Fund Firms in Scandal Feel Loss

Mutual fund firms caught up in the industrywide trading scandal are scrambling to regroup and earn back the confidence of investors. Experts say that won’t be easy.

Fund companies that have made headlines in recent months for all the wrong reasons -- probes into trading abuses -- must grapple with management shakeups, investors deserting with their money and brokers shifting clients to other funds.

“Those firms that had a strong brand name and a major media presence, like Putnam and Janus, have gotten hurt especially hard,” said Lars Schuster, an analyst at consulting firm Financial Research Corp. in Boston, citing two of the largest fund companies to draw regulators’ attention over alleged trading abuses.

With the 2000-02 bear market and a horde of Wall Street scandals fresh in the minds of investors, some shareholders and investment professionals were quick to cut and run rather than take any chances when disclosures of trading abuses became public in September.

Overall, firms mired in the controversy were hit with an average of $10.7 billion in net withdrawals from their stock and bond funds over the last four months of 2003, according to the industry’s chief trade group, the Investment Company Institute.

As least 20 mutual fund companies have been sued by regulators or have come under investigation, and executives at firms such as Putnam Investments, Strong Capital Management Inc., MFS Investment Management and Pilgrim Baxter & Associates Ltd. have been ousted.

And a look at investment returns at the scandal-tainted firms this year doesn’t inspire much shareholder confidence.

In a sampling of 16 stock funds that have been mentioned prominently in state and federal probes, 11 lagged behind the average return of their Morningstar Inc. category in the first quarter.

Strong Growth, for example, gained 2.2% in the quarter, versus a gain of 3% for the average large-cap growth stock fund. Columbia Young Investor rose 0.5%, versus a gain of 1.8% for the average large-cap “blend” fund, which holds a mix of growth and value stocks, according to Morningstar data.

Both funds also fared poorly against the broader Standard & Poor’s 500 index for the six months ended March 31. Strong Growth rose 10.2% in that period and Columbia Young Investor gained 12.7%, while the S&P; climbed 14.1%.

Should investors stick with -- or venture into -- firms touched by the scandal?

Some experts urge caution.

One of the biggest potential problems for troubled funds is redemptions, or the removal of funds.

Two things happen when more money is pulled out of a fund than is invested. One, managers have less money available to place bets on risky stocks that offer potentially big payoffs. And two, managers are typically forced to keep money on the sidelines to meet future outflows, rather than remain “fully invested” in the market like most of their peers.

When the market is moving up, that cash on the sidelines is like an anchor -- dragging down the fund’s overall performance.

What’s more, investors in a fund with a diminishing asset base could face a higher expense burden that might eat into returns. Costs are shared by all investors, so those stuck in shrinking funds are likely to be paying relatively more for overhead. And liquidating stocks to meet redemptions generates extra commission costs.

“It’s appropriate for investors to say, ‘Forget it, I’m not going to wait around. I don’t want to be a guinea pig in the scandal experiment,’ ” said Roy Weitz, editor of FundAlarm.com in Tarzana, an industry watchdog.

Still, analysts note that some of the firms under fire have taken strides to show that they place shareholders first, which might help them weather the controversy.

Putnam Investments, for instance, recently froze its expense ratios on all international stock funds as a way to reward shareholders who keep their faith in the firm, said Stephen Oristaglio, co-head of investments at the Boston-based industry giant. Rapid “timing” trades in the firm’s foreign funds were the subject of a recently settled Securities and Exchange Commission case.

Timers dart in and out of mutual funds, hoping to exploit small price movements. Though not necessarily illegal, the tactic is usually discouraged or prohibited by fund policy because it can siphon profit from ordinary shareholders, in part by driving up transaction costs.

“Putnam is one company that has owned up to its mistakes, brought in new management and tried to make things right,” Schuster said.

In November, Putnam replaced Chief Executive Lawrence E. Lasser with Charles “Ed” Haldeman Jr., a 30-year industry veteran.

Among other reforms, the firm has initiated a redemption fee on short-term trading and enhanced its “fair-value pricing” mechanism as a way to discourage timers who might try to exploit stale fund prices, Oristaglio said.

He acknowledged that the scandal had been a “distraction” within the firm but said, “Morale is good, ironically.” As for investors, their net outflows have slowed in the last two months, Oristaglio said.

Analysts agree that the buy-sell-or-hold decision investors face is, to a large degree, personal.

“The ethical judgment is up to the individual,” said Don Cassidy, senior research analyst at Lipper Inc. in Denver.

The alleged lapses vary widely, he noted. Firms such as Putnam, Pilgrim Baxter and Strong have taken heavy heat because authorities say portfolio managers or senior executives engaged in timing trades -- in effect, trading against their own customers -- whereas other firms allowed outside timers, perhaps inadvertently.

(Putnam has settled SEC charges without admitting guilt. Pilgrim Baxter said it was cooperating with regulators but disputed some of the allegations and conclusions in state and federal civil fraud claims. Strong, like Janus Capital Group Inc., has not been charged with wrongdoing, but it says it is working to resolve “outstanding mutual fund trading practices issues.”)

In another caution against selling rashly, Cassidy noted that longtime investors who sell in protest might generate taxable gains. And if their 401(k) retirement account has only one fund family, it may make more sense to stick with Brand X than to ditch the plan, losing the tax deferral as well as the company match, he said.

And then there is the fact that the scandal is still unfolding. Cassidy said Lipper’s research has turned up something else to consider: Based on his analysis of redemption activity during 2003, an additional 15 to fund companies could be implicated in the timing scandals, he said.

“You wouldn’t want to go from the frying pan,” he said, “into the fire.”

*

(BEGIN TEXT OF INFOBOX)

Tainted funds

Here is a look at performance of selected mutual funds that have been investigated for questionable trading practices.The scandal surfaced last fall, and performance is tracked for the last two quarters (Sept. 30 to March 31) and for the preceding four years. For comparison, the Standard & Poor’s 500 index and the Russell 2,000 index of small companies are included.

*--* Last Prior

two four Parent Fund quarters years Pilgrim Baxter PBHG Growth +10.0% -30.7% Putnam Putnam Europe Equity +18.0 -21.0 Investments Strong Capital Strong Growth +10.2 -17.2 Bank of America Nations International +22.1 -15.2 Equity FleetBoston* Columbia Young Investor +12.7 -32.9 S&P; 500 +14.1 -17.8 Russell 2,000 +21.7 -20.9

*--*

*Now Bank of America

Source: Bloomberg News