Fund Wars A secret battle is raging between fund companies and financial planners--and you may be caught in the crossfire.
By Pat Regnier and Jason Zweig

(MONEY Magazine) – The financial world has a few key power centers: Wall Street in Manhattan, The City in London, Kabuto-cho in Tokyo. And then there's the University Parkway neighborhood in Provo, Utah. That's where two firms specializing in market timing, Paragon Capital Management and Strategic Capital Management, control more than $230 million in mutual funds between them. Over the past few years, these two low-profile firms and hundreds of other market-timing "financial advisers" based anywhere from Long Island to Seattle have burgeoned to become the mutual fund industry's worst and most secret nightmare.

These market-timing firms pool money from their retail and corporate clients, then use that bulk buying power to trade giant blocks of mutual fund shares through discount brokers like Charles Schwab, Fidelity and Waterhouse. It's routine for them to whip millions of dollars in and out of a single fund, often without warning and in a matter of days. Many funds are never invaded by timers. But at funds where timers have struck, managers say this "hot money" disrupts their investment strategies, raises costs for you as a fund shareholder and often creates sudden tax bills.

For their part, the fast-trading advisers make no apologies for what they do, insisting that they are only protecting their clients from volatile markets and inconsistent fund managers. They add that the fund companies are only too happy to take their business in bull markets, and whine about hot money only when the advisers take it away.

Welcome to the war inside your mutual fund. Ask any fund manager what he thinks of the hot-money advisers, and you'd better stand back. "They're evil," growls the manager of an international stock fund. Then he hollers: "They're vermin! They're scavengers! They're dirtbags! I hate them!"

Little has been written about these market timers. But after months of interviews, MONEY has identified more than 100 firms that mutual fund executives and managers say have disrupted their funds by making immense short-term trades over the past few years. Such activity has given portfolio managers fits and may have indirectly lowered your returns. (For the names of 10 big firms, each cited by at least one fund company for fast trading, see the table below.)

You'll hear from a few of these advisers in a moment. They are quite open about what they do on behalf of their clients; it's the fund industry that has swept this story under the rug. The huge fees that the fund companies earn from these hyperactive players--market-timing firms control, by some estimates, more than $25 billion in fund assets--give them so much clout that virtually no fund manager will criticize them in public. Even though the market timers rarely park in any fund for more than a few months, their money easily generates more than $250 million in annual fees for the fund industry. That helps explain why so many leading fund companies have spent millions of dollars from shareholders like you on marketing and promotion to attract the big bucks from the market timers.

As the old African proverb says, "When elephants fight, it's the grass that suffers." With advisers heaving such giant sums in and out of funds, small investors are in constant peril. It's important to emphasize that none of this activity threatens to destroy your fund or wipe out your investments. But as we'll show below, the activities of market timers can take a real bite out of your returns and make it that much harder for your fund manager to pursue his or her strategy. (For more on fund industry troubles, see "Crunch Time" on page 114.)


How exactly do these fund wars hurt investors like you? Let us count the ways.

--They raise your taxes. Last year, fast-trading advisers yanked about $400 million, or a fourth of the total assets, out of one value-oriented small-stock fund over roughly a five-month period. That mass redemption forced the fund manager to sell huge amounts of stock that he would have preferred to keep. Those sales created large capital gains for the fund. As a result, an extra $50 million in taxable capital gains had to be paid out to the fund's loyal long-term shareholders--money that would otherwise have compounded tax deferred for years to come. By MONEY's estimate, these stampeding advisers cost this fund's average retail shareholder $165 in federal tax for each $10,000 invested in the fund.

--They raise your costs. When a fund sells securities to meet a redemption, its trading costs--brokerage commissions, bid-ask spreads and the like--are paid not by the redeeming shareholder but by those who stay. That's why the advisers we met say they prefer trading no-load mutual funds, which they pay nothing to buy or sell, to trading stocks, for which they would incur costs on every order. But someone has to pay the piper whenever big advisers force a fund to sell some of its holdings--and that's you. According to the trading-costs consultants at Plexus Group in Los Angeles, it often costs a fund at least 1% of the proceeds when it sells a stock--a direct hit to your return. "If I have to sell into a falling market," complains one fund manager, "and my loyal shareholders have to pay the freight for the market timers who leave, that really hurts."

--They lower your returns. The golden rule of investing is to buy low, sell high. But hot money makes it harder for your fund's manager to do that. Last August, when bond prices were crashing worldwide, the manager of a new high-yield fund was eager to buy more bonds at bargain prices. But at that very moment several advisers yanked out $2 million--more than a tenth of the fledgling fund's total assets. Instead of being able to snap up bargains for the long term, the manager had to sell stock to meet redemptions. "At just the time when we would have most liked to be buying," the manager recalls sadly, "the fund did not have enough cash left to work with."

The manager of a European stock fund recalls that as European stocks went into a temporary funk in the summer of 1996, "nearly a third of the fund's assets flew out the door in four weeks." Then Continental markets came roaring back--but thanks to the massive redemptions from market timers, the fund manager had no cash left to put to work.

Martin Whitman, manager of Third Avenue Value Fund, sums it up: "These people take money away from us when we could most use it, and they give us money when we have no good place to put it."

In addition, many fund managers say, they are forced to "keep their powder dry." Since they never know when an adviser may snatch a few million dollars out of a fund, they are compelled to keep more cash on hand than they otherwise would like--and that protective cushion dampens your return whenever stocks and bonds outperform cash, which is most of the time.

Along with keeping extra cash on hand, many managers of funds specializing in small companies, emerging markets or high-yield bonds say they must concentrate more of their money in the most frequently traded securities in these illiquid markets so that they can more readily raise cash to meet a rash of redemptions from big advisers. The need to favor more active issues, though, can prevent a fund manager from investing in the less popular securities that, over time, may well generate higher returns.


What do the advisers have to say about all this? They claim the fund managers are crying crocodile tears. None of the advisers we spoke with seemed the least bit embarrassed to learn that the fund companies have fingered them as fast-money men. Many were eager to complain about the funds that have blacklisted them, and--unlike most of the fund managers--all were happy to register their grievances on the record.

Market timer may be a term of derision inside the elite money-management shops of Boston and Manhattan, but most of these guys--and they are nearly all guys--wear the label proudly. (Some prefer to call themselves "dynamic asset allocators," but that's just market timers by a longer name.) Instead of signing on with mainstream professional planning organizations such as the National Association of Personal Financial Advisors (NAPFA), many are members of a smaller club called the Society of Asset Allocators and Fund Timers Inc. (SAAFTI, pronounced safe-tee).

The big timers pile into funds when their charts, computer models and other indicators say the markets are strong, and they cut and run at the first whiff of weakness. They argue that their rapid-fire moves effectively shield their deeply risk-averse clients--often retirees who might otherwise leave their money to languish in money-market funds or CDs--from the painful short-term volatility of the equity markets. "The buy-and-hold mutual funds won't manage market risk," says Dennis Slothower, president of Strategic Capital Management in Provo. "It's managers like me who come in and do that."

Around the corner and up the road a bit from Strategic's modest office, David Allen Young of Paragon Capital Management sounds a similar note. "When the market goes through a 30% or 50% decline, maybe it won't look so noble to sit there with your eyes closed, holding on to your funds," he says. As a none too subtle reminder to his clients that such a bear market disaster is a real possibility, Young displays in his office a 9 1/2-foot stuffed grizzly--he killed it himself in Alaska.

Whether timers like Slothower and Young are really doing their clients a service is debatable; many of the world's leading financial experts contend that market timing is futile. But the real issue here is not the effectiveness of market timing but the indirect harm such rapid trading inflicts on the rest of us shareholders.

There don't seem to be many guilty consciences among the big market timers. "It disrupts [the funds] to some extent," admits Young, who says he has a person on his staff who serves as a liaison to fund companies. "But my attitude is 'if you can't take the heat....'"

Slothower of Strategic Capital goes further and bats the blame right back at the fund companies themselves. "We've got a real conflict here. The fund managers say they love 'buy and hold,' but that's only because they get to hold on to the money," says Slothower. "A lot of fund companies accept our money no questions asked, but then when the market turns down and we [redeem shares], they call us and say, 'We don't like your business.' "

Slothower, whose idea of a long-term holding period is months, says he's up front with fund companies about his approach and tries to avoid firms that don't like rapid-fire trading. But he doesn't always know which companies will object when he dumps their funds. He recalls a recent tiff after he turned a quick round-trip trade at the Berger Funds: "They just called us...and said we can't use their fund."

Paragon's Young, a former professional magician who's pulled a $4 million disappearing act with some funds, adds that many firms can be downright two-faced about trading. "One person at Strong Funds is telling you they don't want your business," he says, "while at the same time a salesman is trying to get you in." James O'Connor of $250 million BG Associates in Phoenix recalls being booted out of Cohen & Steers Realty after making a large sale, only to have one of the firm's salesmen buttonhole him at a conference sponsored by Charles Schwab and beg O'Connor to come back in. Executives at both Strong and Cohen & Steers say that they would never knowingly solicit money from rapid traders.

In any case, there's no reason to assume these warring armies will make peace any time soon. For investors, the struggle between portfolio managers and market timers is going to remain an unfortunate part of life. Again, we want to emphasize that this doesn't change the fact that mutual funds remain the best way for most investors to capture reasonable returns without excessive risk. It does mean, though, that you do need to choose funds more carefully.


Here are some things you should know that can protect you from becoming a casualty of this power struggle.

--Fund companies that do not participate in the "no transaction fee" fund-trading programs of discount brokerages--Vanguard, T. Rowe Price, Acorn and Longleaf, among others--are largely shielded from the fund wars.

--The market timers themselves told MONEY that several firms fight with special ferocity to keep them out; Baron, Oakmark and Montgomery have bad reputations among timers, a fact that should be reassuring to more patient investors in those funds.

--Redemption fees--the sales charges levied on people who hold a fund for less than a minimum period, often 180 days--tend to keep timers out. Plus, the fees go back into the fund, not to the fund company. And precisely because of the war over market timing, more and more funds are instituting these fees, as Oakmark did in July.

--Hot performance streaks, typically enjoyed by funds that buy more volatile investments like small stocks, foreign stocks or junk bonds, quickly draw fire from the market timers. Today when you buy a hot fund, you face not only the traditional danger that it will go cold on you but also the new danger that market timers will rampage through it, wrecking your investment return and inflaming your tax return.

--Conversely, funds with a history of generating consistent, moderate returns rarely attract the attention of the big hot-money crowd.

--Index funds based on broad benchmarks like Standard & Poor's 500, the Wilshire 5000 or the Russell 2000 tend to be relatively free from invasions by market timers.

--A big fund--with assets of $5 billion or more--typically is unlikely to suffer much damage from market timing, since even a $50 million redemption would not exceed 1% of the fund's total assets. (Of course, big funds have other drawbacks, including less flexibility in trading.)

--Call a fund's toll-free number and ask the representative if the prospectus allows the portfolio manager to cash out redeeming shareholders with a "payment in kind." This option, which usually covers only redemptions that exceed $250,000, enables the fund to meet withdrawals not with cash but with proportional amounts of every stock in the portfolio. This provision is almost never used, but the mere threat of ending up with, say, 11.794 shares of a Malaysian sewer company instead of cash may be enough to keep some timers out of the fund.