Fund scandal perils still lurk

Your Funds

Your Money

September 12, 2004|By CHARLES JAFFE

IT HAS BEEN a year since New York state Attorney General Eliot Spitzer fired the shot heard 'round the mutual fund world.

Though much of the coverage of the anniversary has focused on improvements and changes in the fund industry since the scandals over improper and late trading were uncovered, it's more appropriate for investors to look at what happens next.

What fund investors lost during the scandal was not so much money as it was trust. Reform efforts have focused on re-establishing the faith, but there has been no proof that the changes have improved anything yet.

Fund firms must now disclose the incentives used to determine manager pay, and whether managers are invested in the funds they run, but the information has no real meaning to a shareholder who has never had it before.

Likewise, stiffening compliance efforts and board independence is designed to "prove" that the same mistakes in judgment could not happen again. Only time can prove that.

Here are my forecasts for key events in how this year-old saga unfolds over the next 12 months:

More charges of wrongdoing, most likely tied to trading inside variable annuities.

Some of this has surfaced. Last week, ING Investments acknowledged in filings that it is the subject of a regulatory probe concerning frequent and late trading in funds and variable annuity products. The variable annuity cases will be regulators' second wave.

Unlike the early cases, which slammed entire fund firms, the action now appears to be more isolated, situations where a few brokers or insiders appear to have bent rules to their own advantage.

Again, investors in the affected funds will not have lost much money, if anything, to the wrongdoings, but the likely result is a tightening of trading rules concerning variable annuities.

A test of board independence.

Reform efforts have been focused on giving directors some backbone, but the vast majority will remain invertebrates.

But look for one or two boards to stand up and test the waters, either by making a move to displace managers who have underperformed or to shutter funds that have no reason to exist except for the marketing benefit they create for the parent company.

Proxy fights won't become commonplace, but directors know they need to be prepared to make the effort or face the wrath of civil litigation. That being the case, you can expect a few boards to develop enough backbone to fight management.

The outcome of those cases will determine just how successful the board reforms really are.

A way for average investors to benefit from fund reforms.

The problem with most of the reform efforts is that they have focused on stuff ordinary people won't look at. Only the most dedicated souls will actually go looking through the paperwork to see the manager's incentives or how much money he or she has in the fund.

But the data services such as Morningstar, Lipper and Value Line will develop measures based on these goodies, and that is what will make them useful to the average shareholder. If the data firms fail to develop such information, investors will not come out of "fund reform" with any tangible improvement in how they make decisions.

An attack on 12b-1 fees by boards, regulators and shareholders.

The 12b-1 fee - named for the rule that allows it - is supposed to be for sales and marketing efforts of a fund, with the idea that bringing in more money helps to create economies of scales that make the fund more efficient for all shareholders.

Instead, it has evolved into a trailing commission paid to financial advisers, and in some cases it is paid on funds that have closed to new investors and that are no longer involved in "sales and marketing" campaigns.

Independent board members will have a tough time allowing funds to keep the fees in place on closed funds, regulators would like to scrap the whole idea - though they won't get the job done - and shareholders will file some class action lawsuits making a cash-grab into deep pockets.

The best chance for real reform probably comes from the civil cases. One good win and boards would almost be compelled to respond and protect themselves.

No peace without profits; consolidation of the evildoers.

Investors will not trust fund firms again until management can deliver good profits consistently, which is not likely to happen given likely market conditions over the next 12 months.

Without that, the fund companies that have permanently tarnished their reputations will be looking for mergers and consolidations, secure in the knowledge that the easiest way to change a bad image is to simply acquire or create a new one.

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