From Worst to First: Jacob Internet Moves to Cutting Edge of Disclosure

The new year is a time for turning over a new leaf, and the (JAMFX)Jacob Internet fund is doing just that.

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After a 79% drop in year 2000, the fund has returned a positive 14.2% year to date, placing it in the top fifth of Morningstar's technology category. Ryan Jacob, the fund's manager, is also setting new standards for mutual fund disclosure.

Last month, Jacob Internet, like most funds, made use of holes in disclosure rules to exclude its 79% drop in 2000 from its prospectus. How did Jacob respond when I put this practice under the spotlight in my Jan. 16 column?

"I think it's a good thing," Jacob told me this week. "There needs to be more scrutiny in the way funds are looked at. Obviously, it's a much bigger business than it was five or 10 years ago, and fund companies should strive to do better."

Jacob not only talks the talk, he walks the walk.

First, he voluntarily updated his prospectus to include the fund's abysmal 2000 performance, even though the fund could legally omit this information until 2002. (My Jan. 16 column details how funds can pull this off.) While it's true that the Securities and Exchange Commission staff asked Jacob to include his 2000 performance in his prospectus, it did so only after Jacob already had committed to take this unprecedented step.

As discussed below, you won't find another Internet fund that shows its 2000 performance in its prospectus.

Jacob noted that other industry members had suggested that he start a new fund or merge his current fund out of existence. These are legal tricks commonly used by funds that want to erase poor performance and present a clean slate to investors. Jacob rejected these overtures, he said, "because to me it's a very unethical thing to do. It's my obligation to investors to improve things after our performance in 2000."

Second, the updated version of Jacob Internet's online prospectus now includes one of the most forthright warnings that you'll find in a mutual fund filing: "Many [Internet-related] companies expect to incur significant operating losses for the foreseeable future, and may never be profitable."

Third, Jacob took seriously criticisms of the overly prominent statement -- in view of Internet stocks' dramatic decline in 2000 -- on the front of his fund's brochure that he expected "the continuing evolution of the Internet to yield profitable investment opportunities for the discriminating investor." Again under no legal obligation, Jacob has pulled the brochure off his Web site and plans to revise it.

Family Ties

Sensing an opening, I pressed Jacob on another issue: the classification of his uncle, Leonard Jacob, as an independent director of Jacob Internet. Rules adopted last month will require mutual funds to have a majority of directors who are not affiliated with the fund's adviser (see my Jan. 18 column for more details). The Jacob familial tie doesn't disqualify Leonard Jacob from being counted toward the independent majority.

Although it would be more appropriate to treat Uncle Len as a nonindependent director, it's not legally required. When the new governance rules take effect, the fund could rely on Uncle Len's independent status to meet the majority minimum, or it could create a more aboveboard board by naming a new independent director. Although not required to do so, Jacob promised to recommend to the fund's directors that the fund add a new independent director.

Jacob says he has worked hard to be upfront about his fund's performance and risks and to do right by shareholders. The steps he's taken suggest he means it.

Indeed, the changes Jacob's already made set new standards for fund disclosure. The SEC should also take this opportunity to turn over a new leaf, and revise its disclosure rules to ensure that investors receive current information.

But Everybody Does It

Jacob and his counsel, Michael O'Hare of Stradley Ronan Stevens & Young, also point out that some of the fund's questionable disclosure practices are standard in the industry. How right they are.

A sampling of the online prospectuses for 14 Internet funds that were in business for all of 2000 shows a pattern of hiding the facts. Three weeks into 2001, not one prospectus included 2000's horrific performance results.

If you're a savvy prospectus reader, you can find performance results for part of 2000. Let's start with funds that were formed before 1999. SEC rules require that they prominently display their stellar performance for that year in a bar chart near the front of the prospectus. In a footnote under the bar chart you'll find the fund's performance during the most-recent quarter before the fund filed its prospectus. Some funds ignore this requirement and provide year-to-date performance in the footnote. Either way, as you'll see from the first table below, the resulting disclosure can be perverse.

The (MFITX)Monument Digital Technology prospectus boasts a 272% return in 1999 in its bar chart, under which a footnote discloses the fund's negative 10% return from July 1 through Sept. 30, 2000. The footnote skips over the fund's 0% and negative 22% return in the first and second quarters of 2000. Nor is there any mention of the fund's 57% decline for the year.

Disclosure Derby Internet funds formed before 1999 trumpet their '99 performance and downplay 2000 results in their current prospectuses
Fund	1999 Return in Bar Chart	Partial 2000 Return in Footnote	Actual 2000 Return
(MFITX)Monument Digital Technology	272%	-10%*	-57%
(ATCHX)Amerindo Technology	251	-1**	-65
(WWWFX)Kinetics Internet	217	-28***	-52
(MNNAX)Munder NetNet	176	-15****	-54
(WWIFX)WWW Internet	167	-19****	-57
Source: SEC filings and Morningstar. *July 1 through Sept. 30. **Jan. 1 through March 31. ***Jan. 1 through June 30. ****Jan. 1 through Sept. 30.

For funds formed in 1999, there is no bar chart, so you have to dig into the financial highlights in the back of the prospectus, where you'll find partial performance results for 2000 or 1999.

Again, the result is Jekyll-and-Hyde disclosure. For example, the only performance you'll find in the prospectus for the (IINTX)Investec internet.com Index fund is its 82% return from July 30 through Dec. 31, 1999, in the financial highlights. The fund's negative 59% return in 2000 is conveniently omitted.

Disclosure Derby II For Internet funds launched in 1999, the return you see in the current prospectus isn't necessarily what you got in 2000
Fund	Return Listed in Financial Highlights	Actual 2000 Return
(GITAX)Goldman Sachs Internet Tollkeeper	92%	-37%
(IINTX)Investec internet.com Index	82	-59
(OPENX)MetaMarkets.com OpenFund	72	-42
(INGAX)ING Internet	41	-69
(SJPPX)StockJungle.com Pure Play Internet	24	-67
(RIAFX)RS Internet Age	22	-46
(TEFQX)Firsthand E-Commerce	-2	-55
(EIFAX)Enterprise Internet	-12	-51
(PNETX)Potomac Internet Plus	-15	-77
Source: SEC filings and Morningstar

As discussed below, you can usually find more current performance information elsewhere on the funds' Web sites, but not in their SEC-sanctioned prospectuses, which are at best uninformative, at worst downright misleading.

These funds should, as Jacob Internet has, voluntarily update their prospectuses to include their 2000 performance results. Better yet, the SEC should recall the first rule of regulation -- do no harm -- and overhaul prospectus rules to promote full and fair disclosure.

Phantom Fourth Quarter

Where Jacob Internet really puts other Internet funds to shame is in reporting fund performance on its Web site. The SEC requires that fund performance in fund ads -- which generally means any place other than the prospectus -- be current as of the most recent quarter. Jacob Internet again goes one step further, and updates its performance on a daily basis.

One would expect an Internet fund to exploit the advantages the Internet offers to the full by posting real-time performance data. The (SJPPX)StockJungle.com Pure Play Internet, (WWWFX)Kinetics Internet, (WWIFX)WWW Internet, (ETECX)E*Trade E-Commerce Index and (OPENX)MetaMarkets.com OpenFund funds, like Jacob Internet, all update their performance on a daily basis.

Most other Internet fund sites, however, merely comply with SEC requirements by posting performance through the last quarter of 2000.

But even that's better than many funds. The Web sites for (TEFQX)Firsthand E-Commerce, (GITAX)Goldman Sachs Internet Tollkeeper, (IMLLX)iMillennium, (INGAX)ING Internet and (RIAFX)RS Internet Age funds all showed performance through Sept. 30, 2000, more than three weeks after these figures were required to be updated through the fourth quarter of 2000. Many Japan funds, which like Internet funds also experienced large fourth-quarter downturns, posted stale third-quarter performance on their Web sites as well.

The Lost Quarter These Internet and Japan funds' Web sites seem to have forgotten there was a fourth quarter last year
Fund	4Q 2000 Return
(INGAX)ING Internet	-53%
(IMLLX)iMillennium	-48
(TEFQX)Firsthand E-Commerce	-45
(RIAFX)RS Internet Age	-40
(GITAX)Goldman Sachs Internet Tollkeeper	-32
(NJOAX)Liberty Newport Japan Opportunities	-27
(PRJPX)T. Rowe Price Japan	-23
(FJEAX)Flag Investors Japanese	-18
(GSJAX)Goldman Sachs Japanese Equity	-18
(CVJAX)Chase Vista Japan	-17
(JPNAX)MSDW Japan	-17
(DFJSX)DFA Japanese Small Company	-15
Source: Morningstar

During the fourth quarter, technology funds dropped 36% and Japan funds 21%, according to Morningstar. So it's not surprising these funds might not rush to update their numbers. Regulators are unlikely to be as understanding, and hopefully will take prompt action.

The Web site for iMillennium illustrates how misleading stale performance can be. A graph depicting the performance of a $10,000 investment in the fund from its inception through September 2000 shows a small increase in value. Had the graph included performance through the end of December, as required by the SEC, it would have shown an investment worth less than $6,000.

The iMillennium site provides clear disclosure of the fund's 4.4% return since the beginning of 2001. But its 48% decline in the fourth quarter of 2000 is nowhere to be found.

Can Internet Funds Handle the Internet?

The frequent appearance of stale performance results in online fund ads suggests that many funds, even those concentrating on Internet businesses, cannot handle legal compliance on the Internet. Perhaps the ease of updating information electronically breeds complacency, resulting in Web sites being relegated to the bottom of the compliance priority list. But the pattern of noncompliance highlights a more serious problem.

Electronic information delivery magnifies the effect of isolated compliance errors and omissions. When fund ads are mailed with stale performance results, only the recipient, or perhaps a group of recipients, is misled, and then only once.

In contrast, a Web site error can mislead an unlimited number of investors for an indefinite period. The Internet offers an unprecedented opportunity to make more and more accessible information available to investors, but it also increases the potential risk that investors will be misled.

While the Internet is part of the problem, it also is part of the solution. SEC staff and fund lawyers cannot check investors' mailboxes to determine whether funds are complying with disclosure rules. But they can review Web site compliance from their own offices with a mouse click.

Regulators and fund lawyers should do a better job monitoring the Internet. And investors should think twice before entrusting their money to firms that can't follow basic disclosure rules.

Let's hope that both Internet investments and Internet legal compliance stage a turnaround in 2001.

Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md. He welcomes your feedback at [e-mail].