Investors' worry: Will Spitzer point at my fund?

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Investors' worry: Will Spitzer point at my fund?

Christine Dugas and John Waggoner, USA TODAY

November 17, 2003

Snowballing scandals in the $7 trillion mutual fund industry are prompting disgusted investors to dump funds.

While defections haven't made much of a dent in overall fund holdings, investors are transferring millions of dollars in assets to fund firms that haven't been tainted by scandal. Some are shifting to alternative investments such as individual stocks. And others are having funds dumped for them as retirement plans, financial advisers and college 529 savings plans ditch tainted funds.

After years of corporate corruption, brokerage scams and accounting shenanigans, the mutual fund trading scandals have been especially hard felt. Mutual funds, after all, have long been advocated as one of the best investment choices for small investors for their diversification and management expertise. But investors are getting a fresh lesson from Wall Street: Mutual funds can siphon off money just as easily as CEOs can.
How investors are reacting:

•Susie Cooke pulled her money out of Janus funds and is planning to dump her other mutual funds — except those in her retirement plan.
"I prefer to buy and sell stocks where the commissions are out in the open," says Cooke, who teaches computer science at Hillsborough Community College in Tampa. "There are too many mutual funds these days, and I find it hard to determine a good one from a bad one."

•Ted Cartwright wants the fund industry wrongdoers to go to jail and their assets seized. "I know that several executives and others are losing their jobs, but this is not enough," says Cartwright, who lives in Centreville, Va., and works in government relations.

Cartwright says that when he moved his wife's Roth IRA out of Janus funds, he called and wrote the company to say "that I would not be back — ever."

•Robert Tanner, a retiree from Portland, Ore., says he switched to individual stocks awhile ago because he doesn't like fund fees. Now, in light of what's going on, he says, "I would never trust my money to a fund manager again. There are just too many opportunities for the industry participants to enrich themselves."

New York Attorney General Eliot Spitzer has accused Janus Capital, Strong Financial and the mutual fund arms of Bank of America and Bank One of allowing select customers to move rapidly in and out of their funds, even though the funds officially frown on the practice, called market timing. The companies have vowed to cooperate in the investigation and to repay investors.

Spitzer also accused Bank of America of letting a hedge fund illegally buy its Nations funds after 4 p.m. ET but get the fund's share price for that day — called late trading. One former Bank of America trader has been charged with larceny and securities fraud. The bank has promised to repay investors.

The scandal has since expanded at a dizzying pace. At Putnam, top managers are accused of timing their own funds. Spitzer has said he is pursuing a possible criminal indictment against Strong founder Richard Strong for the same thing. Putnam's CEO has stepped down, and the firm has reached a settlement with the Securities and Exchange Commission — though civil fraud charges are still pending in Massachusetts.

Strong has stepped down as chairman. Alliance has sacked its vice chairman. The co-founders of Pilgrim Baxter & Associates, the investment adviser for the PBHG Funds, were ousted.

Charles Schwab & Co. may be next. The brokerage firm said Friday that it is reviewing improper late trading in mutual funds overseen by the company and market timing at its U.S. Trust subsidiary. Two U.S. Trust employees were fired for attempting to destroy records related to market timing.

As vocal as some investors are about the scandal, financial planners say most clients have been quiet. "It does not seem to bother clients as much as it bothers me," says Denver financial planner Judy Shine. One possible reason: the long list of corporate scandals the past few years. "I think they're shellshocked," Shine says.

Bohemia, N.Y., financial planner Ron Roge says only two clients have called him about the mutual fund investigation. Roge's October client newsletter addressed the scandal, including a list of fund companies to avoid. The companies "lost sight of their fiduciary responsibilities to investors and are on our black list," he wrote. Roge notes that his firm sold a $3.5 million position in Nations' Marsico Growth fund.

Robert Adler, head of fund tracker AMG Data, says most withdrawals from scandal-tainted fund companies appear to be from institutional investors, rather than individuals. Institutional investors tend to be quicker on the trigger because it's part of their job to move money faster if something goes wrong, Adler says. Institutional investors also have to answer to their own directors.

Janus outflows have slowed. Strong Financial saw $90 million leave in September, and an additional $136 million leave in October, Adler says — relatively small in comparison with Strong's $13.5 billion in stock fund assets. "There's no inference we can draw that there is a run on these companies," Adler says.

Investors and pension managers have been less forgiving of Putnam, which has been accused of securities fraud related to market timing. It lost $14 billion — or 5% of assets — in the first week of November, according to an SEC filing.

Other pension and 401(k) plans may well pull more business from tainted fund companies. Dick Forsythe, CFO at Eggers Industries, a Two Rivers, Wis., company that makes custom doors, says his company moved its 401(k) plan to Strong in part because it was based in Wisconsin. He recalls joking with his contact at Strong, "If I have an issue, I can get my hands around your throat without a long drive. We all sort of laughed about that."

Now, he's decided to add funds from other companies to the Eggers 401(k). "Our company puts a lot of weight on honesty and integrity," Forsythe says. "I can't say enough about how disappointed I am."
Individual investors have bigger barriers to moving money, Adler says.
Some funds carry redemption fees if you cash in before a certain period.

Individuals also have to worry about capital gains taxes if they sell shares — institutional retirement plans don't. And moving to another fund company could mean additional sales charges. "I don't think a lot of investors will pay the redemption fee for a moral issue," Adler says.
If scandal-tainted fund companies act quickly and strongly, Adler says, many individuals will probably stick with them. In the meantime, however, some are dumping the funds that have been cited by regulators.

Doug Morrell, a health care consultant in St. Louis, told his father to pull out of Janus funds. "I've tried to invest with the most reputable companies, no-load funds that are looking out for me," Morrell says. At the moment, his money is in Vanguard, Fidelity and American Century funds.

Not surprisingly, the biggest fund companies — Fidelity, Vanguard and the American funds — accounted for half the new money to mutual funds in October, Adler says. Adler estimates $24.4 billion went into stock funds in October, the most since March 2002. "Investors appear to be reacting more to economic and market expectations than the regulatory probe," he says. Stocks have been rising, and money tends to flow to stock funds when the market rises.

If history is a guide, investors will shower the most money on funds with the hottest performances. "If Janus can make 50% to 60% when everyone else is making 20%, guess who will be the leader?" Shine says.

Fund alternatives

But there also are signs that individual investors are looking for alternatives. At ShareBuilder, an online broker that caters to small investors interested in individual stocks and exchange-traded funds (ETFs), the average weekly inflow of money into big stocks, such as Wal-Mart and Cisco, increased 35% from the beginning of September, when the mutual fund scandal started, to the beginning of November. In the same two-month period, the average amount going into ETFs jumped 56%, also believed due in part to the fund scandal.

Like index funds, ETFs track a specific index, such as the S&P 500. But unlike mutual funds, which are priced once a day, ETFs trade throughout the day, like stocks. That feature may appeal to investors who worry that market timers could hurt their returns.

Sales of ETFs have soared. Investors poured $1.2 billion into ETFs the week ended Nov. 7, the most this year, according to Barclays Global Investors.

Mutual funds were supposed to be an affordable way for investors to get professional management and diversification. Now it seems that small investors haven't always been getting a fair shake. There's no doubt that the revelations of wrongdoing have hurt investor confidence. But it's harder to calculate the damage to their portfolios. The cost of market timing to buy-and-hold investors is about $5 billion a year, according to estimates by Eric Zitzewitz, an assistant professor at the Stanford Graduate School of Business.

When divided among individual investors, the losses are minuscule, many experts say. But that doesn't take into account the accumulated losses over time. "Even the smallest percentage adds up when it comes to the bottom line," says fund investor John Schettle, a delivery driver from Oshkosh, Wis.

Say, for instance, that you have $10,000 of your portfolio invested in an international fund. If the fund is one in which there has been a lot of market-timing activity, then your returns could have been diluted by 2.4 percentage points a year, Zitzewitz says.

What does that add up to? Over the past six years, if your fund earned 3% a year after fees, trading costs and other fund expenses, you would have $10,365 in your account, Zitzewitz says. That's $1,576 less than someone who invested $10,000 in an international fund with the same returns but no market timing.

And you would have about $3,000 less than an investor who put $10,000 into an international index fund with no market timing and higher returns because it has lower expenses.

"For me, an average investor, it doesn't have to be thousands of dollars to have an impact on my portfolio," says Karl Di Bacco, a bank vice president in Strasburg, Ohio. "This is my future, my retirement, my children's education funding that is being affected."

It may take awhile for the mutual fund industry to earn back investor trust. Madeline Wong, a marketing manager in Atlanta, says that except for her 401(k) plan, she won't invest in mutual funds anytime in the near future.

"Considering the widespread abuse among different companies, it seems everyone accepts these practices as the norm," she says. "In some ways, it doesn't surprise me. I'm disappointed. I'm pretty angry, too."

If the scandal prompts investors to become smarter and more discriminating about the fund companies they invest with, that's a good thing, experts say. But they caution against knee-jerk changes.

Says Philadelphia financial planner Lydia Sheckels: "My fear is that investors will blindly sell out of very good portfolios without having all the facts and find themselves invested in a portfolio that is next to make the headlines, for much more serious reasons."