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Give 'Em The Customer Treatment

Mutual fund scandals continue to widen. Last week it was Putnam and Strong that took the heat. Next week. who knows? Your fund company could be next.

The mutual fund scandal is the latest bubble-era excess that has yet to be purged from the U.S. financial system. It seems the corporate greed and atmosphere of excess that permeated the boardrooms of Enron and Tyco also infected the executives of at least a few mutual fund companies. The list of fund companies with at least an adminstrative inquiry began as a short list of: Bank of America, Janus, Bank One, and Strong. Now the list has grown to include Merrill Lynch, Citigroups Smith Barney, Fred Alger Management, Bear Stearns, and Putnam Investments. The list will continue to grow.

Well before the latest scandal broke on 9/3/03 corporate governance of mutual fund companies has drawn some promient critics. Warren buffett, in his 1992 letter to Berkshire Hathaway shareholders, stated that boards of directors have only two important responsibilities - "obtaining the best possible investment manager and negotiating with that manager for the lowest possible fee ... when it comes to independent directors pursuing either goal, their record has been absolutely pathetic".

In addition, John Bogle, the pioneer and proverbial patron saint of index investing, has slammed his own industry for rising expenses, poor governance, and putting their own interests above the interests of their shareholders. An excellent report by Mr. Bogle was submitted this week to the U.S. Senate.

Certainly, mutual fund companies have been extremely fortunate over the last 20 years. The popularity of defined contribution plans, such as 401k and 403b, favorable tax incentives, expanding participation in the stock market, and the growing wealth of the baby boom generation all worked in the favor of the mutual fund companies. According to the industry's own data, there has been tremendous growth in the overall mutual fund market. As a result, the number of mutual funds (and mutual fund companies) multiplied to meet the growing demand. When the IRA was established in 1974, there were 431 mutual funds with just under $36 billion in assets. By the end of 2002, there were 8,256 funds with over $6 trillion ($6,391 billion) in assets. This is a compound average growth rate of over 11% per year in the number of mutual funds in existence. That's 11% growth per year for nearly 30 years! The growth rate for assets is nearly double. Growth of mutual fund assets over the period 1974-2002 comes in at an incredible 20.4% per year. Few other industries can boast such impressive growth. Despite this phenomenal industry expansion, there are substantial problems with the structure of mutual fund companies.

The Governance Problem

There is an inherent conflict of interest in the mutual fund business. The people that buy mutual fund shares are not really shareholders in the classic sense. Instead they are customers. They are purchasing a product. Let's ignore the fact for the moment, that the product is called a 'share'. The true shareholders in this business are the investors that invested capital and started an investment (mutual fund) company. The Board of Directors is beholden to these investors. Apparently, the directors of at least a few fund companies behave as though they are a regular corporation instead of a mutual fund. In regular corporations, it is not uncommon to grant larger customers a price break. However, mutual funds are not regular corporations, and should not conduct their operations in the same manner.

Mutual fund company directors must serve two distinct constituents. One is their bosses, those who invested capital in the mutual fund company (not the mutual fund products). This group is ever-present, vocal, demanding, and focused on their (own) profit. They second group is the mutual fund shareholders. They are largely invisible and silent, except for when they liquidate their shares and don't return. The regulartory structure is designed to protect the interests of the mutual fund shareholders, but no regulation can substitute for common sense and ethical business practices. Unfortunately, both seem to be much less widespread than they should be.

The Focus problem

A major factor is that too many mutual fund companies are addicted to asset growth instead of asset preservation. Attracting new investors is the name of the game. With the focus on attracting new money, performance is the name of the game. Big gains attract new money. (Let's ignore the fact that big gains often come from taking big risks). This creates a very short term focus. According to an October 29, 2003 BusinessWeek article by Faith Arner titled How Putnam Landed in this Pickle, "the fund managers were under the proverbial gun. If they didn't meet their benchmark every quarter, they get a visit from the performance police". I am not familiar with the perfomance police at Putnam, but I'm sure their visit is not a pleasant one.

The problem isn't the performance police in general. The problem is that missing the mark in a single calendar quarter is cause for alarm. Over the short term stock market price movements are random. Those investing for the long term should not be overly concerned by a single quarter's underperformance. That is the heart of the problem. Many mutual fund managers (and their bosses) are not investing your money with the long term in mind. Their only concern is delivering above-benchmark performance (above-0% is good, but above benchmark is the true measure). This is because above-benchmark performance brings in new money. It's all about attracting new money.

Even if the motivation is skewed toward attracting new shareholders instead of taking care of current shareholders, isn't the focus on performance good for both? The focus on performance is good, however, the exclusive focus on short-term performance is the problem. The focus on short term performance leads to trading. In order to turn in performance in only 90 days, the fund manager has to be in what is hot, and what is hot now. Quick moves into and out of stocks is often a requirement. These moves are not free. There are commissions and fees that must be paid. These fees are paid by the current mutual fund shareholders. Operating a mutual fund in this manner is not investing, it is speculation.

Often if a fund doesn't perform well (thereby ceasing to attract new money), it is 'merged' with another fund (but almost always within the same mutual fund family). A letter goes out to existing mutual fund investors explaining the move and that the future remains bright for the combined fund. There will be significant discussino about how the investment landscape has changed and how the merger matches the investment objectives of the fund(s). The old fund, and most importantly, its poor performance record, disappears.

Of course, not all mutual funds operate with only their self-interest in mind. Many are very concerned about their mutual fund shareholders. The problem is, that it is particularly difficult for the individual investor to determine the good apples from the bad at this point. So what is an investor to do? Sitting tight and hoping for the best is not a good option, in my opinion.

What You Can Do

A good number to investigate is your mutual fund's turnover rate. This is a measure of how much trading is taking place in the fund. You can find it in your fund's annual or semiannual report. Since you probably threw away the one you received in the mail, your best source is your mutual fund company's web site. I would consider a turnover rate of 100% or more a clear warning sign. I prefer a much lower number (15% or less), but there is considerable variation among funds. Index funds should be on the low end of the scale. Vanguard's 500 Index Fund had a 2% turnover rate for the six months ending 6/30 and a 7% rate for 2002. Compare that with Alger's Largecap Growth that turned in a 124% rate for the six months ending 4/30/03 and a whopping 214% for the most recent annual reporting period. Alger funds have been highlighted by regulators. The company has since completely banned market timing in their funds and issued a public statement stating their policy on the issue.

Another method to evaluate your fund is to look at the amount of redemptions (the dollar amount that investors pulled out of the mutual fund) divided by the fund's total assets. If the amount of redemptions is several times the amount of assets, that could be a sign of large amounts of money moving into and out of the fund. Vanguard's 500 Index Fund comes in at 19.9% for 2002 for the common share class [Investor Shares]. If this number comes in over 100%, I would consider that a warning sign, especially if turnover is high as well. For the Alger Largecap Growth (A Shares), this ratio was 499% for the year ending 10/31/02. The warning signs were there for Alger shareholders that were willing to do a little digging.

If you are worried about your own mutual fund investments, there are many alternatives to mutual funds. However, you should first research (or re-research) the funds you own. Revisit your personal investment goals and why you chose the fund in the first place. If there are signs of wrongdoing in your funds or fund family, there are essentially two choices, stay or go. Think of it as a vote between two candidates. You can either vote for the fund managers by staying; or you can vote against them by leaving. In this case, not voting at all is a vote for the fund managers.

Additional Reading: Putnam legal documents

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