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Mutual Funds
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| | Mutual Funds
Fund investors punish the bad guys
Mutual-fund shoppers mete out justice with their checkbooks, pulling billions out of tainted firms and rewarding those with low fees and no rap sheet.
By Timothy Middleton
The agreement last week by Janus Capital (JNS, news, msgs) to settle charges of market timing in its funds marks the climax of Round 1 in the fight between regulators and the mutual fund industry over the abuse of its customers.
The regulators were clear victors in the battle, and fund investors the chief beneficiary. Possibly the deepest wound inflicted on fund companies came from a glancing attack on fees inflicted by New Yorks aggressive and ambitious attorney general, Eliot Spitzer.
Fees werent even an issue in the initial charges filed last September, and the Securities and Exchange Commission has insisted theyre a separate matter -- a matter the agency is loath to take up. But Spitzer has wrested hundreds of millions in fee cuts from tainted companies, and investors are following his lead, shunning high-expense firms and flocking to low-cost operators.
Eliot Spitzer deserves a gold coin cast in his likeness, says G.M. Buz Livingston III, a financial adviser in Santa Rosa Beach, Fla. He has done investors a great service.
Fresh data from Financial Research Corp. show that fund complexes exposed in the scandals continue to hemorrhage assets, while those free of taint prosper. Rather than spook investors away from funds, as some feared last autumn, the scandals have encouraged them to desert bad funds for good.
Withstanding the spotlight
There are some excellent firms that can withstand the spotlight -- the three largest players, for instance, says George Paquin, an adviser in Chelmsford, Mass., referring to Vanguard Group, American Funds and Fidelity Investments, none of them tainted.
The core issues in the scandals have been after-hours trading in fund shares and in-and-out moves characterized by regulators as market timing. The former allowed favored investors, often hedge funds, to buy shares after the markets 4 p.m. Eastern close, when late-breaking news made it clear they would rise the following day.
Market timing was used by the same professional investors to skim short-term profits from funds, particularly foreign-stock funds, whose price movements could be predicted based on time differences and their tendency to follow the American markets direction. This type of trading is believed to hurt long-term fund holders.
In all, 18 fund complexes have been implicated in one or the other of these abuses, or both, and a third of them have already settled with authorities that include the SEC, Spitzer and securities bosses in Massachusetts and Colorado.
Related news and commentary on MSN Money
Out the door
By far the most damage has been done to Putnam Investments, one of the industrys founding firms and the first to be charged. Some of the firms own employees were accused of timing the complexs funds. More than a dozen have since left the firm, top management has been overhauled and Putnam has agreed to pay $110 million, as well as to cut expenses charged to shareholders by $35 million a year.
Shareholders pulled $54 billion from Putnam funds in the fourth quarter, and nearly $8 billion more in the first. The companys total assets under management have been halved from their level of four years ago.
| Outflows continue at tainted funds while untarred rivals flourish | | Fund complex | Net flows, 1st quarter 2004 | | Putnam Funds | - $7.8 billion | | Janus Capital | - 6.0 billion | | MFS | - 1.2 billion | | American Funds | 29.8 billion | | Vanguard Group | 26.3 billion | | Fidelity Investments | 14.9 billion |
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Source: Financial Research Corp.
Janus, also among the first firms to be identified in the scandals, has agreed to slash expenses by $125 million over five years, to set aside $100 million to repay investors and to pay $1 million to Colorado authorities for investor education and future enforcement.
The Janus settlement brings to about $1.9 billion the total fund companies have agreed to pay. Other settlements include Massachusetts Financial Services, which will pay $350 million in restitution, penalties and fee cuts; Alliance Capital, which will forfeit $600 million, more than half of that in fee cuts; and Bank of America (BAC, news, msgs) and FleetBoston Financial, named in separate actions but merging their operations, which settled for a combined $675 million.
Other fallout from the scandals includes sweeping changes at Strong Capital and PBHG Funds, whose founders were accused of profiting, or helping others profit, from abusive practices. Dick Strong, Gary Pilgrim and Harold Baxter have all stepped down. The Old Mutual insurance company, which owns the PBHG brand, has said it will substitute its own name for PBHG.
No reason to sell
Not all of the revelations in the scandal have sent investors fleeing. Loomis Sayles & Co. acknowledged what it called increased trading in its top-notch Loomis Sayles Bond Fund (LSBRX) and said it ended its relationship with the traders. Pimco, operator of even more prestigious bond funds, angrily denounced charges it had allowed market timing.
We evaluated the explanations offered by (those) firms and decided the situation didnt warrant selling the fixed-income fund holdings we had from these firms, says Veena Kutler, a financial planner with Mosaic Wealth Management in Bethesda, Md.
Jerry Wade, principal of an advisory firm in Minneapolis, Minn., says, Were still working with Pimco and Loomis Sayles because their culpability was minimal.
(As I reported in a prior column, more serious charges have been leveled against PEA Capital, an equity firm whose funds carry the Pimco brand, because it and the bond shop have a common owner, but it's otherwise unrelated to the bond firm.)
Indeed, in the wake of the scandals, Pimco has replaced Putnam as the nations fifth-largest fund complex. In the first quarter it enjoyed net inflows of $6.51 billion.
| Largest fund complexes | | Fund group | Assets 3/31/2004 | | Vanguard Group | $658.6 billion | | Fidelity Investments | 646.5 billion | | American Funds | 528.4 billion | | Franklin Distributors | 196.9 billion | | Pimco Funds | 154.0 billion |
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Source: Financial Research Corp.
Other firms that attracted net new assets of more than $6 billion in the first quarter included T. Rowe Price (TROW, news, msgs), Barclays Global Investors and Dodge & Cox. All offer outstanding and inexpensive funds; Barclays are exchange-traded index funds called iShares.
Investors stick with the good guys
Investors reaction to the scandals is putting the lie to the economic axiom that bad money drives out good. Reputable fund firms are winning the fight for investor dollars. And they're validating Spitzers zeal in focusing on costs, despite the SECs reluctance to do so.
The real mutual fund rip-off is the high cost of investing . . . and I applaud Spitzer for highlighting this, says Ken Weingarten, an adviser in Lawrenceville, N.J. When people go to buy a car, they negotiate down to the last dime so they can brag they got a great deal. No one ever brags about getting a great deal on their mutual fund.
But they should, and fund flows show they can.
At the time of publication, Timothy Middleton owned or controlled investments with the following fund companies mentioned in this article: Vanguard Group, Fidelity Investments, T. Rowe Price, Barclays Global Investors, Dodge & Cox. He is also author of a book about Pimcos chief investment officer, The Bond King: Investment Secrets from Pimco's Bill Gross (John Wiley & Sons).
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