New York Atty. Gen. Eliot Spitzer may or may not have uncovered a widespread scandal within the mutual fund industry, but he certainly has caused the $6.9 trillion business to take a long look in the mirror.
And some of the industry’s major players don’t like what they see.
Whether a number of fund companies allowed well-heeled investors to engage in illegal or improper trading games, as Spitzer alleges, may be a minor problem compared with industry issues that have been building for years, and that are potentially far more troubling for the future of the business.
When they speak frankly, fund company veterans worry that the industry has lost its way, or at least its focus on the individual investor. They’re afraid that the business has been co-opted, or even corrupted, by its own aggressive marketing, and by an increasing reliance on third-party distributors–middlemen such as brokers, for example, and company-sponsored retirement plans.
The industry believes it is unfairly under siege on the issue of fees, including the costs investors pay to buy funds and the ongoing costs they pay for the management of the portfolios.
Unfair or not, that siege isn’t likely to end soon, and may worsen if markets enter a long period of subpar returns.
Meanwhile, competition for traditional funds is rising from new products and services that seek to give investors the same or better diversification afforded by funds, but at a lower cost or with the kicker of providing the client with more control over the underlying portfolio.
“I think the fund industry has been out of touch with the growing dissatisfaction by investors and financial advisers,” said Don Phillips, a principal at fund tracker Morningstar Inc. in Chicago.
It’s hardly a surprise that the fund business presents an attractive target to its detractors and its competitors. A $6.9 trillion pile of assets is hard to miss. What’s more, nearly 50 percent of all U.S. households own at least one mutual fund, up from fewer than 31 percent as recently as eight years ago and about 6 percent in 1980, according to the Investment Company Institute, the funds’ chief trade group.
“Mutual funds have penetrated almost as deeply into the marketplace of American investors as they can,” said Matthew McGinness, associate director at financial-services industry research firm Cerulli Associates in Boston.
That’s debatable, of course. Several times in the past 15 years alone it was widely predicted that the industry had reached a plateau. Instead, assets continued to balloon. As the 1990s began, few people on Wall Street foresaw the stock market’s unprecedented rise. The fund industry was the natural beneficiary of that boom because it offered investors an easy way into stocks.
It still does. As the equity market has recovered this year, investors again have become net buyers of stock funds, after shying away from new purchases for much of 2002, as the bear market raged. From April through July the funds saw their biggest net cash inflow of any four-month period in three years. Stock funds’ net inflow in July alone was $21.4 billion, according to ICI data.
So it would be a gross exaggeration to say the public overall is hopping mad at the fund industry. People may be troubled by certain aspects of the business, and Spitzer’s case may make some wonder if they’re getting a fair shake, but so far there hasn’t been an exodus by small investors.
Yet the smartest managers in the industry know there’s no good reason to tempt fate. They also acknowledge that the price they’ve paid for the spectacular growth of the past decade has been the triumph of marketing, at some expense to the industry’s long-standing reputation as a fiduciary–an entity that is entrusted to hold the public’s money, and confidence, and to put clients’ interests first.
The primacy of the marketers, critics say, is what brought the explosion of fund flavors in the late 1990s–the many ill-fated sector funds that focused on technology stocks, for example, and the various share classes that have allowed brokers to sell portfolios whose long-term costs to the investor may not be readily apparent.
There’s nothing illegal about marketing. This is America, after all. But a financial fiduciary is supposed to ask the question: “Are we helping the client in the long run, or are we just enriching ourselves in the short run?”
Federal guidelines
The federal Investment Company Act of 1940, which created the modern fund business, is unambiguous in requiring that the investors’ needs come first. The tough regulations in that law are what have kept the fund industry largely scandal-free, as it has often liked to remind the press and the public.
But in the past decade or so, “I think the marketing people have run amok in the business,” said Roy Weitz, an industry watchdog who operates the Web site fundalarm.com. “We’re talking about aggressive people who are looking for every small advantage.”
The desire at some fund companies to find “every small advantage” to make money could be behind the abuses that Spitzer alleges.
He accused a private hedge fund of striking deals to illegally or improperly engage in “market-timing” trades of fund shares at Bank of America Corp. (the Nations Funds), Bank One Corp. (One Group funds), Janus Capital Group Inc. and Strong Capital Management. In return, Spitzer said, the hedge fund agreed to bring other fee-generating business to the mutual fund companies.
At the highest levels of the fund industry now, there is plenty of praying that Spitzer’s case doesn’t extend much beyond the companies he has already named.
Chip away at that confidence for long enough, and it might change what people are willing to do with their savings.
“Our biggest asset as an industry has been that confidence that comes from our clients,” said Jack Brennan, chairman of Vanguard Group, the second-largest fund company.
The Investment Company Institute’s board is trying to show that it’s out front on this issue. But some critics say the group wasted too much political capital over the past year trying to stymie proposals that funds disclose the names of all the stocks they own more often than the current requirement of twice a year, and that they disclose how they vote their shares on proxy ballots at the annual meetings of the firms in their portfolios.
To Morningstar’s Phillips, however, “They’ve spent time and energy defending their weakest practices.”
More than likely, most fund investors probably don’t care how funds vote their proxies. Over the next decade, however, more investors probably will begin to care about how much they’re paying to own mutual funds, and whether their returns are commensurate with the costs. Fund expenses are the industry’s single biggest challenge.
Fund fees are incurred at three main levels: Investors often pay a commission to buy fund shares, if they use a broker or other intermediary; they pay an annual management fee to the fund company, deducted directly from fund assets; and they may pay an ongoing fee (also automatically deducted from the portfolio) to pay a fund’s various annual distribution and marketing costs, including broker compensation.
Relatively few fund sales these days occur directly between the fund company and the investor. The majority of investors buy from a broker or financial planner or through company-sponsored retirement plans. The continuing decline of direct sales has meant a loss of control for the fund companies. They often don’t know who their customers are, because individual accounts are lumped into “omnibus” accounts. That complicates the issue of fee disclosure.
Critics who say the industry should say in account statements exactly what dollar amount of fees an individual investor has incurred aren’t appreciating the complexity of that equation, fund industry veterans say.
Fees cause controversy
The industry has long been sensitive to the fee issue but has perennially argued that investors are getting a good deal–professional management in a diversified portfolio–for annual fees that typically total between 1 percent and 2 percent of fund assets. It’s also true that the fund industry already discloses far more about its costs than do most other financial services companies.
Banks, after all, aren’t forced to explain to depositors that they could earn higher yields if only the bank didn’t take as much in profit.
“People focus on our costs because they’re transparent,” said James Riepe, co-vice chairman at T. Rowe Price Associates.
Nonetheless, as an industry veteran, Riepe said he recognized that although funds arguably have been held to higher standards, to a large degree that explains their success over the last 60 years.
What about the next 60 years? If the Spitzer case blows over, the question for the industry will shift back to the fundamental one: Does the public believe that mutual funds offer not just integrity but also good value?
Many competitors are gunning for the industry’s best clients. Some brokers tell fund investors that a portfolio of individual stocks can provide adequate diversification and an element of control that funds can’t. Lower-cost competitors are available in exchange-traded funds, portfolios that have been proliferating in recent years.
But it may be that nothing will focus investors on the fund fee issue like a long stretch of low returns in the stock market and relatively low yields in the bond market.
Most fund companies aren’t willing to get into a public debate about their fees. But they know what their critics say, and they know the challenge they will face if competition rises while market returns don’t.
“Fees are going to come down. They’re going to have to come down,” said Vanguard’s Brennan. “The investor eventually is going to notice.”
