Nov. 9–Richard Strong always has known how to make money in the investment business.

He built a built a personal fortune estimated at $800 million and a financial company with $42 billion in assets largely by doing what hundreds of other financial firms do: churning out mutual funds and marketing them aggressively to investors.

So why, as New York prosecutors have suggested, would he risk it by allegedly allowing a big customer to skim money from his mutual funds while milking as much as $600,000 for himself and others close to him through improper trading?

The answer to that question may lie at the center of the crisis swirling through the $7 trillion mutual fund business.

While Strong–like Martha Stewart before him–might be remembered for demonstrating stunningly bad judgment, critics say the industry is in trouble precisely because it encourages people like Strong to push the envelope in search of profit. The explosive growth and go-go marketing orientation of such fund companies as Strong Capital Management Inc. has overwhelmed the governance and regulatory structures intended to protect investors from the self-interests of fund managers, they charge.

“Too many funds have abandoned the interests of their shareholders,” said New York Atty. Gen. Eliot Spitzer in testimony last week. They have “instead permitted, and indeed fostered, an environment that promotes the interests of their managers at the expense of their shareholders.”

Wisconsin money manager William Corneliuson, Strong’s partner until they parted ways after a separate scandal in 1993, put it more simply. “It comes down to personal responsibility, and there’s not a whole lot of that in our country right now.”

Strong, 61, declined to comment for this story and has yet to respond specifically to accusations of improper trading leveled by Spitzer’s office. But Corneliuson and others say the story of the company’s expansion helps explain the conflicts of interest plaguing the industry.

Strong Capital’s rise closely tracks a two-decade boom in the mutual fund industry that saw the number of funds shoot to 8,256 in 2002 from 857 in 1982. According to the Investment Company Institute, assets managed by those funds during that span rose to $7 trillion from $297 billion, as individual investors enjoying the fruits of the historic bull market piled money into 401(k)s and other accounts.

These days, 95 million Americans have entrusted their money to the mutual fund industry and pay at least $70 billion in fees to fund managers. Strong built a mutual-fund marketing machine to capture as many of them as he could.

“Dick is a very bright man, very creative, with a lot of energy,” Corneliuson said. “He’s great at visualizing what can happen–the upside. He’s also an irrepressible optimist, and that’s a very attractive combination.”

Since he launched his first fund in 1982, Strong never has been married to a particular investing style. Instead, he has focused on making the business grow by harnessing hot performance. The key was expanding money under management–and fees.

The firm’s headquarters in Menomonee Falls, Wis., says as much about Strong’s optimism and drive as anything else. He had the state-of-the-art facility built on 300 acres in 1987, even though the firm would fill only 10 percent of the space when it moved in. The challenge was to grow into the rest.

Strong attended to the building’s every detail, from the copper roof to the mahogany handrails. A recent profile in Money magazine described a reporter’s tour with Strong through the building’s tidy boiler room. The message: cleanliness bespeaks a well-run institution.

Once, when a French investor came to visit and immediately excused himself to go to the bathroom, the investor’s assistant told Strong that the visitor didn’t really need to relieve himself. Rather, he felt comfortable entrusting his money only to a firm that paid attention to details as small as spotless restrooms.

Strong passed the inspection.

“That wasn’t a story about a peculiar Frenchman for Dick,” said Steve Hanna, who has been friends with Strong for 20 years and helps edit the firm’s newsletters. “That was a story about doing everything right the first time.”

Corneliuson suspects Strong’s fastidiousness is really about control. It counterbalances his drive for investment results and corporate growth, which has drawn the attention of regulators in the past.

Strong’s results sparkled for much of the firm’s early history. He notably pulled 60 percent of his money out of stocks before the Black Monday market crash in 1987 and became a minor market hero after that.

But through much of the early 1990s, the firm wrestled with government charges that Strong had moved junk bonds between his funds and pension plans without having them priced properly. The moves may have allowed the firm to profit at the expense of some of the funds’ investors. The firm ended up repaying the funds $6.3 million in two settlements but did not admit any wrongdoing.

But the scandal cost Strong his partner, as Corneliuson lost his taste for what he saw as the firm’s reckless style.

“I basically said, `I don’t like the smell of it,'” Corneliuson said. “I couldn’t stand the chaos when I was responsible for billions of dollars in other people’s money.”

Like many fund companies during the 1990s, Strong Capital became a marketing operation as much as an asset-management firm. It’s easy to see why: The more funds the company pushes, the more fees it can earn, regardless of performance.

“You ended up, in many cases, with organizations that were more adept at the marketing of financial services than the management of financial services,” said Don Phillips, managing director of Morningstar, a top fund-research firm. “The marketing people ended up with the upper hand.”

A good example of Strong’s marketing power was its five-year relationship with New York money manager David Schafer.

In 1996, when Schafer was looking for a partner to help market his top-rated Schafer Value fund to new investors, Strong invited him to speak at his annual conference for business journalists in Wisconsin.

Schafer’s fund had a stellar long-term record, and he had entertained several offers from other, larger mutual fund complexes. But over breakfast at the Pfister Hotel in Milwaukee, Schafer, a native of southern Indiana, took a liking to Strong and mentioned he might be willing to do some business with a fellow Midwesterner.

“Dick was a breath of fresh air,” said Schafer. “He gets things done. He’s an ordinary guy, and in New York there aren’t a lot of ordinary guys in this business.”

A few months later, Schafer Value was enjoying the fruits of Strong Capital’s marketing machine. Not only did it immediately get access to fund “supermarkets” like Charles Schwab, but it also benefited from a national team of Strong salespeople who could set up meetings for Schafer with registered financial planners.

The strength of such a network is not to be underestimated. Riding two years of returns topping 20 percent, the renamed Strong Schafer Value fund grew from assets of $185 million in 1995 to $2.25 billion in 1998. That pushed the annual management fee–a standard 1 percent of assets–from $1.8 million to $22.5 million, which Schafer says he and Strong divided according to an undisclosed formula.

Performance fell into the red in 1999 and 2000, as Schafer’s value-oriented investment style fell out of favor with investors hungry for growth stocks. Investors fled with their money. But even with only $500 million in assets in 2001, the fund produced $5 million in fees.

There’s nothing wrong, of course, with generating fees. But some observers said the power of asset growth led Strong to embrace some of the industry’s more questionable practices: promoting funds’ short-term performance and rolling out funds that play to investing fads.

“It did have a history of rolling out gimmicky funds,” said Christine Benz, editor of the Morningstar FundInvestor, noting Strong’s Internet fund and its “Dogs of the Dow” offering.

“It’s an indication of a firm that was looking to cash in on investors’ greed,” she added.

At the height of the Internet bubble, the company advertised a 147.8 percent one-year jump in its technology-focused Strong Enterprise Fund.

“Any questions?” the ad boldly asked.

The fund provided its own answer: An 18.8 percent average annual loss over the past three years.

Some of Strong’s stock funds have suffered as a result of what has become a more common malady in the industry–too much asset growth.

For instance, the money invested in the Strong Advisor Common Stock Fund has soared to $1.55 billion from $762.1 million in 1993. Although the fund is run by Dick Weiss, one of Strong’s most respected managers, its performance has lagged similar funds–earning a subpar two out of five stars from Morningstar for the past three-year period.

The problem, said Benz, comes down to a classic conflict of interest. Although the growth of the Strong Advisor fund generates ever more fees, its size also limits its investment options. Weiss’ focus is on small to midsize firms. Moving big chunks of money into and out of their stock could significantly affect their share prices, lessening his returns.

Weiss did not return a call for comment.

Those conflicts between Strong and his funds’ shareholders allegedly rose to a new level last year. With growth slowing in the market, Strong may have turned to another part of his business–hedge funds–for new opportunities.

Spitzer’s complaint outlines a plan whereby Strong in late 2002 agreed to let an unrelated New York hedge fund called Canary Capital Partners trade improperly in five of his funds. In return, Canary promised to invest an undisclosed amount in Strong’s own hedge fund–and pay the resulting fees.

This was part of a broader strategy by Canary to engage in “market timing” trades. Market timing involves moving into and out of funds quickly, hoping to exploit inefficiencies in the way mutual fund companies price their shares.

Funds calculate their share price, or “net asset value,” only once a day–usually at 4 p.m. Eastern time. But that value sometimes reflects “stale” prices for the stocks the fund holds–one example being a Japanese stock that because of time-zone differences closed on local markets at 2 a.m. New York time.

If news in the U.S. markets appears likely to cause that Japanese stock to rise overnight, an investor might be able to predict as much before the fund closes that day. If he buys the stock, and the Japanese company does rise, he can sell it for a tidy profit the next day.

The problem with market timing is that the market-timer’s gains are paid out of the larger pool of assets owned by longer-term shareholders. Such trades can disrupt fund managers and sometimes crimp returns by causing the manager to keep excess money in cash to help pay off the market-timers.

Strong, like most fund companies, publicly forbids market timing in most of its funds. But internal e-mails included in Spitzer’s September complaint against Canary show that Strong allowed Canary to “time” his firm’s funds in return for fee-generating investments in his hedge fund. Spitzer also is investigating whether Strong personally engaged in similar timing trades to benefit his own accounts.

Strong was one of four fund companies named in the Canary case. But since then, the Securities and Exchange Commission has disclosed that the practice is widespread. That’s why critics are charging that improper trading at the expense of shareholders is an outgrowth of the fee-hungry mutual fund culture. Power in the fund industry is skewed in favor of management, the critics say, and that means that shareholders can’t defend their interests.

To combat such abuses, industry reformers would like to see rules that reinforce the ownership and governance structure of mutual funds. It is easy to forget that a mutual fund like the Strong Advisor is owned by its shareholders.

Strong Capital contracts with the fund to provide shareholders with management and marketing services.

By law, an independent board of directors has a fiduciary duty to protect the interests of those shareholders and negotiate an annual contract with the management company. The problem is, until Richard Strong resigned a week ago as chairman of the fund’s board, he led both the fund and management companies.

Unlike a regular public company, the shareholders know nothing about how much the fund manager gets paid or what stake he or Strong have in the fund. They are not required to report on those annual contract negotiations or how fees are determined.

“While it’s easy to appreciate why management might not want to provide such data, it’s hard to argue why an investor shouldn’t have the right to see it,” said Morningstar’s Phillips in testimony before Congress last week.

Spitzer pointed out in his testimony that mutual funds tend to pay advisory companies like Strong higher fees than pension funds pay for the same services.

“Why the higher fee?” Spitzer asked. “Because fund directors do not–and can not–negotiate hard on fees. What else would you expect when the chairman of the mutual fund is also the chairman of the advisory committee.”

Spitzer, Phillips and others would like to see funds appoint a truly independent board chairman and give the board more clout when it comes to negotiations with fund managers.

But Corneliuson think true reform will take some national soul searching as well.

“There are smart people in this industry,” he said. “There’s not a rule or piece of language that can’t somehow be circumvented. It always comes down to intent. Until we can agree on some level that [personal responsibility] matters, no Eliot Spitzer is going to fix this stuff.”

By Michael Oneal and Rob Kaiser

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