The mutual fund industry has long held itself out as the one part of Wall Street that looks out for the little guy.
Buying individual stocks and bonds requires specialized knowledge and can be highly risky. Many brokers don’t want to deal with small investors. But the mutual fund companies promised that their method of pooling small investors would help Mom and Pop put their toes in the market without risking their shirts.
And small investors believed them. Since 1980, the number of households with mutual fund shares has jumped from less than 5 million to more than 54 million.
But a series of revelations this summer has tarnished the image of the industry:
– Salesmen for some companies may be getting improper incentives to steer investors to certain mutual funds, according to investigators for the state of Massachusetts as well as federal regulators and the National Association of Securities Dealers, the industry’s main self-regulatory body.
– An industrywide investigation found that one-third of fund buyers who had been promised discounts, known as break points, on sales commissions didn’t get them. The average investor lost $364, but refunds are coming, according to NASD.
– Management and advertising fees charged to investors have been rising even as returns have dropped, according to a General Accounting Office study released earlier this year, and a congressional hearing drew new attention to the problem of hidden costs, such as when a fund pays higher-than-normal trading fees to certain brokers in exchange for research and other services that benefit the company rather than investors.
– Most seriously, New York Atty. Gen. Eliot Spitzer alleged earlier this month that at least four big mutual fund companies had cut deals that allowed some wealthy investors to profit improperly from quick trades at the expense of ordinary buy-and-hold investors. He and the Securities and Exchange Commission have asked for information from at least 80 other companies.
“There has been a great confluence of events–accounting scandals, conflicts of interest at investment banks, break points and, of course, a burst bubble, to mention a few–that have deeply shaken investor confidence,” said NASD Vice Chairman Mary Schapiro. “And now mutual fund investors who thought they were doing all the right things have seen that in some instances the process wasn’t quite fair.”
Tough to find portfolio errors
While holders of individual stocks can see clearly which parts of their portfolio are lagging, mutual fund investors have little or no opportunity to spot many of the problems that are sapping their returns.
“Enormous amounts of money can be made by taking a nickel from every customer from every trade. And the ways to take a little from individual customers are so technical, and the regulations so opaque, that enforcement has never done a good job covering those industries,” said former SEC enforcement lawyer Gregory Bruch. “The victims never even know they were victimized. … It’s just ripe for abuse.”
So what’s a small investor to do? Hedge funds and investment banks cater to people with big bucks. Banks and certificates of deposit aren’t giving much in the way of interest. And the market’s recent history would give pause to anyone trying to pick the next big stock.
The answer, say most finance experts, regulators and even industry critics, is to stick with mutual funds. That’s because they have a record of cleaning up problems pretty quickly and remain almost the only way for someone without a lot of cash to diversify their holdings.
“Mutual funds are still far and away the best option,” said Mercer Bullard, who quit the SEC to found Fund Democracy, a shareholder advocacy group. “Have they made some mistakes? Yes. But they are still head and shoulders over other financial products. And I’m one of their biggest critics.”
So far investors are taking this long view, as well as focusing on the fact that the stock market has been heading up sharply this year. TrimTabs Investment Research, which tracks the flow of money into and out of mutual funds, estimates that $25 billion to $30 billion will move into equity funds this month, the highest monthly total in more than a year, said chief executive Charles Biderman.
But industry leaders and government investigators are also well aware that the markets can ill afford to alienate the small investors who are the funds’ bread and butter.
“We are based on investor confidence. We aren’t insured by the government. We are totally dependent on investor trust,” said Matthew Fink, president of the Investment Company Institute, the main mutual fund trade group. “You have an industry that wants to stay as clean as possible.”
He noted that the industry has been heavily regulated since Congress passed the Investment Company Act of 1940 and promised that the current problems are being taken seriously.
Need for reforms is evident
Regulators, too, say they plan to take rapid steps to identify and punish funds and brokers who have been selling out their small investors to win favor and fees from hedge funds and large investors.
“It’s a hornet’s nest, and it will be cleaned out,” Spitzer said. “What should be troubling to investors is the [mutual fund firms’] inability to say, `No. That’s contrary to the interests of the investors and we shouldn’t do it.’ That mind-set is enormously troubling, and it has got to change.”
Market observers say that some of the alleged abuses now coming to light flourished for years but were largely ignored by investors and the media during the bull market of the late 1990s.
“When everybody is making money and investors are happy, the appetite for reform is diminished,” said Paul Roye, director of the SEC’s division of investment management. “We were trying to focus investors on the importance of mutual fund fees and expenses two or three years ago, but when they’re making money, those things don’t seem as important. Now, when everyone is losing money, the importance of fees comes into sharp focus.”
The bear market of the past three years has also squeezed fund managers and brokers, who must find new ways to attract investors to maintain their own commissions and bonuses. Because of the consolidation in the financial-services industry during the boom years, many managers and brokers are now part of larger organizations and may face pressures, and opportunities, to help their parent companies at the expense of investors.
That makes them vulnerable to a relatively new player: hedge funds, which are largely unregulated investment pools for the wealthy and often are looking to cut special deals or exploit market inefficiencies.
“The pressure has been building on fund managers. The money hasn’t been rolling in over the past few years,” said Barry Barbash, a former director of the SEC’s division of investment management. But now, “if a trader says I’ll give you $30 million or $40 million, that’s meaningful.”
Similarly, Schapiro said her investigators have been particularly focused on brokers who may be pushing clients into inappropriate products because they offer higher commissions.
“I worry enormously when brokers have to reach to maintain the level of income they became accustomed to in a bull market. That’s when we worry about improper sales tactics,” she said.
NASD has brought more than 200 mutual-fund-related cases since 2000, including two dozen where brokers wrongly steered investors into Class B shares of mutual funds, which pay brokers higher commissions but also charge higher fees and make all but the longest-term investors pay a “back-end” fee when they sell their shares.
While praising the efforts of Spitzer and other enforcers, some legal experts say the new revelations about mutual funds call for stronger regulation and laws.
“The system exists for the big guys and not for us,” said Frank Razzano, a former federal prosecutor and former SEC lawyer. Investors “should be demanding that their congressman and senators do something about this.”
House bill tackles fees
The House Financial Services Committee has passed a bill that would require each fund to tell investors how much they paid–in actual dollars, not percentages–in fees and to appoint a compliance director, much like brokerages. The Senate Finance Committee has scheduled hearings on the state of the overall securities industry. Neither committee has plans to specifically tackle the issue of whether and how timing affects ordinary investors, spokesmen said.
NASD is working on a proposed rule that would require brokers to disclose to the buyer any special incentives they are offered to push a specific fund, rather than making general information available to consumers who go looking for it, which is the current practice.
The SEC has a host of new proposals coming this fall as well, including rules for fee disclosure and recommendations on regulating hedge funds.
“We are coming at this using all our regulatory resources to get a handle on the problem quickly,” said Roye, head of the SEC division that regulates mutual funds. “We’re trying to understand, is this a small problem, a big problem, an isolated problem?”
