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| | Mutual Funds
From lousy fund companies come lousy funds
It's no coincidence that the companies accused of cheating investors also run funds producing pathetic returns. One more reason to give them the boot.
By Timothy Middleton
More bad news about funny-business mutual funds came out almost hourly last week, as investigators said Strong Mutual Funds' chairman took part in improper trading and Putnam Investments was implicated in the burgeoning scandal. All this led 401(k) plan sponsors and state pension managers to begin tossing tainted funds out of their portfolios.
Massachusetts, Rhode Island and Iowa, among others, are dumping Putnam from their public-employee pension plans. Standard Insurance, of Portland, Ore., reportedly is banishing Janus Capital (JNS, news, msgs) funds from its employee retirement plan. Janus was one of the first fund families thrown into the scandal when New York's attorney general said a hedge fund used Janus funds for improper trading. The scandal also caused Marsh & McLennan (MMC, news, msgs), which owns Putnam, to oust the fund firm's CEO. Richard Strong, meanwhile, stepped down as Strong Mutual Fund's chairman but remains chief at Strong Capital Management, which runs the funds.
Things have gotten a little bit hotter over the last week with the Putnam issue raising its head, and I would say people are leaning to getting out sooner rather than later, says Robert McCarthy, president of Kanon Bloch Carr, a 401(k) consulting firm.
You ought to do the same.
Churning and burning
Seven mutual fund companies have so far been implicated in the worst scandal in the industrys history. The issue boils down to one word: greed. Fortunately for investors, greed has a public as well as a private face
Greeds public face is a witchs brew of churning -- managers as well as portfolios -- and burning -- extravagant expenses -- that subtracts directly from shareholder returns. Almost without exception, funds with long-established managers, low portfolio turnover and modest expenses generate better returns to shareholders. And for the most part, funds that emphasize those attributes haven't been caught up in this scandal.
Ive never owned Putnam (funds) because theres always a manager shakeup going on there, says Lou Stanasolovich, president of Legend Financial Advisors in Pittsburgh. Janus was always coming out with a new fund that was a virtual copy of an old fund. Strong has had numerous regulatory problems over the years.
You notice every one of these firms are big names, the adviser adds. Theyre all worried about bringing in new assets, not protecting clients. Theyre all about profit.
| Funny-business funds | | Fund company | Allegation | | Alger | Market timing, late trading | | Alliance | Market timing | | Janus | Market timing | | Nations (Bank of America) | Market timing, late trading | | One Group (Bank One) | Market timing | | Putnam | Market timing | | Strong | Market timing |
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(This chart as originally published said funds at Prudential Securities, Merrill Lynch and Citigroups Smith Barney unit were implicated in the fund scandal. In fact, brokers at the these firms were implicated, but no funds were.)
Systemic problems
Allegations of late trading and market timing have rained down from the attorneys general of New York and Massachusetts and the Securities and Exchange Commission. The most egregious offenses are alleged at Strong and Putnam, where officials are accused of market timing their own funds.
Late trading, which is illegal, and market timing, which is forbidden in most fund prospectuses, are both designed to skim quick profits from fund shareholders through fly-by-night trading in a funds shares. My attitude, however, is that illegality or ethical lapses are apt to be symptoms of other behavior that harms shareholder interests.
Ethics is a one-strike-youre-out issue, says John Henry Low, principal of Knickerbocker Advisors in Pine Plains, N.Y. Usually its not just one or two people; its something in the system that permits this to go on.
Outrage among financial advisers is growing, and Rebecca Preston, an adviser in Providence, R.I., wants clients to get out of the states 529 college savings plan because it uses Alliance Capital portfolios. Alliance has been implicated in the scandal. The problem: They cant be moved within two years or the state tax deduction is lost, she complains.
But if you can move, do. The offending fund companies are chock-a-block with lousy funds nobody should have owned in the first place. As an example, consider Strong Growth 20 Fund (SGRTX). The fund's investor class (no-load) shares were launched in the summer of 1997, and it was a brilliant success during the Internet bubble.
But the manager who made that record has since surrendered the reins. In the 12 months ended Sept. 30, it returned 11.5%, worse than 94% of similar large-cap growth funds. Not surprisingly, it has hemorrhaged assets, falling to $260.7 million from a peak of $765.8 million in 2000. So Strong launched an "adviser" class of shares, sold by brokers, which has managed to attract $6.7 million of assets.
Watch those turnover rates
Among the ugliest aspects of this fund is its stratospheric expenses, due mainly to annual turnover of more than 450%. That in turn generates huge trading costs. Personalfund.com, a research engine that analyzes ownership costs, says the investor shares generated total annual ownership costs of 7.73% in the latest 12 months, including transactions, as well as its expense ratio.
The burden on adviser shares is roughly the same -- 7.41%. If Warren Buffett is right and stocks return an average of 7% in coming years, this fund will spend more money than it makes.
Why would a fund that owns only 20 to 30 stocks trade so heavily? Follow the money, says adviser (and former stockbroker) Bedda Emous, principal of Fiduciary Solutions in Andover, Mass.
When you have high turnover, you are saying, Were going to trade this fund very actively because the broker that custodies our fund makes a lot of money if we do,'" she says. The brokerage firm in turn has an incentive to flog the fund to its customers.
Why would those customers invest in Strong Growth 20? Absent arm-twisting, they wouldnt. Among broker-sold funds, American Funds AmCap Fund (AMCPX), another large growth fund, returned 26.5% in the latest 12 months and imposed total ownership costs of only 1.15%, thanks in part to an 18% turnover rate.
Among no-loads, Fidelity Capital Appreciation (FDCAX) returned 49.2% despite ownership costs of 2.33% and turnover of 120%.
Could investors have known in advance that Strong would be implicated in scandal? It doesnt matter: They knew in advance the fund stunk, and with a minimum amount of work could have figured out why.
Stick with boutiques
In prior columns, Ive described other attributes of good funds, notably heavy ownership of shares by the funds managers. Adding lengthy manager tenure, low turnover and low overhead, you end up with this solution -- boutique funds.
Groups implicated in the scandal are run by employees, not owners, says Stanasolovich. We use a lot of boutique-type firms where the owners are the managers.
In other words, one tack small investors can take to make sure they and their managers are on the same side is to shun giant fund complexes in favor of companies that run only a half-dozen funds, or less. They're run by investors, not salesmen. Strong and Janus were great companies when they were boutiques.
Families like Nations, owned by Bank of America (BAC, news, msgs) and implicated in the improper trading scandal, and Prudential, on the other hand, are factories for me-too funds that satisfy no demand except for corporate profits. And be warned: Bank of America's deal to buy FleetBoston Financial (FBF, news, msgs) will add the Liberty and Columbia funds to Nations. (Fleet is renaming its funds Columbia.)
One of those is Liberty Acorn (LACAX), which when it was a boutique fund was one of the best in the small-cap universe. Now saddled with sales loads and 12b-1 fees and other high expenses, it has fallen to the 34th percentile.
This is a scandal you can see coming straight at you.
All Bank of America has to do to erase the tainted Nations name from its products is to slap on a different name, perhaps the Columbia name Fleet is using.
It worked for Dean Witter, one of the lousiest families of funds in the industry. It gobbled up a better name, Morgan Stanley, but it cant shake off its heritage and today faces lawsuits over -- what else? -- its sales practices.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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