For investors like San Jose, California, resident Glenn E. Perkins, the latest mutual fund scandals have shaken his confidence. But the engineering manager still thinks mutual funds are one of the safest ways for individual investors to invest in the stock market.
Perkins is also financial partner of the South Bay Investors Club of the National Association of Investors Corporation (NAIC). He says that while being part of the investment club allows him to have some control over his stock selection, “I’m watching [the market] a little more closely than I had been before.” Perkins, who has placed most of his 401(k) savings into Vanguard funds, is “still fairly comfortable” with mutual funds because he hasn’t lost money as a result of the current scandals. He is also using his involvement in the investment club and some personal brokerage accounts to diversify his holdings.
While the scandal concerns him, Perkins feels there are few choices for most individual investors other than mutual funds. But he’s not so naive as to think scandals like this won’t happen again.
A GROWING SCANDAL
New York Attorney General Eliot Spitzer is inclined to agree. Spitzer, who launched the first mutual fund investigations in early September, has been quoted saying the scandal is bigger than just “excising a few bad apples from the industry,” suggesting that improper short-term trading may have skimmed more than $4 billion a year from investors.
Spitzer alleged that several companies, including Bank of America Securities and Janus Capital Management, had questionable dealings with hedge fund company Canary Capital Partners L.L.C. Hedge funds are unregulated investment pools for wealthy, financially sophisticated investors. Spitzer’s investigations alleged that Bank of America and Janus had engaged in market timing arrangements and after-hours trading deals that benefited certain large clients at the expense of individual investors. The scandal has spread like a virus across the $7 trillion mutual fund industry, with many of the big mutual fund companies coming under scrutiny. Those targeted by the U.S. Securities and Exchange Commission (SEC) for “market timing” violations include Janus, Bank of America, Prudential/Wachovia, BankOne, Pilgrim Baxter & Associates, and Strong Capital. Mutual funds suspected of late-trading or rapid trading include Alliance Capital Management, Charles Schwab Corp., Federated Investors, Loomis Sayles, and Putnam Investments. American Express allegedly withheld discounts on mutual funds to investors; Fred Alger Management was guilty of obstructing the fund-trading investigation; and brokers at Morgan Stanley are accused of recommending inappropriate share classes to investors.
The National Association of Securities Dealers (NASD), an agency charged with regulating securities trading, says market timing–taking advantage of price differences between international and domestic markets by rapidly shifting in and out of funds–is not illegal, but most funds publicly discourage it. NASD officials say market timing drives mutual fund costs up and waters down profits for those investing long term.
Late or after-hours trading involves buying and selling shares after the U.S. market has closed at 4 p.m. Eastern Standard Time. This is typically off limits to most investors. Some companies allow special clients to participate in late trading, which lets them buy at the current day’s closing price and profit if the price rises when the market opens the next morning.
Why were certain investors allowed to play by different rules? Because of greed. Over the last three years, when the economy was limping along and many mutual funds were struggling, generating fees from trades became one way for companies to make money.
By allowing big players to make special trades, fund managers stood to gain by taking an increased share of the profits of larger clients and by generating income from fees charged for executing the trades.Some mutual fund executives made a pretty penny. For example, the board chairman of Strong Mutual Funds, Richard Strong, was caught trading within his own funds in ways that benefited him and his friends and family. Strong, who is under investigation by the SEC, Spitzer’s office, and Wisconsin financial regulators, has resigned in the wake of the multiple investigations.
Christopher L. Davis, executive director of Washington, D.C.-based Money Management Institute, a company that represents companies that handle individual managed accounts, says some fund managers took advantage of mutual funds because their activities weren’t seen by the rest of the investing public. Unlike individual managed accounts where clients see their holdings at all times, mutual funds are set up in such a way that there is little oversight. “The lack of transparency allowed these activities to go on,” says Davis. “The SEC needs to improve disclosure laws.”
HOW MUCH HAVE YOU LOST?
Tim Forde, vice president, Strategic Analysis with the Investment Company Institute, an organization that represents mutual funds, says individual mutual fund investors haven’t lost large dollar amounts like what has happened in the recent accounting scandals. However, “[investing in mutual funds] is an enormous leap of faith, and something like this raises serious questions about trust,” Forde says. “The larger potential harm is to mutual fund companies and how individuals save for retirement,” and Forde warns that investor confidence is again at risk.
The Investment Company Institute, whose membership manages about 8,672 mutual funds, reports that the nation’s 95 million mutual
fund shareholders are typically pursuing long-term financial goals such as retirement security or paying education costs for children. The group says the typical shareholder is middle-aged, married, and college educated.So what can investors do to safeguard themselves?
Ken Janke, chairman of the Michigan-based NAIC, says it’s best to look for a mutual fund that can weather the good and bad times. “Most funds have managers who have been there for some time,” says Janke. “It’s not a matter of jumping in and out.” (See “Before You Leave Your Fund.”)
Steven L. Sanders, president of Pittsburgh-based MDL Capital Management, speculates that unethical mutual fund companies will eventually be eliminated. “If investors punish fund families that are not playing by the rules, this will send a clear message that investors are the ones in charge,” Sanders says. “You can punish them by moving your money.”
Chicago-based Morningstar Inc., a global investment research firm, also tells its investors to look for ethical or shareholder-friendly companies that lead the way in quality and corporate governance measures. Morningstar analysts say big fund companies like American, Vanguard, T. Rowe Price, and Fidelity have done an outstanding job in those areas. Unfortunately, there is no way to predict which fund will be implicated with wrongdoing next. Barron H. Harvey, Ph.D., dean of the Howard University School of Business, says, “Investors have a major obligation to do their homework.” SEC Chairman William H. Donaldson says the “Commission is moving swiftly and aggressively to take all necessary steps to protect mutual fund investors from abusive and harmful activity.”
In an attempt
to remedy the situation, in December the SEC backed new rules intended to curb mutual fund abuses. The rules require mutual funds to restrict orders to a 4 p.m. EST deadline; to disclose market-timing policies and company procedures for determining the fair value of securities; and to appoint a chief compliance officer to make sure all rules are followed. Forde says it’s going to take tough enforcement and very strict regulations by the SEC in order to restore trust to mutual fund companies.So f
ar, Bank of America and Janus have pledged to pay restitution to mutual fund shareholders. Canary settled with the New York attorney general for $40 million. Morgan Stanley has agreed to pay $50 million to settle federal charges of mutual fund abuses. Spitzer doesn’t feel that that’s enough and has vowed to seek criminal charges against certain individuals implicated in the scandal. Stay tuned.
Before You Leave Your Fund
If you have investments with companies that have been named in the widening mutual fund trading scandals, financial advisors urge you to exercise caution before you move your funds. There is no telling which fund may be charged with wrongdoing next, and you could lose more by taking your money out of a fund if you don’t pay attention to the following:
Taxes: If you are invested through a retirement account, don’t worry. If you’re not, you’ll owe up to 15% in capital gains taxes for any gains made in 2003.
Sales charges: Moving between funds in the same mutual fund family won’t cost you, but if you move to a different fund family, there will likely be a fee.
Redemption fees: Many funds charge redemption fees if you leave before a specified number of years. These penalties can be as high as 6%, much more than any investor has lost in the current scandals.