Is the Fund Industry Toying With Its Integrity?

As competition in the mutual fund business grows increasingly intense, more players in the industry appear willing to sacrifice integrity in the name of performance.

For a $2-trillion business built on public confidence, this trend is disheartening at best and downright dangerous at worst.

So far this year, the industry’s drift has been apparent in allegations of insider trading by fund managers, unsavory fund sales practices at banks and the use of high-risk securities in normally conservative money market funds.

And in the latest blow to public confidence in the funds, someone at industry titan Fidelity Investments decided last Friday to send newspapers Thursday’s prices for most Fidelity funds because the Friday data wasn’t ready.

In the ensuing public humiliation suffered by Fidelity this week, as it was forced to ‘fess up to its intentional mistake, the firm has emphasized that nobody bought or sold a fund direct from Fidelity at the wrong price.

Though newspapers last Saturday unknowingly listed Thursday prices for about 150 of Fidelity’s 208 funds, the firm says transactions effected Friday were made at the correct prices, which Fidelity got after it met newspaper deadlines with the wrong data early Friday evening.

But that doesn’t change the fact that most Fidelity shareholders were lied to, in varying degrees, if they looked at their fund prices in newspapers last weekend. For most funds, the difference between the true and incorrect price was less than 1%, but a wrong number is a wrong number.

The unidentified Fidelity employee who made the decision to go with incorrect prices should simply have listed them as “not available.” That would be standard Fidelity procedure, said Jane Jamieson, senior vice president at the Boston-based company. “This was an error in judgment on our part,” she said. “We have taken several steps to ensure that it doesn’t happen again.”

Fidelity’s mistake and most of the fund industry’s self-administered black eyes this year have one thing in common: They could have been prevented if the employees involved were playing by the rules--either the fund companies’ internal rules or the “prudent man” rule that is supposed to govern the investment of money entrusted by the public to allegedly professional money managers.

The problem is that it can become very tempting to bend or break the rules in the name of staying “competitive.”

Take Fidelity’s case: Someone there had to make a fast decision when a software problem resulted in botched fund prices last Friday, shortly before the company was due to report the day’s data to newspapers. Had Fidelity provided no prices for most of its funds, it would have appeared to be having a problem that wasn’t shared by other fund companies (which, of course, was true).

Moreover, investors who compare fund prices and performance by using weekend newspapers would have had little data on Fidelity funds, perhaps costing Fidelity some new investment.

Fidelity won’t say what motivated the employee who made the decision, but it’s hard to imagine that the issue of competition wasn’t involved somewhere along the line.

In the same way, competitive pressures have figured prominently in the brouhaha over sales of funds by banks. State regulators charged earlier this year that many conservative bank customers who were buying fund shares from bank salespeople had no clue about the risk and weren’t being adequately educated by the salespeople.

Yet many mutual fund companies that had partnered with the banks insisted they could do little to control the transactions beyond providing “clear” warnings of risk in fund literature--which, unfortunately, we know that many eager fund buyers don’t read or comprehend thoroughly.

Some regulators argued that a bank lobby was no place to sell uninsured mutual funds and that the uninformed customer today would be a litigious customer tomorrow, when his or her fund shares suddenly lost a big chunk of their value in a market downturn.

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But as burgeoning fund companies battle for market share, creating new funds at a blistering and unprecedented pace, the risk of taking on the uninformed customer has been outweighed by the near-term profit potential--in the form of management fees and commissions on new money.

“There’s a pattern here, and it’s changing the whole dynamic of the business,” worries one former fund executive who requested anonymity.

Certainly, some growing pains in this now-gigantic industry were unavoidable. The bigger the business gets, the greater the potential for problems, either within formerly small and relatively easily managed organizations or at the fringe, with the entry of so many new fund players.

“This business is so large now that you’re naturally going to have some stupid people doing stupid things,” says Kathryn McGrath, a Washington lawyer who oversaw the fund business for the Securities and Exchange Commission in the 1980s.

What she worries more about, McGrath says, is the potential for a large contingent of the industry to lose its traditional tendency toward overcautiousness, a quality that helped keep the business remarkably clean for most of the last 50 years--unlike the banking, brokerage and S&L; businesses.

“It used to be that the fund industry was good and scared,” McGrath says. “They’d call the SEC before they’d do anything” that might appear at all questionable. Now, she says, the risk is that too many funds “feel as if they’re too smart.”

The great danger is that public confidence in the funds may be slipping, a victim of so much recent bad publicity. And in the financial services business, confidence ultimately is all there is between prosperity and ruin.

Is this overstating the case? Most fund executives would probably say so. “I don’t believe there is an erosion of public confidence in this industry,” says Matt Fink, head of the Investment Company Institute, the funds’ chief trade group.

He argues that the industry continues to police itself well, this year’s controversies notwithstanding. Moreover, several fund companies’ recent decisions to cover money market fund losses caused by so-called derivative securities demonstrate the industry’s commitment to keeping public confidence, Fink and others say.

But fund shareholders might ask a more basic question: Why were normally conservative money market funds investing in derivative securities in the first place? The answer, naturally, has to do with performance and the need to stay competitive--perhaps too competitive.

Standard & Poor’s Corp., which rates the quality of 200 money market funds, this week announced that it may downgrade the AAA rating of BankAmerica’s Pacific Horizon Government fund, depending on the fund’s ability to reduce its exposure to derivative securities in the portfolio. In May, BofA spent $17.4 million to cover derivative-induced losses in one of its other money funds.

S&P; analyst Sandy Bragg says money funds have felt compelled to cross into the risky territory of derivatives to try for an edge over competitors. “The environment they’ve been in is such that getting a few extra basis points in yield means a lot” in marketing a fund, Bragg says.

As it turns out, those few extra points are costing some fund players dearly, financially and image-wise. An early warning for the entire industry?

Margin of Error

Here are some of the Fidelity funds whose June 17 prices were incorrectly reported by Fidelity, the true prices and the incorrect prices’ percentage differences from the true prices.

June 17 NAV per share: Pctg. Fidelity fund Original Corrected error Small Cap $10.28 $10.18 +1.0% Magellan 67.18 66.62 +0.8 Select Auto 23.25 23.16 +0.4 Hi Yield 12.14 12.09 +0.4 Equity Income 32.83 32.72 +0.3 GNMA 10.34 10.32 +0.2 Canada 16.89 16.93 -0.2 Emerg. Markets 16.52 16.61 -0.5 Japan 14.59 14.76 -1.2

Source: Fidelity Investments