Sounding the Alarm on Mutual Funds

The founder of FundAlarm looks back on Lifecycle proliferation and the explosion of ETFs.
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Scandals. Mergers. Government agents on the prowl. Is this a promo for a new TV drama? Maybe the plot of a blockbuster movie?

Nah, it's just another year in the mutual fund industry.

It's time once again to ring out the old and ring in the new. And when it comes to highlighting the year in mutual funds, there is no better person to sound the alarm than Roy Weitz, the California-based mutual fund advocate. A lawyer and CPA by trade, Weitz is the founder and editor of FundAlarm.com, a free site that tracks the mutual fund industry by alerting investors to cheating fund families and poor performers.

TheStreet.com

recently caught up with Weitz to get his views on the biggest fund stories of 2006, as well as his predictions for 2007.

What were the biggest trends in the mutual fund industry in 2006?

Lifecycle funds continued to multiply. Large fund companies continued to acquire smaller ones, and, even more dramatically, just a handful of the largest fund companies had another year in which they took in the lion's share of new investment dollars.

Also, ETF offerings continued to explode -- in fact, some would say that the ETF creators finally went off the deep end in 2006, although we suspect there's even more to come in 2007.

Are exchange-traded funds a threat to mutual funds, or is it just a lot of hype?

As of October 2006, ETF assets under management represent about 3.5% of total mutual fund assets. Given all the talk about ETFs, you'd think that this percentage would be much, much higher, so yes, I think the current threat to mutual funds is a lot of hype. The vast majority of specialized ETFs being introduced today will never get very large, because they simply don't have mass market appeal and never will. ETFs that follow more conventional indexes have some potential to compete with index mutual funds, but there's no reason to believe that all ETF index funds, combined, will ever have more assets than all traditional open-end mutual funds, combined, and traditional open-end mutual funds, in total, still represent a fairly small part of the overall fund universe.

On the other hand, if and when actively managed ETFs are introduced, it could be a different story. Actively managed ETFs could potentially offer everything that traditional funds offer, plus investors will be able to trade their ETFs continuously throughout the day. That additional feature could be very attractive. And if brokers start to offer commission-free trading on active ETFs, even just a few free trades per month, I think traditional funds will have a real fight on their hands.

What surprised you the most in 2006?

The lack of interest in the Bisys scandal. Admittedly, this isn't as big a deal as the late-trading scandals, but one could make a good argument that Bisys is a bigger deal than the market-timing scandals back in 2003. Funds that negotiated kickbacks from Bisys made a conscious decision to take money from shareholders -- there are no judgment calls here, as there were with some of the market-timing situations.

Also, the damage from the Bisys kickbacks can be easily quantified, yet I haven't seen a single fund company -- or more significantly a single board of directors -- try to make investors whole.

I thought fund scandals were supposed to be behind us, but then this one popped up. Is the system for catching illegal activities improving at all?

At least some fund boards of directors should have been able to detect the Bisys kickback scandal and nip it in the bud. By and large, fund directors are still not doing their job representing the financial interests of fund shareholders.

Regarding the trend of large fund companies acquiring small funds, is it too hard for small fund companies to compete due to the cost of Sarbanes Oxley regulations? Should they be eased?

If a small fund produces good performance, it should be able to accumulate a sizable asset base, and the owners of the fund management company will make a lot of money, even under Sarbox. If Sarbox compliance costs are a problem for a small fund, the fund probably isn't producing good performance, and perhaps it shouldn't exist anyway.

As for start-up funds, well, the entrepreneurs just need to be prepared to dig a little deeper into their pockets and pay for those Sarbox compliance costs. If a new fund is good, the management company can still look forward to 40% or 50% profit margins, and in many cases a lot more. They can afford to pay for Sarbox, and I don't feel the least bit sorry for them.

Eliot Spitzer was kicked upstairs to governor in 2006. Is the mutual fund industry happy to see him go?

Spitzer had pretty much made his point by 2006 and moved on, so I don't think the fund industry was all that concerned with him anymore. But yes, I'm sure that they are still delighted to see him otherwise occupied.

What are your predictions for 2007? Any mergers, scandals or new regulations on the horizon?

I think the

SEC

will take action on the fund side of the Bisys scandal. The independent director rule will die a quiet death. It's about time for a front-running scandal, with fund managers discovered to be buying stocks for their personal accounts ahead of their funds.

Congressional Democrats will champion reform of mutual fund capital gain distributions, and investors will finally be able to defer capital gain tax bills until they sell their funds. And I have a feeling that something big is going to happen at

Janus

(JNS)

-- either an acquisition or a management buyout.

Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.