What fund investors are wondering now

Your Funds

Dollars & Sense

November 16, 2003|By CHARLES JAFFE

CARRIE is a single, disabled woman from Washington state who has money in the Putnam funds. In that last way, she's similar to Larry from Palm Beach Gardens, Fla., a married retiree who has his life savings there.

They share common questions that have sprung up since Boston-based Putnam Investments was charged in a civil suit by Massachusetts Secretary of the Commonwealth William Galvin.

They're not exceptionally concerned about the departure of Lawrence J. Lasser, the Putnam chief executive who took it on the neck two weeks ago, and they don't, in fact, own funds directly tainted by the scandal.

The U.S. Securities and Exchange Commission announced Thursday a partial settlement with Putnam, which includes the company making significant reforms and establishing a way to repay investors harmed by excessive market timing.

But as they watch billions of dollars in pension and retirement plan monies gush out of the firm, they have some basic fundamental worries:

What happens if the fund management company collapses?

Can a fund go bankrupt?

Will trouble at the management company, or a run on the funds, translate into losses for me?

The structure of mutual funds is what leads to confusion on these basic issues.

When someone buys into the Putnam or Strong funds, they are invested in the fund, not in the management company. The fund is a separate entity.

That doesn't mean that trouble with management won't affect a fund company, but it does mute the effect.

Investors in the fund own their shares, which represent their cut of all of the stocks, bonds or other securities held by the fund. They do not own the fund management firm.

Currently, the most interesting case of what-if in the fund industry revolves around Strong, where company founder Richard Strong resigned from the mutual fund group but remained chairman and chief executive officer of the management firm.

Strong resigned shortly after New York Attorney General Eliot Spitzer said he was considering filing charges against Strong and one other executive for improper short-term trading in the firm's funds.

While those charges have not been filed, let's play the Strong scenario out to its most drastic conclusion, one that sees Richard Strong barred from the asset management business.

If that were to happen - and we are miles from any endgame today, so it is purely hypothetical - it would create a problem, because Richard Strong controls the management company that the funds employ.

Judging from the handful of past events where money management firms have approached going belly up, the funds would see a rescue orchestrated by regulators or the industry, in which a new investment adviser would be appointed and would work for cost - agreeing not to take a profit - until such a time as shareholders can approve the change.

Another, more likely option in the current cases would be for a board of directors to sense impending trouble and to avoid it by appointing new advisers, simply taking the fund to a new manager.

This is why independent directors are so crucial to the fund process, and why so many critics believe they have failed in their job to this point. Because the majority of a fund's board is independent, they should feel no strings tugging at them if they need to make the tough choice to dump the management company.

As a last resort in a management company collapse, investors could see a fund liquidated, in which case the fund would be sold and they would get their share of the proceeds.

But with the health of a fund dependent on the market more than the financial and regulatory state of the management company, closing a fund is unlikely. That makes the worst-case scenario for fund investors a change in management companies, so that the XYZ fund they bought morphs into the new ABC fund and picks up a new manager in the process.

None of those cases trickle down directly to an investor's bottom line. There's no worry of losing everything because of the financial misfortunes of the management company (you could, of course, lose everything if the guys overseeing the day-to-day management of the fund can't invest to save their life, but that's a risk all fund investors share regardless of the management flag that flies over their fund).

Runs on a fund - huge withdrawals of money - can have a more direct impact on shareholders.

Since the charges against Putnam were filed, the firm has seen about $5 billion in pension and retirement plan monies head for the exit. That kind of action can hurt a fund.

Typically, mutual funds keep enough cash on hand to meet ordinary redemption activity. If the amount of money bailing out of a fund exceeds that cash stash plus any new monies being invested - and even in the middle of these crises, many retirement savers are still plugging weekly or monthly deposits into their funds - then management has to liquidate some of its holdings to pay off the departing investors.

Wall Street is notoriously harsh on desperate buyers and sellers. If a management firm comes to market with a lot of stock to sell for no reason other than meeting redemptions, the market will punish the fund by paying low-ball prices.

The result: The fund's net asset value suffers. The effect may be temporary, lasting a few days, or can linger. It's nearly impossible to guess at the impact or even to tell which specific funds are likely to take big hits. Pensions are saying they're pulling money from the firm, they are not identifying which specific funds they have money in.

Other potential direct impacts from the scandals at the management company: the investment talent - the real reason an investor should care about a fund - heads for the door because they see the ship sinking.

That hasn't happened at any of the firms implicated in the current scandals. But if these allegations keep growing, it will be part of the next wave of coverage.

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