2003 mutual-fund scandals an affront to small investors

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2003 mutual-fund scandals an affront to small investors
Dishonest deals particularly stung ordinary Americans

By John Waggoner, USA TODAY

January 1, 2004

If investors learned one thing in 2003, it's that even the most trustworthy companies aren't above suspicion.

When the Internet bubble burst, most people were disappointed, but not surprised. In the cold light of day, buying pet food via the Web probably wasn't the best idea.

And when the government settled with brokerage firms for selling tainted advice, old investment hands giggled privately. They were shocked — shocked! — to learn that there were conflicts of interest on Wall Street.
But when New York Attorney General Eliot Spitzer leveled charges of trading improprieties at mutual funds, investors really were stunned. The mutual-fund industry was supposed to be different. It was supposed to give a small investor the same treatment as the swells. Some funds, however, sold out their investors for a few big clients.

If there is hope for Wall Street and the fund industry, it's that reform follows in the wake of collapse and scandal. The Great Crash in 1929 and its aftershocks in the 1930s brought wide-ranging reforms, as did the bear market of 1973-74. The 2000-02 bear market, second only to the decline during the Great Depression, may bring new reforms too. But if Wall Street wants to figure out how to regain trust, it can't rely on legislation alone. It will have to make amends to the small investors. And there's a potential bonus there too: Eventually small accounts grow large, if they're managed skillfully.

Wall Street is plagued by scandal because it's where the money is. Money attracts robbers. Scandals go with the territory. But rarely has the territory been so filled with small investors.

Wall Street began to attract middle-class investors in the 1980s, when inflation devastated traditional pension payouts. To retire comfortably, investors needed higher returns.

Wall Street seemed to welcome them. Brokerage commissions were deregulated in 1975, opening the way to discount brokerages, which let investors trade stocks for a fraction of what it would cost through full-service brokers. Mutual funds began shedding sales charges, or loads, and marketing themselves directly to individual investors, not just through brokers.

Money poured into stocks and mutual funds at a torrential pace. Mutual-fund assets soared from $135 billion in 1980 to $7 trillion in November. Stock ownership jumped up from 19 percent of U.S. households in 1983 to 50 percent in 2002, the latest figures available from the Securities Industry Association.

But the new wave of middle-class investors ran squarely into the time-honored Wall Street tradition of sticking it to the little guy. The retail investor, as opposed to big, institutional investors, has always been lowest on the food chain. Big institutional accounts normally got Wall Street's best research, its cheapest commissions and fastest execution. And despite the flood of money from small accounts, Wall Street was unable to overcome tradition. When the bull market ended in March 2000, the scandals started to unfold, and many of them hit small investors the hardest; Merrill Lynch, Enron, Imclone and HealthSouth all were implicated.

But the mutual-fund trading scandal showed clearly just how callous Wall Street could be. Some fund companies allowed large clients to make rapid, in-and-out trades in the funds. That's not illegal. But the same fund companies clearly stated in their prospectuses that they wouldn't tolerate rapid-fire trading. Making exceptions for big clients is illegal. And some companies also let clients buy shares at the 4 p.m. closing price after 4 p.m., and that is illegal.

The fund-trading scandal marked a new low for Wall Street, even worse than the pump-and-dump tactics employed in the mania for initial public stock offerings in the 1990s. "It's hard to feel sorry for people who bought some stupid dot-com stock," says Joe Nocera, an observer of the financial world whose book, "A Piece of the Action," captured the middle-class embrace of Wall Street. After all, Wall Street had always preyed on naive speculators.

Funds were supposed to be better. "Mutual funds were supposed to be the honorable alternative — they would let you give your money to a professional, who would manage it well on your behalf," Nocera says. That just wasn't the case, says Massachusetts Secretary of State William Galvin, who uncovered market timing by Putnam portfolio managers this fall. "The funds said, 'We are all in this together. You can trust our competence,'" Galvin says. "What they delivered was deceit and underperformance."

Robert Olstein, who blew the whistle on some of the 1990s' shadiest accounting, says that Wall Street seems to be cleaning up its act. "Right now, there's more clean accounting than there has been in prior years," says Olstein, whose mutual fund, the Olstein Financial Alert fund, looks for stocks of companies with clean balance sheets. Both Congress and the Securities and Exchange Commission are likely to pass new, more stringent laws to keep Wall Street in general — and mutual funds in particular — more honest.