If you’re an optimist, you say that these trials and plea bargains and admissions show that the system is correcting itself and things are getting better. But the problem is that we keep getting new scandals. We’re not just chewing over old cases like Enron and Tyco. We’re seeing whole new patterns that continued way past the point when Enron imploded, which should have been a wake-up call for everyone.
The mutual-fund scandal, which is still expanding, could well turn out to be the most disturbing of all–worse than even Enron, WorldCom and Wall Street analysts shilling for the companies they were supposed to be covering. You expect some bad behavior out of Wall Street and corporate America. But mutual funds? They’re supposedly regulated up the yin-yang. You may have to worry about some funds’ excessive fees and crummy performance and inappropriate marketing. But on the whole, mutual funds are supposed to be trustworthy outfits you can rely on to handle your investments while you sleep soundly at night.
But thanks to New York Attorney General Eliot Spitzer, who steps up to the plate while the Securities and Exchange Commission is still working on its lineup cards, four fund groups have admitted allowing big guys to do trades that hurt other holders, who are mostly little guys. We’re talking household names: Janus, Alliance, Bank One, Bank of America. A fifth fund house, Strong Capital, says it allowed such trades but doesn’t think anyone was hurt. And former hedgie Markovitz’s plea makes it look likely that more fund families are about to join that sorry roster.
One reason I’m so shocked by the funds’ behavior is that it’s just so stupid. Here’s the deal. Funds earn fees based on the amounts they have under management. So if funds that say they discourage market-timers willingly let them in, the fund companies do, in fact, make slightly bigger fees. But it becomes much more difficult to run the funds well. That hurts the funds’ investment performance–and undermines the value of the entire enterprise. And it risks the funds’ reputation, their most valuable asset.
I’m not the only one surprised–and outraged–by the funds’ behavior. “I was absolutely floored by it,” Don Phillips, the managing director of Morningstar and arguably the most savvy fund analyst in the country, told me. He thinks that some fund companies grew desperate when the stock-bubble burst, which reduced the dollar value of their funds and thus shrank the fees the funds were paid. So people did whatever it took to get large amounts of money in the door. “It’s easy to be noble when the assets are flowing in,” Phillips said.
Talk about penny-wise and pound-foolish. Janus, the biggest of the five families caught up in the scandal, estimates it made $1 million in fees by allowing market-timing trades. Big whoop. Barely a rounding error for a company with revenues of about $1 billion a year. Janus and Bank of America say they’ll give fund holders the fees they got by handling timers’ money. They’ll also cover losses regular holders suffered. Bank One and Strong say they’ll make up losses, but wouldn’t comment about disgorging fees. (Alliance wouldn’t discuss whether it would make up holders’ losses.) No matter how many noble noises the companies make, though, they will never be trusted the way they were.
The fund industry is lucky that so many people have their 401(k)s on autopilot, and that inertia will keep most investors from leaving unless more wrongdoings surface. But even if certain funds get vaporized by investor outflows, bad actors will still be with us. Because, as the saying goes, even if a nuclear war kills every human on the planet, the cockroaches will survive.