Mutual Fund Woes Go Beyond Latest Scandal

New York Atty. Gen. Eliot Spitzer may or may not have uncovered a widespread scandal within the mutual fund industry, based on the investigation he announced this month.

But for certain he has caused the $6.9-trillion business to take a long look in the mirror. And some of the industry’s major players don’t like what they see.

Whether a number of fund companies allowed well-heeled investors to engage in illegal or improper trading games, as Spitzer alleges, may be a minor problem compared with industry issues that have been building for years, and that are potentially far more troubling for the future of the business.

When they speak frankly, fund company veterans worry that the industry has lost its way, or at least its focus on the individual investor.

They’re afraid that the business has been co-opted, or even corrupted, by its own aggressive marketing, and by an increasing reliance on third-party distributors -- middlemen such as brokers, for example, and company-sponsored retirement plans.

The industry believes it is unfairly under siege on the issue of fees, including the costs investors pay to buy funds and the ongoing costs they pay for the management of the portfolios. Unfair or not, that siege isn’t likely to end soon, and may worsen if markets have entered a long period of sub-par returns.

Meanwhile, competition for traditional mutual funds is rising from new products and services that seek to give investors the same or better diversification afforded by funds, but at lower cost or with the kicker of providing the client with more control over the underlying portfolio.

“I think the fund industry has been out of touch with the growing dissatisfaction by investors and financial advisors,” said Don Phillips, a principal at fund tracker Morningstar Inc. in Chicago.

It’s hardly a surprise that the fund business presents an attractive target to its detractors and its competitors. A $6.9-trillion pile of assets is hard to miss.

What’s more, nearly 50% of all U.S. households own at least one mutual fund, up from fewer than 31% as recently as eight years ago and about 6% in 1980, according to the Investment Company Institute, the funds’ chief trade group.

“Mutual funds have penetrated almost as deeply into the marketplace of American investors as they can,” said Matthew McGinness, associate director at financial-services industry research firm Cerulli Associates in Boston.

That’s debatable, of course. Several times in the last 15 years alone it was widely predicted that the industry had reached a plateau. Instead, assets continued to balloon.

As the 1990s began, few people on Wall Street foresaw the stock market’s unprecedented rise. The fund industry was the natural beneficiary of that boom because it offered investors an easy way into stocks.

It still does: As the equity market has recovered this year, investors again have become net buyers of stock funds, after shying away from new purchases for much of 2002, as the bear market raged.

From April through July the funds saw their biggest net cash inflow of any four-month period in three years. Stock funds’ net inflow in July alone was $21.4 billion, according to Investment Company Institute data.

When they weren’t buying stock funds in the last few years, many small investors were shoveling cash into bond funds, generating record inflows for that segment of the business.

So it would be a gross exaggeration to say the public overall is hopping mad at the fund industry. People may be troubled by certain aspects of the business, and Spitzer’s case may make some wonder if they’re getting a fair shake, but so far there hasn’t been an exodus by small investors.

Yet the smartest managers in the industry know there’s no good reason to tempt fate. They also acknowledge that the price they’ve paid for the spectacular growth of the last decade has been the triumph of marketing, at some expense to the industry’s long-standing reputation as a fiduciary -- an entity that is entrusted to hold the public’s money, and confidence, and to always put clients’ interests first.

The primacy of the marketers, critics say, is what brought the explosion of fund flavors in the late 1990s -- the many ill-fated sector funds that focused on technology stocks, for example, and the various share classes that have allowed brokers to sell portfolios whose long-term costs to the investor may not be readily apparent.

Marketers are charged with finding ways to bring more capital to a fund company, because more capital means more management fees and opportunities to sell investors other products.

There’s nothing illegal about marketing. This is America, after all. But a financial fiduciary is supposed to ask the question: “Are we helping the client in the long run, or are we just enriching ourselves in the short run?”

The federal Investment Company Act of 1940, which created the modern fund business, is unambiguous in requiring that the investors’ needs come first. The tough regulations in that law are what have kept the fund industry largely scandal-free, as it has often liked to remind the press and the public.

But in the last decade or so, “I think the marketing people have run amok in the business,” said Roy Weitz, an industry watchdog who operates the Web site fundalarm.com. “We’re talking about aggressive people who are looking for every small advantage” to boost their own business.

The desire at some fund companies to find “every small advantage” to make money could be behind the abuses that Spitzer alleges. He accused a private hedge fund of striking deals to illegally or improperly engage in “market-timing” trades of fund shares at Bank of America Corp. (the Nations Funds), Bank One Corp. (One Group funds), Janus Capital Group Inc. and Strong Capital Management.

In return, Spitzer said, the hedge fund agreed to bring other fee-generating business to the mutual fund companies.

At the highest levels of the fund industry now -- and particularly in the executive suites of the biggest players -- there is plenty of praying that Spitzer’s case doesn’t extend much beyond the companies he has already named.

Even for the vast majority of people who aren’t thinking much about these issues, a basic sense of confidence in the fund industry’s integrity is what keeps them invested. Chip away at that confidence for long enough, and it might change what people are willing to do with their savings.

“Our biggest asset as an industry has been that confidence that comes from our clients,” said Jack Brennan, chairman of Vanguard Group, the second-largest fund company.

The Investment Company Institute’s board is trying to show that it’s out front on this issue.

Last week, the board published a “statement on the fiduciary obligations of mutual funds to individual investors,” addressing the Spitzer case. The board pledged to take “whatever steps are necessary” to make sure that its members comply with regulations that prohibit favored investors from rapid trading of fund shares that could hurt longer-term investors’ interests.

For some in Congress, that may not be enough. A bill that is being pushed by Rep. Richard H. Baker (R-La.) would force fund companies to boost disclosure of certain practices and increase oversight of fund operations, including by requiring the hiring of compliance officers.

Sen. Richard C. Shelby (R-Ala.) also may weigh in. He will hold a hearing Tuesday on fund practices.

The fund industry has been combative in the past when Congress or the Securities and Exchange Commission have tried to impose new rules on certain aspects of the business.

But now, “They’re going to have to be very careful about the issues they oppose,” said Geoff Bobroff, an independent industry consultant in Rhode Island.

Some critics say the Investment Company Institute wasted too much political capital over the last year trying to stymie proposals that individual funds disclose the names of all the stocks they own more often than the current requirement of twice a year, and that funds disclose how they vote their shares on proxy ballots at the annual meetings of the companies in their portfolios.

The funds argued that more disclosure was either unnecessary or anti-competitive, or both.

To Morningstar’s Phillips, however, “They’ve spent time and energy defending their weakest practices.”

More than likely, most fund investors probably don’t care how funds vote their proxies. Over the next decade, however, more investors probably will begin to care about how much they’re paying to own mutual funds, and whether their returns are commensurate with the costs.

Fund expenses are the industry’s single biggest challenge -- in terms of justifying them and keeping them under control.

Fund fees are incurred at three main levels: Investors often pay a commission to buy fund shares, if they use a broker or other intermediary; they pay an annual management fee to the fund company, deducted directly from fund assets; and they may pay an ongoing fee (also automatically deducted from the portfolio) to pay a fund’s various annual distribution and marketing costs, including broker compensation.

Relatively few fund sales these days occur directly between the fund company and the investor. The majority of investors buy from a broker or financial planner or through company-sponsored retirement plans.

The continuing decline of direct sales has meant a loss of control for the fund companies. They often don’t know who their customers are, because individual accounts are lumped into “omnibus” accounts.

That complicates the issue of fee disclosure. Critics who say the industry should say in account statements exactly what dollar amount of fees an individual investor has incurred aren’t appreciating the complexity of that equation, fund industry veterans say.

What’s more, the dominance of the intermediary means the funds’ own image is, to a large degree, at the mercy of that intermediary.

In many cases, “There’s very little the fund company can do to contact their own investors,” said Cerulli’s McGinness.

One ugly issue that has concerned regulators this year is brokers’ sales of so-called class B fund shares, which don’t levy upfront sales charges but instead raise the marketing fee (known as the 12b-1 fee) that is deducted every year from fund assets. Some of that fee goes to compensate the broker every year.

Over time, that can mean that an investor’s total cost of owning those shares may be far higher than if he had simply paid a one-time, upfront commission.

Many fund industry critics also say that 12b-1 fees, which averaged 0.43% of fund assets in 2001, according to the Investment Company Institute, have become abusive because some fund companies are charging investors for marketing expenses that shouldn’t be investors’ costs.

The industry has long been sensitive to the fee issue but has perennially argued that investors are getting a good deal -- professional management in a diversified portfolio -- for annual fees that typically total between 1% and 2% of fund assets.

It’s also true that the fund industry already discloses far more about its costs than do most other financial services companies. Banks, after all, aren’t forced to explain to depositors that they could earn higher yields if only the bank didn’t take as much in profit.

“People focus on our costs because they’re transparent,” said James Riepe, co-vice chairman at T. Rowe Price Associates.

Nonetheless, as an industry veteran, Riepe said he recognized that though funds arguably have been held to higher standards, to a large degree that explains their success over the last 60 years.

What about the next 60 years? If the Spitzer case blows over, the question for the industry will shift back to the fundamental one: Does the public believe that mutual funds offer not just integrity but also good value?

Many competitors are gunning for the industry’s best clients. Some brokers tell fund investors that a portfolio of individual stocks can provide adequate diversification and an element of control that funds can’t (on taxation of capital gains, for instance, or in structuring a portfolio of dividend-paying shares).

Lower-cost competitors are available in exchange-traded funds, portfolios that have been proliferating in recent years.

But it may be that nothing will focus investors on the fund fee issue like a long stretch of low returns in the stock market and relatively low yields in the bond market. A 1.5% annual fund management fee may not hurt much if the fund is earning 18% a year. If it’s earning 6% a year, that 1.5% takes a far bigger bite.

Most fund companies aren’t willing to get into a public debate about their fees. But they know what their critics say, and they know the challenge they will face if competition rises while market returns don’t.

“Fees are going to come down. They’re going to have to come down,” said Vanguard’s Brennan. “The investor eventually is going to notice.”

Tom Petruno can be reached at tom.petruno@latimes.com.