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The Great Mutual Fund Scandal of 00 is both a surprise and an inevitability. An inevitability because a debacle like the aftermath of the telecom/media/tech boom almost demands a big scandal in the financial markets -- thereby opening a window for some ambitious, heretofore relatively obscure public servant to burnish his resume scourging the malefactors.
It is a surprise as aggregate damage to investors circumstances, and the individual consequences of abuses, were far worse from the excesses of the late, great boom. Whereas the subdivisions of America are full of tech-loaded 01(k)s and depleted online brokerage accounts, the net damage to the worst affected mutual-fund shareholder was a few percent per year. Even the highest numbers from academics indicate an effective transfer from mullets to millionaires in single-digit billions per year, compared with scores of billions of compensation to a mutual admiration society of traders, investment bankers, high-rolling brokers, venture capitalists, preferred IPO customers and corporate promoters in the tech Internet bacchanals of the late 0s. Mutual fund abuses should be only a second-tier excess in a crowded roster.
Nevertheless, the public, while angry about tech and post-bubble losses, seems to make important distinctions. Investors, even small ones, who threw themselves into the speculative maelstrom of the late 0s are generally seen as responsible for their own follies and -- absent extenuating circumstances like egregious broker abuse of discretion -- their losses. The mutual fund scandals resonate differently. A group of fiduciary institutions represented themselves as protecting a class of clients. They failed, accepting and even soliciting business harmful to the supposedly protected classs interests.
The mutual fund scandals are relatively easy to explain. They have unambiguous wrongdoing. Whether Frank Quattrone knew he was covering up culpability by underlining CSFBs document destruction policy can be, recently was, and apparently will be, argued in court. No one is defending allowing a limited number of preferred mutual fund customers to trade after the markets closed, when other shareholders could not avail themselves of the same privilege. The damaged investors tend to be smaller and less sophisticated. The beneficiaries tend to be relatively well-paid industry professionals and private pools of speculative capital. Worse, supposedly abusive behavior was practiced by employees, officers and directors of some mutual funds.
The prosecutors are edging into a compelling theory that mutual funds that represented that they rejected timers while soliciting them defrauded their investors who did not time, by lulling them into leaving their money in an underperforming fund while assets, and the management fees paid on them, were boosted by timers money attracted by the enhanced pile of patsies. In fact, press coverage implies New York Attorney General Eliot Spitzers office is out to try to ban all market-timing, which would present difficulties. Mutual funds, with their emphasis on ready liquidity and unavoidable mandatory cut-off times are designed to be timed. They are intended to allow ready portfolio switching at low cost by retail investors. The line between good active management and bad professional timing is not clear-cut or easy to police. Nor would some solutions -- redemption fees, advance notice on redemptions, delayed evaluation for redemption purposes -- necessarily be popular or beneficial with mutual fund investors as a whole.
The growth of exchange traded funds and other traded financial derivatives might allow a new differentiation between mutual funds, which would be re-categorized as public investment vehicles with significantly diminished liquidity; and public derivatives, which would better reflect immediate market prices. Since, however, much of the public likes actively managed mutual funds as opposed to index funds, which already have much lower fees, look for little clamor for that reform. Similarly, closed end funds have attracted minuscule amounts of money relative to open end funds, notwithstanding all sorts of liquidity provisions. Retail investors are likely to be quite sensitive to decreased liquidity for mutual funds. Moreover, some mutual funds welcomed active flows, made no effort to dissuade them, and openly solicited timers. Similarly, all inconspicuous comers could time other funds. The spectacular pension performance by a group of blue-collar workers recently reported in the Journal implied the practice was hardly a preserve of Wall Streets sharpest.
Press reports say the investigation is moving on to brokerage houses that facilitated timing, often in omnibus accounts, which made even those funds actively policing timing less likely to discover it. To the layman this looks like a mares nest. Shouldnt a broker in such a firm encourage a client to time if possible? The brokers fiduciary duty is to the client, not the fund. How is timing advice, which does not require violating stated purchase or redemption procedures, different from other trading advice, which also presupposes a positive sum game with relative winners and losers? Does the brokerage firm have a duty to police timing in an unaffiliated fund when its timing clients will benefit and its non-timing clients will be hurt? Did the brokerage firm have a fiduciary duty to time when it could in a discretionary account? And affiliated funds? Would the obligations be different, and do they extend to the brokerage arm when the mutual fund is in a separate management subsidiary?
The likely remedies, including hamstrung mutual fund liquidity, less flexible annuity investments and mammoth corporate penalties will play well across the headlines. They may make Mr. Spitzer the Democratic Dewey of our age. They wont, however, address the continuing agency problems that facilitate scandals; many of the remedies for which are already in place.
Corporate penalties come out of the hides of fund management company shareholders. The directors of those companies do not seem to be doing a good job of directing managements to build compensation systems that would actually penalize employees who benefit from abusive policies, especially supervisory managers who were not direct parties to timing arrangements.
Moreover, where are the boards of the funds? Where were they when massive fund flows from timers diluted their reported returns? Did they ever look at dilution from timing in light of what were presumably board policies to restrict timers? Which of them has terminated the management contract of a management company or even announced their intention to consider the question? This is hardly surprising. Fund management fees as a percentage of assets on large institutional accounts have regularly trended lower for years while mutual fund boards, often of funds managed by the same investment management teams as large institutional accounts, rarely, if ever, negotiate fee reductions. The apparent passivity of fund boards is consistent with their customary aggressive defense of shareholder interests.
The question is not one of new remedies. It is one of making old remedies work and requiring investors, in both funds and management companies, to be represented in substance as well as form so that we minimize occasions for repeating the old Street joke that the salesman made money and the fund manager made money and two out of three aint bad.
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