Three More Mutual Fund Scandals in the Making - TheStreet

Three More Mutual Fund Scandals in the Making

Reader email says rot still exists in the fund industry. Here's what could be next.
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Here's a prediction for you: A year from now, the mutual fund scandals still will be going strong. The list of those being investigated will have expanded to include new mutual fund companies. And the crimes under investigation will have grown to take in parts of the money management business, such as annuities and trust departments, which so far haven't been implicated.

Don't believe me? You don't have to take my word for it. That consensus emerges from the email of readers who know the money management industry best. Those readers think the current investigation has just scratched the surface.

Let me share some of that mail with you. (Names and details have been omitted or changed, of course. Many of these emails are from people who manage money for a living and who would like to keep their current jobs.)

Double-Dipping on Fees by Banks

Much of the current scandal involves incentives mutual fund companies pay to brokers who sell their funds. The point of these arrangements is to give brokers extra commissions for selling specific funds to customers, even if these funds are not the ones best suited to customer needs.

Sometimes the mutual funds being sold are managed by the brokerage house itself. Sometimes they're the funds of companies that have special arrangements with the brokerage house. And sometimes, as the recent settlement with

Morgan Stanley

(MWD)

revealed, a single sales force can cash in both ways.

But there are more fee deals that need to be investigated, according to my email. "Spitzer hasn't touched on a new scandal flying way under the radar," writes a reader from the South. "The trouble is with the mutual funds run by banks and their cozy fee arrangements with their own trust departments."

This reader claims that trust companies at some banks invest trust money in mutual funds run by the bank itself to bring in higher management fees and commissions to the parent bank, even when the fund isn't best suited to trust beneficiaries and even, this reader says, when beneficiaries object. The result is classic double-dipping when the trust account winds up paying management fees to the bank for trust management and for mutual fund management.

I'm inclined to agree that bank trust departments are likely to prove rewarding hunting ground for investigators. For example, it's the wealth management unit at U.S. Trust that has drawn

Charles Schwab

(SCH)

into the mutual fund investigation. Regulators are examining possible late trading at U.S. Trust's Excelsior funds unit. (Schwab acquired U.S. Trust in 2000.)

Undisclosed Fees in Annuities and Other Products

In the last decade, the mutual fund industry has been tremendously successful in repackaging mutual funds into new products such as annuities and brokerage wrap accounts.

And that struck more than one reader as an area in need of investigators' attention. A money manager from the West Coast suggested two prime targets for exploration: "One, annuities and how fees are charged and calculated, and two, the use of proprietary mutual funds in the retirement plans of vendors, banks, etc. with minimal due diligence and indifference to share class so that plans investing billions of dollars use retail shares with higher fees and commissions instead of cheaper institutional shares."

Mutual fund fees and expenses are hard to calculate because the official "expense ratio" reported by a mutual fund is allowed, by regulation, to exclude all kinds of charges eventually paid by investors. The costs of buying and selling stocks and bonds, and including any brokerage fees, don't count in the reported expense ratio, although they are paid by fund shareholders.

But expense and fee disclosure can get even murkier when a mutual fund is repackaged as an annuity. That allows the financial industry to add another layer of fees and to disguise the total cost of the product, if the fund company is so inclined.

More Manipulation of the Rules

At the heart of this scandal has been the willingness of mutual fund companies to manipulate or ignore their own rules forbidding market-timing. The companies, or their brokers, did so for the benefit of a select few outside money managers and hedge fund operators, and to pad the pockets of individual fund managers and fund company executives.

So why not look at other areas where fund companies have internal rules but are expected to police themselves?

"Has anyone investigated," asks one reader who has had money with

Putnam Investment Management

in the past, "the possibility of mutual fund companies' skimming a bit more off shareholders by dragging their feet on conversion of B shares to A shares? Those extra basis points charged by B shares add up to a lot of dollars each year." This reader notes that a Putnam service representative recently said that it can take up to a year to convert fund shares from one class to another.

It's Not Just Bad Apples

These readers' concerns might seem to involve just nickels and dimes compared to scandals involving $6,000 shower curtains or $2 million birthday bashes. But fundamentally they represent something more important. These kinds of charges represent systemic corruption in the industry, and they can't be dismissed as the actions of just a few bad apples.

So what happens to the fund industry if my readers are correct? Because there's an almost endless supply of individual infractions to bring to light, and just about any firm that manages or buys and sells mutual funds can be subpoenaed, the scandal will run as long as investigators can get headlines and generate public anger with their work.

In other words, the limit to these investigations isn't the supply of wrongdoing. Instead, because of the nature of these charges, the limit is investigators' self-interest. The scandals will finally stop only when the public has convincingly lost interest and various attorneys general and investigative bureaucracies move on to some other scandal.

How long will that take? Credible reform efforts by Congress and the

Securities and Exchange Commission

could encourage the public to turn its attention elsewhere sooner rather than later.

So could better performance by mutual funds. It's no coincidence that this investigation is taking place in the aftermath of the bear market in stocks that started in March 2000. When stocks were soaring, no one really worried if fund companies were skimming off a few pennies. It took truly terrible performances by mutual funds to focus investors on the very real abuses of trust in the industry by specific fund families.

But it's possible to get too cynical and say that this scandal is all about investors taking revenge on fund companies for their own stock market losses. Many of the worst offenses by mutual fund companies were the result of fund companies trying to boost revenue and profits to offset declines in the assets they managed due to poor investment performance by the company's funds.

The connection between poor investment performance and the anti-investor practices that have come to light in these investigations will shape, I think, the industry that emerges from this scandal.

Fund companies that are well managed, have delivered decent performance for shareholders and have not committed major violations of shareholder trust will be able to dig firebreaks around themselves. The firewalls will prevent the flames that are now sweeping across the industry from scorching them as well.

Only Modest Changes

The incentives to do so are huge. Any company that can successfully differentiate itself from the dishonesty of the pack will be able to pick up billions of dollars in assets from weaker players in the mutual fund industry. And investors can expect a wave of consolidation in the fund industry as this process plays out.

The size of the wave of consolidation will depend on how deeply any new regulations cut into the profits that mutual fund companies now make from directed brokerage, from hidden fees, from double-dipping and the like. If regulations require mutual fund companies to compete for investors on the basis of price and performance, then the inefficient companies in the industry will go under. That will produce a huge consolidation as the assets now controlled by companies that rely on paying brokers to sell their funds struggle to compete with houses like

Vanguard

and

Fidelity

.

But if, as I expect, any new regulations only require changes at the margins and leave the economics of the brokerage-sold fund companies essentially intact, then the consolidation will be much more limited. In that case, I think investors will see a fund industry evolve with huge efficient producers on one end that struggle to drive their costs down to the levels of today's super-low-cost ETFs (exchange-traded funds). This part of the industry is likely to undergo rapid introduction of new products as fund companies try to innovate their way through the challenges posed by the new ETF products.

The other end of the industry will be dominated by companies with huge sales forces that can push product to consumers. Consolidation will eliminate the smaller sales forces, and investors are likely to see increasing acquisitions of delivery pipelines such as banks, trust companies and investment advisory services that represent "captive audiences" that can be sold mutual fund products by armies of brokers.

In that world, the choices confronting investors will be clearer than ever, if we get reforms to the rules for disclosure and fee calculation that will let us see the real difference between products.

At a minimum, it's that kind of disclosure -- of all fees and costs, of all marketing arrangements and their fees, of all relationships between fund providers and fund marketers -- that we need to be fighting for in the next year while the scandal is still at center stage.

Without those reforms -- and I think they are only a bare minimum -- the mutual fund industry will

be

very different in the future than it is now, but investors still won't be able to tell the good guys from the bad.

At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column. Email Jim Jubak at

jjmail@microsoft.com.