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| | Mutual Funds
Marked-down funds are damaged goods
Mutual funds need to cut fees, and Alliance, Putnam, MFS and American Century are cutting or waiving them. But there's a catch: They're lousy funds.
By Timothy Middleton
In settlements with the New York attorney general, Alliance Capital and Massachusetts Financial Services (MFS) have agreed to slash the fees they charge investors by $350 million and $125 million, respectively. Putnam Investments has voluntarily agreed to cut its fees $35 million a year.
And American Century has climbed on the fee-waiver bandwagon to offer some relief to long-suffering holders of its Giftrust Fund (TWGTX), which wasnt involved in the scandal.
Suddenly, an industry that has staunchly defended extravagantly high fees is acting contrite. Why the change of heart?
They have been caught red-handed, says John Freeman, professor of law at the University of South Carolina. Theyre cutting their fees because (Eliot) Spitzer has caught them gouging.
Fee waivers are meant to hide something dirty. Heres the dirt:
- Alliance, MFS and Putnam have betrayed their investors confidence.
- American Century has simply failed to manage a nearly $1 billion portfolio.
I love low fees, but I like good performance better. You have to look past what youre paying to what youre buying.
Competition is key
Tell them to kiss off. Theres always competition, even for American Centurys fund, which tax-law changes have made quaint, if not obsolete.
As its name suggests, American Century Giftrust is designed to be owned by a charitable trust. It was introduced 20 years ago as a way to invest for a childs college education. The minimum investment period used to be 10 years; two years ago it was raised to 18 years for new investors.
American Century is waiving the funds 1% expense ratio for six months because, a spokeswoman explains, Giftrust hasnt performed up to our standards, and because of the irrevocable nature of the fund, we understand theres a problem, and were working hard to fix it.
A stellar performer in its first decade, performance at the fund collapsed in 1996 and has, with the exception of 1999, gone downhill since. For the 10 years ended Dec. 31, it delivered annualized returns of 3.1% -- less than a bank certificate of deposit.
The funds essential problem has been that American Century has repeatedly overhauled its management team in the worst possible way -- by shifting its strategy every few years to what had been successful, but which promptly went out of fashion. When you and I do it, its called performance-chasing.
Weve made three manager changes in last 10 years in part at the wrong time in the cycle, says Harold Bradley, who supervises the funds management for American Century. People at management companies are like people everywhere: You make wrong decisions.
Newer, better options
Two years ago, the latest new team did OK at first, losing a little less than the market in 2002, but then crashed. Last year, the fund underperformed its bogey, the Russell Mid-cap Growth Index ($RDG.X), by nearly 23 percentage points.
These days a gift-trust fund has been rendered largely obsolete by 529 college funding plans, which have fewer strings and stronger management alternatives. In addition, a rival sprang up, Royce TrustShares (RGFAX), which has more flexible rules.
It has a 10-year minimum, but the maximum can be tailored for a variety of planning purposes, including estate planning. You could, for example, fund it with money for college, but if the child decides not to go, you could put off disbursing the funds until he reaches age 35, say, when presumably he could manage it more responsibly.
The funds expense ratio is almost half again as high as American Centurys (pre-waiver), but look what an extra 49 cents will buy.
| Focus on performance, not price | | Fund | Expense ratio | 5-yr. return | Manager tenure | Assets | | Royce TrustShares (RGFAX) | 1.49% | 16.4% | 8 years | $42 million | | Amer Century Giftrust (TWGTX) | 0.00%* | - 0.96% | 2 years | $936 million |
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*For 6 months; its usual expense ratio is 1%
The Royce fund is managed by Chuck Royce, who has posted excellent numbers as the value-oriented manager of Pennsylvania Mutual (PENNX) and the Royce family of funds. He doesnt change his investment style from year to year.
Creating an opportunity
TrustShares long holding requirement creates what Royce calls an excellent capital structure for managing money. The fund is more concentrated than the usual Royce fund, owning about 50 names, and, he says, Its run slightly more -- I hate to use this word -- aggressively. Its a value fund where we use concentration to try to do better.
As for the scandal-tainted funds:
Alliance and Putnam were destroyed in the bear market. Between them they have exactly two five-star funds, as rated by Morningstar. Royce, with vastly fewer funds and assets, also has two.
Massachusetts Financial Services (MFS) is a much better money manager, with 10 five-star funds, but is deeply entangled in scandal, accused of countenancing both late-trading and market-timing abuses, at a cost to shareholders of at least $100 million. No fee is too low to offset the risk of fraudulent money management.
Even as these fund companies were trumpeting fee cuts, the Investment Company Institute, which represents the industry, was issuing another broadside against Spitzer, arguing that mutual fund fees are just fine. The fact is that there is little difference in fees for comparable services provided to pension funds and mutual funds, asserted Matt Fink, the groups president.
Try again
Thats not true. Freeman and another professor, Stewart Brown, published a paper Spitzer cited before Congress, which concluded institutions pay roughly half as much as fund investors. A Wharton School study commissioned by the SEC more than 40 years ago reached similar conclusions, so did a different SEC study four years later, noted a Money magazine article in 1995 and a Wall Street Journal report in 2001.
The ICI has never published industry data refuting these conclusions, although it could collect it from its members. Heres a question for you, Freeman posits. They represent all mutual funds. Why dont they go to them and get their data and publish it? Why dont they do that? What are they afraid of?
An ICI spokesman says it isnt necessary for the group to do its own study because Freemans work is flawed conceptually, not taking into account additional expenses fund companies incur such as account services and legal compliance. Freeman asserts these add no more than three basis points to annual costs. The spokesman says the actual figure is much, much more, but he couldnt quantify it.
Ive been harping on high fund fees since long before the scandal broke and, given the ICIs stubbornness, will be doing so in years to come. But these fee cuts are the kind merchants slap on sale items: Theyre stuck with junk, and they know it.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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