broke, I urged shareholders to dump funds from the Feckless Four complexes, mainly because they cant be trusted, but also because remaining shareholders could face taxes on sales of securities to meet redemptions. Four days later, Morningstar made the same recommendation.
But Morningstar and I tend to be followed by investors who choose their own funds, rather than those who let brokers handle their affairs. It appears self-directed investors reached the same conclusion we did, but brokers at Nations Bank and Group One did not. I wonder why.
Heaven forbid that brokers self-interest might conflict with that of their customers. In addition to commissions on fund sales, brokers also earn whats called trail commissions as long as the funds are owned. Dumping a bad fund puts an immediate hole in the pocket of the broker who sold it.
Prepare now for dark days to come
The pall cast by the scandals shadow is surely darker than the industry had feared it would be, and the Three Stooges of fund regulation -- the ICI, the SEC and the National Association of Securities Dealers -- may yet take forceful action to rein in the industrys greed. If so, that would be new, and welcome.
Fee gouging exploded in the 1990s, as Ive detailed before in this column, and abuses by brokers have proliferated, notably at Morgan Stanley, which has steered four-fifths of its customers into the most expensive fund option, B shares, to enrich itself and its sales force. Dereliction of duty by boards of directors has become routine, at fund companies no less than at the New York Stock Exchange.
The bear market took equity investors by surprise. So did the action of a state attorney general (rather than the industrys own regulators). But armed with this new information, we shouldnt be surprised if more abuses are discovered, and the time to prepare for them is now.
More than ever, fund investors should limit their dealings to funds that have shareholder interests in mind. Fortunately, that is most of them. Im not boycotting funds; Im just shopping harder for ethical operators.
At the time of publication, Timothy Middleton owned funds sponsored by the following organizations mentioned in this article: Vanguard and Fidelity.
|
