NEW YORK (MONEY magazine) -
All of a sudden, it seems, fund is a four-letter word that begins with F-U.
Mutual funds had long looked like the cleanest corner of the financial industry -- until last September, when New York State attorney general Eliot Spitzer unleashed his stunning charges of illegal trading in the fund industry.
|The MONEY Fund Survey
Week after week, the revelations of misconduct spread until, at last count, well over a dozen prominent companies had been implicated.
Fund investors are left worrying whether they can trust the people who manage their money. Worse, investors have no practical way to determine how trustworthy those people really are.
|Fund family ||Comment |
|American Century ||80 percent of board is independent; no use of "soft dollars" from trading |
|American Funds ||Manager bonuses based on four-year performance; no gimmicky funds |
|Ariel ||Supplied copy of interoffice memo on new policy restricting fund trades |
|Brandywine ||All fund directors "have elected to receive fund shares in lieu of cash" |
|Clipper ||75 percent of board must be independent; code of ethics being revised in wake of scandal |
|Davis ||"Soft dollars" discontinued in October 2003; bonuses based on five-year performance |
|Harbor ||All directors required to invest at least twice their annual pay in Harbor funds |
|Longleaf ||Directors review ethics code annually; employees invest exclusively in Longleaf funds |
|Oakmark ||2 percent redemption fee on all funds held for 90 days or less; four of seven funds closed |
|T. Rowe Price ||Bonuses based on three-, five- and 10-year risk-adjusted performance |
|Tweedy Browne ||Employees who invest in the firm's own funds must hold them for at least 180 days |
|Wasatch ||Six of nine funds closed to all investors; managers have more than $20 million in funds |
So MONEY has undertaken a sweeping survey of the policies and practices of the largest retail mutual fund managers in America.
In early December we sent out a six-page questionnaire covering everything from fees and expenses to portfolio managers' pay. Our cover letter set out our goals:
"This survey will provide a comprehensive picture of industry practice and offers an unprecedented opportunity for you to show investors precisely why they should have confidence in your firm. We hope you will provide as much information as possible. If your firm is unable or unwilling to complete every part of our questionnaire, we encourage you to respond at least partially. (Nonparticipation will be noted in our results.) Our goal is to illustrate the seriousness with which fund firms take their fiduciary responsibility."
And how seriously did the firms take our inquiries? For the most part, very seriously. In all, 59 of the 100 largest fund companies participated -- some at the highest levels.
NeubergerBerman president Peter Sundman spent nearly 45 minutes on the phone with us, making sure that he -- and we -- fully understood the implications of all the questions. Wally Weitz, head of the Weitz funds, called two times with questions about our questions; his general counsel called twice more.
A roomful of senior officers at the Wasatch funds spent half an hour on a conference call with us. And an executive at TIAA-CREF, which is not among the 100 largest fund managers, called to ask whether the firm could fill out a survey anyway.
Surprisingly, several of the firms at the heart of the scandal -- Bank One, Federated, Janus, PBHG, Putnam and Strong -- also responded. So the good news is that many people in the fund industry saw this project as an opportunity to show you why you should trust them.
The bad news is that nearly as many firms did not participate. To be sure, we put them on a tight deadline, and everyone is busy at year-end. Still, the nonparticipation of so many firms is disappointing.
A spokesman for the Goldman Sachs funds said, "Some questions we're just not able to answer for proprietary reasons, and others the lawyers didn't want us to answer until the smoke clears. And we didn't want to submit a partial response." (Aren't Goldman's investors entitled to know just a wee bit more about how their funds are run?)
Scudder opted out by stating that "we're not a retail mutual fund complex. We're distributed through intermediaries." (Brokers and other intermediaries, of course, regularly sell Scudder funds to retail investors.)
It's a shame that any fund company missed this opportunity to communicate more fully and forthrightly with its investors. At least, in this time of distrust, it's reassuring that most of the big firms recognize their obligation to explain why they deserve your confidence.
What we asked
With its 44 questions -- many of them consisting of multiple parts -- the survey delves deep into the central areas of concern for investors (MONEY subscribers and AOL members can see the full list of questions here).
Where might conflicts of interest arise, and how are they managed?
How do the fund managers restrict potentially harmful trading?
How are managers paid, and how much do they invest in their own funds?
What are the funds' boards of directors doing to protect your interests?
Are expenses under control or are they out of control?
We began by asking whether the management company has a written code of ethics. Every firm that responded to our survey has one, and that's good. On the other hand, in the wake of the trading scandal, every fund's board of directors should have demanded that the management company's code of ethics be reviewed and, if necessary, revised to forbid insiders from churning fund shares.
For example, at Friess Associates, manager of the Brandywine funds, a provision was added to the code of ethics requiring advance approval for all trades in the funds' shares by employees. The Longleaf funds added prohibitions on market timing and selective disclosure of portfolio holdings.
And yet several major fund companies -- including Dreyfus and Eaton Vance -- admit that they have not reviewed or revised their codes of ethics since the scandal broke. Perhaps that's because their ethical codes were already so strict that they needed no tightening.
But there's no easy way for investors to be sure, since fewer than half of the firms we surveyed display their codes of ethics on their website or print them in their routinely distributed fund documents. (Surprisingly, Vanguard is among those that do not offer convenient access to the code of ethics.)
Just seven fund outfits -- American Funds, Ariel, Brandywine, Longleaf, Oakmark, Royce and Thornburg -- supplied us with a copy. (see them here.) All the others expect you to hunt down their code of ethics on www.sec.gov.
Actions speak louder
But even Enron claimed to have a moral code; what really matters is not what a company says it will stand for, but what its actions prove it stands for. One of the clearest signs that a firm is on your side is a willingness to close funds to new investors.
That's because taking in unlimited amounts of money will jack up the manager's fee income -- but will often hurt the performance of funds that focus on such less liquid markets as junk bonds, foreign stocks or small stocks. On the other hand, keeping out new investors is likely to improve returns for existing investors -- but certain to reduce the fee stream for the manager.
Therefore, firms that close funds have shown that they have the character to cut their own profits in hopes of raising yours. The kings of closure are Oakmark (with four of seven funds closed to new investors) and Wasatch (with six of nine funds closed even to existing investors). Almost half of the firms in the survey -- 24 -- say at least one fund they manage is closed to new investors.
Unfortunately, that leaves nearly three dozen that may be putting the uninterrupted growth of their own fees ahead of the health of your returns.
The timer temptation
Regulators have alleged that Alliance and Strong welcomed market timers into their mutual funds in exchange for deposits into hedge funds that the two firms also manage. Speculating with borrowed money and charging exorbitant fees, hedge funds can create a conflict of interest.
If a money manager gets a good investment idea, is he more likely to put it into his plain old mutual fund -- or into his hedge fund, where it can earn a higher return (since he can buy on margin) and a fatter fee?
Two companies chose not to tell us whether they run hedge funds. Thirteen firms said they do, including American Express, Franklin, NeubergerBerman, pbhg and Wells Fargo. That doesn't mean these companies aren't to be trusted; it does mean that you have the right to ask what internal safeguards prevent the hedge funds from getting preferential treatment.
Franklin, for instance, says that "to minimize conflicts of interest," its hedge funds are not managed by the same people who run its mutual funds.
We were curious about another underexposed area of the fund business: incubation. In this technique, a fund is set up and run privately; typically, for at least the first year, only the employees of the management company can invest in it.
If the fund's returns are good, it's then sold to the public on the basis of that carefully coddled track record; if not, it's quietly liquidated. Most companies denied ever incubating any funds. Davis said that it had incubated only one; Eaton Vance, Putnam and State Street Research admitted to at least one incubation apiece.
MFS, which has in the past conceded incubating up to eight funds at a time, declined to answer, as did Oppenheimer. (The same two firms were among the few that chose not to tell us how many funds they had created and eliminated over the past decade.)
Is trading fading?
We also wanted to know what steps fund companies have taken to curb trading abuses. The answer: not enough.
Nearly all the firms say they can use fair-value pricing in illiquid markets like junk bonds or foreign stocks. (This procedure updates the prices of securities to reflect news that emerges after the market closes.) But most say it is not mandatory.
And Janus, one of the firms at the center of the trading scandal, says it "does not currently use fair-value pricing as a means to eliminate opportunities for arbitrage." That could leave its funds vulnerable to market timers seeking to trade on, or arbitrage, stale prices.
Six firms say they have the authority to use "delayed" or "confirmed" exchanges to discourage market timers. But only Fidelity and Vanguard said they have done so.
For example, if Vanguard identifies someone as a speculator, the firm can force him to wait up to seven days to move money from one fund to another -- thus making market timing too inconvenient to be profitable. It's an excellent idea that more companies should adopt.
Managing the managers
What about the problem of portfolio managers trading the funds they run? Amazingly, our survey suggests that most companies still do not require employees to keep their fund shares for a minimum holding period.
We can't be sure, since the vast majority of the firms we surveyed refused even to answer the question. According to the handful of companies that responded, fund managers are rarely required to hang on to the shares of their own funds for more than six months at a time.
So when the next flier or newsletter comes from your fund company reminding you about the virtues of "long-term investing," you are entitled to wonder whether the managers practice what they preach. Tweedy Browne told us its employees will soon be required to hold their own funds for at least 180 days -- a lonely step in the right direction.
You might think that if your fund manager gets a great investment idea, the only place it belongs is inside your fund. You'd be wrong. Only two firms -- Janus and Longleaf -- effectively prohibit employees from investing outside each company's funds. (Many others, including American Century, Brandywine and NeubergerBerman, do put severe restrictions on employees' trades.)
Incredibly, only Longleaf and Waddell & Reed have a written policy that requires fund managers to own shares in the funds they manage. Everywhere else, managers are "encouraged" to invest in their own funds -- but until the Securities and Exchange Commission mandates better disclosure, there's no way for you to know how much they've put in. Several firms, however, voluntarily disclosed how much money their managers have put into the funds they run.
We also poked our noses into portfolio-manager compensation. Critics contend that too many portfolio managers are paid based partly on how big their funds get or how much money comes into them. That can lead to a conflict of interest:
While a bigger fund is always better for the management company (which thus earns higher fees), it can be worse for the investor (who often earns lower returns as asset elephantiasis makes the fund less nimble).
At least six firms admitted paying fund managers partially on the basis of fund size or the amount of new money coming in. (More than a dozen others did not answer the question -- including Janus and Strong, where the conflict between fees and returns has been painfully exposed in confidential e-mails released by Eliot Spitzer.)
By law, every publicly traded company must disclose in its proxy statement how much its top executives earn. So fund managers never have to invest in a company whose bosses refuse to reveal their pay. Fund investors, however, have no such luxury.
When we asked how much portfolio managers earn, the fund companies clammed up. "Confidential," they said. "Proprietary.... We do not disclose." At Wasatch, compensation averaged $480,000 in the latest fiscal year; at Weitz, the managers earned an average of $300,000. And that's it.
Out of the 100 biggest fund companies in America, there are only two that are willing to tell you how much your portfolio managers make.
Watching the watchdogs
Next, we wanted to learn about the people whose sole responsibility is making sure that your fund is run in your best interest: the board of directors. If these folks did their job properly, marketing would take a back seat to investing, funds would be closed before they got too big and, above all, fees would be forced down.
Instead, critics contend, directors are overpaid and underworked: They earn fat fees, they barely invest in the funds themselves, and they give scanty attention to dozens of funds. And, skeptics add, boards lack independence -- too many members are relatives of the fund managers, are former executives of the management company or are collecting consulting fees from it.
Ten firms, including Dreyfus, Oppenheimer and Wells Fargo, do have "independent" directors who used to work for the management company. (In an absurd loophole, the SEC permits even a former chairman of the fund manager to be considered independent two years after leaving the firm, although it seems obvious that he might favor the interests of his former employer over those of the fund.)
Do directors oversee too many funds? According to our survey, not one fund family restricts the number of boards on which a director can serve. At American Express that means a single board watches over 64 funds; at Federated, 135; at Fidelity, some 280; at T. Rowe Price, 86; at Vanguard, around 100.
We think American Funds has a better idea: Each of that firm's 15 stock funds has a different board, and no independent director serves on all of them.
How are directors paid? Armada and Brandywine are the only two fund families that pay their directors with fund shares instead of cash. Only eight families require directors to invest a minimum amount in the funds they oversee.
If more funds paid directors with shares and required them to invest their directors' fees alongside the general public, more directors might understand how fund investors expect -- and deserve -- to be treated.
Then, perhaps, instead of acting as though they were employees of the management company, the directors might actually be able to think like owners of the funds. Still, many management firms compensate directors as if they were in-house fat cats.
MFS, Oppenheimer, Putnam, SunAmerica and Waddell & Reed pay pension and retirement benefits for their "independent" directors, while at least six firms offer "optional deferred compensation plans" (tax shelters for directors' pay). Hey, it's nice work if you can get it.
The cost of owning a fund is the single most powerful determinant of its returns. And yet even a glance at the findings of our survey shows that the directors of mutual funds have done an unconscionably bad job of supervising fees and expenses.
More than one out of four of the companies that answered the questionnaire -- 15 in all -- admit that their management fees do not include "breakpoints" that automatically reduce your expenses as the funds grow larger and more efficient. Since it's more profitable for the management company to run a big fund than a small one, why shouldn't it be more profitable for you to own a big fund than a small one?
That can happen only if your fees fall as a fund grows, allowing you to keep more of what it earns. Why is no one enforcing this basic principle of fairness?
Only eight firms, including Fidelity and Vanguard, have "performance incentive fees" that reward the management company for above-average returns and penalize it for below-average results. Such fees give the managers a direct financial incentive to act in your best interest, which makes their rarity that much more disappointing.
It's up to you
You have every right to know more about how your money is managed. Unfortunately, it seems, most fund companies -- despite the obvious lessons of the recent scandals -- just don't get it.
Many firms do have proper and sometimes impressive procedures in place to protect your money. But most of them stubbornly refuse to provide the same sort of information they routinely demand from the companies they invest in.
That needs to change. This survey is the first step in that direction. Your insistence on your own right to know more is the next step, and we hope you will take it.
Reporter associates: Carolyn Bigda, Jonah Freedman, Megan Johnston, Tara Kalwarski, Lysa Price, Farnoosh Torabi, Amy Wilson