Nov. 2–As federal and state regulators launch investigations into some of the nation’s best-known mutual fund companies, investors are gripped by a single question: How could such a thing happen inan industry that prided itself on steering clear of the investment scandals that have dogged Wall Street? Mutual fund advocates, consultants, regulators, and money managers said the industry’scurrent troubles are propelled by more than the misdeeds of a few greedy players.
The longest bull market in history, a drive to sustain fund firms’ profits after the market correction, the spread of Wall Street’s go-go culture to fund managers, and regulatory failures dovetailed to create the crisis, they said.
“The events in the fund industry are more egregious and more numerous that at any time in memory,” said Don Phillips, founder of Morningstar, the investor services firm that advocates for small investors. Ninety-five million investors in half the nation’s households now own mutual funds. Over the past 15 years, funds have become the investment vehicle of choice in an era of do-it-yourself 401(k) retirement plans. Mutual funds have ballooned into a $7 trillion pool of assets since their birth in Boston in 1924.
Charges rocking the industry appear to some investors to demonstrate that those involved are no different from insiders at Drexel Burnham Lambert or Enron Corp., where executives engaged in deals at shareholders’ expense. They “make a lot of noise in their prospectus and websites that we’ll treat your money like it’s our money, and the investors’ interests come before everything else,” said Fort Lauderdale, Fla., investor James Day. “It’s just not true.”
Scandals are threaded through the history of the US mutual fund industry. Most amounted to egregious acts by a few players. Today’s crisis is more serious, said specialists, because it violates the premise on which the industry was founded: the sanctity of the investor.
“People in the industry are losing their moral compass,” said Burt Greenwald, a Philadelphia consultant who has worked in the industry since the 1950s. “This is the first time you can honestly say that there is sufficient evidence to suggest that there is a systemic series of breakdowns.”
The industry’s woes began in September when New York Attorney General Eliot Spitzer began investigating Janus Capital Group Inc., the Strong funds, Bank One, and Bank of America’s Nations Funds. Last week, federal and Massachusetts regulators filed a civil complaint against Putnam Investments charging improper trading practices. Two Putnam money managers had rapidly moved thousands of dollars of their own money into and out of Putnam’s funds to turn a fast profit in a fraudulent practice known as market timing, regulators charged.
Federal prosecutors are reported to have launched a criminal investigation of the Boston fund company, which manages $272 billion. Putnam said in a statement last week that it “did not act fraudulently.” The firm said it is cooperating with investigators.
Allegations against other fund companies are expected. A top SEC official disclosed it requested information from 88 major fund companies; as many as half may have permitted some market timing. Current investigations revolve around one type of market timing in which privileged clients or fund company insiders are allowed to move in and out of funds rapidly in violation of the fund’s own public policy.
The raging stock market in the 1990s contributed to abusive trading practices, fund industry analysts said. The boom attracted two new breeds of investors with swelling portfolios — risky hedge funds and firms that specialize in market timing for investment clients, said James Weiss, an independent money manager in Concord who until last year managed millions of dollars for a large Boston fund company. “The market was very volatile, particularly the last 18 to 24 months of the boom, and there were more opportunities to come in and out,” he said.
Hedge funds, popular among wealthy investors, are lightly regulated and pursue high returns. One recently settled charges with New York regulators of improper trading in mutual funds. Market timing firms fly under the radar of the average investor. But Weiss said they aggressively tried to execute rapid trades into and out of the funds he managed. His former employer strictly enforced an explicit policy that banned market timing.
When the market crashed, a new incentive fueled the practice. Fund companies’ profits were squeezed as assets under management shrank. Market-timing firms were, for some, a source of business in a downturn. “If you’re lax on the ethical side of the equation, you might accept these market-timing dollars because you can charge a fee. And because the market-timers aren’t welcome in so many places, when they find a fund that will look the other way, or even court them, they’re all over it,” Weiss said.
Changes inside the mutual fund industry set the stage for the current crisis. Under the Investment Company Act of 1940, the investment manager’s primary duty is to shareholders. Fund industry critics said priorities have shifted in the fast-paced world of mergers, intense competition, and a relentless quest for bigger profits.
For some, the shift by industry leaders away from a focus on investors’ interests is symbolized by the allegations against Richard Strong, chairman and founder of Strong Financial Corp. Spitzer said last week he is considering legal action against Strong for alleged improper trading. Regulators said Strong earned $600,000 in personal profits through trading in some funds managed by the firm.
The allegation against Richard Strong is “profound in that it shows not only was the board not doing its job; it was allegedly participating in the fraud,” said Mercer Bullard, a University of Mississippi professor who formed Fund Democracy, a shareholder advocacy group.
Strong, with $42 billion in fund assets, said in a statement that it has launched an internal investigation, and its chairman agreed to reimburse funds for any losses incurred by his transactions.
Investors also played a role in fostering a selling culture, chasing top-earning funds in what one former SEC official called the industry’s “cult of performance.” But Morningstar’s Phillips blames the industry for focusing on selling a product and failing to make changes that would benefit investors. For example, he said, Morningstar frequently proposed that companies disclose to investors how much their fund managers earn or what their pay is based on, but the efforts failed.
“We know to the penny what Michael Eisner’s paid to run Disney. We have no idea what Bob Stansky is paid to run Magellan,” he said. Magellan is Fidelity Investments’ largest mutual fund, with $62 billion in investor assets. “How is that not material if you’re thinking about buying the fund?”
Geoff Bobroff, an East Greenwich, R.I., consultant, said changes in the distribution of mutual funds have ceded more control to third-party firms such as Charles Schwab & Co., Fidelity’s discount brokerage, and 401(k)s. Third parties can provide cover for a market timer trying to place a fund order. The rise of third-party sellers means fund companies do not “truly know how and where orders are coming from,” he said.
Another problem is that regulation isn’t keeping up with the industry’s explosive growth. The SEC was slow to crack down on market timing as the practice mushroomed in recent years, said critics. State regulators launched the current investigations. The fund industry’s relatively clean reputation may have lulled the SEC at a time its staff has been strained by investigations at Enron, WorldCom, and other high fliers.
The commission has been widely viewed as underfunded. The SEC has only 987 employees to enforce regulations governing mutual funds, brokerages, the stock exchanges, US capital markets, and public companies.
“We’re getting exactly the level of enforcement we, the public, are willing to pay for,” said Michael Goldstein, a finance professor at Babson College. “It was well known during the ’90s that more of us were putting our money into the stock market, yet the budget for the SEC did not increase commensurately.”
States have also lost regulatory teeth. Congress in 1996 said state securities regulators could no longer register the mutual fund share offerings sold to their residents, leaving only an SEC registration.
Activist state regulators no longer review offerings to determine whether they made adequate disclosures and treated investors fairly, said Texas securities commissioner Denise Voigt Crawford.
Boston money manager John Spooner also detects a loss of “civility” in the fund industry. Gone are the days when seasoned portfolio managers mentored the younger ones and instilled a sense of their responsibility to the investor. Portfolio managers who “buy $3,000 suits made to order” have “zero sense of history” today.
“If you look at a trading desk and someone’s making $1 to $2 million a year, you want in, too,” Spooner said. “If it means funding fudging a little bit, it’s the spirit of the game.”
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